MACOM Technology Solutions Holdings, Inc. Q3 FY2022 Earnings Call

Welcome to MACOM's Third Fiscal Quarter 2022 Conference Call. This call is being recorded today, Thursday, July 28, 2022. At this time all participants are in a listen-only mode. I will now turn the call to Mr. Steve Ferranti, MACOM's Vice President of Strategic Initiatives and Investor Relations. Mr. Ferranti, please go ahead.

Thank you, Olivia. Good morning, and welcome to our call to discuss MACOM's financial results for the third fiscal quarter of 2022. I would like to remind everyone that our discussion today will contain forward-looking statements, which are subject to certain risks and uncertainties as defined in the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those discussed today. For a more detailed discussion of the risks and uncertainties that could result in those differences, we refer you to MACOM's filings with the SEC. Management's statements during this call will also include discussion of certain adjusted non-GAAP financial information. A reconciliation of GAAP to adjusted non-GAAP results is provided in the company's press release and related Form 8-K, which was filed with the SEC today. With that, I'll turn over the call to Steve Daly, President and CEO of MACOM.

Thank you and good morning. I will begin today's call with the general company update. After that, Jack Kober, our Chief Financial Officer, will review our fiscal Q3 results. When Jack is finished, I will provide revenue and earnings guidance for fiscal Q4, and then we will be happy to take some questions. Revenue for the third quarter was $172.3 million and adjusted EPS was $0.73 per diluted share. Gross and operating margins increased sequentially in the third quarter, and we continue to generate strong cash flow, ending the quarter with $536 million in cash and short-term investments. Our financial performance reflects ongoing business improvements along with the growing revenue contribution from new products within our portfolio. The book-to-bill ratio for the third quarter was 1.1:1, which was the seventh consecutive quarter above 1. Our backlog remains strong, providing us with good near-term visibility. While we are pleased with the bookings, I'll note that it is normal for our book-to-bill ratio to periodically fluctuate below 1. Our turns business was approximately 15% of our total revenue during the quarter, which is in line with the last few quarters. Q3 revenue breakdown by end market was as follows: Industrial and Defense was $75.5 million, Telecom was $62 million, and Data Center was $34.8 million. I&D revenue was up 12.5% sequentially, while Telecom and Data Center were relatively flat following the strong Q2. These results were mostly in line with our expectations. Industrial and Defense remains a key area of opportunity for MACOM. We believe this market has the potential for significant revenue growth over the next few years. Within aerospace and defense applications, we expect growth to be driven by radar modernization programs, electronic warfare applications, unmanned aircraft systems, avionics, secure communication networks, and SATCOM applications. All of these areas are priorities within the broader U.S. defense budget and our critical programs within the various branches of the Department of Defense. As a result, we expect opportunities within this market to remain robust for the foreseeable future. Our Telecom end market revenue saw a modest sequential decrease in Q3 following a very strong Q2. Telecom is another broad market for MACOM, and it includes broadband access networks, active optical fiber networks, wireless networks including 5G, metro long-haul optical networks, and broadband satellite communication applications. The primary driving forces for growth across all of these applications are higher data rates and more bandwidth supporting increased computing power closer to the end users. MACOM has a very diverse product portfolio to address the Telecom markets, including our Monolithic Microwave Integrated Circuits, or MMIC product line, coherent drivers and TIAs, small signal RF products, RF power amplifiers, high-performance analog ICs, and lasers, to name a few product lines. Finally, our Data Center end market revenue was relatively flat in Q3 following a strong Q2 performance based on continuing demand for our high-performance analog solutions. We are pleased to see modest revenue contributions from our new 25G DFB laser portfolio, and our expectation is for continued slow but steady laser revenue growth and market share gains during the remainder of FY 2022 and throughout FY 2023. Customer interest in our recently introduced linear equalizers remains high, and we see growth opportunities in active copper cable applications at both 200G and 400G data rates for high-performance computing systems. I'd like to highlight that we recently updated our five-year strategic plan. This was the third annual update of our strategic plan. While we've made great progress executing over the past three years, we are pleased to have further refined and honed our compelling strategy with the goal of creating long-term stockholder value. Our bottoms-up strategic plan includes an in-depth review of all elements of our business and establishes strategic goals and growth objectives through 2026. The foundation of our strategic plan revolves around expanding our served addressable markets or SAM by extending existing product lines, introducing new product lines, and raising the bar on semiconductor performance in areas where we choose to compete. Our goal is to provide compelling and differentiated solutions that help solve complex technical challenges for our customers while driving highly profitable growth for MACOM. An important element of our strategy is to leverage our existing capabilities and technology portfolio to find adjacent opportunities to expand our markets. Some examples of this over the past couple of years have been our 0.14 micron GaN silicon carbide process, our pure carbide product line, active copper cable ICs, KV CAPS, and RF power amplifier pallets. We believe thus far, these new products have helped us expand our SAM by about $400 million to $500 million. And I'll note our market share in these product categories is negligible today, which provides us with a great opportunity