Greetings. Welcome to Semtech Corporation's Fiscal Year 2020 Second Quarter Conference Call. Please note, this conference is being recorded. I would now like to turn the conference over to your host, Sandy Harrison, Director of Investor Relations. Thank you. You may begin.

Thank you, Devon, and welcome to Semtech's conference call to discuss our financial results for the second quarter of fiscal year '20. Speakers for today's call will be Mohan Maheswaran, Semtech's President and Chief Executive Officer; and Emeka Chukwu, our Chief Financial Officer. Our press release announcing our unaudited results was issued after the market closed today and is available on our website at semtech.com. Today's call will include forward-looking statements that include risks and uncertainties that could cause actual results to differ materially from the anticipated results in these statements. For a more detailed discussion of these risks and uncertainties, please review the safe harbor statement included in today's press release and in the Other Risk Factors section of our most recent periodic reports filed with the Securities and Exchange Commission. As a reminder, comments made on today's call are current as of today only, and Semtech undertakes no obligation to update the information from this call should facts or circumstances change. During the call, we will refer to non-GAAP financial measures that are not prepared in accordance with generally accepted accounting principles. Discussion of why the management team considers such non-GAAP financial measures useful, along with detailed reconciliations of such non-GAAP measures to the most comparable GAAP financial measures, are included in today's press release. All references to financial results in Mohan's and Emeka's formal presentations on this call refer to non-GAAP measures unless otherwise noted. With that, I will turn the call over to Semtech's Chief Financial Officer, Emeka Chukwu. Emeka?

Thank you, Sandy. Good afternoon, everyone. For Q2 of fiscal 2020, net sales increased 4% sequentially to $137.1 million. This was above the midpoint of our guidance. In Q2, shipments into Asia represented 74% of net sales. North America represented 16%, and Europe represented 10%. Total direct sales represented approximately 28%, and sales through distribution represented approximately 72%. Our distribution business remains balanced with 52% of the total POS coming from the high-end consumer and enterprise computing end markets; and 48% of total POS coming from the industrial and communications end markets. Bookings grew sequentially and resulted in a book-to-bill above 1. Those bookings accounted for approximately 41% of shipments during the quarter. As expected, Q2 GAAP gross margin was flat sequentially at 61.9%. Q2 fiscal '20 GAAP tax rate was 63.4% and reflected a discrete $6.5 million tax provision impact resulting from finalized trade-free regulations related to the 2017 U.S. transition tax. We expect our GAAP tax rate for the rest of fiscal year 2020 to be in the range of 13% to 17%. Moving on to the non-GAAP results, which exclude the impact of share-based compensation, amortization of acquired intangibles, acquisition-related, and other nonrecurring charges. Q2 non-GAAP gross margin was flat sequentially at 62.2% as expected, and we expect our Q3 non-GAAP gross margin to decline 20 to 80 basis points due to lower absorption of manufacturing overhead as we work to bring inventory down to target levels. In fiscal year 2021, we expect non-GAAP gross margin to return to normal levels as overall demand strengthens, driven by our higher-margin growth engines. Q2 non-GAAP operating expense was $53.8 million, slightly higher than Q1 and in line with expectations. In Q3, we expect non-GAAP operating expense to be flat to down 3% sequentially as higher new product expenses are offset by lower supplemental compensation expenses. While maintaining our investments in our key growth drivers, we expect our non-GAAP operating expense for fiscal year 2020 to be approximately flat or only modestly higher compared to the prior year. We expect our fiscal 2020 non-GAAP tax rate to remain in the 14% to 18% range. In Q2, cash flow from operations increased and returned to more normalized levels at 24% of net sales compared to 5% of net sales in Q1. As a reminder, Q1 includes our annual disbursements for supplemental compensation. We repurchased approximately 446,000 shares for approximately $20 million during the quarter, and our stock repurchase authorization now stands at approximately $161 million. We expect to continue to use our cash to opportunistically repurchase our shares, make strategic investments and pay down our debt. In Q2, accounts receivable decreased 12% sequentially due to improved shipments linearity and represented 42 days of sales, which is within our target range of 40 to 45 days. Net inventory in absolute dollars increased 2% sequentially and days of inventory increased to 129 days, which is above our target range of 90 to 100 days. In Q3, we expect net inventory to decline in both absolute dollars and days as we work to get inventory back in line within the target range. In summary, we were very pleased with our execution in Q2 despite this difficult macro environment. Our gross margin was stable, operating expenses were under control, and cash flow generation was strong. While the recent geopolitical challenges continue to contribute to near-term customer uncertainty, we believe our diversified customer base and end markets, along with the secular nature of our growth engines, position us well for future growth.

