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Edited Transcript of LITE earnings conference call or presentation 5-Feb-19 1:30pm GMT

Q2 2019 Lumentum Holdings Inc Earnings Call

Milpitas Feb 8, 2019 (Thomson StreetEvents) -- Edited Transcript of Lumentum Holdings Inc earnings conference call or presentation Tuesday, February 5, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alan S. Lowe

Lumentum Holdings Inc. - President, CEO & Director

* Christopher W. Coldren

Lumentum Holdings Inc. - Senior VP & Interim CFO

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Conference Call Participants

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* Alexander Henderson

Needham & Company, LLC, Research Division - Senior Analyst

* John Warren Marchetti

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst

* Jun Zhang

Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst

* Mark Daniel Kelleher

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Michael Edward Genovese

MKM Partners LLC, Research Division - MD and Senior Analyst

* Roderick B. Hall

Goldman Sachs Group Inc., Research Division - MD

* Samik Chatterjee

JP Morgan Chase & Co, Research Division - Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* Thejeswi Banavathi Venkatesh

UBS Investment Bank, Research Division - Associate Director and Analyst

* Thomas James O'Malley

Barclays Bank PLC, Research Division - Research Analyst

* Timothy Paul Savageaux

Northland Capital Markets, Research Division - MD & Senior Research Analyst

* Troy Donavon Jensen

Piper Jaffray Companies, Research Division - MD and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning. My name is Matthew, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Second Quarter Fiscal Year 2019 Lumentum Earnings Conference Call. (Operator Instructions)

Chris Coldren, Interim CFO and Senior Vice President, you may begin your conference.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [2]

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Thank you, Matthew. Welcome to Lumentum's Second Quarter Fiscal 2019 Earnings Call. As Matthew highlighted, this is Chris Coldren, Interim Chief Financial Officer. Joining me on today's call are Alan Lowe, President and Chief Executive Officer; and Jim Fanucchi from Darrow Associates, who is helping us with Investor Relations.

This call will include forward-looking statements, including statements regarding the markets in which we participate, including potential market sizes, trends and expectations for products and technology, including product development and projected new product releases, purchasing trends and demand for our products, our expected financial performance, expenses and positions in the market as well as statements regarding our recent acquisition of Oclaro. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. We encourage you to review our most recent filings with the SEC, particularly the risk factors described in our 10-K filing, which was filed with the SEC on August 29, 2018, and the registrations statement on Form S-4 relating to our acquisition of Oclaro, which was declared effective on May 31, 2018, and in our 10-Q for the second quarter fiscal 2019, which we expect to file with the SEC later this week. The forward-looking statements we provide during this call, including projections for future performance, are based on our reasonable beliefs and expectations as of today. Lumentum undertakes no obligation to update these statements, except as required by applicable law.

Please also note, unless otherwise stated, all results and projections discussed on this call are non-GAAP. Non-GAAP financials should not be considered as a substitute for or superior to financials prepared in accordance with GAAP. Our press release with our second quarter fiscal 2019 results is available on our website www.lumentum.com under the Investors section and includes additional details about our non-GAAP financial measures and a reconciliation between our GAAP and non-GAAP results. Our website also has our latest SEC filings, which we encourage you to review and supplementary slides relating today's earnings release. A recording of today's call will be available by 11:30 a.m. Pacific Time this morning on our website.

Now, I would like to turn the call over to Alan for his comments and second quarter market and product highlights.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [3]

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Thank you, Chris. Good morning, everyone. I am very pleased to be here to discuss our second quarter results.

First, I'd like to make some comments regarding our recent acquisition of Oclaro. On December 10, after receiving Antitrust approval from China and nearly 9 months after announcing it, we closed the acquisition. I believe joining forces with the talented employees of the former Oclaro has created the industry's strongest team and the industry's leading portfolio of telecom transmission and transport products.

Further, the combined team's capability in the design and manufacturing of high-performance indium phosphide lasers and photonic integrated circuits is unparalleled. The chemistry, cultural fit and shared purpose of the combined team is excellent. I cannot be more excited about our bright future together.

I would like to take this opportunity to review key elements of our acquisition's strategic rationale. The first is leadership at the indium phosphide photonic chip level. Photonic chips are of increasing importance to the full range of the world's rapidly expanding communication infrastructure spanning access, wireless, data center, metro and long-haul networks. Indium phosphide lasers and photonic integrated circuits and the only practical devices for generating the optimum wavelength of light for transmission over optical fiber. Customer requirements are unrelenting in their drive toward higher speed, lower power consumption, smaller size and lower cost.

Our thesis is that the only way to meet the future customer requirements in the optical communication transport -- transmission market and sustainably differentiate ourselves from our competition is innovation and economies of scale at the fundamental indium phosphide photonic chip level. We have employed this same strategy in the industrial and consumer markets with gallium arsenide materials, and we believe our success in these markets validates this strategy. We further believe indium phosphide could meaningfully penetrate consumer and automotive sensing market.

The second element of our acquisition rationale is to establish a clear leadership position and to improve the industry structure in the growing optical communications market. The world continues to become more reliant on ever-increasing amounts of data flowing through optical networks and data centers.

