MACOM Technology Solutions Holdings Inc

NASDAQ:MTSI

Earnings Call Transcript 2019-Q2

[Operator]

Good afternoon, and welcome to MACOM's Second Fiscal Quarter 2019 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 conference call is being recorded today, Tuesday, May 7, 2019.

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

[Stephen Ferranti, VP, IR]

Thank you, Shannon. Good afternoon, everyone, and welcome to MACOM's second fiscal quarter 2019 earnings conference call. Joining me today are MACOM's President and Chief Executive Officer, John Croteau; and Principal, Financial Officer, Conor Hegarty.

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 turning 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, its annual report on Form 10-K for fiscal year 2018 filed on November 16, 2018, and it’s quarterly report on Form 10-Q for the fiscal quarter ended December 28, 2018 filed on February 6, 2019. Any forward-looking statements represent management's views only as of today, May 7, 2019, and MACOM assumes no obligation to update these statements in the future.

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

For those of you unable to listen to the entire call at this time, a recording will be 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 Croteau, President and CEO]

Thanks, Steve. Welcome, everyone, and thanks for joining us today.

I'll begin today's call with an overview of our second quarter results for fiscal 2019. I'll then turn the call over to Conor Hegarty, who will review our financial performance in further detail. I'll conclude today's prepared remarks by providing an update on our secular growth drivers and cloud data centers, 5 G telecom and Global and Homeland security including a more in depth discussion of our pending joint venture with Goertek to service the China 5G opportunity. And finally, I’ll close the call with guidance for the third fiscal quarter of 2019.

Jumping right into the numbers, consistent with our preliminary Q2 results that we provided on April 24, adjusted revenue for the fiscal second quarter was $121.5 million down 19% sequentially driven largely by broad-based weakness among our data center businesses.

Adjusted gross margin was 48.7% including an inventory charge of roughly $8 million that accounted for 600 basis points of negative gross margins impacts. Adjusted earnings per share was a loss of $0.18. That said, free cash flow was positive $13 million and our cash balance was up $6 million sequentially.

This was obviously a very challenging quarter on top of the forecast of softness in China and seasonality in our IND business, we had a number of unexpected headwinds which were rooted in the datacenter inventory correction that we discussed in our last earnings call. For much of 2018 the industry had faced the supply shortage as module suppliers struggle to keep up with demand for major cloud deployments. Service providers had put sustained pressure on their suppliers, our customers to expedite shipments during this period.

Earlier this year those plant operators clamped down on new orders in order to digest inventory. This has been well reported by the customers and peers across the industry. This heart stopping orders following a prolonged period of hyper growth created a [indiscernible] effect that has reverberated throughout the supply chain over the past few months.

To start inventories of our datacenter opponent stacked out their marginal vendors to levels well beyond what we anticipated 90 days ago. This resulted in a shortfall in product revenue, as compared to our original Q2 guidance.

Secondly cloud operators de-prioritize the qualification of ramp of new module suppliers, creating uncertain prospects for our white box solution’s customers. This entrance usually take the brunt of market downturns as incumbents leverage existing supply agreements to wind down inventory levels more smoothly. We do the exact same thing in product areas where we hold an incumbent position.

In light of these market conditions and soft backlog, we believe that prudent to record inventory reserves on certain datacenter products which were in the process of ramping. This resulted in a charge the cost of goods sold more than $8 million which accounted for a $0.12 hit to EPS and 600 basis points of negative gross margin impacts.

Excluding this unanticipated accounting adjustment, gross margin would have been close to the low end of our guidance range. It's worth noting that we did bring on a new solutions customer during the quarter. We collected the first tranche of cash associated with the initial milestones, but did not recognize revenue as we originally anticipated due to current market uncertainties.

We may or may not be able to recognize revenue at some point in the future so we're not factoring that into our Q3 guidance. I’ll get into this further at the end of my prepared remarks. The magnitude of this correction has been deeper and far more destructive than we originally anticipated. However, we believe we're at the bottom of the cycle and our customers remain optimistic for a strong rebound in the second half of the calendar year.

All of the underlying demand drivers for hyperscale productivity remain in place. Customer and market analyst forecasts called for a pickup in forward shipments in the second half of 2019 and again strong growth in 2020. I'll talk more about this later in the call along with our secular growth drivers.

We will now turn it over to Conor for more in depth review of our fiscal second quarter financials. I’d like to take moment to thank Bob McMullan for his service at MACOM. For the past five years Bob was instrumental in the rebuilding and reshaping our portfolio, for numerous acquisitions by divestitures and corporate financing transactions. We all wish Bob continued success in his future endeavors.

With that, I’ll let Conor go through the financials. Take away Conor.

[Conor Hegarty, Principal and CFO]

Thank you, John. Good afternoon everyone.

Adjusted revenue in fiscal Q2 was 121.5 million down 19% year over year from a $150.4 million. I’d like to highlight that our fiscal Q2 GAAP revenue includes $7 million associated with our datacenter solutions business. This amount was previously included in our non-GAAP revenue in the third fiscal quarter of 2018.

Accordingly this $7 million amount has been excluded from our fiscal Q2 2019 non-GAAP revenue. The revenue amounts and any associated percentages presented and discussed in our call today relate to non-GAAP revenue also referred to as adjusted revenue. Revenue by end markets industrial and defense was $50 million and 42% of total revenue up 15% year-over-year underlying with our forecast. Telecom was $47 million and 39% of total revenue down 26% year over year bottom line with our forecast.