Thank you, Emeka. Good afternoon, everyone. I will discuss our Q2 fiscal year '20 performance by end market and by product group and then provide our outlook for Q3 of fiscal year '20. In Q2 of fiscal year '20, net revenues increased 4% over the prior quarter to $137.1 million. We posted non-GAAP gross margin of 62.2% and non-GAAP earnings per diluted share of $0.38. In Q2 of fiscal year '20, net revenues from the industrial end market increased 24% sequentially, led by very strong growth from our LoRa business and represented 36% of revenues. Net revenues from the enterprise computing end market increased 4% and represented 27% of revenues. Net revenues from the communications end market increased 10% over the prior quarter and represented 10% of total net revenues. Net revenues from the high-end consumer market decreased 15% sequentially driven by lower smartphone demand and represented 27% of total net revenues. Approximately 16% of high-end consumer net revenue was attributable to mobile devices, and approximately 11% was attributable to other consumer systems. I will now discuss the performance of each of our product groups. In Q2 of fiscal year '20, net revenues from our Signal Integrity Product Group increased 10% over the prior quarter and represented 40% of total net revenues. As expected, demand increased sequentially across the data center and the wireless base station markets, while the PON market remained soft. In Q2 of fiscal year '20, data center demand rebounded as customer inventory levels have reduced over the last two quarters and demand from cloud and hyperscale data center providers appears to have stabilized. In Q2, we saw strong bookings for our ClearEdge CDRs used in 100 gigabit per second NRZ optical modules. We expect demand for our ClearEdge CDRs to continue to increase, driven by global cloud and mega data center deployments. In Q2, we were pleased with the progress of our Tri-Edge PAM4 CDR platform that we are now sampling to data center customers. We expect our first Tri-Edge revenues in Q4 of this fiscal year, with growth accelerating in the second half of next year. Our Tri-Edge platform delivers low-cost, low-power, and low-latency performance, ideal for PAM4 base optical modules. In September, Semtech will be part of the Open Eye MSA Interop demonstration for 10-kilometer, 50 gigabit per second PAM4 links. The Open Eye MSA, which consists of 19 companies, builds on key performance advancements of PAM4 CDRs and optics to enable lower cost and lower power PAM4 optical modules. Our FiberEdge PMD platform, which complements our Tri-Edge and ClearEdge CDR platforms, also continues to gain momentum with key data center PAM4 module customers where we have collaborated with DSP partners targeting PAM4 optical modules. We expect to see our FiberEdge PAM4 revenues also ramp in fiscal year 2021. In Q2 of fiscal year '20, demand from the wireless base station market increased. Semtech's market opportunity from 5G deployments is expected to triple compared to 4G due to the higher 5G volumes and additional CDR content. For the rest of fiscal year '20, we expect 4G and 5G deployments to increase modestly, with much stronger growth from 5G platforms expected in fiscal year 2021. In Q2 of fiscal year '20, our PON business, which is largely driven by China, remains soft due to lower China government investment in PON and the impact of the Huawei ban. We expect this weakness to continue through the second half, due mostly to the Huawei ban. Over the next few years, we do expect the PON market demands to increase, driven by 10 gig PON deployments. Semtech remains the PON market leader, providing highly integrated solutions for 1 gig, 2.5 gig, and 10 gig PON platforms. The greater demand for higher optical data rates at the lowest power and cost is driving greater demand for Semtech's ClearEdge, Tri-Edge, and FiberEdge platforms. We expect this trend to continue, driven by the global expansion of cloud and hyperscale data centers, the global transition to 5G base stations, and the acceleration of 10 gig PON, and we expect our SIP product group to benefit from these global trends over the next few years. Our broadcast video business has been very stable for the last few years, and with the acquisition of AptoVision, we are finally starting to see an opportunity to drive significant growth in this business. As a reminder, we are focused on transitioning the pro audio/video industry from expensive proprietary equipment to standard IP-based solutions through the adoption of software-defined video over Ethernet. The primary market focus has been healthcare, enterprise, industrial, and entertainment. Recently, we received post-silicon of our SDVoE platform, which appears to be functional, and we now expect to have production silicon by the end of this year. We believe this will be a significant catalyst in the adoption of SDVoE for all Pro AV applications as customers realize the benefits of delivering uncompressed, ultra-high definition, 4K TV content over a standard 10 gig Ethernet network. We will update you on the progress of our AptoVision platform on future earnings calls. For Q3 of fiscal year '20, we expect net revenues from our Signal Integrity Product Group to be flat to up modestly as global demand increases will be offset by the Huawei ban. Moving on to our Protection Product Group. In Q2 of fiscal year '20, net revenues from our Protection Product Group grew 4% over the prior quarter and represented 29% of total net revenues. Our Protection business growth was driven by increases in broad-based demand from the industrial, automotive, and consumer markets. In particular, we saw nice increases from our North American smartphone business and from our automotive business. These were somewhat offset by lower Korean and Chinese smartphone demand. Several of our newly released parts such as the RClamp3324P deliver higher performance protection for the most advanced HDMI, Ethernet, and USB interfaces. The increasing proliferation of high-speed interfaces across multiple market sectors is driving our growth in demand. In particular, the rapid adoption of these high-speed interfaces in automotive systems such as infotainment, in-vehicle communication, and advanced driver assistance systems is contributing to the growing demand for Semtech's high-performance protection products. In Q3 of fiscal year '20, we expect our Protection business to increase due to continued strength from the automotive and industrial segments and stronger smartphone demand from North America and Korea. Turning to our Wireless and Sensing Product