Next-generation wireless and access technology, including 5G, will further accelerate network bandwidth requirements. The economics of 100G and higher-speed technologies along with ROADMs are becoming more favorable every day for network operators. This is accelerating the pace of global, long-haul, regional, DCI and metro network deployments utilized in these products and technologies. The optical communication components industry has long needed industry consolidation. We believe our acquisition of Oclaro has given us a first mover advantage in consolidation.

Further, we believe it has catalyzed and will accelerate further consolidation. The acquisition establishes leadership in high-speed transmission that complements our existing transport leadership. With market-leading products and technology and strong long-term customer relationships and a growing and consolidating industry, we are well positioned for long-term profitable growth. The final element of our acquisition rationale is to create options to profitably participate in the datacom market. It is anticipated that growth in hyper-scale data center build-outs and 5G wireless deployments will drive new levels of growth in the high-speed datacom market.

Profitability in these markets at the transceiver level is challenging. Hyper competition and limited product differentiation are driving rapid price declines. Though some competitors have left the market, we continue to see new competitors emerge at the transceiver module level, though none with indium phosphide chip capabilities. Combining with Oclaro gives us a differentiated leadership position across a range of photonic chips, on which the datacom, wireless and access markets critically rely. This creates new avenues to profitable growth through meaningful chip sales and more cost-competitive transceivers. In Chris' remarks, he will provide more details on the acquisition.

Now turning to our second quarter results. Revenue at $373.7 million contained $29.6 million of contribution from the acquisition. Our prior guidance did not include any acquisition contribution. Excluding the acquisition, revenue came in at roughly the midpoint of our prior guidance. Strength in demand and manufacturing capacity expansions drove ROADM and fiber lasers to new record levels.

Revenue from our Telecom product lines grew 21% sequentially, driven primarily by the strong growth in ROADMs -- ROADM sales and the 20 days of contribution from Oclaro's Telecom product lines. ROADM revenue grew 29% quarter-on-quarter and 110% relative to the prior year. Demand from our customers for our Telecom products is very strong and is spread across a broad customer and geographical base. We continue to add ROADM capacity, but demand will outstrip our ability to supply throughout the third quarter.

Datacom revenue was down slightly sequentially. The previously anticipated decline was partially offset by the acquired datacom revenues in the quarter. In the third quarter, we expect datacom revenue to decline relative to combined company historic levels. We continue to be selective in our sales of transceivers in this margin-challenged product area, and this is impacting revenue. With the closing of the acquisition, we now have chip sales in the datacom and 5G markets, which we expect we will continue to grow.

Turning to our industrial and consumer product lines, which includes 3D sensing. As expected, second quarter revenues from industrial and consumer diode laser product lines were down 10% quarter-on-quarter, driven by softer demand for 3D sensing lasers. Android customer revenue came in as expected, and we continue to make excellent progress with additional Android customers and additional new design wins. The market for laser-based sensing is still in its infancy. We believe the market opportunity over the long run is tremendous, as the applications that use our lasers' enhanced security, safety and new functionality in the billions of electronic devices that people rely on every day. The seeds for this long-term to market opportunity continue to be planted.

During the second half of calendar 2018, additional customers announced or started shipping high-end 3D sensing-enabled devices. During calendar 2019, based on customer engagements we have today, we expect new and existing customers will announce and release additional new 3D sensing-enabled products. Several of these opportunities are expected to bring new functionality that could expand our content per device, including world-facing capabilities.

We believe these new customer products are the first step to broad incorporation of 3D sensing in lower-priced, higher-volume devices in the years to come. The customer learnings, software APIs and supplier ecosystems developed in these initial products will enable and allow more rapid adoption of 3D sensing in subsequent product cycles. We believe our leadership position in the market is sustainable, and we will see strong growth in our 3D sensing business over the long run. We have a proven capability that customers around the world know they can rely upon. We have shipped hundreds of millions of devices with unmatched performance, quality and reliability. The advantage this experience gives us is a valuable attribute and is difficult to replicate and overcome.

Customer requirements for the next several product generations to come require us to further push the edge of laser device technology and manufacturing capability. We believe the same technology differentiation and unique depth of experience that enabled our success today in the current-generation devices will be even more critical to future generations of 3D sensing lasers.

Our commercial lasers segment revenue was up 10% quarter-on-quarter and 9% relative to the prior year. During the second quarter, we benefited from capacity expansion and further ramped volumes of our newest fiber laser products to meet the strong customer demand. We again achieved record revenue from our Kilowatt-Class Fiber Lasers, which grew 12% sequentially and 133% relative to the prior year. We're making healthy investments in new laser product development and production capacity, targeting higher-growth material processing applications. In calendar 2019 and over the long run, we have good opportunities for growth, driven by new product design wins in addition to market growth.

Throughout my remarks, I've highlighted significant long-term trends that create terrific market opportunities for Lumentum, and even more so, with the closing of the Oclaro acquisition. Further, I've highlighted our strategy to accelerate growth and drive sustainable margin expansion and customer and end market diversification. These are very exciting times at Lumentum for all of our stakeholders.