for growth. I'll also note a characteristic of our growth strategy is to target market opportunities that support our financial goals of achieving best-in-class profitability. This requires developing many new and oftentimes niche semiconductor product lines to address these requirements. It might be helpful if I highlight a few recent examples, which exemplify MACOM's strategy. First, at this year's International Microwave Symposium, which was held in June, we announced the expansion of our power amplifier product portfolio with the introduction of a seven kilowatt power amplifier operating in the 960 megahertz to 1.2 gigahertz frequency range. This product is based on MACOM's pure carbide GaN on silicon carbide technology, and we believe it represents the highest power level RF amplifier in the industry. This extremely high power level was achieved by combining novel, high-voltage circuits with advanced packaging materials for improved thermal performance. This product is ideal for high power and high voltage aerospace and defense applications, including radar and electronic warfare systems. Our goal is to establish ourselves as a leader in RF power. Second, we are actively expanding our R&D teams and bringing new engineering design capability to MACOM. We recently opened two design centers, one on the east coast of the U.S. and one in South Korea. These actions of hiring more experts in analog and digital IC design and adding new microwave subsystem engineering capability support our future product development plan and initiatives. Hiring best-in-class designers to support organic growth is a strategic priority. Third, we recently introduced a new optical time domain reflectometer or OTDR photodetector product line to support customers that utilize fiber connectivity in their defense, industrial, telecom systems, or data center networks. An OTDR test instrument is used to measure fiber optic cables, optical loss, and to identify the location of a fiber cable break or performance problem. Portable OTDR test equipment is used during fiber network installation, and OTDR functionality can be embedded in remote fiber test systems to permanently monitor a live telecom network or an operating system for any changes or failures. We believe the field portable OTDR test equipment market is growing due to the worldwide deployment of PON in 5G optical networks. To be clear, the heart of an OTDR is the indium phosphide-based optical photodetector, and our strategy is to be a leading supplier of OTDR photo detector IC-based products. Here we have utilized our proprietary internal MBE technology and photo detector IC design expertise to achieve industry-leading results. We plan to sell our OTDR products with pigtail fiber for an easy turnkey solution or chip-on-carrier format, depending on the customer requirements and desired form factor. In recent months, we received two qualifications from leading OTDR equipment manufacturers. The three examples I just discussed show how MACOM is addressing small and medium-sized high-performance applications with solutions that rely on our internal semiconductor process expertise and/or our IC and system design and application expertise. We believe more and more customers are viewing MACOM as a strategic supplier of high-performance analog, RF, microwave, and lightwave semiconductor solutions. This is directly attributable to the strengthening of our product portfolio. Today, we focus our budgets on R&D, product development, and then engaging customers face-to-face with our regional and technical sales staff, design engineers, and technical leadership. I'll note a key element of our strategy is strengthening and expanding our relationships with Tier 1 and Tier 2 OEMs, and we are making good progress in this area. To a certain degree, our strong bookings for the past seven quarters is in large part due to the outstanding execution and collaboration between our sales, operations, and business development teams and our customers. Today, we see a growing trend of Tier 1 and Tier 2 customers providing us with their latest requirements for gallium arsenide and GaN mimics, filters, diodes, lasers, and analog and mixed-signal ICs. These development projects with our customers across all markets validate that our design capability, products, and new technologies are compelling. Before I turn it over to Jack, I would like to highlight that we are cognizant of the uncertainties around the broader global macroeconomic environment. We do not presume to think our business would be immune from a global recession. Our longstanding posture has been to run the business in a way that enables us to remain both profitable and cash flow positive during all parts of the business cycle. As such, given the heightened economic uncertainty, we have and will continue to manage the business, particularly the capital investments and spending budgets very carefully. I'll highlight, however, that we have very little consumer market exposure, and we believe our defense business is typically decoupled from near-term negative economic trends. Additionally, we believe our business is relatively small compared to the semiconductor industry at large, and growth can be supported by market share gains as we expand and ramp our latest products and technologies. At a higher level, we believe semiconductor industry growth over the long term is supported by secular growth trends. More specifically, the drive towards more bandwidth, faster data speeds, higher frequencies, and higher power levels, whether in radar, electronic warfare, broadband access networks, 5G, or the data center, play to MACOM's strength in RF, microwave, and optical. In many cases, addressing these markets requires advanced semiconductor technologies like GaN, bulk acoustic wave or BAW filters, advanced lasers and detectors, high-speed analog ICs, and high-voltage capacitors. In summary, we believe our position within the industry is improving due to our strengthening portfolio. We have many compelling new process technologies underway, a growing team of world-class IC designers, and unique manufacturing and packaging capabilities. I’m confident we will continue to push the boundaries of semiconductor engineering and gain market share. Jack will now provide a more detailed review of our financial results.