As a reminder fiscal Q2 last year included our core revenue of $12 million. Datacenter was $24 million and 19% of total revenue down 44% year over year. This highlights the magnitude of the data center infantry correction. Adjusted gross profit and adjusted gross margin in fiscal Q2 were $59.1 million and 48.7% of revenue respectively which includes $8 million in inventory reserves primarily associated with datacenter materials or roughly 600 basis points of gross margin impact.

Total adjusted operating expenses were $63.3 million comprised of R&D expenses of 40.4 million and SG&A expenses of $22.9 million. Total adjusted operating expenses were up approximately $500,000 or 1% sequentially, adjusted loss from operations $4.2 million translating into negative 3% operating margin. Adjusted net interest expense was 8.4 million up $600,000 sequentially primarily due to approximately $400,000 of charges associated with leased equipment which is not expected to continue in the future periods.

Our non normalized adjusted income tax rate in fiscal Q2 continued at 8%. Fiscal Q2 adjusted net loss was $11.6 million translating into negative $0.18 per fully diluted share. The share count used to calculate fiscal Q2 adjusted EPS was 66 million fully diluted shares. Adjusted EBITDA our earnings before interest, taxes, depreciation and amortization was $3 million.

Moving up to cash flow. GAAP cash flow from operations was $24 million in fiscal year Q2 aided by reductions in networking capital of $26 million dollars. Capital expenditures in fiscal Q2 were $11 million or 9% of revenue and depreciation expense was $8 million. Free cash flow was $13 million up from negative $9 million sequentially due primarily to the improvements in working capital amounts.

Cash, cash equivalents and short-term investments were $192 million up from $186 million sequentially. Account receivable were $87 million, day sales outstanding were 66 days. Inventories were $120 million, inventory returns were 2.1 times down from 2.2 times sequentially.

Long-term debt was $686 million inclusive of capital leases. Long-term debt of $657 million is turned with minimal annual principal repayment until maturity in May 2024 and covenant lights. MACOM has an undrawn $160 million credit line available through November 2021.

Back to you John.

[John Croteau, President and CEO]

Thanks Conor.

For the remainder of my prepared remarks, I’ll provide an update on our secular growth progress, and why despite all of the near-term ugliness as is bullish as other, I mean opportunity for MACOM that lies ahead. The transfer opportunity set we’re ever positioned today than we were just 90 days ago.

Starting with Cloud Data Centers, the current inventory correction does not alter fundamental need to high speed connectivity in Data Centers. Cloud operators revenue streams and future growth initiatives are dependent on ultra high speed data links between server racks and across their datacenters.

As the timing is ample, last quarter Facebook in build its next generation hyperscalers technology called F16. It’s a group of massive growth of data traffic inside of its datacenters. F16 is designed to provide 1.6 terabytes of bandwidth of top of the rack switch based on 100 gigs CWDM building blocks.

There's architectural shift is expected to drive a 4x increase in the number of 100 gigs CWDM employees on Facebook while also providing a migration pass to 200 and 400 gig in the future. We expect other cloud customers to follow similar patterns.

This is an excellent example of why we continue to believe that 100 gig has long life cycle ahead. Customer forecast tell this out predicting strong growth for both 100 gigs CWDM4 and PAM-4 in the remainder of 2019 and 2010, while 200 and 400 gig on top of that demand starting next year.

MACOM remains extremely well positioned to capitalize on all of these trends. This year’s Optical Fiber Conference in San Diego was one of share event in terms of highlighting leadership and production readiness of our brand portfolio analog, DSP, laser and optic solutions for the quarter.

Our CWDM4DSP customer finely unveiled their new 100 gig PAM-4 transceiver at OFC. Center stage notebooks which was one of high rated traffic over its PAM-4 using our DSP. Most of you attended the conference and have a chance to see that demo to now appreciate the significance that customer describes that products for their overall kind of datacenter strategy. This is a really big deal for them and is a really big deal for the rest of the industry too. This is the first of several customers that are poised into production using our DSP.

Broadly speaking, DSP PAM-4 gain traction within those cloud operators with fiber infrastructure that’s rooted in PSM4. Initial 400 gig traction has been in the form of DR4, which much like PSM reach out floor single wavelength streams over four fibers to four 100 gig PAM-4 transceivers. That means four 100 gig transceivers will ship for each 400 gig transceiver another reason we believe 100 gig as a long life cycle ahead.

There are deep routes in architectural partnerships with key players and the datacenter industry, we believe that our PAM-4 DSP is poised to achieve a preeminent share in those 100 gig transceivers that’s why we are laser focused ramping production of our flagship present DSP.

While many people equate PAM-4 with DSPs, certain cloud operators response whole new dimension to their 200 and 400 gig strategies, analog, CDR based PAM-4. This approach provides a smooth operating path 200 and 400 gig for those with CWDM base fiber infrastructure. CWDM multiplex four wave-lengths over a single fiber. This initiative place directly to our strengths and incumbency in high performance analog controls.

Earlier today we announced the formation of the open IMSA group, an industry consortium founded by MACOM along the Semtech with participating numbers including Huawei tight silicon, Juniper [indiscernible] among nearly a dozen others. The multi source agreement aims to promote interoperability and accelerated adoption of 200 and 400 gig PAM-4 interconnects using analog approach which maybe MACOM Semtech and other purchase spends MSA members supplied nearly 100 of the CDRs to broad customers.