I will now hand it over to Chris for more details.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [4]

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Thank you, Alan. I will first run through the second quarter financial results, add some additional details around the Oclaro acquisition and then provide our guidance for the third quarter. Net revenue for the second quarter was $373.7 million and included $29.6 million of revenue contribution from the Oclaro acquisition. GAAP gross margin for the second quarter was 33.4%. GAAP operating margin was 3.1%, and GAAP diluted net income per share was $0.08. Second quarter non-GAAP gross margin was 40.1%, which was approximately flat with the last quarter. Non-GAAP operating margin for the second quarter was 22%. Operating expenses totaled $67.5 million or 18.1% of revenue. R&D expense was $39.3 million and includes increased investments in new product development in addition to the added R&D expense from the acquisition.

SG&A expense was $28.2 million. Non-GAAP net income was $78.3 million for the second quarter and includes $2 million of other income and a tax expense of $5.9 million. Included in the tax expense is a onetime tax adjustment of approximately $2.7 million due to the Oclaro acquisition impacting our full year estimated tax expense. Non-GAAP diluted net income per share was $1.15. This includes an approximate $0.04 negative impact to -- due to the aforementioned tax adjustment related to the acquisition and is based upon a fully diluted share count of 67.8 million. The share count includes approximately 2.4 million new shares due to the Oclaro acquisition being in the quarter for only 20 days.

Turning to the segment and product line details. Our Optical Communications segment revenue at $325.4 million increased 5% sequentially. Within our Optical Communications segment, Telecom revenue at $172.5 million was up 21% sequentially. Datacom revenue at $33.4 million was down 2% sequentially. Industrial and consumer revenue at $119.5 million was down 10% sequentially, due to lower low 3D sensing revenues. Optical Communications segment gross margin at 39.7% increased 60 basis points sequentially due to lower industrial and consumer in the revenue mix. Our laser segment revenue at $48.3 million increased 10% sequentially, driven by growth in fiber laser sales. Second quarter lasers gross margin was 42.7% and increased 240 basis points due to higher volumes and product cost reductions.

Now turning to more details on the acquisition. The stock portion of the acquisition consideration, excluding unvested stock tranche for continuing employees consisted of 11 million new Lumentum shares. The cash portion of the consideration was $964.8 million. The cash consideration was funded by the combined company's balance sheet, which at the end of the first quarter, preacquisition, had a total of approximately $1.1 billion in cash and short-term investments.

The cash consideration was also funded by a new term loan of $500 million. After the paying of $964.8 million of the cash consideration and more than $50 million in fees related to the acquisition, between the 2 companies during the second quarter, our second quarter ending cash and short-term investments was $684.1 million. This is only $50.2 million lower than Lumentum's first quarter levels due to strong cash generation by the business during the quarter. The ongoing annual interest expense associated with the new term loan is LIBOR plus 250 basis points. Today this results in an approximate interest rate of 5% or $25 million per year in additional interest expense.

Since we're focused on similar customers, geographies and manufacturing capabilities and purchase the same types of raw materials, we have strong, tangible expense synergy opportunities. As highlighted when we announced the acquisition, we believe these synergies will be in excess of $60 million per year within 12 to 24 months from the close of the transaction. To date, we estimate that we have achieved more than $10 million in annual expense synergies. We expect modest levels of new synergies to be attained in the third quarter, and then we expect synergy attainment will accelerate in the fourth quarter and into fiscal year 2020.

Work done since the closing of the transaction gives us confidence in our ability to meet or exceed our expense reduction target. I think it is important to highlight these expense synergies did not include any increased revenue or profit due to new project differentiation or product roadmap acceleration resulting from the combined companies innovation engine. However, we believe over the long run, it is these types of synergies that will create the most long-term value and underpins our strategic rationale for the transaction.

Now onto our guidance for the third quarter of fiscal 2019. Noting again that all projections are on a non-GAAP basis and now include Oclaro for the full quarter. We project net revenue for the third quarter to be in the range of $420 million to $440 million, with the operating margin in the range of 16% to 18% and diluted net income per share to be in the range of $0.76 to $0.94. These projections incorporate an approximate share count of 77 million and tax expense of approximately $4 million at the midpoint of the range. Note, our third quarter projections have several million dollars of additional expense related to a reset of labor fringe rates in the new calendar year.

Notable quarter-on-quarter changes in product line revenue and our projections include commercial lasers increasing, primarily due to new product growth; industrial and consumer declining due to consumer electronics customer seasonality; Telecom increasing, driven by continued market growth and having a full quarter of the acquisition; and datacom increasing to $50 million to $55 million due to having a full quarter of the acquisition.

We're providing more clarity on the datacom projections, given the amount of change there has been in these product lines over the past few quarters. We don't expect to provide this level of detail on an ongoing basis.