Thank you, Steve, and good morning, everyone. Financial results for our third fiscal quarter ended July 1, 2022 remain strong, and MACOM's team continues to perform strongly in executing toward our business strategy. Revenue for the fiscal third quarter was $172.3 million, up 4.3% quarter-over-quarter, and exceeded our guidance range based on strength in the industrial and defense market. On a geographic basis, revenue from U.S. domestic customers represented approximately 45% of our fiscal Q3 results, with continued diversity across our customer base. Adjusted gross profit was $107.2 million, or 62.2% of revenue, up 50 basis points sequentially. Exceeding 62% gross margin represents another major milestone in improving our profitability. Total adjusted operating expense was $53.1 million, consisting of research and development expense of $34 million and selling, general and administrative expense of $19.1 million. As anticipated, total operating expenses were sequentially up by $2.1 million from fiscal Q2 as we continue to expand our R&D team and their capabilities. We continue to carefully manage administrative spending as we support growth-related investments across the business. Adjusted operating income in fiscal Q3 was $54.1 million, up from $50.9 million in fiscal Q2. Adjusted operating margin increased 60 basis points sequentially, crossing the 31% threshold to 31.4% for fiscal Q3. Depreciation expense for fiscal Q3 was $5.9 million, and adjusted EBITDA was $60 million. Trailing 12 months adjusted EBITDA was approximately $224 million, as compared to $214 million in our prior fiscal quarter. Adjusted net interest expense for fiscal Q3 was $433,000, down approximately $500,000 from fiscal Q2, primarily driven by higher short-term investment balances and the associated interest income. With increases in interest rates, we anticipate higher net interest expense during our next fiscal quarter ending in September. Our adjusted income tax rate in fiscal Q3 was 3%, resulting in an expense of $1.6 million. Our net cash tax payments were approximately $1.1 million for the third quarter, up $600,000 from fiscal Q2, primarily based on our increases in profitability. We expect our adjusted income tax rate to remain at 3% going forward. Fiscal Q3 adjusted net income was $52.1 million compared to $48.4 million in fiscal Q2. Adjusted earnings per fully diluted share were $0.73, utilizing a share count of 71.1 million shares, compared to $0.68 of adjusted earnings per share in fiscal Q2. Now moving on to operational balance sheet and cash flow items. Our Q3 accounts receivable balance was $106.6 million, up from $100.6 million in fiscal Q2, reflecting our $7.1 million increase in revenue over the prior period. As a result, days sales outstanding as of the end of June were 56 days. During the past three quarters, our quarterly revenue has increased by $17 million, which is the primary driver for the fiscal 2022 year-to-date increase in our accounts receivable balance of $22 million. Inventories were $110.2 million at quarter end, up from $93.4 million sequentially. Inventory turns were 2.4 times, down sequentially in Q3 from 2.7 times in the prior quarter. During fiscal year 2022, we have made strategic investments in various inventory items such as manufacturing consumables, substrates, precious metals, as well as critical wafer stocks and finished goods. This strategic increase in inventory is expected to support our growing backlog, which we feel will provide additional stability in the current supply environment. Fiscal Q3 cash flow from operations was approximately $40.4 million, down $2.1 million sequentially, primarily from increases in working capital. Capital expenditures totaled $6.6 million for fiscal Q3, with additional investments in fab capability and R&D equipment. We expect our fiscal year 2022 capital expenditures to now be in the range of $25 million to $30 million due to the timing of receipt of certain CapEx items. Next, moving on to balance sheet items. Cash, cash equivalents, and short-term investments for the third fiscal quarter were $536.3 million, up $33.3 million sequentially. With our continued cash generation and 5% increase in trailing 12-month EBITDA, our third quarter gross leverage is 2.7, down from 2.8 in Q2. Our net leverage remains below one and our net debt is now $67 million. We recognize that we are still in a net debt position. However, we are pleased that the increases in our cash and short-term investment balances will provide us with new and expanding strategic options for future growth. Finally, I would like to also note that this week, we published an updated environmental, social, and governance report, which can be found in the Investor Relations section of our MACOM website. The report highlights the progress we have made in improving our ESG reporting metrics. I will now turn the discussion back over to Steve.