Demonstrating MSA interoperability across the broad group of electronics, laser and component suppliers does achieves the fact though industry standardization. Today we simultaneously announced our portfolio of MSA targeted CDRs drivers and TIAs which had low cost, low power feature for the PAM-4. Instead of using a 16 or 7-nanometer DSP which contains power [indiscernible] blocks, our PAM-4 CDR add modulation, detection and analog equalization in a much more cost effective process. This is inherently lower costs and much more power consumption staying entirely in the analog domain.

The end result is 25% of less powerful gigabit and similarly lower costs per gigabit and CWDM4 and DSP based PAM-4 solutions. Our customers expected double delivery with only minor incremental power cost using the analog CDR based approach.

I want to be clear here, we are not promoting the Open Eye MSA as a replacement for IAAA single vendor and we are not promoting CDRs instead of DSPs. We supply both with complete portfolios of the analog and photonics components for both PAM-4 approaches equally.

As I explained earlier, the two approaches coexists, serving different parts of the industry with different fiber infrastructure and datacenters. Adversely we also announced with global foundries 12 inch silicon photonics wafer production to support our L-PIC at hyperscale data center volumes.

Our L-PICs portfolio stands PAM-4 at 100, 200 and 400 gig covering both analog and DSP approaches. So we’re covered whichever way the industry goes. Silicon photonics in general including our L-PICs is poised to play a key enabling role in PAM-4 in both DSP and [indiscernible] we are obviously for otherwise possibly in lasers which have been a major impediment to PAM-4 adoption.

As part of today’s product announcement, our PAM-4 L-PIC is poised to enable 200 gig transceivers later this year at or below the current costs of 100 gig modules. By this time I hope its evident we believe our secular wealth opportunity in datacenters is fully intact.

Our portfolio is expanding geometrically to improve DSPs, lasers and L-PICs and our share is blooming in a market that is expected or cover if not snap back in the second half of this calendar year. Separating the short term cyclical from the long term secular, our future has never been brighter in cloud datacenters.

Next onto 5G telecom, anyone who attended Mobile World Congress knows that 5G is real and is starting in a big way later this year on a global basis and application ranging from some six bigger Macrocell base stations, some millimeter wave fixed to wireless networks.

We are great roster of customer in Barcelona with major network operators, as well as leading base station OEMs worldwide. One clear conclusion from field trials is that GaN is now a department for 5G Macrocell base stations. One major OEM actually try to use LP mass because it was all they can source in volume, that failed miserably.

The Chief Technology Officer of one of the largest wireless operators told us that their antennas in field trials were twice the target power consumption and three times too expensive. Some antennas even had to be liquid quote.

Major players now understand that GaN on silicon uniquely provides it all. Target efficiency, cost and high volume supply chain. With a squarely fixed dated our ramping production with ST and supported the 5G buildout globally.

Marco Monti, President of STMicros Automotive and Discrete Group joined us at our national event in Barcelona. He outlined how they gain capacity expansion, copy exact it will be in Singapore we’ll be able to service over 80% of global demand for 5G base stations exclusively through MACOM and our pending joint venture in China.

That brings me to the really big news this quarter that JV in China. This is the capstone to MACOM strategy to become skilled player in the multibillion dollar 5G opportunity worldwide.

We taken a page out of the semiconductor industry playbook and formed the JV that can credibility and locally serviced a multibillion dollar opportunity in China's domestic market.

Over the last quarter we ran a comprehensive process to find the Chinese investment target. I'm very proud and excited to say that the process concluded with Goertek a proven success story in China. Goertek is a high volume supplier of semiconductor components, modules and assemble products to the most demanding smartphone OEMs and service providers worldwide.

Over the last 10 years they’ve grown revenue from around a $100 million peaking over $4 four billion growing at over 30% compound rate during that period. Our 5G [indiscernible] opportunities fits Goertek operating model perfectly. They service proprietary semiconductor product and technology from industry leaders like TI, Broadcom and Inphi in this case sales force make on stand on silicon wafers directly from SD Micro and supply 5G power amplifiers to China based OEMs.

Okay here is the key fact about the transaction we signed and announced a JV on April 24th we expect the transaction to close in two to four months. Given the Goertek size the transaction is subject to anti-trust approval from China state administration from our regulation. We taken great care that the only commodities and technologies that MACOM will share our freely exportable to China under U.S. law. The license products are several to our communication grade or EAR99 we might as well be selling fountain pens.

No technology or existing U.S. business will transfer so we don’t expect any issues with U.S. ex-working flow [indiscernible]. Goertek will provide two consideration with MACOM of up to $134.6 million consisting of other upfront payment of $10 million and revenue with profit based milestone payments. And exchange with 51% equity stake in the venture. Separately Goertek and MACOM will each initially contribute $25 million and working capital to fundamentally venture.

So the net cash benefit to MACOM is up to %110 million. It worth noting that Goertek accruing and paying $4.6 million while more than return on our total investment to-date in GaN on Silicon. In terms of ongoing economics MACOM will be entitled dividend preferences and royalties from the joint venture.