Group. In Q2 of fiscal year '20, net revenues from our Wireless and Sensing Product Group were approximately flat from the prior quarter and represented 30% of total net revenues. Very strong sequential growth from our LoRa business was offset by very weak demand for our proximity sensing products due to the Huawei ban. In Q2, our LoRa-enabled business grew nicely. The momentum and interest in LoRa is very strong, and we are seeing more and more IoT use cases emerge every day. LoRa is rapidly becoming acknowledged as a critical technology for low power IoT sensor networks, and we expect to see LoRa emerge as the de facto standard for low power wide area networks over the next few years. Some of the more recent noteworthy use cases include Comcast announced it has partnered with Universal Parks & Resorts to deploy LoRaWAN networks in its parks to increase operational efficiency in the parks. LoRa sensors will be used to monitor temperature, monitor energy consumption, and track assets across the parks. Seluxit, a leading European IoT provider, has developed a LoRa smart meter and cloud platform to enable their customers to closely monitor energy usage in real-time. Customers using Seluxit get insight into their energy usage and consumption patterns, enabling a reduction in energy waste and reduction in energy costs, which enables a more sustainable energy grid worldwide. Axino, a European IT solutions integrator, added LoRa into its smart refrigeration solutions used to track food temperature, helping customers reduce food wastage and ensuring food safety. Skysens, a Turkish provider of IoT solutions, is deploying 10,000 LoRa-based sensors in its smart asset tracking solution at Istanbul airport. Conserv, a leading IoT solutions provider for art and museum applications, has developed a smart conservation solution based on LoRa that utilizes low-power sensors to provide museums with accurate, efficient, and simple art help metrics in real time. Oizom, an IoT solution provider for environmental applications, is leveraging LoRa using Tata Communications' LoRaWAN infrastructure in India to deploy smart agricultural solutions, enabling farmers to optimize their water usage and create smarter and more efficient farms. And Lacuna Space in Europe announced it has completed its first phase of testing in its mission to provide complete satellite IoT global coverage from LoRa sensors anywhere in the world, however remote. Lacuna's demonstration, LoRa constellation, will be completed by the end of this year. Lacuna also demonstrated a connectivity range of over 300 miles. These are just a handful of examples of new use cases emerging in the LoRa ecosystem. Interest in our recently announced cloud-based LoRa services, which includes our LoRa-based geolocation services, has been very high as we start to demonstrate the unique value of a LoRaWAN-based geolocation service offering. We believe that customers will begin transitioning from testing our geolocation services to qualification and commercialization early next year. Based on our anticipated growth in LoRa sensors and the assumed attached rates of sensor geolocation, asset tracking, and other services, we expect our LoRa Cloud services to grow to $100 million in recurring revenues within the next five years. Our LoRa momentum continues to build nicely, and we are seeing very exciting momentum across the globe underscored by the key LoRa metrics we track. Our key metrics update includes the number of public or private LoRa network operators increased in Q2 to approximately 120 from 100 at the end of fiscal year '19. We expect 130 LoRa network operators by the end of fiscal year '20. The number of countries with LoRa networks grew to more than 82 countries. By the end of fiscal year '20, we expect over 90 countries to have LoRa networks. The estimated number of LoRa gateways deployed increased to more than 350,000. These gateways will support approximately 1.5 billion connected end nodes. We expect the number of LoRa gateways deployed to exceed 500,000 by the end of fiscal year '20, supporting a LoRa end node capacity of over 2 billion end nodes. The cumulative number of LoRa end nodes deployed increased to 105 million. We now expect this number to reach 130 million by the end of fiscal year '20. The LoRa opportunity pipeline is now over $475 million with an additional $200 million of leads feeding the opportunity pipeline. We anticipate that, on average, 40% to 50% of this pipeline will convert to full deployment over a 24-month timeline. Our pipeline of opportunities is geographically well-balanced and also includes a growing number of consumer use cases where the volumes could be significantly higher. We will continue to provide LoRa metric updates on future earnings calls. In fiscal year '20, given the slower than expected start to the year driven by extremely soft demand from China, we are now expecting our LoRa-enabled revenues to come in between $80 million and $100 million. We expect to exit the year at a quarterly run rate closer to the high end of this updated range. We still anticipate a 40% CAGR over the next five years, and we continue to expect LoRa to become the de facto standard for LPWAN use cases over the next few years in what we expect to be a multibillion unit industry. In Q2 of fiscal year '20, demand for our proximity sensing platforms decreased as expected, driven by lower China smartphone demand due to the Huawei ban. While our Huawei smartphone business will continue to be a challenge, we believe our proximity sensing business will benefit from increasingly stringent global SAR regulations as governments recognize the health risks associated with increasingly powerful 5G radios. Over the next few years, we expect the majority of smartphones and wearable devices to have SAR sensors included in their system designs. For Q3 of fiscal year '20, we expect net revenues from our Wireless and Sensing Product Group to increase due to stronger LoRa-enabled demand. Moving on to new products and design wins. In Q2 of fiscal year '20, we released 12 new products and achieved a record 2,460 new design wins. Now let me discuss our outlook for the third quarter of fiscal year '20. We are currently estimating Q3 net revenues to be between $135 million and $145 million. To attain the midpoint of our guidance range, or approximately $140 million, we needed net terms orders of approximately 36% at the beginning of Q3. We expect our Q3 non-GAAP earnings to be between $0.38 and $0.42 per diluted share. Our Q2 guidance assumes no further direct shipments to Huawei in this fiscal quarter.