Thank you, Jack. MACOM expects revenue in Q4 to be in the range of $175 million to $180 million. Adjusted gross margin is expected to be in the range of 61.5% to 63.5%. Adjusted earnings per share is expected to be between $0.74 and $0.78 based on 71.4 million fully diluted shares. In Q4, when compared to Q3, we expect revenue for Industrial and Defense and Data Center to increase by mid-single digit percentages sequentially, with Telecom to be relatively flat. In summary, we stand in front of a multibillion-dollar SAM with a unique and growing technology portfolio. Our strategy is to further diversify our products, customers, and end markets. We maintain a long-term perspective on executing our strategy, and we will work to manage our business to be profitable throughout all business cycles. We are confident we can continue to improve our financials and take market share in the months and years ahead. I would now like to ask the operator to take any questions.

Thank you. And our first question coming from the line of Tom O’Malley with Barclays. Your line is open.

Good morning. And thanks for taking my questions. My first one is just related to the segments. It looks like with your guidance for September, the Data Center business is declining slightly for the year, but the Telecom business is looking a lot stronger than you initially expected. Could you just walk through the puts and takes of what's going on between those? You mentioned some of the Data Center lasers ramping, but any more color on what you saw a little bit weaker in Data Center and what you’re seeing a little bit stronger in Telecom?

Sure. Good morning, Tom. So you’re correct in terms of the trends that you outlined. I’ll just also note that on a year-over-year basis, all three of our end markets were up: I&D was up 6%, Data Center was up 5%, and Telecom almost 30%. On a relative basis, we think for the full year, two or possibly three of the markets will be up. We think the strongest market on a full year comparison will be our Telecom business, again, about 29% year-over-year growth; Industrial and Defense mid-single digits around 5% year-over-year growth; and Data Center right now is trending to low-single digit or flat performance on a year-over-year basis. Given the variety of the products that we’re selling and the diversity of our revenue, there are a lot of puts and takes. I think one thing to highlight inside the Data Center is that during the course of this year, we’ve seen significant movement of our 100G CWDM4 business from U.S.-based customers over to Asia-based customers. And that trend is favorable and continues. On the Telecom side, I would highlight the tremendous growth from Telecom coming from access markets, including 10G PON and also a lot of strong growth in metro long-haul. So I think those are just a few key items that I would probably highlight as it relates to the three markets.

That’s helpful. And then in your preamble, you talked about your lack of consumer exposure and how the Defense business is relatively protected from what you think would be a macro downturn. Can you talk about the broad-based industrial business? When you look at that business, do you think that, that should track relative to GDP? Or do you think there’s areas within the industrial business? I think you’ve broken it out like 60% defense, 40% industrial in the past. But in that 40%, can you just talk about any areas that may outperform GDP and how you think that market – how you think that segment may perform in a down market? Thank you.

