MACOM Technology Solutions Holdings Inc

NASDAQ:MTSI

Earnings Call Transcript 2020-Q2

[Operator]

Good afternoon. And welcome to MACOM’s Second Fiscal Quarter 2020 Conference Call. This conference call is being recorded today, Wednesday, April 29, 2020. At this time, all participants are in a listen-only mode.

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

[Steve Ferranti, Vice President, Investor Relations]

Thank you, Operator. Good afternoon. And welcome to MACOM’s second fiscal quarter 2020 earnings conference call.

I would like to remind everyone that our discussion today will contain forward-looking statements, which are subject to certain risks and uncertainties as defined in the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those discussed today. For more detailed discussions of the risks and uncertainties that could result in those differences, we refer you to MACOM’s filings with the SEC.

Management’s statements during this call will include discussions of certain adjusted non-GAAP financial information. A reconciliation of 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 with that, I will turn over the call to Steve Daly, President and CEO of MACOM.

[Steve Daly, President and CEO]

Thank you, and good afternoon. I will begin today’s call with a general company update. After that, Jack Kober, our Chief Financial Officer, will provide a more in depth review of our fiscal 2020 Q2 financial results. When Jack has finished, I will provide revenue and earnings guidance for Q3, and then we would be happy to take some questions.

Revenue for Q2 was $126.4 million and adjusted EPS was $0.17 per diluted share. Our Q2 results show positive trends in our performance and our employees should be proud of these results.

We continue to focus on a list of internal initiatives to enhance the overall efficiency of the business. Notably, during Q2, we made progress in our inventory management processes and the net result was an improvement in inventory turns and a reduction in total inventory levels. While we still have a significant amount of work ahead of us, the operations team is doing an excellent job with this and other continuous improvement projects.

Before moving to the details of our Q2 results, I would like to provide an overview of the impact of the COVID-19 pandemic on our business. As you know, MACOM is a global company and we have employees across Asia, Europe and North America.

Since the beginning of this pandemic, our top priorities have been to maintain the health, safety and wellbeing of our employees, keeping our business operational and delivering on commitments to our customers.

Among other things, MACOM manufacturers certain essential products for U.S. defense and telecommunications infrastructure applications. Accordingly, our U.S. based manufacturing facilities have remained operational.

In addition to following local regulations and guidance in order to maintain a safe work environment, we practice social distancing protocols, provide enhanced employee screening, restrict onsite visitors and non-essential staff and conduct enhanced facility cleaning and disinfecting procedures regularly.

We have also implemented a work from home posture for our employees and non-manufacturing functions, including customer service, engineering and administration. At the same time, our global salesforce has remained actively engaged with customers using video and teleconferencing.

Our operations team has been working with our global suppliers to mitigate the impact of COVID-19 related interruptions to our business. During the quarter, we experienced both supplier closures in partial shutdowns, specifically from certain Asia based suppliers, including assembly and test subcontractors in Malaysia. We have managed these issues effectively and we do not believe these interruptions have had a material impact on our business to-date.

However, the situation is dynamic and it requires daily management by our operations team to support our customers. But simply put, our dedicated employees have rallied to keep our business and operations up and running in an effort to service our customers and meet our commitment.

Our Q2 revenue by end market was as follows. Data Center was $26.7 million, Telecom was $51.6 million, and Industrial and Defense was $48.1 million. Data Center and Telecom has sequential growth rates of 16% and 13%, respectively. Industrial and Defense was down 5% sequentially.

On a geographic basis, 45% of second quarter revenue was from domestic customers and 55% from international customers similar to prior quarters. Our book-to-bill ratio was approximately 1.25 to 1, and our churns business or business booked and shipped within the quarter was approximately 22% of total revenue.

Generally speaking, demand for our products was strong in the second quarter. We experienced strong bookings across all three of our end markets and we are pleased with the growth of our backlog. I will highlight that we have very little consumer electronics or automotive business exposure.

We are staying in close contact with our largest customers and closely monitoring channel inventory, general order activity and long-term demand forecasts. We believe that strong Q2 bookings is due to a combination of improved Data Center and Telecom end market demand, market share gains and to a lesser degree from customers ordering ahead of end demand to the fear of future component shortages caused by COVID-19 supply chain disruptions.

For Q2, sequential growth in our Data Center end market revenue was driven by cloud data center demand. Our 100G high performance analog products and our emerging 200G and 400G analog product lines support this market segment.

We view ongoing demand for data bandwidth and associated infrastructure upgrades inside the Data Center to be a strong growth driver for MACOM in the years ahead, and we see the emergence of 200G and 400G to be opportunities to expand our position in the market.

Sequential growth in our Telecom end market revenue was primarily driven by demand for 5G products, as well as from new products such as our 64-gigabaud metro long-haul product lines. As a reminder, we have a broad portfolio of 5G products today consisting of receive side RF, front-end modules, control products for base stations, high-performance analog ICs for 5G front-haul and high-performance coherent driver and TIA products for mid-haul.

