MACOM Technology Solutions Holdings Inc

NASDAQ:MTSI

Earnings Call Transcript 2018-Q1

[Operator]

Good afternoon, and welcome to MACOM's fiscal first quarter 2018 financial results conference call at this time all participants are in a listen only mode. At the conclusion of today's conference call, instructions will be given for the question-and-answer session. As a reminder this call is being recorded today, Tuesday, February 6, 2018.

I will now turn the call over to Steve Ferranti, Vice-President of Investor Relations at MACOM. Steve, please go ahead.

[Stephen Ferranti, MACOM Technology Solutions Holdings, Inc.]

Thanks, Brian. Good afternoon, everyone, and welcome to MACOM's fiscal first quarter 2018 earnings conference call. Joining me today are MACOM's President and Chief Executive Officer John Croteau and Senior Vice President and Chief Financial Officer, Bob McMullan. If you have not yet received a copy of the earnings press release, you can obtain a copy on MACOM's website at www.macom.com under the Investor Relations section.

Before I turn the call over to John, I would like to remind everyone that management's prepared remarks and answers to your questions contain forward-looking statements which are subject to certain risks and uncertainties. Because actual results may differ materially from those discussed today, MACOM claims the protection of the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

For more detailed discussion of the risks and uncertainties that could result in those differences, we refer you to MACOM's filings with the SEC including its current report on Form 8-K filed today and its annual report on Form 10-K filed on November 15, 2017. Any forward-looking statements represent management's views only as of today, February 6, 2018, and MACOM assumes no obligation to update

these statements in the future.

The company's press release and management's statements during this conference call will include discussions of certain adjusted non-GAAP measures and financial information including all income statement amounts and percentages other than revenue unless otherwise noted. These financial measures and a reconciliation of GAAP to adjusted non-GAAP results are provided in the company's press release and its related Form 8-K which was filed with the SEC today and can be found at the Investor

Relations section of MACOM's website. And for those of you unable to listen to the entire call at this time, a recording will be made available via webcast for at least 30 days in the Investor Relations section of MACOM's website.

And with that, I'll turn over the call to John for his comments on the quarter.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Thank you, Steve. Welcome everyone, and thanks for joining us today. I'll begin today's call with an overview of our first quarter results for fiscal 2018 followed by a review of our current end market conditions and near-term business trends. I'll then turn the call over to Bob McMullan, our CFO, who will review our financial performance in further detail. I'll conclude our prepared comments by providing an update on key business developments related to our long-term secular growth drivers before wrapping up with guidance for the fiscal second quarter of 2018.

Jumping right into the numbers, revenue for the fiscal first quarter was $131 million, coming in at the lower end of our guidance. Overall, Q1 demand was mostly in line with the expectations that we had factored into our guidance. Looking back, Q1 was obviously a challenging quarter across the board as we dealt with the full impact of the geopolitical downturn in China. Perhaps more importantly, we believe that December was indeed the bottom of the cycle at least for our particular mix of businesses in China.

Our Q2 revenue guidance reflects an expected recovery of demand within certain end markets in China. While it's still too early to call the exact slope of this recovery, we do expect that demand will progressively strengthen through the remainder of FY 2018. Looking at some of the moving parts, first in telecom, telecom revenue was down quarter on quarter and declined 39% year-on-year driven by softness in China network infrastructure spending across our served markets. We believe that recovery is underway in our telecom business in Q2.

Most prominently thus far in Q2, we have already seen recovery in orders in backlog in PON and fiber backhaul which were among the hardest hit during the depths of the recent downturn. This combined with lean channel inventories has led to a point where we are now supply constrained for

the March quarter across all of our laser product lines. In the near-term, our priority will be on maximizing short-term returns. Looking forward, we expect output to increase throughout 2018 with capacity expansion and supply chain improvements across all of our laser product lines.

In metro long haul, we have also seen some recovery off the bottom, albeit modestly, transceiver customers in China who service domestic and global demand. We believe customers are burning through remaining pockets of inventory, placing orders for first half delivery, and are forecasting 15% growth in port count in 2018. While we clearly see improvement in China, we are also seeing a shift in carrier spending that we believe will moderate the slope of metro long haul recovery through 2018.

First, in our coherent driver and TIA portfolio, there's a shift in demand from long haul form factors to lower cost metro CFP products as carriers push 100G out toward the edges of their networks. Customer

forecasts for these metro products show higher unit volumes but significantly lower ASPs thereby softening projected recovery of our metro long haul business this year.

Second, in our telecom OSA products, we're seeing a transition from LR4 to lower cost CWDM4 as carriers shift focus to 5G. While we expect this will be a favorable for MACOM in the medium to long-term, in the

short-term, it too will moderate recovery of our metro long haul business this year. The net effect is that we expect our core business in metro long haul networks to recover but with a different mix and at a more gradual pace through 2018 than we had previously anticipated.