Sure. So first, I’m not sure if our growth rate will not track GDP, so I can’t really address that. But I would point towards some of the products that we’re introducing for the Industrial and Defense markets. This past June at the International Microwave Symposium, we went through a whole range of product demonstrations and announcements. I’ll highlight a few of these because they demonstrate the focus of the company. For example, we launched a new SLI switch product line for test instrumentation. We launched our 0.14 GaN on Silicon carbide mimic process. This is the process we’ve been working on now coming up on two years, and that is focused on a wide range of SATCOM and Industrial and Defense applications. We demonstrated a 7-watt Ka band mimic there. We also demonstrated a 10-watt e-band amplifier, again, focusing on satellite communications, ground-to-satellite communications. So just some really interesting technology there. We also announced our new BAW filter line and demonstrated a switch filter bank at L-band, targeting defense and next-generation switch filter banks that our customers are looking for. So a lot of the focus and work we’ve been doing has really been targeting telecom at large, a lot of the wireless standards in addition to high-performance defense applications. When we think about future growth from the defense industry, it will involve radar-based platforms, communication-based platforms, handheld and mobile radios, high-power radios, jammers, and UAVs. It’s a very diverse application set for our Defense business. On the Industrial side, we’ve been making tremendous progress penetrating the medical market. We’ve been focusing on next-generation functions, both on discrete diode-based technology and on our analog and mixed-signal technologies. Over the past year, we've been focusing some of our analog designers more on industrial applications, and that's been doing quite well. The last thing I’ll add is on the test and measurement industry. This is an industry that needs to support the higher data rate applications and higher-speed applications, whether in the compute market or the telecom market. MACOM is doing a tremendous amount of chip development for applications like memory testers, high-speed analog testers, or even optical testers. The industrial market for us is a target-rich environment with a lot of diversity there.

Our next question coming from C.J. Muse with Evercore ISI. Your line is open.

Yes, good morning. Thank you for taking the question. I wanted to focus first on Data Center. I think your outlook for September is a little bit worse than what you thought three months ago. When I look at the growth trajectory, it's running at about a 4% CAGR. I’d love to hear your thoughts as we move into fiscal 2023 and beyond, whether we should start to see a reacceleration in growth there. If so, what are the key drivers, and do you already see some of that business in your extended backlog?

Yes. Thanks for the question, C.J. We have definitely seen revenue numbers that are below what our previous expectations were for the full year. Even as we have looked at the business, we’ve seen shifts within our business there. First, before I talk about the moving parts within the market segment, I’d like to highlight two things for investors to remember. We did announce about a year ago that there would be about a $15 million decrease in our Data Center business due to legacy programs falling off. This included platforms like PowerPC and some of our networking products that were legacy AMCC product lines. When you add that $15 million back to our current run rate, you would have over 10% growth. The second thing I would highlight is that this market has been more challenged with supply constraint issues, but those challenges have been opening up. We saw growth in Q3 and good performance in Q4, which is improving. Looking forward to fiscal 2023, our 400G PAM4 business will be strengthening, and we like the fact that there's more work at 800G. We will address these markets with multi-channel TIAs and drivers for very high-speed applications. We also see tremendous opportunities with coherent light, as our customers look to extend the high-speed reach. They see limitations with PAM4. The product lines are also just beginning to blossom within the data center market, particularly our linear drivers, which are applying pressure on DSPs for short reach applications as well as our lasers. This year we have been very active with design wins, not just for telecom markets, but also inside the data center. I was surprised to see many module manufacturers interested in our lasers for the data center. As we think about the long-term growth and new technologies we'll bring to the data center, we announced some early successes with our new EML laser technology, which has strong price points and markets. We’re excited to start introducing that technology in the back half of 2023 and into 2024. There are tons of opportunities there within the data center, and we are quite bullish on long-term prospects.

Very thoughtful and thorough. Thank you. As my follow-up, just a quick modeling question. How should we be thinking about OpEx beyond the September quarter? You talked about interest expenses ticking higher; how should we model that into September and beyond?

Yes. Good morning, CJ, this is Jack. So, as we’ve discussed in the past, and as you may have seen in our June quarter, there was a bit of an uptick in our operating expenses as we continue to invest primarily in R&D activities across the organization. Depending on revenue growth, you’ll see a bit of an uptick in our sequential operating expenses going forward. From an overall interest point of view, obviously interest rates are on the rise. Going into the fourth fiscal quarter, that will include the full quarter impact of the rate adjustment we saw back a month or so ago. We’ll also have some impacts from the recent rate increase. So that will drive some of the interest rates up from an expense point of view, but some of that will be mitigated going forward depending on short-term investment returns.

And our next question coming from the line of Quinn Bolton with Needham. Your line is open.