Cody?

Just a clarification on that last point. You're not shipping to Huawei this quarter at all. Are you completely eliminating your expectations for Huawei going forward? And are you shipping, like many other companies, a new portion of your previous revenue?

Yes, Cody, we are shipping as Huawei requests us to ship and of course, if we are allowed to ship. The comment is that we don't plan in our guidance to ship anything more even though we have backlog to Huawei and that's really related to them. There is an indirect impact as I have mentioned on previous calls where we may be able to ship a product, but if they can't get a component from another manufacturer, then they can't ship their system anyway. And so part of that is our kind of approach is assuming that they're going to have difficulty in assembling all the components they need to build their systems.

And then just the Chinese versus the Huawei implications. How have you seen the ban or the trade conflicts impact your broader Chinese activity, particularly in the smartphones market, not necessarily PON? Just broadly, are you seeing any hesitation? Or are you seeing any share shifts that might give you encouragement that you could see China grow even if Huawei is not?

I don't believe the tariff situation significantly affects us. The softness in demand from China is certainly a challenge for everyone, and that has been an ongoing issue even before the tariffs came into play. While the tariffs have added to the uncertainty, I don’t see them as the primary factors impacting us. The ban on Huawei is a clear direct effect and is the biggest impact we face. Despite that, I still maintain high expectations for growth in China.

Our next question comes from the line of Tore Svanberg with Stifel.

First of all, to just close the loop on Huawei. So it's about 5% of your revenues last quarter, right? So roughly $7 million and that's going to go away in the October quarter, is that the math?

We've estimated about $10 million impact this quarter, Tore, from a direct standpoint. There may be additional indirect impact, again, that we're not aware of, but the direct impact for us is about $10 million.

Very good, that's helpful. And then as we sort of look at outside of China and Huawei, I know last quarter you had talked about backlog kind of firming, inventories were pretty low, as you mentioned, in the data center market. As we now are here 90 days later, would you say that, outside of China, the environment is still relatively healthy?

Yes, I think that's fair to say. I mean, I think the smartphone market is a little bit skewed because of Huawei's inability to shift. So we don't really know if someone else is going to pick that up or they're picking that up when we see a pickup there. So outside that though, I do think that the rest of the markets, data center for sure, IoT for sure, are doing reasonably okay. So it's very segment specific and yes, I don't see any other regional issues.

Very good. And just last question on LoRa. As cloud services start contributing to revenues perhaps early next year, is this going to be a separate line item? Are you kind of going to talk a little about perhaps where you're seeing the geographic implementation there?

Yes, we will start to give more color as we start to get revenues from the geolocation services and as it becomes a material number, of course, we'll break it out.

Our next question comes from Rick Schafer with Oppenheimer.

My first question is about LoRa. This business has shown solid growth, but it seems to be slower than expected, especially compared to last year. Can you share what has surprised you the most in this area compared to your expectations from two or three years ago? Is it just the slowdown in China that has caught you off guard? Additionally, I'm interested in what milestones we should look for in LoRa revenues as we aim for your target of $500 million to $1 billion over the next three to five years. This suggests we will see significant growth at some point to reach that run rate. Could you provide any insights on whether next year will be a key growth year or if you could clarify any of this?

We've been experiencing a growth rate of 60% per year in terms of revenue, and we expect this year to follow that trend. Although we started the year slowly, particularly in China, which accounts for 60% of our revenue for LoRa, there are important factors to consider, especially our opportunity pipeline. This pipeline is becoming more balanced geographically and includes a variety of new use cases. We still project a 40% compound annual growth rate over the next five years, and when we include cloud services, that could elevate to around 50% growth. Key aspects to monitor include the opportunity pipeline, conversion rate, number of deployed gateways that reflect our end node capacity, the actual end node deployments, and overall momentum. Additionally, we foresee several promising use cases related to consumer products and smart buildings that could serve as significant catalysts. Once we gain momentum in these areas, it should become clear to everyone that LoRa is set to be the standard for low-power wide-area networks. We are diligently working on these use cases and remain optimistic about their potential.

I have a quick follow-up regarding base stations. I estimate they contribute around mid-single digits to our revenues. You mentioned that this business is expected to grow modestly in the latter half of the year, presumably without Huawei's involvement. Is this growth primarily due to higher content, as you noted earlier? Are you gaining market share among non-Chinese wireless OEMs like Nokia, Ericsson, and Samsung? Any additional insights would be appreciated. You have a strong relationship with Samsung, especially in the handset sector, so I'm curious if there might be opportunities arising from that collaboration.