Moving to data centers, data center revenue was down sequentially but up 107% year-over-year. As most of you know, there were two major elements to our data center business. The first comprised of legacy OTN framers and mappers, the second being our 100G portfolio of high performance analog components, lasers, photonic chips and PHYs for Cloud Data Centers.

Looking at each of these separately, our legacy portfolio declined sequentially in Q1, driven by a combination of the pause in China as well as sluggishness in other regions where telecom grade OTN routers are being displaced by enterprise grade switches. Looking ahead, we anticipate recovery in this

Business, driven by new OTN deployments in Asia Pacific.

Overall, we expect this legacy data center business will remain lumpy and see gradual recovery from the Q1 baseline. In our Cloud Data Center portfolio, demand for 100 gig connectivity remains robust and we expect 2018 to be another strong year for 100G port growth. CWDM is becoming the technology of choice in DCI and campus networks for reaches ranging from 500 meters to 10 kilometers. Below 10 kilometers, CWDM4 is displacing higher priced LR4 modules similar to what is happening in

telecom market.

On top of this, the market is rapidly undergoing a sea change as cloud service providers begin to consolidate their supply chains around certain high volume manufacturers enabled by silicon photonics solutions. While we expect both of these factors to be unequivocally positive for us in the medium to long-term, in the near-term, the resulting ASP declines are expected to moderate overall SAM growth for our components business, which has been at the heart of our 100 gig data center revenue to-date.

We expect this scenario to improve as we ramp our own CWDM silicon photonics platform through the course of this year. I'll talk more about that later in the call when I address longer term growth prospects.

Finally, Industrial and Defense was $40.7 million for the quarter. This part of the business played out largely as expected with Q1 revenue being down sequentially off an exceptionally strong Q4.

With that, let me turn it over to Bob to review our fiscal first quarter financials in further detail.

[Robert McMullan, MACOM Technology Solutions Holdings, Inc.]

Thank you, John, and good afternoon, everyone. I will review MACOM's fiscal first quarter results and financial position. Revenue in the first fiscal quarter was $131 million, declining 14% year-over-year and down 21% sequentially. Revenue by end markets in fiscal Q1: telecom $55 million and 42% of revenues, down 39% year-over-year; data center $35 million, 27% of revenues, up 107% year-over-year; Industrial and Defense $41 million and 31% of revenue, down 6% year-over-year.

Non-GAAP gross margin and gross profit in the fiscal first quarter was $70 million and 54% of revenue, respectively compared to $87 million and 57% of revenue respectively year-over-year and $97 million and 58% respectively on a sequential basis. Gross margin is highly influenced by product mix and the associated gross profits. As our telecom and data center product revenues decline, our gross margins were negatively affected.

In terms of operating expenses, total non-GAAP operating expenses were $57 million, compared to $46 million year-over-year and $59 million sequentially. Adjusted operating expenses were up 24% year-over-year and down 3% sequentially, as we aggressively managed through expense controls. Adjusted R&D and SG&A expenses were $36 million and $21 million respectively in the fiscal first quarter.

Non-GAAP income from operations and operating margins were $13 million and 10% of revenues, down 67% in dollars and 62% on a percentage basis respectively year-over-year, and down 65% in dollars and down 55%, or 1,310 basis points respectively on a sequential basis. Net interest expense was $6 million, flat with fiscal Q4. Our normalized non-GAAP income tax rate in the fiscal first quarter was 8%, in line with guidance.

As the cash taxes in our fiscal first quarter, we had cash payments of $4 million associated with our Japan operations, where we're working to minimize future tax exposures. Briefly on the new U.S. tax law, our significant net loss carry-forwards will reduce our accumulated foreign earnings and profits to zero, negating any tax liability and payments. Going forward, the new law allows for full deductibility of capital expenditures in the year paid, which we expect to decrease MACOM's U.S. taxable income.

Our fiscal first quarter non-GAAP net income and EPS were $7 million and $0.10 per fully diluted share, respectively, decreasing from $32 million and $0.57 year-over-year and $30 million and $0.46 sequentially. Non-GAAP net income decreased 79% year-over-year and 78% sequentially. Non-GAAP EPS decreased 82% year-over-year and 78% sequentially.

Adjusted EBITDA or earnings before interest, taxes, depreciation and amortization was $21 million, down 57% from $48 million in our fiscal (sic) 2017 first quarter and down 56% from $47 million sequentially. GAAP cash flow from operations was $0.5 million, including acquisition related cash payments of approximately $4 million.