(Operator Instructions) Matthew, let's please begin the question-and-answer session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Samik Chatterjee with JP Morgan.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [2]

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If I can start off with one just relating to the quarter itself. You -- kind of, on the revenue front, you came in, in line with expectation or kind of in line with guidance that you had issued, but on the operating margins, on the gross margins, you were lower. Is that kind of driven by the Oclaro integration and can you kind of help us with what's the starting point for Oclaro in terms of gross margins and operating margin that you are building off?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [3]

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I'll make a couple of remarks, and see if Alan has any additional. I would say first is the product mix so obviously, with the decline in 3D sensing that has an impact to margin. And then further, we're not going to break out any Oclaro gross margin. There's no Oclaro going forward. Those product lines have been merged with ours. But certainly, if you go back and look at prior quarters, Oclaro had been running below where our 40% gross margin was in the prior quarter. So there is some level of dilution of margin associated with acquisition.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [4]

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Okay. And so if I can just follow up on -- with the 3D sensing question. You are obviously expecting lot of product launches from the Android guys, and you have position on those launches. How should we think about the ramp-up on those volumes? What are your expectations in terms of when deep volumes on Android smartphones for you guys becomes comparable to kind of volumes with your lead customer? Is it kind of a 1-year time horizon? Are you thinking about it as a multiyear time horizon before you kind of see more diversification on your 3D sensing customer base?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [5]

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Yes. I'd say that we're expecting more diversification throughout this calendar year. It's hard for me to predict when the Android 3D sensing business will -- the half of our 3D sensing business, but there's certainly plenty of potential for that to happen. And I think the key to that is moving from the high-end devices that are in the market today to more the midrange, lower-cost, higher-volume products. And that really is in our customers' hands, so we're providing them the technology and capability to announce those products. It's just not clear to us when exactly that will happen. But I think, it will happen, and it's just a matter of time.

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Operator [6]

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Our next question comes from the line of Alex Henderson with Needham & Company.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [7]

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Great. I would like to talk a little bit about the Oclaro acquisition, post the conclusion of it. Really focusing on what your expectations are in terms of pairing out redundant revenues and much lower margin type products that were in the Oclaro mix. Obviously, it's a pretty nice chunk of change coming in, in terms of revenues, but I assume that you're going to pair some of that stuff out. So it'd be helpful to have some sense of what the impact is both on terms of reduction in revenues from line consolidation as well as the impact on margins from that?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [8]

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Yes, I mean I think you've already seen a part of that in our guide for datacom, and that's why we were very specific about the absolute revenue in the $50 million to $55 million in Q3. We are going through the product rationalization as well as fab utilization optimization, and we'll be talking to our customers later this quarter and putting in place the actions to drive to the lowest-cost product or the highest-margin product where appropriate, where there is overlap, but the overlap is pretty minimal, and we expect to drive those to conclusion throughout this calendar year.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [9]

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Is it reasonable to think of $50 million to $100 million kind of range for line pairing?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [10]

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Well, I think if you go back in history and look at the 2 company's datacom business, you'll see that there's a good chunk of that already out of our Q3 guide in datacom. There will be more product rationalization, so it's not unconceivable that we hit that number. But I think...

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [11]

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Great.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [12]

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I think on the other side, we're focused on driving innovation to grow our healthy new products faster, so we're hoping that, that will more than offset the product pairing.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [13]

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And the margins on those are sub-20 gross? Is that kind of the right range?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [14]

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On which?

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [15]

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On the stuff you're pairing.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [16]

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There is some that are much more challenged than that, that we're taking action with, and that's, again, one of the reasons you saw the guide on datacom in the short run.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [17]

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One last question, then I concede the floor. The 3D sensing, obviously, the -- Apple brought in numbers pretty sharply in the fourth quarter. There seems to be a wide lay of estimates for the upcoming quarter. I assume that what we're looking at here is a supply chain that had 8 to 10 weeks worth of process in it that takes time for that to run through. Hence, I would assume that, that would result in a very low number for the March quarter. Is that the right thought process?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [18]

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Well, I'll give you my thoughts, and Chris can add to it. If you remember, it was November 12 when we got the first heads-up. And so there was action taken during the December quarter that was very different than the end of calendar 2017, where the heads-up came very, very late. It's not even into early part of the calendar year. So there was -- there's been adjustments both from our supply chain as well as, I think, through our customer supply chain and the module integrators to address some of that, so that the buildup is not nearly like it was a year ago. That said, we don't have total visibility beyond what -- beyond our walls, but we are taking a conservative approach with respect to March quarter guide and then whatever's remaining for the June quarter in the numbers we provided. Chris, you have anything?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [19]

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I have nothing further.

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Operator [20]

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Our next question comes from the line of Simon Leopold with Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [21]

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I wanted to ask about the ROADM business in particular. I'd like to get some updates, just my rough math suggest that the quarter you reported was $90 million, $95 million in sales, and I understand you've added capacity. So just, sort of, trying to get an idea of how you see that particular line of business trending? And I'd like to include in your answer some thoughts on the competitive landscape, and how that's evolving?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [22]

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Sure. I don't think your math is too far off, Simon. And I'd say that growing by 30% or 29% quarter-on-quarter was no simple task. Had we been able to grow another 30%, we would have sold all of that product as well. So there is still tremendous amount of pent-up demand for our leading-edge technology from twin 1x20 to even higher port count. And now on the end-by-end product line where, I'd say, we have, if not years leadership in those kinds of products. So we're expecting, and we're seeing continued demand strength across all of the regions from Europe to China to North America on all of those products. At the same time, we're starting to see continued strength at the low-end edge ROADM where, historically, we had not had such a competitive offering. We announced a very competitive offering in calendar '18, and that product line is sold out. So it's a broad range of product demand that our customers are asking us for. And I think we -- from a competitive landscape standpoint, we're out in front and continue to invest to maintain that leadership to continue to have a large share of that market.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [23]