Once the transaction closes MACOM will receive cash payments from the JV of $8 million per quarter and IP license, maintenance fees for a period of two years hope of signing. Those will begin growing as of April 24th with data signing and the accrued cash will be paid when the transaction closes. MACOM also retains rights GaN on Silicon sales outside of Greater China which has traditionally comprised half the global market for our seller.

So in total on a combined basis MACOM retains more than 75% percent of the global economic opportunity for GaN on Silicon base stations. So expense in turn will provide MACOM a fantastic cost structure and supply chain and the ability to invest further in GaN innovation in the U.S. with which we can replicate that earnings power on a global basis.

So in summary we believe that our progress last year expanding and adding manufacturing and investment partnerships with companies of the scale and strength of SD Micro Goertek forms a powerful combination to unlock the China 5G opportunity and provide tremendous earnings power for MACOM and our shoulders.

I’ll remind everyone again on silicon power amplifiers is but a subset of our overall 5G. opportunity from MACOM. We have similar opportunities with other RF technologies like Lgas as well as our high performance analog DCP and photonic products in the 5G optical build out. In interest of time I’ll defer those discussions to our next earnings calls. Suffice to say that our telecom portfolio was poised for long-term secular growth on the back of 5G infrastructure investments beginning later this year. I look forward to providing more detail and delivering on the vision in the quarters ahead.

Finally before closing today’s scripted remarks I'd like to touch briefly on some noteworthy developments in Global and Homeland Defense. Since our last earnings call two of our major customers Raytheon and Lockheed Martin announced the team and agreement to pursue the sensor contract. We believe this greatly simplified the bidding landscape since combined Raytheon and Lockheed Martin represent 80% of overall ground based radar deployments globally.

While many of the moving pieces are still playing out we believe that this may ultimately result in a more timely deployment of what is shaping up to be the largest build out of ground based radar in the history of the United States. While sensor deployment is couple years out final bids are expected to require full scale preproduction builds which were ready to support in engineering and in manufacturing.

Outside of sensor the threat from unauthorized drones continues to be a major challenge for open air venues, high rise apartments and public facilities. Just last month another unauthorized drone incursion took place over another public venue. This time it was over [indiscernible] product here in Boston. Now it's getting personal. There is new found urgency among government agencies including the FAA, FBI and DHS to address these vulnerabilities. This is driven a surge in interest in our radar tile technology from a wide variety of stakeholders.

We've been very active recently with government agencies not only for sensor, but also for opportunities to protect these civil open air venues. After years of investment in development work we're at the right place at the right time with a novel approach that offers proven field performance.

The world's leading radar customers and government agencies understand the value that we're bringing to bear with scalable plenary better than anyone and our team would make precisely that reason. We view Global and Homeland Defense to be a strong domestic secular growth engine stretching for arguably decades to come.

To conclude while all of our secular growth opportunities in fact datacenters, 5G telecom, and Global and Homeland Defense remained fully intact. We believe that the current inventory correction in data centers will continue through the June quarter. With that in mind we are guiding fiscal Q3 to be essentially flat to Q2. More specifically for the third fiscal quarter ending June 28, 2019 revenue is expected to be in the range of $120 million to $124 million.

Gross margin is expected to be between 53% and 55% on adjusted earnings per share between a loss of $0.08 and a loss of $0.04 on an anticipated 66.5 million fully diluted shares outstanding. Again our fiscal Q3 guidance anticipates no material recovery and demand before the end of the quarter. Also not factored into our guidance is potential recognition of licensing revenue for funds that we received last quarter from a new solutions customer. And any benefit of license maintenance fees if our JV with Goertek closes before the end of the quarter.

Each of these could represent upside to our current Q3 guidance. We believe that worst is behind us. As far as this quarter we look forward to getting back on track with improving financial performance as the market recovers late this year. Some of our customers indicate they will be exiting the quarter and more normalized inventory levels which is a positive leading indicator of recovery.

Despite this temporary or be it precipitous [indiscernible] and datacenters the fundamental demand drive us for each of their growth opportunities remain intact. In each case we’re positioned with a portfolio of disruptive technologies, protected by strong and proven intellectual property. With the progress we've made just in the last quarter, we've never been more optimistic about MACOM’s future prospects for growth and profitability.

This [indiscernible] datacenters highlight interesting challenge for the company that we started dealing with head on last quarter. Several of our growth initiatives are coming to fruition simultaneously. Our challenge is to deploy sufficient resources to meet our customer’s demands within the meadows of opportunity. This brings us a valid question of affordability. Our JV with Goertek is a great example of a proactive solution to address that challenge.

Putting the business in a even better position for a success one of the framing operating expenses and at the same time we’re trailing substantial earnings power for our shareholders. We believe there are similar opportunities for other parts of our portfolio.

Operator, you can now open the call for questions

[Operator]

[Operator Instructions] Our first question comes from Quinn Bolton with Needham. Your line is open.

[Quinn Bolton, Needham]

This is Mitchell on for Quinn. Thanks for taking the question. My first question I guess GaN things. Can you guys give us an update on your competence level for volume shipments taking place in calendar 4Q this year and does that remain on track and is there any update on the $23 million invest in micro and where that stands too?

[John Croteau, President and CEO]

So we have very clear line of sight to the first wave of deployments over in China, specifically and we’re completing the product deliveries and qualification, validations with our lead customers in line with collecting orders and ramping production and support of those 4Q shipments.