After deducting capital expenditures and excluding acquisition related payments, adjusted non-GAAP free cash flow was negative $9 million and negative 140% of non-GAAP net income in the fiscal first quarter, compared to $15 million and 49% of non-GAAP net income in the fiscal first quarter of 2017 and $7 million and 25% of non-GAAP net income sequentially, also after excluding acquisition related payments.

Now to MACOM's balance sheet. At fiscal first quarter end, our cash, cash equivalents and short-term investments were $197 million, down from $214 million last quarter, accounts receivable were $97 million, down from $136 million sequentially. Days sales outstanding improved to 68 days compared to 74 days. Inventories were $143 million, up 5% from $136 million sequentially. Inventory turns declined to 1.7 times compared to 2.1 times. Long-term debt was $680 million inclusive of capital leases. We also have $160 million of availability in an undrawn credit line.

Capital expenditures in the fiscal fourth quarter were $14 million or 11% of revenue compared to $8 million, or 5% of revenue sequentially. Our capital expenditures are directed to increasing capacity to fulfill expected customer demand for our GaN on silicon and silicon photonic products. Depreciation expense was approximately $7 million as compared to $7 million sequentially. Our investments in capital expenditures exceeded our current level of depreciation, reducing our free cash flow by $7 million.

Back to you, John.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Thanks, Bob. Turning to the longer term secular drivers for our business, as mentioned in my earlier remarks, coming out of the downturn in China, we do see a shifting market landscape in product mix for our telecom and data center businesses in 2018 and beyond. I'd like to spend a few minutes discussing these trends in more depth.

I'd like to start by sharing a conversation I recently had with the founder of one of our large network customers. He shared with me his vision of data center connectivity, and his view of the current lay of the land. In his words, he thought the industry is just now entering a golden age of optical connectivity. I found that comment fascinating, especially now at the bottom of this cycle, amidst the geopolitical pause and associated inventory correction. But I get it. His vision mirrors what we outlined in our Cloud Data Center forums back in May. He then shared with me his industry forecast model, which shows port count increasing in a 30% compound annual growth rate. Bandwidth through those ports is increasing at 100% compound rate or doubling each year, in other words, moving right into our wheelhouse.

MACOM is poised to be a major beneficiary of the corresponding upgrade from 10 and 40 gig to 100 gig CWDM and single-Lambda PAM-4. That's why we still firmly believe that the opportunity for our company and Cloud Data Centers will be transformative over the next several years. We're facing unprecedented growth in port count in both concentrated Cloud Data Centers and soon distributed edge computing architectures for 5G Telecom. I'll talk about that next.

There is tangible economic demand behind those build-outs in new services like IoT, virtual reality, augmented reality and artificial intelligence. These services and build-outs will fuel industry growth for the next decade to come. Optical is a key enabling technology in this future, and there are firm technical requirements underpinning that demand that are rooted in reduced latency, increased bandwidth and improved quality of service.

That brings me to the reason why I'm so passionate about MACOM's long-term prospects in Cloud Data Centers and 5G Telecom against the backdrop of the current optical environment. We're building a semiconductor caliber supply chain with wafer scale laser manufacturing, silicon photonics with automated assembly and the supporting high performance analog and mixed signal portfolio that can support the cost structure and scale to enable these new optical mass markets. In fact, every cloud service provider in every major network OEM we work with resonates with that vision. And it's those customers that inform and fuel my passion behind MACOM's long-term prospects in this area.

Ultimately, the pace at which we scale data center revenues in 2018 will be determined by how quickly we and our transceiver customers ramp production. Today that ramp is limited by conventional discrete transceiver designs. Our proprietary silicon photonics L-PIC technology is poised to accelerate that ramp with the potential to dramatically reduce transceiver production times and increase manufacturing output. To that end, this quarter we successfully expanded our partner engagements for CWDM and PAM-4 solutions adding both new networks OEM customers as well as additional low cost manufacturing partners.

Now over to telecom side of the business. Telecom carriers are clearly shifting capital investment this year to building out 5G networks both optical and wireless, creating what we expect will be a long-term breakout in our telecom business much akin to Cloud Data Centers.

To handle the massive increase in network data traffic ahead, some say by as much as 100X, emerging 5G network architectures are relying more heavily on high speed optical interconnects from the network backbone, through the baseband processing, all the way to the antenna. Some call this fiber to the antenna. In these front haul applications, copper cabling running from the base stations to the antennas will be upgraded to optical and existing 100 gig transceivers will be upgraded to higher speeds. And for backhaul, new fiber deployments will be pushed deeper into the network with the majority at ranges below 10 kilometers, well within the capability of our L-PIC technology.