Yes, a bit of everything you mentioned, Rick. I think we are generally seeing a pickup in the demand of 5G deployments. I wouldn't say it's huge. I would say it's very modest, but it is a pickup. Obviously, Huawei is a bit of a headwind for us on that, but I think, as with smartphones, we do expect over time, someone else to pick up the demand that Huawei can't ship. So we'll see how that plays out, but yes, that's our expectation.

Our next question comes from the line of Craig Ellis with B. Riley FBR.

And just to make sure I'm clear on the Huawei effect, are you saying that there was $10 million of Huawei revenue in the fiscal second quarter but you don't expect there to be any so that's the $10 million sequential headwind?

Yes, we've shipped some already, Craig. But we're not expecting to ship anymore. And so the total impact is about $10 million for us.

Got it. And then following up on some of the LoRa questions, Mohan. So it seems as I look at the performance of the business versus targets, you're actually tracking in network operators and countries potentially to exceed the targets that you had set at the beginning of the year. And yet, we did reduce the end node target from $140 million to $130 million, I believe, and then you updated the revenue target. But if I look at that data, it would seem to suggest that the business is getting good traction outside of China, but maybe not getting the end node deployments as fast as we had thought perhaps three and six months ago. Is that a fair depiction or is there really something else going on?

I think that's a fair assessment, Craig. It's important to remember that predicting end node deployments involves forecasting how quickly opportunities transition into proof of concepts and then into revenue from actual deployments. This process is largely based on estimates. Currently, LoRa is still a relatively small business, below $100 million in revenue. Therefore, minor changes, such as economic softness in China regarding smart metering, can have an impact. However, as the business scales and the opportunity pipeline becomes more balanced, I believe these small fluctuations will have less significance. The large opportunity pipeline suggests that if we can effectively convert those opportunities, we will achieve the projected 40% or more compound annual growth rate.

Okay, that's helpful. And then switching over to Signal Integrity. So it seems like the company is pleased with the momentum it has with the ClearEdge parts and the Tri-Edge PAM4 parts. I think we're specific that we'd start to see revenues for some of these PAM4 parts in the fourth quarter. But then, really more again in the second half of calendar '20. Is the point there that seasonally we would expect the business to be softer in the first half of the year just given enterprise and data centers spending? Or is there something else going on and should we expect a similar revenue and demand profile for your ClearEdge parts?

Yes, I think it's more weighted to when the market is ready for PAM4. I think we see customers interested. We see design and activity, but revenue, I think, is still towards the back end of next year. And we are working very closely with them. Obviously, as we bring out our products and we see momentum, that may change, maybe a first half phenomenon. But I think at this point in time, we'd project more second half next year revenue.

Okay, that's helpful. Last one's for Emeka. Emeka, I haven't forgotten about you. The guidance on gross margin was helpful as it relates to the fiscal '21 color rising back towards more normal levels. The question is, what is 'normal'? Would that be the 61% to 62% range or is that 62% plus? And I take it that's driven by valuation, but would there be any microservices revenue included in that guidance?

I believe the normal levels I'm responding to have been around 62% and above over the last several quarters, which I now consider our baseline. As we move into the next fiscal year, I anticipate growth coming from LoRa, hyperscale data centers, our Pro AV products, and industrial or protection products. These markets typically have a higher gross margin expectation. Therefore, I am confident that as demand strengthens and returns to normal levels, we can resume our manufacturing activity at those same levels. This is why I expect to see normalized levels of 62% and higher again.

Our next question comes from the line of Tristan Gerra with Baird.

When you mentioned the 5G content opportunity to triple, could you give us some color on how does that translate in dollars in terms of the 5G content per base station and also the pace of increase that you expect for next year?

Yes, Tristan, it's tough to determine exactly. It depends on the system architecture, including the number of fronthaul, backhaul, and middle links in each deployment. We are certainly noticing an increased demand for CDRs, which benefits us as more content is generated. Additionally, 5G architecture generally necessitates more base stations. Our customers are indicating that this will indeed be the case, leading to a greater number and variety of base stations, as well as more CDRs, which is driving the content. We're beginning to observe a modest increase, and I believe that next year will reveal more, likely in the second half. The market is definitely showing demand, so the need is present. The next question is whether the technology is ready and if customers and service providers are prepared to invest. I anticipate that this will begin next year.

Okay. And then moving on to the impact of 5G but this time on the consumer side. Does your Protection business potentially benefit from the rise of 5G phones? Are there any changes that you expect in the regulatory environment for 5G model powering phones that would have an impact on your content per cellphone?