Hey guys, congratulations on the nice results. Steve, you mentioned acknowledging more challenging economic conditions. I’m wondering, are you starting to see any changes in your customers' order patterns or weekly orders becoming more variable on a week-to-week basis? Are you seeing any pushouts or adjustments to delivery schedules, or any cancellations, anything like that yet?

Thanks for the question. This is something we’ve been very focused on in trying to look for early trends of possible future softness. At the end of the day, we’re not seeing that. We’re actually seeing continued strong bookings across all of the different end markets; that’s the good news. As I think we mentioned in the early remarks, this was our seventh consecutive quarter of having a greater than 1 book to bill. I’ll also note, one thing we have seen improvements on are some of the availability and lead times for our third-party foundries; we’re seeing some of the process nodes that we use come down in lead time. We think that suggests that there’s capacity opening up, which we see as a benefit; allowing us to bring some of our manufacturing cycle times down. I’d say that’s the only noteworthy item. Some of our third-party large silicon fabs are quoting slightly shorter lead times, which we see as good. In terms of daily business and bookings, I can say that we’re keenly sensitive to daily booking trends and keep a close eye on it.

Perfect. Thank you for that color. Wanted to know, just ask on the laser opportunity: you’ve got lasers for PON, lasers for 5G backhaul, and now starting to emerge into the data center. Can you give us a – just of those three opportunities, maybe relative size or rank order – is one significantly larger than the others, or how do you see those three opportunities for lasers ramping over the next couple of years?

It’s an interesting part of our portfolio. The thing about our lasers as you highlighted, we are actually focusing on three different markets, and now sort of four, since LiDAR is starting to emerge where we are seeing requirements for very high power lasers. Of course, you’ve got the data center, we’ve got access, and we have telecom. In terms of our portfolio, we have the Fabry-Perot Lasers, which are good for short distances. We have the DFEs for longer distances, and now we’re working on EMLs for very long-distance applications. MACOM does not today produce pixels, which is a large part of the market. I can tell you that we have approximately 20-25 customers that we are engaged with, qualifying various lasers depending on the application. We’re seeing qualifications with LR4, Korea for WDM 12 for 5G, CWDM 6 for 5G, and different data rates applications for 5G. If I had to pick one market which is the largest, I’d say the PON market is particularly interesting. At 2.5 GPON, annual laser consumption was about 80 million lasers at its peak. We are going through a period today where MACOM is one of the largest producers of 2.5 GPON lasers. Over the next two to three years, there’s going to be a shift from 2.5 to 10G. driven by both the China market and the global expansion of passive optical networks for fiber-to-the-home. We plan on being major participants in that market. Our 10 GPON laser revenue is almost zero right now; we’re only in qualification phases. We think that market will turn on sometime in 2023. There are tremendous opportunities within each of the segments. As some of the markets adopt silicon photonics, they’re going to want high power CW lasers or laser arrays. We’re actively engaged with customers in both those applications, and we expect the profitability of this product line to be accretive to our margins.

Now, next question coming from the line of Tore Svanberg with Stifel Nicolaus. Your line is open.

Yes. Thank you, and congratulations on the record operating margin. Steve, when you talked about TAM 4, you said you’re happy to see 800 gig activity. I was just wondering, does that mean some customers will be skipping 400, going straight from two to four to eight? Or is this more of a timing thing where the market is already starting to do some 800 gig designs?

I think it’s very early, Tore, for 800, and we have – we are engaging customers not only at 800 but at 1.6 as well. I don’t believe customers will be skipping 400-G. In fact, 400-G is becoming or is the majority of our revenue today within the data center across numerous subsegments. We actually divide our data center revenue into about nine different categories depending on the distance, length, and speed. When we look at our 400-G platforms, whether it’s short reach DR4/FR4 or active copper cables, we see the 400-G revenue growing. We have a strong position from our product set point to address that market. So, I think no, I’m not suggesting that there are customers skipping the 400G.

Very good. Thanks for clarifying that. My follow-up, either for you or for Jack: you’re coming as striking distance now from no longer being in a net debt position, and I was just wondering once we get to that level, will the company’s capital management plans change?

Yes, Tore, this is Jack. As we look at our cash position and our net debt position, as you highlighted, we do view ourselves as still being in a net debt position. We’ll have to see how things go as we move forward. We continue to make investments internally throughout the organization, and we believe our cash balance is a strategic asset that provides us with various options going forward.