We anticipate that our same CWDM and PAM-4 L-PIC solutions that we've developed for Cloud Data Centers have an equally large opportunity in 5G networks with distributed edge computing. In this way, 5G Telecom networks are evolving to look more like Cloud Data Centers, which have built extensively on a high speed, low latency optical framework. Telecom operators see tremendous benefit as it allows more efficient sharing and pooling of network processing resources, much like server racks inside a hyperscale data center. That's why we expect 5G to be a strong secular growth driver for our telecom business moving forward.

At the same time, we can't overlook the wireless side of 5G, which is also moving into our wheelhouse. New antenna designs and the corresponding migration from 4 to 4.5, 4.9, and ultimately 5G, plays to all of our strengths as a company and is expected to expand our SAM geometrically over the next 5 to 10 years cycle of network build-outs. Everything from active beam forming techniques in massive MIMO arrays to GaN on silicon power amplifiers and MIMICs to our ability to embed optical connectivity directly in the antenna.

Let me close on 5G by clarifying our expectations as to the timeline. Carriers and our OEM customers are working on deterministic schedules, making technology product and vendor selections today. Field trials are expected this year and field deployments will begin next year. Our planned roll-out and ramp up highly differentiated proprietary products and technologies like L-PICs and GaN on silicon will ride this wave for many years to come.

Before wrapping up, as many of you saw today, we announced an agreement with ST for the manufacture and supply of GaN on silicon wafers. This addresses the third and final leg of our GaN growth strategy, installing the requisite supply chain to bring GaN mainstream across all parts of the wireless base station market, 4G LTE as well as 5G.

To-date, we've worked diligently to validate and prove GaN on silicon technology in base stations, first in amplifier performance and most recently in reliability to support the requisite decades of operating life in the fields. That yeoman's work is effectively complete in the eyes of our customers. Our collaboration with ST is expected to have the scale, cost structure and frontend wafer supply chain which we believe will uniquely position MACOM to become a top-tier supplier servicing the roughly $1 billion market for 4G LTE power amplifiers.

Better yet, we expect the ST collaboration to unlock the biggest commercial opportunity yet, massive MIMO antennas for 5G. As antennas transition from two or four MIMO channels to 64 element massive MIMO arrays, the cost per channel of power amplification must undergo radical improvements over conventional GaN on silicon carbide technology, otherwise 5G antennas will not be commercially viable in volume. Based on conversations I've had recently with some of the biggest customers, I believe they view the MACOM ST collaboration as solving a major supply challenge that they're facing for GaN and for 5G. Like for L-PIC technology, we believe GaN on silicon sourced from ST will play a key industry-enabling role in realizing the potential of 5G networks and that MACOM will be the exclusive supplier with a fundamental intellectual property position.

In summary, we're encouraged to see the early signs of market recovery, albeit modest, following last year's industry-wide downturn. We expect that recovery to progress through the better part of fiscal 2018. For that reason, we view FY 2018 as being a transitional year in our served markets. As demand comes back, the technology landscape is shifting an anticipation of the next major wave of infrastructure investments in both Cloud Data Centers and 5G Telecom. While near-term these shifts will likely moderate the pace of recovery, they're leading to much, much bigger breakout opportunities that play directly to our strengths.

Looking ahead, we will continue to invest aggressively this year in bringing L-PIC and GaN programs to fruition, programs that are today backed by industry leading customers. We expect these investments over the course of FY 2018 to usher in the next phase of MACOM, in which we monetize what previously were strategic investments anticipating future technology disruptions. We believe these technologies are now poised to enable major industry transitions that are now clearly underway. Simply put, MACOM will be an active participant, not a casualty in these targeted areas of secular industry growth.

Now let's talk about next quarter guidance. For the fiscal second quarter ending March 30, 2018, we expect revenue to be in the range of $142 million to $150 million. Adjusted gross margin is expected to be between 50% and 54%, and adjusted earnings per share between $0.10 and $0.16 on an anticipated $66 million fully diluted shares outstanding. It's worth spending a moment to provide additional color on the March guide.

In the December quarter, we believe we saw the bottom in terms of market demand and revenue. Entering the March quarter, we expect Q2 will be the bottom for gross margin mix as we anticipate in coming quarters, progressive recovery and growth in the higher margin parts of our portfolio. Longer term, we are still committed to our target of delivering 60% adjusted gross margins.

Operator, you can now open the call to questions.

[Operator]

And our first question will come from the line of Blayne Curtis with Barclays. Your line is now open.

[Blayne Curtis, Barclays Capital, Inc.]