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And just as a follow-up, I wonder if you could give us your perspective on the 3D sensing market in terms of 2 opportunities, as I see them, one, world facing; and two, 5G. How either of those could play into the opportunities as we look out beyond calendar '19 perhaps?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [24]

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Well, I think from world facing, we have multiple designs with multiple customers, pretty much across the board, and the who's who in mobile devices working on time-of-flight world-facing sensors. And so we're very confident in our leadership ability to meet the market demands of these products where the technology continues to evolve and get pushed. So I think that will come into fruition. It's already starting to shift. We'll see more and more devices throughout calendar '19 as well as into calendar '20. And I think, the interesting thing there is that the whole new set of application use cases that should drive our customers to want to introduce those things sooner. So that's, again, out of our hands, we're just enabling the technology and the capability. As far as 5G is concerned, I mean, that's really more of a question for our customers and when they come out with 5G-capable handsets and what they put on those devices. So hard for me to say, but I'll tell you that the carriers are getting ready and investing. So it's coming.

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Operator [25]

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(Operator Instructions) Our next person is Michael Genovese with MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [26]

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First question on the ROADM demand, specifically in China, can you discuss from your perspective the evidence that these are real tenders turning into real deployments by multiple carriers versus whether it is inventory build going on? So what's your view on that?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [27]

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Yes, I mean we have direct interaction with the carriers in China, and they have -- this is beyond those pilot type of deployment, this is real deployment that are happening today. And so based on the constant pressure from our customers, executives across the globe, including in China, I have to believe that there is not a tremendous amount of inventory buildup. But again, we don't have full visibility for that. I will say that we know that product that we shipped into our network equipment manufacturers in China are ending up being deployed in the field. And so that gives us confidence that these are real demand that our customers need and are deploying, and it's verified by the carriers in China.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [28]

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Yes, I'd add that our engagement with our lead customers as well as the carriers in China date back several years. And while we don't, as Alan said, have great visibility per se into inventory levels at our customer, at least the rate of deployment that was advertised when we kicked off these programs between our network equipment manufacturer customers and the carriers seem to be what's coming to fruition. So they're not -- it's not a recent surge, if you will, we've seen in ROADM sales out of the blue. It's very consistent with the several-year roadmap that we've had between the equipment manufacturers and the carriers.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [29]

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I think the other thing, Michael, is that with these higher port count ROADMs and more complex ROADMs, the average selling price is substantially higher than a 1x9 edge ROADM that we sell and have been selling for many, many years. So part of the uptick in ROADM revenue is average selling price in these 1x32 type devices where it's multiple factors of higher price compared to a normal [one in] our competitors. So...

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [30]

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Okay, great. And then as a follow-up, this strength, I know you talked about a 100% year-over-year growth. It does seem to be concentrated in ROADM area. You're probably also seeing it in pumps and amps, some other type of very high double-digit growth rate. But what about the pull-through to transmission, and specifically, the Oclaro portfolio. Are we going to see specifically, for these metro builds, are the regions like China or other regions where the Oclaro demand is still in front of us that's going to catch up with this strong ROADM demand we're seeing -- or I guess, another way of asking is why is this so concentrated in ROADMs? And will it broaden out at some points?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [31]

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Yes. I would say, there's a couple of pieces to that, Mike. First, it's certainly, we expect ROADMs as -- ROADMs and pumps and other transport products as a leading indicator, if you will, of future transmission deployments, given you need to put the ROADM and the amplifier infrastructure in generally ahead of the transmission infrastructure. I would say though that we're seeing disproportionate growth in the transport, and particularly ROADM space, simply because previously there were not significant deployments in China that were ROADM based, but there were 100 gig, 200 gig ports deployed. Whether that be in long-haul and then switching to regional. So we expect to see great growth in the transmission, as you said using the word pull-through. But I think the ROADM piece is a bit more pronounced, given from a geographical standpoint. China not being a large consumer, domestically at least that is, of ROADMs in the past and now they're. Now with that said also, China's consumption, at least our Chinese customers there -- if we summed up all of their ROADM consumption, it's still below their share of the world's networking market. And therefore, we continue to believe there's continued growth -- above market growth and bringing our Chinese customers up to the levels that they should be purchasing ROADMs at.

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Operator [32]

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Our next question comes from the line of Meta Marshall with Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [33]

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I wanted to dive into a couple of things. First on the industrial laser business. I know that you guys have tried to expand capacity to be able to meet more than the needs of just your kind of one major customer. I just wanted to get a sense of are you selling to multiple customers at this point? Would you expect to, kind of, by the end of the fiscal year and just what -- if you're not, kind of what level of revenues should we think of as being the threshold to meeting other customer needs? And then maybe just a second, more logistical one. On splitting the -- if we can get split of the S29.6 million for Oclaro between telecom and datacom for the quarter would be helpful?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [34]

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Yes, maybe I'll start with the latter first and let Alan answer the former. The $29.6 million was approximately equally split between datacom and telecom.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [35]

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And as far as our commercial lasers business and record revenues in fiber lasers, that's still our primary fiber laser customer, and we still have some catching up to do. So we still have not met their overall demand. We're getting closer this quarter. And once we do that and satisfy their needs, then we'll look at penetrating outside of that customer. So I wouldn't expect meaningful revenue this fiscal year. I think, it will be more into fiscal 2020.