Yes, the main shift we anticipate is regarding our proximity sensing. As I mentioned during the call, 5G radios are quite powerful. With an increase in the number of 5G radios and their range, there is a need for higher power to cover greater distances, especially due to the high bandwidth. Typically, these radios will be more powerful and potentially more hazardous. Currently, the attachment rate for proximity sensing related to SAR functionality in most phones is relatively low, but we expect that for 5G phones, this rate will be significantly higher. This presents a strong opportunity for us. Additionally, in terms of Protection, we expect to see similar improvements necessary from a production perspective, including high-speed interfaces for advanced processors and various displays that require protection. The environment will be more demanding as everything becomes faster and incorporates more advanced lithography and displays. Therefore, we anticipate good performance in both Protection and proximity sensing due to the influence of 5G moving forward.

Great. And then last one, in terms of the growth for LoRa that you see for this year, how should we model China? I thought China will have a decline as a percentage of total LoRa revenue. Do you actually expect China to be flat to up year-over-year this year? Or is the new target embedding China to be down year-over-year?

I would think that China would be maybe slightly up year-over-year, Tristan. But I think we did anticipate it would be a much higher growth this year, to be fair, as we planned the year. A lot of the growth that we did expect from China. But I make the comment on the opportunities being more balanced just for that reason, and we just don't know where this whole tariff thing is going to lead to and those types of things. And one of the things we pride ourselves on is having geographical balance and end-market balance, and this is one of the reasons, it's that we can't predict what's going to happen regionally. All we know is we have very good momentum also in North America. We have good momentum in Europe. But yes, for this year, the projection was that China would be growing faster, and I think it's going to be fairly muted growth.

Our next question comes from the line of Karl Ackerman with Cowen and Company.

Emeka or Mohan, your comments on China PON demand largely echo peers who have reported already, but I think you sound a little bit more optimistic on 100 gig optical components than peers. So what are you seeing here in terms of bookings for 100 gigs for the second half of the year? And how should we think about the opportunity for your PON business as 5G ramps later this year?

Well, Karl, I think it's important to distinguish between PON and data centers as we operate in two different markets. PON is primarily driven by China, focused on 2.5 gig and 1 gig PON technologies, with some growth in 10 gig deployments. However, the challenge for us in the PON market is that Huawei has been a crucial player in China, and the Huawei ban presents significant hurdles for our business. Additionally, China has been the leading region for PON deployments, with other areas also participating, but at much lower volumes. The reduced investments from the Chinese government in PON, combined with the Huawei ban, have created headwinds for this segment. On the other hand, the data center business has shown signs of improvement since we observed inventory builds in Q4 and Q1. We've started to see a better balance in Q2, and we anticipate that the remainder of the year will be more favorable for data centers, particularly with our 100 gig and 4x25 gig deployments, as well as our Z optical modules. This is where we expect to see benefits in our business.

Understood. For my last question, if I may, could you elaborate on what you expect from the proximity sensing business for the back half of calendar 2019? I understand that Huawei is an overhang, but I guess I was under the impression that business outside of smartphones should grow at kind of high teens or plus or minus clip. So if you could elaborate a bit more on what you're seeing in that market outside of Huawei/smartphone, that would be helpful.

Yes, the proximity sensing business is performing well outside of China, particularly in Korea. Currently, the majority of our volume comes from smartphones, although we are securing design wins in wearables and other applications where the radio interacts with the human body. The major smartphone manufacturers driving volume are in Korea, with some contributions from North America and China. We have made significant progress in diversifying this business, which was previously heavily reliant on Korea. This year, challenges faced by Huawei, the key player in the proximity sensing market in China, have impacted performance. We are anticipating that Samsung will see some improvement in the latter half of the year, though their performance has not been strong to date. If Huawei is unable to ship phones outside of China, we expect that another company will fulfill that demand, which should benefit us in some way in the proximity sensing sector.

Our next question comes from the line of Harsh Kumar with Piper Jaffray.

I have a couple of questions. Mohan and Emeka, you mentioned LoRa and data center as areas for growth. LoRa has traditionally relied heavily on China, but there was notable growth in the July quarter you reported. I'm interested to know if this recent growth came from China or other regions. Additionally, regarding data centers, are you observing growth primarily in the U.S. and Europe rather than China? It would also be helpful if you could differentiate between cloud, enterprise, and hyperscale growth.

Yes, let's address the last question first, Harsh. Currently, the data center activity is primarily driven by North America. While we may be shipping to China because of the supply chain, the actual demand is aimed at serving North America. This is clearly the situation. Most of the activity is focused on hyperscale data centers, although there is also some involvement with cloud services, but primarily it is hyperscale data centers. And then on the LoRa side, yes, it is China. I would say a large chunk of that growth is China but it's also rest of the world. As you know, Q1, we had pretty weak LoRa business and that was driven mostly by China's softness, and I think we saw a little bit of a pickup from that in Q2, but I would say it's more balanced but still yet a lot of the growth is driven by China.

Got it. Some of the other companies, including many that have already reported their June and even July numbers, have indicated that China has reached its lowest point, except for Huawei, of course. Would you agree with that perspective concerning your business?