Hey, guys. Thanks for taking my question. Maybe just starting with gross margin, I just want to understand the mix of the moving pieces here. Obviously, mix has a little impact, but it didn't shift that much. And then, John, you talked about some issues in terms of mix within products that kind of lower margin and I'm just trying to understand, is that just getting started or kind of how do you think about – I know you expect gross margins to recover, I'm just trying to understand that slope. Are those transitions just starting or has that all kind of happened and then you can grow from the space? I'm just trying to understand all the moving pieces.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yes. Good question. So there was part of the gross margin mix, which was fully expected and then a development within the quarter, which was unexpected. So the part that was expected is, hey, at the bottom of the cycle, it's never uglier than that point. So the part that was expected was the hardest hit in the downturn was among our highest margin part of our portfolio.

The thing that happened that we didn't anticipate was the transitioning from LR4 to CWDM, which impacted two things. One is SAM compression, so there was simply business that was lost from our customers to CWDM solutions, so there's SAM compression. The second is ASP erosion, so CWDM is much lower priced than LR4.

And we had a very nice business in LR4, which has suffered within the quarter and we expect that to bottom out in the second quarter. That was my last comment about being the bottom. We absolutely see everything being up from that point. This is really the bottom point for that LR4 impact, but the growth that we're anticipating is all in the high margin stuff.

[Blayne Curtis, Barclays Capital, Inc.]

And then, John, just on that CWDM4, you've been looking to win some big projects, maybe just give us an update. But then more importantly, as that market gets more competitive, even if you do win it, would that be accretive or dilutive to gross margin going forward?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yes. Believe it or not, it's all rooted in our laser position and specifically the silicon photonics. So the current generation of CWDM4 is largely discrete TOSA designs, optical subassemblies. So you have discrete lasers and then separate MUX/DEMUX type functions on the TOSA and the ROSA. What's happening right now is specifically silicon photonics based solutions are both driving price compression on CWDM4. Secondly, they're getting up to 10 kilometers reach. At 10 kilometers that's where LR4 thrived. And what we see is in the telecom side of things, not just in the data center side, CWDM coming in and it's really kind of a precursor to what's developing where CWDM4 looks to be central figure for 5G.

So that's where my commentary about our L-PIC ramp is so critical because a couple reasons. One is cost and margin. We've got a fantastic cost structure for that product. But I think more importantly, the ability to scale volume because the manufacturing throughput and manufacturing output goes way up when you talk about that automated assembly. That's always been our L game and that's exactly where we're in the process of ramping right now this year.

[Blayne Curtis, Barclays Capital, Inc.]

Got you. And then just a quick one for Bob, the inventory levels are up large amount on days but even on absolute dollar amount is I think the highest you've had. So if you just talk about why the inventories are so high and how you're going to manage them back down?

[Robert McMullan, MACOM Technology Solutions Holdings, Inc.]

Well, again, even to the extent of lower revenues, we still ship a large quantity of products, over 2,000 units in the different product numbers. And most of our inventory that increases is in raw materials like wafers and subassemblies that are ready to go as things turn around. Some of those commitments have long lead times, therefore we cannot cut them back as quickly as one would expect. They're not necessarily tied to the same vision of the revenue forecast. And I think we've hit the top here at this level of inventory that we'll see to probably stay even next quarter and down for the rest of the year. But it is really difficult to match the cycle times required to be in a position to ship the products that are ordered by the customers.

[Operator]

Thank you. And our next question will come from the line of Quinn Bolton with Needham & Company. Your line is now open.

[Quinn Bolton, Needham & Co. LLC]

Hey, guys. I wanted just to follow up on Blayne's question of gross margin. Are you guys seeing any impact from under-absorption when your revenues have been cut by 40%, 50% over the couple quarters, I would think that under-absorption may be a factor here.

[Robert McMullan, MACOM Technology Solutions Holdings, Inc.]

Quinn, certainly some of the absorption is higher now with lower revenues. But it's not a function of revenue, per se, it's a function of build. And some of that is reflected in the inventory levels as well. So it's not necessarily flowing through to the gross margin today and it's absorbed in some of the inventory levels. But it's really – absorption is not critical or really material to our overall gross profit. It's really product mix that drives gross margins.

[Quinn Bolton, Needham & Co. LLC]

Got it. Okay. Thank you. And then for John, you had mentioned capacity constraints on the laser side. I know probably back around the datacom sessions, you had said you were taking a lot of the PON laser capacity, switching it over to 25 gig data center laser capacity. Can you just give us an update when you talk about laser constraints, is it just that you shifted a lot of the laser capacity over the data center and therefore you're short on PON? Can you bring that laser production back to the PON space? Just what's going on in the laser production side of the business?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yeah, I mean what we started seeing developing in November was totally unanticipated recovery in PON, and as we had originally planned, we're kind of one of the last guys standing. So as the PON market recovers, that's actually very, very nice cash flow business for us. So where we had empty capacity before that we could focus solely on ramping data center product, we're moving back to a more balanced supply at this point, frankly, fixated on gross revenue per wafer. So maximizing short returns and also focusing to make sure we're sustaining the customers that are important for our strategy moving forward.