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Operator [36]

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Our next question comes from the line of Thejeswi Venkatesh with UBS.

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Thejeswi Banavathi Venkatesh, UBS Investment Bank, Research Division - Associate Director and Analyst [37]

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With the acquisition of Oclaro, you now obviously have a deep presence both at Huawei and ZTE. Both of those systems customers have been in the news quite a bit recently. So I was hoping you could characterize overall Chinese demand to the extent you can on these 2 customers?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [38]

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Well as we said earlier, the ROADM demand in China because of it being nonexistent a year ago for domestic deployments is quite strong today at all of the leading network equipment manufacturers in China, including the 2 you mentioned, but there are others. I would say that the relationship with both of them is very strong. I can't control what's going on between the 2 countries, I wish I could. But I'd say that at this point in time, we're working with them closely across the range of products from telecom transport, next generation ROADMs through the next generation of transmission from ACOs to DCOs and 400 gig. So I'd say that the relationship engagement is broad and very strong at this point.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [39]

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Yes, I'd say our aggregate exposure between those 2 customers is still less than their exposure, if you will, to their markets, which you can argue is a good or bad thing. It's a bad thing in that we want to grow that, ultimately, over the long run. But vice versa, if there's concerns about any interruption of business with them, yes, we have exposure and that would be very painful to lose that business, but we're not overexposed to it relative to most other participants in the market.

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Thejeswi Banavathi Venkatesh, UBS Investment Bank, Research Division - Associate Director and Analyst [40]

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Got it. And with respect to your lead customer -- lead 3D sensing customer, any change in the competitive situation as you look out into the phones launched in the second half of 2019? I assume, by now you have a fair sense of what that could look like?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [41]

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Yes, I think, we're still very happy with our share of the production shipments that we've today. And I would say that we're very happy with where we're positioned for next-generation new designs, whether that be front facing or world facing across the product and customer portfolio. So as I said in the prepared remarks, the next generation of devices is pushing the technology for higher identification, higher wall-plug efficiency and things like that don't allow people just to catch up because they have the capability today to make yesterday's product. So we're pretty excited about where we're and how engaged we're with many, many customers R&D development efforts as part of their extension of their development. So I couldn't be happier with where we are.

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Operator [42]

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And our next question comes from the line of Mark Kelleher with D.A. Davidson.

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Mark Daniel Kelleher, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [43]

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I want to go back to the datacom side. Could you just kind of clarify what your strategy is to differentiate on the datacom side? Is that a market you're leaning to? Is that something that faster speeds will lean into your strength? What exactly are you thinking about on the datacom side?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [44]

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Yes. So from a datacom standpoint, we're very excited about the market opportunity because there's an awful lot of volume that ships in that market, both between datacom and wireless. The real challenging puzzle to figure out has been profitability, particularly at the transceiver level over the past several years. So what we think the Oclaro acquisition brings to us -- there's a couple of things: First is meaningful chip sales, which is operating at a different level in the sort of ecosystem or food chain, if you will, where it may not have the same kind of rapid price reductions et cetera, that are occurring at the transceiver level because there's fewer competitors than there are at the transceiver level. There's also much more significant barriers to entry and a much more focus on leading-edge technology. So as you said, as we look to higher and higher speeds or lower and lower power consumption at a given speed or wider environmental operating range, those are all things that play into now the combined company strength. With world-class chip capabilities, if there's a way to make money at the transceiver level then we expect with that chip capability, we would be in the running as best as anybody else could be at the transceiver level. That remains to be seen, obviously, because we also have to see what the competition is doing and where prices land in that space. So again, our strategy is to focus on where we have the best technology, lead with that, and then choose where to play in the market where there are a bit -- an ability to make money.

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Mark Daniel Kelleher, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [45]

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Okay. And then as a follow-up, what chips exactly are you thinking about? Are those photonic integrated circuits? Are those DSPs? What chips?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [46]

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So these are lasers, so either directly modulated or EMLs, electro-absorption modulated lasers as well as some receiver products to transmit and receive indium phosphide chips.

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Operator [47]

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Our next question comes from the line of Rod Hall with Goldman Sachs.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [48]

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I guess, I wanted to start on lasers' margins and just see, I know you said that you think that eventually could get to 50%. Could you just comment on kind of whether that's still reasonable to think, it eventually gets there? And what sort of trajectory it might have? And then I have a follow-up to that.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [49]

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Sure, Rod, this is Alan. Yes, I think that there's a clear path to 50% gross margin on lasers. Part of it has to do with volume, obviously, but part of it also has to do with the mix between fiber laser and our micromachining business where typically in the fiscal Q1 and Q2, the micromachining revenue is low. And so as that comes up and has higher than average lasers' gross margin, that will pull up the gross margin of lasers overall. I'd say that as we continue to move more and more of our laser-diode packages into our own factory in Thailand, we're seeing cost reductions that you saw part of the benefit in the gross margin improvement in fiscal Q2. We're going to continue to see that as we drive costs down. That will also help our gross margin. So I think that the combination of driving costs down on fiber laser as well as a mix towards additional micromachining should get us there before the end of the fiscal...