Yes. I would say that's probably true, Harsh, although Huawei is a fairly significant influencer in the region. So I think if you would exclude them, then you have to look at the whole ecosystem around them. But I think outside that, yes, I do think that China seems to be doing better now. As I mentioned, there are indications that the China demand as a total is now starting to do better outside the tariff uncertainty, which doesn't really impact our demand so much. I think outside that I think China demand seems to be doing better.

Our next question comes from the line of Gary Mobley with Wells Fargo.

Let's start with a quick question for Emeka on the OpEx. So your Q3 OpEx guide implies a $2 million year-over-year decrease. And just to get to the question of sustainability for that lower level, is there anything more than just lower bonus accruals or putting the cap on any sort of travel expenses and whatnot?

No, there's not much more to it. As you can imagine, we entered the year with much higher expectations. Our bonus programs were aligned with those expectations. Unfortunately, that hasn't materialized, so we do not anticipate other programs will pay out as much as we had hoped. Overall, we manage our operating expenses effectively, and currently, around 20% to 25% of our operating expenses are variable, providing us opportunities to maintain control. However, there's nothing extraordinary that we are doing to manage our operating expenses.

Okay. This Huawei shipment ban in the U.S.-China trade issue has prompted Chinese companies to try to accelerate their development and reduce their reliance on Western chip companies. With 35% of your revenue coming from China, have you noticed any anti-U.S. sentiment affecting design win activity or the adoption of technologies like LoRa, which may be perceived as U.S.-based?

Yes. Actually, that's a really good question. I think we have seen that, but I think that's nothing unusual. I mean, that was going on before any tariff situation. The Chinese have been driving a whole kind of vision of having more component suppliers in the region. Fortunately for us, most of the stuff we do is really high-end stuff, and I think they're challenged. I mean, the companies, they are challenged to achieve the levels of performance we achieved. Now that said, because of some of the situations we have like the Huawei ban, it may drive the customers, the end customers to actually change their specifications to accommodate poor-performing devices. And so we have to be faced with that. I think that's just one of the challenges we have to deal with, in addition to being faced with Chinese competition as customers may be changing their specs to accommodate lower-performing devices. That said, I think that for us we have enough opportunity across both China and the rest of Asia and other regions of the world to still expand our SAM and our opportunity.

Our next question comes from the line of Quinn Bolton with Needham & Company.

Wanted to ask first on the data center business. With the nice uptick that you saw in the second quarter and the guidance for continued growth into the second half of the calendar year, do you think you're now sort of through all of the inventory correction? Or do you think even in the second half you may still be shipping under and consumption of optical modules in the data centers?

Quinn, we think most of the inventory is now burnt through. I mean, I think it's been two quarters now where we've seen softness in data centers. Difficult to call, it's not a huge increase we're seeing, but we are seeing a modest increase, and so our feeling is, yes, in the second half that's going to be a little bit stronger. So I think the assumption from that is that inventory mostly is reduced.

Okay. Great. And then just a question on the smartphone business. I know historically the company has had very high share in the OLED display protection market. I think certainly that was the case with the Korean manufacturers. But as you see Chinese manufacturers ramping OLED displays, do you have the same market share with some of the newer Chinese OLED manufacturers on the protection side like you did with the Korean OLED manufacturers?

Yes, many of the phones from China are still utilizing Korean displays and will continue to do so for a while. While our position is strong, it may not be as robust as in the Korean smartphone market. However, our longstanding relationship with Samsung remains strong, and our presence in China is developing in the display sector. Overall, we believe we maintain a solid global market share.

Got it. And then my last question is on the LoRa business. You've sort of discussed that it was a little bit of a slower start this year and the new revenue target for fiscal '20 sort of implies a low single-digit to maybe a mid-20% year-on-year increase, so below that 40% kind of CAGR that you expect for the next five years. Should we think that to the extent we get into a better economic environment in 2020, that you could rebound above that 40% level for a year? Or would you sort of encourage us to think that the best way to think about that LoRa business is that the growth rate is going to be much closer to that 40% kind of off the fiscal '20 base that you've just given us?

Yes. The way I would think about it is that we have been growing at 60%, which was our expectation coming into this year. We have adjusted that down to a 40% compound annual growth rate. However, as I mentioned, we are anticipating one or two major catalysts over the next 12 to 18 months that could drive faster growth. When that occurs, we can discuss its impact on our numbers, but it is still some time away. We need to execute this plan, and our customers must go through the proof of concept process to demonstrate value and inform us of their intentions, which will generate significant volume. For now, I believe modeling a 40% growth rate is appropriate.

Our next question comes from the line of Scott Searle with Roth Capital.

Quick clarification on the guidance, just want to make sure I was clear. Proximity sensors, you are expecting to be down sequentially, but overall the Wireless and Sensing Group is expected to increase into the third quarter, is that correct?

That's correct.

Okay. So just to follow up. Samsung has historically been a slightly larger customer for you. I think in the last several quarters they've been running $10 million to $14 million; was a little bit softer this quarter. It sounds like proximity sensing was part of the issue there. But is there something else going on? Is there a share loss or something else? Are we just clearing some inventory here before you expect that demand to come back to a more normalized level?