And there's some – believe it or not, there's some crossover. As you talk about 5G entering CWDM and PAM-4 over in China, some of the customers that we have high volume PON customers are actually becoming data center 5G customers. So it's not a simple answer, but the two things are optimizing short-term returns and then ramping capacity as quickly as we can to supply both. And when we're going to have a breakout in data centers this year, we have to feed as well as supplying the PON market.

[Quinn Bolton, Needham & Co. LLC]

So we shouldn't think that the laser production in PON is going back to that peak level you hit in 2016 of something like 5 to 8 million units a month. You're not anticipating that kind of recovery in the PON side. You're going to keep a fair amount of capacity on the 25 gig laser to support the data center business?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Actually, it is. It's snapping back to similar volumes as you thought. The ASPs are slightly down compared to what they were, but the demand has actually snapped back to the previous run rates, to our surprise. So between the 2.5 gig lasers, the 10 gig lasers, now the 25 gig lasers, we're pretty much constrained in all parts of the portfolio. And like I said, step one, when we saw the upturn in November, it was not an instantaneous supply situation because you have materials you've got to get in and order (00:34:54). So we didn't see the full impact on the March quarter guide. But as you get into the June quarter and beyond, we'll be clipping in terms of supply but at the same time, we're doing everything we can to ramp capacity in that timeframe and beyond.

[Quinn Bolton, Needham & Co. LLC]

Thanks for the color, John.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

You're welcome.

[Operator]

Thank you. And our next question will come from the line of Mark Kelleher with D.A. Davidson. Your line is now open.

[Mark Kelleher, D.A. Davidson Companies]

Great. Thanks for taking the questions. Just want to look at the R&D. You made some comments that you're going to be investing more this year. Kind of took a step up sequentially. Is this the new baseline? Should we be looking for a build from here? Was there anything unusual in the quarter? What should we be looking for operating leverage and R&D?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yeah. I wouldn't say it is definitely the new baseline. We have an interesting problem here. When I talked about the L-PIC programs and the GaN programs, we have a premier set of customer commitments that we're ramping programs, so we don't have the luxury of cutting back OpEx in those things, actually we're doubling down. We've made a lot of portfolio decisions internally to focus our investments very heavily in those two areas, well, I should say including 5G frontend modules. So between 5G, both on the transmit side with the GaN side as well as 4G LTE as well as the L-PICs for both Cloud Data Centers and 5G Telecom, 5G Optical, we're burning rich on OpEx and now is not the time to leave customers high and dry on that.

It's kind of an unfortunate timing that at the bottom of the cycle that we've got that demand. But the good news is these are all customer programs. I think the big difference in our R&D this year is we're focused on monetizing what previously were – could be called more speculative investments in technology transitions. Those are now turning into customer programs for revenue ramps through 2018 and 2019.

[Mark Kelleher, D.A. Davidson Companies]

Okay. And just a quick second question. Some of your partner programs that you're ramping with CWDM. I think you may have addressed this earlier, I missed it. But what's the gross margin profile? Does that help? Is that higher or lower than your average gross margin?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

So the OpEx will be at above our corporate target.

[Mark Kelleher, D.A. Davidson Companies]

Okay, great. Thanks.

[Operator]

Thank you. And our next question will come from the line of C.J. Muse with Evercore. Your line is now open.

[C.J. Muse, Evercore ISI]

Yeah. Good afternoon. Thank you for taking my question. I guess first question, trying to get a holistic view of what you're seeing in China. Would love to get an update on where we are in terms of excess inventory, demand and I guess as part of that, in terms of sort of the pressure we're seeing today. How much of that pressure is just working through inventory versus ASP pressure?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Well, I'd say in terms of the recovery from a unit standpoint, it's upon us. I used the example, we had a substantial laser business in PON and backhaul and front haul, and that's back. I mean that's back on strong, as I mentioned. So it's why I emphasized for our particular mix of businesses, we hit the bottom and we're seeing recovery. It's too early to call the pace of that recovery, but it's unquestionably going to be progressively stronger as we go through the year.

On the metro long haul stuff in terms of the China – the infamous China pause, I want to emphasize, we sell analog components, modulator drivers, TIAs, to Chinese transceiver customers. That demand, they have burned through much of the inventory. There's a little pocket of inventory left that they're burning through. We have seen recovery there. We have seen lifts in that business. We anticipate 15%. All of our customers have said, used the same number, 15% port count growth.

The moderating factors are important, though. There's a big shift stronger than what we had anticipated from long haul form factors to metro, so these are CFP and there's a very substantial difference in ASPs. Gross margin percentage is still quite good. In fact, very good, but the ASPs are profoundly different. So that produces an element a little bit of a SAM compression in that traditional part of our business.