Yes, I think that’s exactly right, Jack. I’ll just add that we recognize that a growing cash position is a strategic advantage; as that grows, it will allow us to have more options moving forward. Given the fact that we are either in or maybe soon to be in a recession, having a large cash position also allows us to sleep well at night.

One moment for our next question. Our next question coming from the line of David Williams with Benchmark. Your line is open.

Good morning, David, are you there?

One moment for our next question. Our next question coming from the line of Matt Ramsay with Cowen. Your line is open.

Yeah. Hi guys. This is Ethan Potasnick on for Matt. Congrats on the great results and guidance here. I was wondering if you could discuss gross margins. Things are still progressing incredibly. I was wondering if you could dive into where do you see levels from here? Is the strength being driven by timing or product mix? I’m wondering if you could explore that dynamic.

Yeah, sure, Ethan, and good morning. As we look at our gross margins, we have been pleased with the progress that we've made over the past couple of years. As we've also discussed, we have a continuous improvement culture here at MACOM. So we're constantly striving to make improvements across the organization. There have been a number of different things we've done in terms of reducing scrap and waste and trying to improve yields across many, if not all, of our different product lines that we have, both internally manufactured products as well as those from outside vendors. So we keep picking away at this and making those improvements. We continually say we'd like to see incremental improvements over time, but we know things don’t always occur in a straight line. As our gross margins get up to this higher than 62% range, we understand it can be more challenging moving forward. In the longer-term, slow and steady sequential improvement remains our goal, but it’s not always going to be in a consistent direction. One other thing to think about with new product introductions is that they’re a core element of our strategy to bring in more products at higher gross margins to meet customer needs. So as we feather in some of those new products looking out over the longer term, we hope that will also be additive to our gross margins.

Understood. I was intrigued by some of the commentary on the script regarding the OTDR product line, given the recent qualifications as deployments of PON and 5G optical networks continue. I was wondering if you have any insight into the timeline for revenue there?

Yes. We just introduced the products recently. We actually had to go through about three different iterations of the photodetector to meet customer qualification requirements, which are starting now. We should expect a slow ramp over the course of the next 12 months. We expect contribution in the near-term, ramping up over time. Just note there are multiple markets that would use this type of functionality, including PON but also metro and long-haul. There's military applications as well, like underwater cables or systems in active platforms that need to monitor electronics. It’s a fundamental feature necessary in many optical fiber applications, and MACOM wants to lead in this area. We have some outstanding packaging technology, and we have dialed in the performance of these detectors to be very fast. That way you can identify issues on a fiber close to a break or a bend in the cable. I’ll highlight this is a niche market, not a multi-hundred million dollar market. From our perspective, we think this is somewhere between $20 million and $40 million. Over the next few years, if we can capture a reasonable portion of that market, I think we’ll be doing well. This also exemplifies a path to increase gross margins through a specialized product.

And our next question coming from the line of Mark Lipacis with Jefferies. Your line is open.

Hi. Thanks for taking my question. Steve, I have a question on the defense commentary you made. You’ve always talked about it as a growth sector for MACOM. Maybe I’m reading too much, but it seemed like you highlighted it in particular this quarter. Are there particularly good visibility or improving visibility in that sector now? Do events like the Ukraine war typically lead to increased demand or visibility for component suppliers like MACOM?

Thank you. We are very pleased with the performance of our defense business across many different applications. Historically, MACOM was known to be a supplier of discrete diodes and some instances, mimics mostly for RF and microwave applications. Over the past three years, we’ve branched out and introduced different technologies to our defense customers, which have been well received. We’re excited about it. As highlighted in my script, we’re also bringing in new design capability that allows us to provide components, modules, and multichip assemblies or subsystems. Six months ago, I highlighted a 45-kilowatt multimillion dollar contract from the Navy. We expect more of these types of large programs in the next few years. This is something MACOM was not doing four or five years ago. I should mention the CHIPS Act, as the Senate passed it recently; it provides about $53 billion to the semiconductor industry. We are excellent candidates for this funding. These funds will flow through many DoD agencies or sponsors. In the past few years, we have reestablished new relationships with those agencies that will help us as these chip dollars start to flow. They’re looking not only to improve manufacturing but also funding for semiconductor R&D, which we want to be a major beneficiary of. We’re focused on defense across many technology areas, whether RF, optical, high-speed analog, or RF power. We're excited about the market; we’ve gone from a stagnant revenue of $40 million a quarter to approaching $80 million. That growth is due to market share gains and pursuit of new programs, unrelated to specific events like Ukraine. The world situation drives higher frequencies, power levels, and data rates, benefiting MACOM.