I would say in general with ST those – that capital equipment investment is in the process. There’s equipment on order and it’s going to be entering the first ST factory to the course of the year for completing qualifications.

At Mobile World Congress, we actually shared with Marco Monti, the production ran timeframe and its basically big steps ups as you step through 2020 from both the Italy and second core base factories in ST.

[Quinn Bolton, Needham]

So the PAM-4 analog the ER base success you announced today. It sounds like these solutions are sampling today. Can you give us some model on how you see this solutions ramping overtime and what types distances you are targeting?

[John Croteau, President and CEO]

Yes. So actually its more than sampling. We’ve actually been working in the labs of their cloud customers demonstrating interoperability with specifically Semtech products, so that’s the goal of this multisource agreement is demonstrating multiple sources for each of the components and transceivers and that’s very far along.

We’re now in process with a MSA group of documenting specification so that we can actually publish the specs later this year but yes, those products are real and available and cloud customers and transceivers guys are actually designing them in. So its – top of the race is it’s not the concept its actually hard work in the lab demonstrating performance.

[Operator]

Our next question comes from Mark Lipacis with Jefferies. Your line is open.

[Mark Lipacis, Jefferies]

First one on the free cash flow. Nice to see that up in the quarter. Can you give us a framework for thinking about how we should be modeling free cash flow going forward either on like a projection on what you think its going to do for the rest of the fiscal year or you know I say how we should think about in terms of net income conversion? That’s the first question. I have a follow up. Thanks.

[Conor Hegarty, Principal and CFO]

In terms of the free cash flow Mark for Q2, obviously a very strong performance with the improved working capital position we posted. So our free cash flow was much better than we expected for Q2 and actually is positive for the year today.

In terms of Q3, Mark, there was lots of puts and takes for Q3 and lots of variability around the free cash flow number. We will see slightly higher CapEx in Q3 and hope to offset that was some improved, for the improvements in working capital. We don’t give guidance into…

[Mark Lipacis, Jefferies]

And then John, could you describe, what is your appetite for M&A today versus two years ago let’s say.

[John Croteau, President and CEO]

Yeah, that’s a fantastic question. We’re actually building over that right now. What I’ am referring to at the end of scripted remarks is this JV is a fantastic launch that we are working not to bring more technology into the company, but to actually get more leverage.

You know, our big problem that we’re dealing with right now and if we go through the scripted remarks, also stopping datacenters whether it’s the L-PICs, the DSPs as well as [indiscernible] GaN on silicon stuff all of the that growth initiatives actually come to fruition right now and they become all consuming in terms of management focus, operating expense, capital expense and so on and there is JV concert that we came upon and running that process over in China I think is a great model.

I mean we put that business in China in a much better hands and service that domestic market locally with different operating expense $8 million per quarter begins accruing April 24. So that’s directly offsetting OpEx and we retain some very substantial economic value for our shareholders.

I mean, between preferred dividends, royalties and the maintenance fees its very large share of the economic value in China and 100% outside of China we retain. So its like well more than 75%, more than 80% for that. So it’s a great model and I think we’re going to be exercising lots of things that we can do to be able to relieve pressure on the balance sheet and relieve pressure on the P&L

[Operator]

Our next question comes from Blayne Curtis with Barclays. Your line is open.

[Tom O'Malley, Barclays]

This is Tom O'Malley on for Blayne Curtis. Just looking on to the June here. Can you give us the puts and takes across the businesses. Are you guys are guiding flattish revenue but just in terms of segments do you have any color on which ones are growing or which ones are setting back of it?

[John Croteau, President and CEO]

So they are all within a few percentage points of the same kind of things and the visibility is now in telecom. Right now its China visibility key issue. Datacenters, there’s zero visibility in terms of recovery.

In IND we’re still there we won seasonality and we were down sequentially by up 15% year-on-year so that’s really an issue of lumpiness in defense programs to be honest but I would say that the presentation of our forecasting is greater than the numbers that we have in the log here.

[Tom O'Malley, Barclays]

And then just talking about the broader opportunities and since more longer term. You kind of described again opportunity being more Q4 to start and then into next year ground base radar raise is a little further out as well.

And then the telecom market you said maybe improving slightly but what’s driving the growth in the back half of this calendar year and how do you guys keep growing revenue before some of these bigger opportunities?

[John Croteau, President and CEO]

Well, in the September quarter you are going to see datacenters begin to recover and its very clear. When we have multiple customers time are getting back to normalize inventories by the end of this quarter that’s indicative of a less its far too early to call back a strong left.

There is some left they were talking about its not that. So datacenter will look like I would say in telecom we are waiting for 5G and the issue would begin on silicon stuff now is we’re working through the accounting treatment with Deloitte. So assuming we don’t need to consolidate which is my expectation. You are going to start getting P&L benefit with certainly $8 million of cash benefit for quarter and again that started accruing April 24. So when that transaction closes we get that cash accrued to this quarter, if we close this quarter and if you get [indiscernible] on a Q3 guidance but if it goes into next quarter that’s no clause in to the next quarter.

[Operator]

Our next question comes from Mark Delaney with Goldman Sachs. Your line is open.

[Mark Delaney, Goldman Sachs]

First question I was hoping to better understand the gross margin guidance for next quarter I think if wasn’t the inventory write-down gross margin was about 55 for this quarter pretty flattish revenues and at midpoint of gross margins down a little bit for next quarter or so. Maybe help us understand, what's been factored in for gross margin for next quarter?