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [50]

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Okay, Thanks, Alan. I wanted to come back to the 3D sensing in the guide and just check the pricing situation. I mean, we would anticipate like 10% year-over-year declines. Is that sort of in the ballpark of what you're seeing? Or is pricing, particularly in the big, big sole, we're interested in what's happening with the pricing trajectory? And also, I'd be interested in your thoughts on inventory like how much module inventory might be out there? Is that perturbing the guide?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [51]

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Yes. I'm reluctant to be talking about our 3D sensing pricing, given that I'm sure our competitors are listening to this call. So you can imagine prices go down over time and whether that's low single digits or in the double digits, I'll let you be the judge of that. As far as module inventory, we really don't have much visibility of that, both at the module integrators as well as at the next step in the process. So I will say that we're shipping units today and so it gives me visibility that they're continuing to build new modules, but that it's hard to extrapolate anything else other than that.

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Operator [52]

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Our next question come from the line of John Marchetti with Stifel.

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John Warren Marchetti, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [53]

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Maybe just a quick follow-up on that inventory side. You had obviously a big jump in your inventory levels at the end of the quarter. Curious as to how much of that maybe comes from the addition of the Oclaro business coming in? And then how much of that is 3D sensing or VCSEL inventory that didn't sell through, given some of the cuts that you've seen at your big customer?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [54]

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Yes, so John, this is Chris. There's very little or immaterial change in 3D sensing inventory on our balance sheet. What you're seeing is a combination of both the Oclaro inventory as you would think about it coming over as well as the accounting associated with the acquisition where that inventory is stepped up in value. So that causes the inventory value to swell with it.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [55]

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I'd say the only inventory build that we're having is as we wind down our Chinese based contract manufacturer, we're building up some inventory to be able to move that equipment into Thailand and not disrupt the ability to supply our customers. So there was high single digits of inventory growth, but done on purpose to make sure that we make an orderly transition to our factory in Thailand.

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John Warren Marchetti, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [56]

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Got it. And then maybe just as a follow-up, for Chris. How should we think about sort of the normalized OpEx levels here, as we look to the back half for the fiscal year? Just trying to get a sense for, obviously, we had a partial contribution in the December quarter, but just trying to think of where we're from an expense perspective as we start to think about the second half of the fiscal year?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [57]

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Yes. So we really only guide one quarter a time. And obviously, as we look to attain synergies, which will bring down our operating expense. So I think, you can impute from our guidance what the operating expenses are and then you have to make some assumption around synergies for the next quarter. So we don't have a good answer on being able to provide guidance for operating expenses out in Q4 and beyond.

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Operator [58]

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Our next question comes from the line of Jun Zhang with Rosenblatt Securities.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [59]

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So could you talk a bit about VCSEL content in existing clients and the potential Android clients? And also could you share with us about the VCSEL competition landscape in the Android markets?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [60]

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The what market?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [61]

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Android market.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [62]

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In Android.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [63]

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Yes. Well, it varies depending upon what type of 3D sensing and whether it's world-facing, front-facing or both. So I would say that in the Android environment, it ranges from single-chip content to what I would expect in calendar '19, 2 to 3 potential chips that could drive additional content per device or additional dollar content per device. From a competitive landscaping standpoint. In the Android market, it's a little bit different as we see the cast of people that currently have volume 3D sensing at the Android customers, it's a little bit different than we have with our lead customer. But I mean, they are all capable, I think, eventually and will -- I think, the key to our differentiation is pushing technology and allowing our customers to do something unique that they couldn't necessarily do with last year's technology.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [64]

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Sure. So you mentioned that some of your existing clients might see a content growth this year. So do we expect meaningful change in the content this year? Or counting to next year for your existing client base?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [65]

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Well, I think based on our design work with our customers, there are many that are working on world-facing time-of-flight high-powered VCSELs that when they announce them in the products, that will increase the content per device. I can't tell when they're going to do it or what models they're going to do or if they're going to do it on a single high-end model, or if they're going to put it on a range of products. We're just focused on making sure that when they do announce a product, it's with our VCSEL and with our solution that gives them something that's unique.

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Operator [66]

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Our next question comes from the line of Tom O'Malley with Barclays.

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Thomas James O'Malley, Barclays Bank PLC, Research Division - Research Analyst [67]

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I guess, I'll start with the organic live data service. So it was down 45%, and then it's guided down again. You guys have talked about some strategic decisions with the business. Can you first update that? And then further, could you see some gross margin uplift from the product pairing with Oclaro? And what does the profitability of that segment look like at these levels versus where it could go in the future?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [68]

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Hey, Tom, can you clarify, are you referencing the datacom business?

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Thomas James O'Malley, Barclays Bank PLC, Research Division - Research Analyst [69]

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The datacom business.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [70]

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And for clarity, our just reported Q2 was Oclaro plus Lumentum datacom business not just the organic business. But to your question, they're both going down quarter-over-quarter.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [71]

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Sorry Tom, go ahead.

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Thomas James O'Malley, Barclays Bank PLC, Research Division - Research Analyst [72]

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Go ahead, just following up on the gross margin uplift of that business.