And the reason why I said it's a transitional year is now we see the lift on the 5G side, the transition from LR4 to CWDM, which is placed right to our – the same products, CWDM4 and 100 gig PAM-4 showing promise to begin ramping in 5G over in China. So again, selling analog components, photonic components, lasers to Chinese manufacturer, servicing that local demand and quite likely global data center demand as well.

[C.J. Muse, Evercore ISI]

That's helpful. As my follow-up, Bob, could you talk a bit about given the call for fiscal 2018 to be more of a transitional year, how you plan to manage your cost structure over the near to medium term?

[Robert McMullan, MACOM Technology Solutions Holdings, Inc.]

So if we look to define the term as fiscal 2018, we are seeing – we feel good about a recovery in revenue. As the mix improves and new products come in, we will see a recovery in our gross margin. We do not forecast longer than the forward quarter, but I don't think as we see the visibility today that we get to 60% in fiscal 2018.

But we have critical programs that are underway that we're spending one, to increase capacity, to finalize quals, to get product in the customers' hands, all of which is increasing our expenses over the year in that backdrop. So I anticipate for the forward fiscal 2Q a modest increase in R&D and operating expenses here in the fiscal second quarter.

[C.J. Muse, Evercore ISI]

Very helpful. Thank you.

[Operator]

Thank you. And our next question will come from the line of Tore Svanberg with Stifel, Nicolaus. Your line is now open.

[Tore Egil Svanberg, Stifel, Nicolaus & Co., Inc.]

Yes. Thank you. John, I was hoping you could address a little bit more on the LR4 (00:41:59) When exactly will we go from these lower ASP partnerships to L-PIC? Because I know you're really ramping the capacity, but if you could give a little bit of a timeline, that would be really helpful.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yes. So the LR4, we've had a very nice business globally outside of China and Japan and North America for LR4, actually largely subassemblies, which have suffered some loss. Our customers suffered lost business, and then (00:42:36) they lost business to CWDM4 modules, specifically silicon photonics enabled, the silicon photonics enabled to 10 kilometer reach, which was not anticipated. So that's what the downside impact is.

On the ramp of the L-PICs, we are ramping our production, our capacity, as Bob said. I mean this is transformative unit volumes but just for Cloud Data Centers and the numbers are now shaping up for 5G Telecom and pulling in low cost Chinese manufacturers for those solutions. And each quarter through this calendar year, you'll see a progression of that coming to fruition.

Obviously, much stronger with the near the curve as you get into the second half of the calendar year. And it will continue to ramp, I believe, very aggressively as we ramp silicon photonics wafer supply. I think in terms of our product availability, that's going to gate what our products can do. We'll have enough laser capacity to populate those with flip-chip lasers, but it's really going to be the PIC wafers that'll be gating our production ramp. But we have customers piling on right now.

As bizarre as it sounds in this environment at the bottom of the cycle, whether it's laser supply or these L-PICs, we have kind of a feeding frenzy right now of people trying to get hands on product to be able to begin sampling their cloud customers and 5G over in China. So from a demand standpoint non-issue, but we're doing the best we can to ramp production of those products sequentially and progressively each quarter.

[Tore Egil Svanberg, Stifel, Nicolaus & Co., Inc.]

That's really helpful. And as my follow-up, could you also elaborate a little bit more on the ST partnership? When did we start to see some revenue production out of that partnership? And I assume there's no issues here with the IP litigation, right. So this is something that's going to materialize regardless of the outcome of that litigation?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yeah, actually, it's not unrelated. It's a very insightful question. Thanks for asking. So we've been working with ST for the past few years. That's who I was referring to over time. Very, very, very exciting partnership. I can tell you, given my background, I know the scale of manufacturing that's required to service base stations, an emphasis on required. We've been using modest compound semi factories like our Lowell factory to prove the technology in performance and field reliability.

But now ramping it at ST delivers the required capacity, surge capacity, cost structure that, frankly, is second to none. From a timing standpoint, I had hoped to be able to announce it sooner. The reason why we're holding off was we were in the midst of litigation. And on January 29, the Federal Circuit Court affirmed the ruling in Los Angeles District Court confirming that our contract is fully valid and fully in place, which grants us not just exclusive rights in our field of use, but also grants us sub-license rights.

So the relationship with ST involves a sub-license, enabling them to go off and develop the markets they care to develop. They'll be driving very high volumes in automotive, consumer, mobile applications and so on. They'll be benefiting from our volumes in wireless infrastructure where we reserve exclusivity. And I can tell you right now the cost structure in that supply chain is a fraction of the cost of the most mature LDMOS technology.