You're referring to the Samsung cellphone business?

Yes.

Samsung has not performed as well for us in the first half of the year. We are expecting a stronger third quarter from them. However, in the first half, their demand was not as robust as they had projected. We are considering whether they will be able to capture some of the smartphone demand in China that Huawei has. It's possible that their past business in China and Asia, coupled with Huawei becoming more aggressive in those markets, has impacted their performance. The smartphone market in Korea has also been weak for us in the first half. We do expect some recovery in the third quarter.

Thank you. To follow up on some previous questions regarding the data center, there was a good recovery in the second quarter. It seems you are aiming for further growth in the third quarter. Previously, it was anticipated that China would contribute to domestic demand for new data centers being developed in the mainland. Is that still part of your growth outlook moving forward? Or is the ongoing recovery primarily reliant on hyperscale cloud environments in North America?

No, China is included in that, just not Huawei. So I think we include other China customers, yes.

Okay. And lastly just to wrap up on LoRa. As you exit the fourth quarter, more that $100 million type run rate, China has been a big component of that. What is your expectation of what China is as a component of that $25 million in the fourth quarter?

As we conclude the year, I believe that China will account for about 60% of our revenue. The pipeline is becoming more balanced, but we need to see evidence of other regions generating revenue before we can geographically shift our revenue profile, which typically doesn't change rapidly. China might decrease from 60% to around 58% or 55% until we identify a significant catalyst. There are multiple potential catalysts, including various consumer-oriented use cases related to devices and smart home technology, which tend to have a higher volume than industrial applications like smart metering or smart cities. Our aim for LoRa is to transition it from being mainly an industrial IoT sensor to a versatile IoT solution applicable to various sectors, including both consumer and industrial markets. This is the type of catalyst we are looking for.

Our next question comes from the line of Hamed Khorsand with BWS Financial.

Just a couple of questions here on LoRa. Outside of China, are you seeing any pricing pressure that's creating this issue with revenue not growing as fast to offset the weakness in China?

No, we aren't experiencing any significant pricing pressure. It’s primarily about converting proof of concepts. We are noticing momentum in other regions, but revenue is growing more quickly in China. One reason for China's faster adoption of LoRa and revenue generation is the greater access to system integrators, software engineers, hardware engineers, and sensor developers in the area, which allows them to quickly address bottlenecks and resolve issues. This process is a bit more challenging in Europe, North America, and other areas, but progress is being made.

And how much of a factor is the slowdown in the automotive industry playing a role in your Protection business?

Our Protection business is not significantly impacted at all. Currently, it is mostly driven by smartphones, while the automotive segment is growing quite well for us. This area is relatively new for our Protection business. As I mentioned earlier, we are witnessing a surge in infotainment, ADAS, and other new applications in vehicles that require high-end protection due to their advanced lithographies. Therefore, our Protection business is experiencing notable growth in this sector.

Our final question comes from the line of Craig Ellis with B. Riley FBR.

Thanks for taking the follow-up question, team. I just wanted to follow up and see if I could ask a question about how you would look at the fiscal fourth quarter seasonality in this environment given all of the macro crosscurrents? It's hard to think of any quarter seasonality. But to the extent that you have a view there, can at least share some of the positives and negatives that you would see from this early juncture, I'd appreciate the color.

Yes. It's tough to call, Craig, mostly because of Huawei, I would say. I think we would expect Samsung to be down obviously, in Q4, but they haven't had a great year. So normally, when they've had a fairly modest year, sometimes their Q4 is not as extreme downward. So that may be not as weak. I think data center will continue to be quite strong. Obviously, we expect LoRa and IoT to be quite strong. So it's going to be tough to call it. I think we'll just have to wait and see how China plays out. And the Huawei ban is the one thing that obviously does impact us, and we would expect a similar type of impact in Q4, unfortunately, so we would need to look at that. But my sense is Q4 could be better than we normally would see it.

You mean just the margin there is a headwind or you mean there could be an incremental $10 million headwind in the fiscal fourth quarter, Mohan?

I think the $10 million we have would be included in the numbers. So if you take the Q3 run rate, I would anticipate normal seasonality from that standpoint, and then you look at my comments on Korea. So Q4 could be stronger than we have seen in the past. Typically, it's down for us at least 5%, but I would say it's probably not going to be down as much, but we'll see.

We have reached the end of our question-and-answer session, and I would like to turn the call back over to Mohan Maheswaran for any closing remarks.

Yes. In closing, despite the ongoing uncertainty and geopolitical headwinds that contributed to a slower first half, and despite the ongoing Huawei ban, we are seeing modest signs of recovery in several of our targeted markets. We remain confident in the underlying strength of the secular drivers behind our growth engines, in the IoT, data center, and mobile markets, and we remain confident that our overall end market, geographical and product balance will enable us to outperform the industry. With that, we appreciate your continued support of Semtech and look forward to updating you all next quarter. Thank you.

This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.