Very helpful. Thank you.

Thank you. One moment for our next question. Our next question is coming from the line of Harlan Sur with J.P. Morgan. Your line is open.

Good morning. Thanks for taking my question. So as a follow-up to that, Steve, several of your fabs are AS9100D certified and aerospace qualified. I think your facility has trusted fab status by the Department of Defense. You’ve also got a number of standard products and custom programs for defense initiatives as you outlined in your prepared remarks. Since you’re an important partner to the U.S. Defense and Aerospace Industry, with the high probability of CHIPS Act passing, it seems likely you’ll gain access to associated subsidies. I know that proposals were requested by the Department of Commerce a few months back. Can you provide a sense of how much you’re requesting in subsidies? CapEx is 4% to 5% of your revenue, so any subsidies would positively impact free cash flows.

Yes, it's probably too early for us to provide that level of detail or share specifics. It’s still early in the process. What I'd emphasize is that we want to align funding toward our manufacturing facilities and also work with different agencies to develop technologies for new programs. So it’s not just about manufacturing; it's also about semiconductor R&D, which can come in various forms including process development, circuit design, or package technologies. We are AS9100 certified, and our trusted facility has growing capabilities. It’s too early to talk about specifics until we better understand how the funds will flow.

A good example of accessing R&D dollars is your 0.14 GaN on Silicon mimic process, transferred from the Air Force research lab. Characterize this technology as one of the key emerging growth drivers for the team. Is the manufacturing process fully qualified? I know it's running in your lower facility; is the manufacturing process fully qualified? Given this was a technology transferred from AFRL, are you limited to custom and standard products solely for defense initiatives, or can you offer this process to non-defense-related standard and custom products?

Yes, great questions. To highlight, the 0.14 GaN on Silicon Carbide process that we transferred from the Air Force was paid for by MACOM. We used MACOM R&D dollars; there was no government funding for that. This was a commitment to the Air Force because we felt it was strategic. We wanted to build relationships and this has been a success. It’s a royalty-free technology transfer; there are no royalties associated. The second point is that we are not constrained by how we use the process; we can also sell it into the commercial markets. In fact, that’s exactly what the Air Force wants; they want to see the process go to volume production. However, limitations can arise when it comes to specific circuit designs. The qualifications status: the process is not fully qualified yet. We expect it to be qualified by year-end or early Q1 of 2023. However, our PDK, the design tools, are qualified and our designers are off collecting requirements and designing devices since the process is frozen. This technology is a launching point for future advancements. We know U.S. competitors are producing hundreds of millions of dollars of revenue in this area, whereas today we have zero revenue. Our goal is to step into the market, win market share, and drive growth.

Thank you. And our next question coming from the line of Richard Shannon with Craig Hallum. Your line is open.

Hi guys. Thanks for taking my question. I had one that kind of covered a few recent comments you made here in the last couple of minutes. To take a phrase you used earlier in the call about staying in your lane, I think that was in context to not going after DSPs, which makes sense to most people. You've also discussed a lot of opportunities in new markets, being niche, but it seems like with the potential from the CHIPS Act, this might allow you to go after slightly bigger markets. Can you expand on that? Could staying in your lane help you explore much larger markets than in the past, especially with the CHIPS Act money?

Yes, I do think that. Well, first of all, we have a long-term strategic plan, and that plan is a self-funded plan. We are not betting our future strategy on winning dollars from the CHIPS Act. For us, this is an accelerator. It will enable us to do things faster and provide financial benefit along with cash flow benefits and solidifying long-term relationships with major agencies and customers. We recognize there’s potential for us to continuously expand our SAM, and that's key for our growth strategy. Today, we estimate our SAM to be about $5 billion, and we want to push that to about $8 billion or $9 billion over the next few years. By spending only $130 million or $140 million a year in R&D, you can only do so much. We have a methodical approach to stepping into markets where we know we can succeed. The CHIPS Act serves as an accelerator but won’t change our fundamental strategy.

I appreciate those comments, Steve. That's all for me.

Thank you.

In closing, we'd like to thank our employees, customers, and suppliers for their continued support. Have a nice day. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.