[John Croteau, President and CEO]

Yes, we assumed similar mix to this quarter excluding the inventory adjustment, the inventory reserves. [Indiscernible] I mean across the board we just the visibility is so poor that it's difficult to get much more appreciation than that. I would say the tough part of this downturn is as odd as it sounds. Our high performance analog business and our connectivity business are among the highest gross margin in the company. And so it hurts. There is depression and data set of revenues is actually a pretty material dilution on our gross margin but when it comes back you'll see a lift.

So I'm very hopeful that in the September quarter especially December quarter, we'll be snapping back and that that on our merge towards 60.

[Mark Delaney, Goldman Sachs]

And then follow-up on the telecom segment, if I recall properly last quarter guidance was for the Metro long haul to be a very, very strongly and in March driven by Telecom applications, it sounded like that came in line with your expectations. Could you just talk a little bit about to what extent that they did in fact come through and the regional drivers for China or other regions and what your view is that going forward for that business? Thanks.

[John Croteau, President and CEO]

Yes, good question Mark. So yes metro long-haul which is the shining great star in the portfolio right now. The Metro hydraulics were I think somewhat 36% quarter-on-quarter. And I would say that that ends up being lost in the telecom numbers with the other parts of the telecom portfolio like backhaul from all and then shows because Metro long haul business it's nice, it's just not a large driver that can make up for the big downturn in data center but outside of the data center, things are looking.

I mean I think we're fully booked through next quarter, right in this quarter mix forward. So that's a very strong part of the business right now.

[Operator]

Thank you. Our next question comes from Tore Svanberg with Stifel. Your line is open.

[Tore Svanberg, Stifel]

Yes, thank you. John, could you elaborate a little bit more on the [indiscernible] JV especially as it relates to applications should be selling into so will tech be selling PAs for base stations only or could they also be selling into smartphone or other applications?

[John Croteau, President and CEO]

The current license agreement is entirely base stations, 100% base stations. They have ambitions to move beyond that, as we can quantify demands and frankly get consideration for that and we'll consider expanding it. I'm very bullish. I mean the tech team, [indiscernible] the CEO, University of Maryland, Jason Louis, Stanford Grad, he is the CEO of the JV. I think it's going to be a great partnership to have to be able to put a lot of products into China. I think my lesson having worked at XP, they were very successful setting up very similar JVs. That is one thing to supply boutique $50 million businesses like we traditionally do in China.

It's an entirely different thing to ship hundreds of millions of dollars, if not a billion dollars of PAs. So I think we have a long healthy partnership with those guys before.

[Tore Svanberg, Stifel]

That's very helpful. And as my follow up on the PAM-4 analog side, so I understand it's going to coexist with DSPs. So what's the size of the market either by dollar terms or maybe millions of ports?

[John Croteau, President and CEO]

It ends up, the division of the guys who come at PAM-4 from a PSM port heritage and those who come at it from a CW port heritage. It's about a balance of 50:50. It isn’t 80:20 maybe it's 60:40 you can’t quantify it but if you look into the guys who have been PSM consumers big names and so IEEE absolutely has lot of traction, a bright future. Likewise the guys at CWM heritage very strong names on that side.

So I mean the common denominator for us to be honest is chock full of high performance analog laser and ultra content. We've been quantifying things even in the DSP, instantiation 70% of the build materials is analog over time. So it's we've got a very interesting position with OpEx that go 100, 200, 400, 28 gigabyte for the analog, 53 gigabyte for the DSP base stuff. PAM-4 is going to be a very nice growth driver for us for the foreseeable future frankly once the industry recovers.

[Operator]

Our next question comes from Mark Kelleher with D.A. Davidson. Your line is open.

[Mark Kelleher, D.A. Davidson]

I just wanted to ask about a little clarification. You mentioned your white box module vendors were having some difficulty getting qualification. Can you just kind of revisit that. How important is that to your data center ramp and I think you connected that to the inventory charge if I heard that right, is that right?

[John Croteau, President and CEO]

No, I don't think there's a direct connection to the inventory charge but the solutions that I would put it in context, we run a very, very healthy business of selling components to people who buy components and design and manufacture their own transceiver solutions.

That's a very successful business model for us. We do have some customers that have taken higher level deliverables from us and plan ramps and I just put it this way, the whole industry has just gone into a pause, right. The inventories have built up throughout the supply chain.

What tends to happen is the end customers and the transceiver customers, they end up falling back on their incumbents because frankly they prioritize keeping their incumbent suppliers healthy and the new entrants have to wait. So I don't necessarily consider it long-term bad news for the new entrants. It's just not good news in the short term while we have this glut of inventory. So it’s a pause is the best way to put it.

[Mark Kelleher, D.A. Davidson]

And then just as a follow-up, could you just clarify what the inventory charge was. I might miss that?

[John Croteau, President and CEO]

Yes, I mean the biggest part of it was we’re ramping our 25-Gig DMO lasers very aggressively in anticipation of supply shortages which is what our customers were indicating that they had anticipated this year. And just as we're bringing to fruition in the first calendar quarter, the whole supply chain turned over on us.