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [73]

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Yes, so, yes, these products are low, low gross margin. So certainly any -- either improvement through having a better product and replacing the low-margin products or pruning out low-margin products is going to result in gross margin uplift, overall, for the company. With that said, that's obviously got to be balanced with ensuring that if we were to prune products that we don't leave any overhead -- overhang of overhead, if you will. But I don't think that's going to be a challenge, but that's something, we just have to keep an eye on.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [74]

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Yes, I think just to add to that. As we continue to grow out chip business, that will be a good bump to the gross margin and datacom. And then we're continuing to work on driving lower-cost 100 gig transceivers and 400 gig next generation transceivers to the market. So the combination of bringing in new products and driving higher levels of chip sales should drive gross margin on the datacom business in the right direction.

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Thomas James O'Malley, Barclays Bank PLC, Research Division - Research Analyst [75]

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That's helpful. And then just as follow-up, your guide implies, I think, a slightly higher tax rate than expected, I think about 6%. I mean, you kind of walked us through the moving parts there. Can you talk about the expected run rate there for June? And do you still expect that rate to move up slightly into '19?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [76]

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Yes. I think, the rate might be a little lower than -- but that's in the ZIP Code. I would not expect, on a relative basis, that to change going into the fourth quarter.

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Operator [77]

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Our next question comes from the line of Tim Savageaux with Northland Capital Markets.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [78]

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You'd mentioned briefly with regard to China, I think, that obviously, there's applications across the board. The ACL platform, which, historically, is a pretty important part of the Oclaro franchise. I wonder, if you could talk about kind of trends in that product line, both focused on DCI and metro markets? And then maybe step back to address the overall cloud opportunity, maybe differentiating between data center interconnect, trends that we're seeing basically inside versus outside the data center, both your exposure to those via the ACO platform and how that might evolve heading forward?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [79]

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Yes, so Tim, I would say the way we think about it is the following that the ACO platform that you reference, certainly has a lot of customers today, either buying mostly at the module level, in some cases at component level. The product roadmap though is to aggressively ramp DCO products across the existing ACO customer base as well as many other customers that have not adopted ACOs. ACOs certainly are a little bit more complex for a customer to adopt in that they have to have a DSP, and integrate the DSP with the ACO. So we see the industry en masse shifting towards DCO over the mid to long-term, and we're very well positioned both with the lower speed 100 gig, 200 gig as well as 400 gig, looking forward over the next few years. In terms of -- I said across the customer base, thinking generally of the telecom NIMs, but as you've highlighted, there's certainly the cloud customer base, who very much look to DCO modules as a great way for them to get their coherent solutions without having to be experts in integrating DSPs and ACO modules or building modules themselves, buying components. And so there's definitely an emerging market here between the cloud guys, primarily for DCI.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [80]

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Great. If I could follow up just to wrap up. We've covered kind of overall demand trends in China on the telecom side and they look, I guess, perhaps surprisingly strong. Wonder if you could make sort of any similar comments about more carrier metro long-haul focused markets outside of China and your North American and European OEM customers, whether you see similar trends relative to some of the growth you're looking at in China or how you would characterize that relative to your overall telecom growth?

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [81]

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Yes, I'd say that we're seeing broad demand growth, North America, Europe and anecdotally throughout Middle East and Africa with respect to the products where we've clear leadership, ROADMs, next-generation transmission components and ACOs and DCOs. So it is a broad range of demand that, I think, is a combination of just pure market growth. But in addition to that, I believe we're gaining significant share with our leadership capability and the things that we talked about earlier. So I think the combination of the two are driving our top line telecom transmission and transport.

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Operator [82]

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And our next question come from the line of Troy Jensen with Piper.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [83]

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Just a follow-up on that last question, Chris. Could you give us a timeline for when you expect to have the DCOs generally available?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [84]

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We expect to be ramping those this summer.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [85]

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Is that shipping samples or generally available?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [86]

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I would say generally available.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [87]

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All right, perfect, and just a follow-up on that. Do you expect to use multiple DSP partners? Or would you be standardizing on just one?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [88]

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We have multiple DSP partners. Certainly, we've got a lead partner that's a very public relationship.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [89]

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All right. Then my last question to you, it's been a while since we got an update from Oclaro in their 400G lasers. And the same question line, when do you expect the lasers to be generally available?

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Christopher W. Coldren, Lumentum Holdings Inc. - Senior VP & Interim CFO [90]

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I don't think we want to talk about -- that's a competitive product for sure, but it's something that we expect to be a leader in, in that.

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Operator [91]

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And there are no further questions at this time. I'll turn the call back over to Alan Lowe.

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Alan S. Lowe, Lumentum Holdings Inc. - President, CEO & Director [92]

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Thank you, Matthew. I want to thank our customers for their business and partnership. I also want to thank our employees for their hard work and putting us into an excellent position for long-term growth. We regularly discuss our business in Investor Relations events. These events are listed on our website in the Investor Relations section and are regularly updated. This concludes our call for today. We would like to thank everyone for attending, and we look forward to talking with you again in another few months. Thank you.

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Operator [93]

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This concludes today's conference call. You may now disconnect.