So the brilliant thing is we have the performance of GaN validated, field reliability proven, and now the supply chain that where you can drive the transition. I'll finish by saying we have wafers in line of the first high volume products that we believe will be delivering revenue. So this isn't speculative. This is tape-outs of proven products with proven customer demand servicing all the right guys. So like the L-PIC stuff, this year GaN is turning on, moving from speculative technology transition to monetizing those investments. So it's exciting time.

[Tore Egil Svanberg, Stifel, Nicolaus & Co., Inc.]

Very helpful. Thank you.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

You're welcome.

[Operator]

Thank you. And our next question will come from the line of Richard Shannon with Craig-Hallum. Your line is now open.

[Richard Cutts Shannon, Craig-Hallum Capital Group LLC]

Thanks, John and Bob for taking my questions. Maybe I'll ask a question on GaN. John, you had some interesting comments in your prepared remarks around the use of that technology, not only for power amplifiers but also on antenna arrays. Is the antenna arrays part of the opportunity here or is anywhere near the size of the power amps?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Its integer multiples bigger. So I was over in China two, three weeks ago. Met with the top sourcing guys at our customers. They quantified the number of antennas that they'll be shipping. And I should emphasize these are sub-6 gigahertz. These are not the millimeter wave small cell type devices. And if you do the number of antennas that they – base stations they anticipate deploying in China alone times the number of elements, it's integer multiples times bigger. So we view the GaN space 4G LTE growing to 5G as a growth market SAM expansion, not decline.

[Richard Cutts Shannon, Craig-Hallum Capital Group LLC]

Okay. That's helpful. Second thing, just a follow-up on the previous questions about data center. You're talking about a breakout happening this year. And it sounds like it's constrained by, if I gathered your response to that question, John, some internal things like wafer supply or something like that. I wonder if you could detail a little bit more and give maybe a little bit more precise timeframe by which those constraints will be relieved.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Well, I would say it's a hockey stick ramp quarter-to-quarter-to-quarter-to-quarter-to-quarter. When you say constrained by the – I mean everything has a finite ability, I mean this is hardware not software. So I would say silicon photonics wafers, if you look at where silicon photonics has been applied so far, and you look at the unit volume and wafer consumption, frankly, it pales by comparison to where we're now applying it, which is inside of data centers, inside these 5G networks and so on. I mean it's a much larger market for wafers than what has materialized to-date.

So we've been working with the top executives at our PIC wafer supplier, one of the known global foundries in the world. And quarter-by-quarter through this year, this calendar year, and especially into 2019, there's a very material ramp. Again, the exact shape of it, we're being very cautious not to frankly guide more than a quarter at a time. But there is not a demand issue whatsoever. We've got customers and end cloud customers who are chomping at the bit. And it's just a matter of getting that capacity in place and the wafers flowing and so on.

[Richard Cutts Shannon, Craig-Hallum Capital Group LLC]

Okay. That's helpful as well, John. The last quick question from me on PAM-4. Where do you sit in terms of qualifying your single end of the products here? What's your view on the ramp of that product line?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Yeah, so it's all gated by our lead customers. And I'm at a disadvantage because we're dealing with customers that don't appreciate us talking to the public about the status of their programs. But we have qualifications in process and we see fabulous opportunities at 100 gig. I would describe this as another area where we can monetize what previously were strategic investments. That's the way we view that area this year as well. I was very pleased. I had great – I referred to the meeting I had with a customer. I was talking about his vision of the data center market. And the comment he had was he expected a 10-year life in 100 gig single lambda. He's passionate about that and so on. So that's encouraging. And it's a matter of monetizing into the different configurations and products and market segments for that product portfolio. That's what this year's going to be about in that space.

[Richard Cutts Shannon, Craig-Hallum Capital Group LLC]

Okay. Appreciate that detail as well. That's all the questions for me, guys. Thank you.

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

You're welcome.

[Operator]

Thank you. And I'm showing no further questions at this time. So it's my pleasure to hand the conference over to Mr. John Croteau, President and Chief Executive Officer, for some closing comments and remarks. Sir?

[John R. Croteau, MACOM Technology Solutions Holdings, Inc.]

Sure. So before closing out today's call, I want to mention the investor events and trade shows that we'll be attending in the coming month, which includes the Goldman Sachs Technology and Internet conference on February 14 in San Francisco, Mobile World Congress in Barcelona on February 26 and 27 and OSC in San Diego on March 13 and 14. If you'd like to arrange a meeting at one of these events, please email us at [e-mail]. That concludes today's remarks. Operator, you may now disconnect the call.

[Operator]

Thank you, sir. Ladies and gentlemen, thank you for your participation on today's conference. This does conclude our program, and we may all disconnect. Everybody, have a wonderful day.