I went to RC and one of our biggest target customers told me that they were sitting on six months inventory lasers which I almost instantly fainted. But so these are things where reserves every quarter, we do it the same way and it’s a calculation, you look at your backlog, you look at your sales in context of your inventory and it's a straightforward calculation.

And in this particular instance, we had the ramping width, right. It's a lot of weapons not necessarily finished goods over there is some, we just don't have the backlog because there's no orders to be had. So it's not necessarily scrap, it's just writing down evaluation. So we rely a good cash flow despite the operating loss.

[Operator]

Our next question comes from Tim Savageaux with Northland Capital. Your line is open.

[Tim Savageaux, Northland Capital]

First question on the joint venture in China. The $8 million a quarter that you mentioned is that part of the milestone cash consideration, is that to the extent there's 135 minus 30 upfront or is that something different or incremental?

[John Croteau, President and CEO]

That’s [indiscernible] so there is license maintenance fees which are $8 million. We started accruing April 24th and then separate from that there's the $30 million upfront and the milestones which are entirely revenue and profit, gross profit based earnouts as we ramp will be burning through those and taking off those that consideration. And the last thing is we actually collect royalties on sales as well. So and there's actually preferred dividends. So it's economically speaking, the ongoing economics are very attractive. But the $8 million a quarter happens regardless.

[Tim Savageaux, Northland Capital]

I think you said that was two years with the agreement for that?

[John Croteau, President and CEO]

Yes, the initial agreement is two years, I wouldn't fully expect, there's no reason it won’t continue on beyond two years, just for two years there was clearly a dependency on us supplying the product, licensing the product and not just the technology. So it made sense to maintain it for two years. But there's again, I don't want to speculate two years out but I would see no reason why that wouldn’t continue.

[Tim Savageaux, Northland Capital]

And I don't know if we should think of that in a similar fashion to the solutions revenue over on the datacom side obviously it’s not recurring but greater kind of customers that you license. I wonder if you could maybe drilldown a little bit more on the dynamics of being able to recognize revenues from your most recent solution customer is that part of the whole qualification slowdown process and was that unlocked that?

[John Croteau, President and CEO]

Thanks you got a double question and let me make sure I cover both. So the $8 million per quarter we're going through the kind of treatment right now with the way. And first question is consolidate not consolidate I assume it doesn't consolidate because we're relinquishing control no just equity ownership, but I mean the economics of dealing with the customers and supply chain are now in the hands of the JV partner but with that the $8 million and comes into how it would be treated.

It’s counter OpEx which is the spirit of the of the maintenance fees or is it treated as a consulting fee if you remember when we sold the automotive business Autoliv if you covering back then. That showed up as a consulting fee but so then second thing is and due to math I mean substantial impact on EPS again a growing affected of April 24th. So it's got material contribution this quarter and it closes and it doesn’t forecloses this quarter that’s no plough whether full quarter next quarter. So that’s our guide that pockets are rechecking.

Separately you ask the question about the license revenue that we did not declare revenue on. We just cleared no one has asked the question, but we just cleared the $7 million of non-GAAP revenue and the GAAP revenue recognition from a year ago right. And getting to the new accounting standards and basically if you have initial milestones in the multi-milestone program. The new accounting standard at least as we’re interpreting now are don’t declare revenue at least GAAP revenue until a completion of the entire program.

So that’s the reason why it took so long for $7 million in the initial customer in this particular instance we actually got customer expectance and the initial tranche the milestones but we said out there we’re not doing our GAAP revenue again. As you can see it’s sit in liabilities and other liabilities our balance sheet and we will declare revenue when we complete that contract. So that could happen this quarter.

I mean there is customer completion stuff this quarter but until it’s there it’s not so we’re not going to declare this revenue but upside of the Q3 guidance as well.

[Tim Savageaux, Northland Capital]

And last question from me I think at the close of your initial comments you kind of talked to the model again on solution JV and then maybe the solution business to. It something that might be kind of extensible to the rest of your business I wonder off the top of your head are still going to share kind of any thoughts on what parts of your business might also be relevant to that type of opportunity.

[John Croteau, President and CEO]

Yes, so it’s very good question. So obviously [indiscernible] specific but here is kind of recipe for success and the promise they will invest. I know realize and appreciate investors have been waiting a long time whether to GaN on silicon, or the OpEx so DSPs or various broken archers that were putting then putting money and I think it would have taken longer. They're now coming fruition go through my script if I am asking here exactly what the status is of all these things come to fruition.

And the problem is there demand, the customers are demanding more deliverables, more effort, more resources both operating expenses and capital expense and this downturn has just put a big spotlight on the fact that we're burning to rich. Right and it’s a valid question of affordability. So I love the JV. I'm struck if we can do more of that great. And the recipe is put the business in hands in a better position for success.

Goertek JV is a good example we’d be kidding ourselves frankly if we thought we're going to add a $1 billion dollar business per year in China servicing and domestic market yeah. Even suppliers of magnitude of my car employee NXP they use the JV contract to address a domestic market.

So one thing is you want to put in better hands for success. Secondly, absolutely wanted to fray operating expenses, right if we put into a JV probably transfer the resources out we couldn’t do that with Goertek because there is expert control issues so we have to do the maintenance restructure and the last things is you know retaining substantial earnings power for our investors and I’ll tell you we start running the numbers and I would suggest people doing it.

You look at the magnitude of the opportunity over in China for instance and the probability in which share and you run the economics and you see what earnings power this unlocks as anybody rappel its very eye opening let me put it that way and I will tell you the other things that I spoke about in my scripted remarks that come in fruition as well.

There is real gain on silicon is directed you know progression that we are maintaining in other parts of the business. So we’re taking our situation very seriously where each of the OpEx issue head on. We delivered $8 million per quarter of OpEx to fray expenses.

Now until closes we can’t declare that but its accrual as of April 24. We can pull up more of those deals and be able to get a locking earnings power for our shareholders we’re going to do so. There’s certainly limits to what we can funds with our current days of revenue even after recovery.

[Operator]

Our next question comes from Harlan Sur with JPMorgan. Your line is open

[Harlan Sur, JPMorgan]

On the JV formation with Goertek, obviously it’s a great channel into the China infrastructure market where are the China couldn’t suppliers in the process of evaluating and qualifying new PA vendors. I wonder assume that they are pretty far along on the process much like you with your existing customers. So what is the timeline for you guys getting qualified, potentially getting qualified with your GaN PAs with some of these potential China equipment guys?

[John Croteau, President and CEO]

Sur, it’s a great question. And let me emphasize something its perfect for us not only as there is a crisis over China with local OEMs and the European subsidiaries of Nokia, Ericsson severely access to our GaN material. I had markets in the one on one with the top sourcing guys one of the top base station [indiscernible] he told me exactly how many wafers he got for whom, what how and so on.

They can’t source on our GaN. So I want to be clear here. This is great news for us than the JV and ST its great news for anybody who can produce GaN by first in short to medium term the sensational demand. So there is – so the customers are very highly motivated. Very, very highly motivated to qualify our products since they appreciate the fact.

They look at SP and its profoundly different than anything else but they look at for GaN sourcing. Its - Marco Monti in Mobile World Congress he said finally there is 10000 8 inch wafers a week. Singapore that they are going to be ramping 12000 per day. So its totally different scale and I don’t anticipate any top of that. Frankly, the internal problem is they want more sugar. So it’s a – that’s a problem.

[Harlan Sur, JPMorgan]

And you guys actually had also good success with your front end modules your front modules. Is this part of the JV partnership is well for them to be a channel for your PAM solutions, its often time go kind of hand in hand with your PA solutions?

[John Croteau, President and CEO]

Yes, its big very question. So [indiscernible] work down for the whole purpose of export control and so on not in PAM or export control but I mean running now its focused on PAs. There’s no question that there trends that receive funding modules where the GaN, PA is integrated into the sum and yes, the JV would bring more attributable channel use to bring those trends. Whether its trends that receive or trends that only its different flavors at the same stuff. So that’s for China and other thing I want to emphasize here is half of the station market even the Chinese OEMs would tell us its that capital market outside of China. The service providers taking out old share obviously no one wants to end up with monopolistic supply condition from China.

So there is some very healthy business for trends that we do is the logical candidates outside of China. Therefore global patch build out is it couldn’t be better for us. Our trend position is almost as strong as right now as silicon position. Probably about half the build materials over trends that side but its still half of them very large numbers, still the very large number.

[Operator]

Our next question comes from Richard Shannon with Craig-Hallum. Your line is open.

[Richard Shannon, Craig-Hallum]

I will follow upon question on Goertek as well. You referred to the uncertainty on counting of the $8 million payments you are recurring by core the rest of the payments. I was assuming those would be recorded revenues and be 100% gross margin or if not can you help us understand that structure?

[John Croteau, President and CEO]

So the 134.6 is the consideration won’t be a write down. The $8 million even if we do not consolidate which is [indiscernible] we are working to that with our auditors. I wouldn’t expect $8 million would be treated as well. Our hope is - discount for OpEx but [indiscernible] OpEx and maybe consulting fees like when we have other lease agreement. Did I answer your question?

[Richard Shannon, Craig-Hallum]

You did answer the question. Another gross margin question basically on the manufacturing again on silicon PAs you are obviously you are still under process of getting equipment both for you and your partner but any update on the thought process of gross margins there. Certainly you can talk about that is in line better with your longer term gross margin goals of 60%. What’s your current expectation there?

[John Croteau, President and CEO]

We have lock down cost structure our ST arrangements through the cross license we’ve got are very strategic relationship with ST in terms of capacity and costs through enabling NAND and also other market that they try to address - that we don’t care we address and we actually have five year growth targets from Chinese most aggressive, the aspirational price targets and we just leave – we can leave those price targets with the ST cost structure and be accretive to our corporate targets. So its one of those – its one of the great benefits of manufacturing and mainstream silicon semiconductor factory. Fantastic cost structure.

[Operator]

Thank you. And this concludes the question-and-answer session. I would now like to turn the conference back over to management for closing remarks.

[John Croteau, President and CEO]

Very good. Before closing on today’s call I’d like to mention several upcoming events or events that we’ll be attending this quarter. We’ll be at Cowen TMT conference on May 29 in New York, the Stifel conference, June 11 in Boston and Piper Jaffray symposium on June13 also in Boston.

If you'd like to arrange a meeting at any of these events, please email us at [e-mail]. That concludes today's remarks. We look forward to provide any further updates on next quarters earnings call. Operator you may now disconnect the call.

[Operator]

Ladies and gentlemen, this concludes today's conference. Thanks for your participation. Have a wonderful day.