We view 5G infrastructure deployment as a key growth driver for MACOM revenue in the years ahead, and in the coming quarters, we anticipate expanding our current 5G portfolio by launching complimentary new products including additional optical components discrete RF components and more high-performance analog and mixed signalize ICs.

Our Industrial and Defense end market revenue continues to be driven by long-term U.S. defense programs, particularly in electronic warfare applications along with satellite communication applications and increased sales to test and measurement customers.

Ultimately, we believe that revenue growth in our three end markets will be driven by our ability to design and bring new products to market quickly and win market share. We are confident that the changes made in our engineering management and broader organization last year, as well as the updates to our product development process will enable us to improve MACOM’s competitiveness and time to market.

Before discussing our notable new product releases for the second quarter, I would like to highlight that in Lieu of Attending OFC, we hosted virtual product demonstrations. In total, we hosted over 30 demonstrations in an interactive private video meetings with customers.

We had three engineering testing showcasing MACOM products in real world optical applications. We believe these demonstrations were well received and serve to further educate our customers and we expect these efforts will ultimately lead to new design wins.

We had three demos. First, we showed a complete chipset or 50G PAM-4 transmit and receive lengths with Ethernet security for 5G mid-haul deployments over 10 kilometers. This chipset featured a total of five MACOM ICs including our new prism 50 DSP, Silicon Photonics IC and 26-gigabaud TIA, high-speed photo detector and a Max Set 5 SOC [ph].

Second, we showed a high-speed analog chipset to support 200G modules for use inside the Data Center that is compliant with the Open Eye MSA Standard. Our demo included customers 200G and 400G QSFP modules and active optical cables built upon the MACOM chipset. These analog modules were plugged into commercial Ethernet switches running live traffic and were successfully working with other DSP based optical modules.

And third, we showcased a 100G Single-Lambda, DR/FR, PAM-4 link over two kilometers of fiber, leveraging MACOM’s latest PRISM DSP, 56 GBaud TIA and high-speed Photodiode. This setup is ideal for point-to-point or 4/100G breakout applications inside the data center.

Our lightwave engineering teams released a number of new products during the second quarter, including a 25G Avalanche Photodiode or APD. APDs are key optical components in 5G wireless and data center applications. Our 25G APD is capable of operating between 1250 and 1650 nanometers and features very high sensitivity of minus 22 DBM will coupled to a low noise amplifier. MACOM will offer the 25G APD as a bare dye and in chip-on-carrier formats to provide maximum design flexibility to our customers.

As a reminder, our lightwave engineering team designs best-in-class APD devices, as well as a portfolio of over 15 unique laser configurations. Our laser technology is targeting applications in the Data Center, Telecom Infrastructure, as well as Industrial and Defense markets.

We approach customers with a strong knowledge and experience in high speed data transmission, optical transmission, lightwave detection and communication systems, with the goal to win semiconductor component business. We seek applications in all markets where customers transmit and receive high-speed digital signals using optical technology.

During Q2, our high-performance analog team extended our Trans-Impedance Amplifier or TIA portfolio with two new TIAs optimized for use in applications ranging from 100G DR1 to 800G DR8 and FR8.

The first new of TIA supports high throughput optical data links in a very low power profile, optimal for use in high density optical data center interconnects. The devices intended for 50G to 400G receivers using PAM-4 modulation.

The second new TIA is a quad 26 and 53 GBaud linear PAM-4 TIA with automatic gain and integrated AGC loop. The TIA consumes very low power and is primarily targeted for single mode fiber applications. These new TIAs are available to customers in flip chip and wire bonding packages, options for flexible deployment.

Our RF and Microwave engineering teams continue to expand their product lines with the goal of gaining further market share in our core Industrial and Defense markets. We are focused on executing our product plans more efficiently, while also challenging our designers and technologists to raise the level of innovation with more best-in-class products.

We believe that our mimic and diode product lines are getting stronger and we will continue to expand what differentiated performance. The products I have just highlighted in our other recently introduced the products, provide us the opportunity to gain market share and drive revenue and profit growth in the near- to mid-term. At the same time, we continue to work on long-term R&D, which will support our next-generation products and MACOM’s long-term growth.

Given the uncertainty in the markets, I would like to highlight to investors that MACOM is a strong company that has a deep and diverse technology portfolio, and we service three very large end markets. We have thousands of customers and dozens of product lines. Some of our product lines have extraordinarily long life cycles and they produce revenue years after they have been introduced.

Our R&D team continues to compliment the strong foundation with new products and technologies, some of which I have discussed today. We are fortunate to have limited customer concentration, limited to no consumer electronics and automotive business exposure, and limited product revenue concentration. We believe that this business attributes along with our improved execution and financial performance will support new successes and new market share gains.

We maintain a long-term view on our business and while COVID-19 may disrupt or impact us in the coming months or quarters, we believe it will not change our fundamental long-term growth opportunity, as our business is small relative to the large end markets we serve. That said, we are planning for both best and worst case scenarios, given the risks and uncertainty associated with the COVID-19 pandemic.

Jack will now provide a more detailed review of our Q2 financial results.

[Jack Kober, Chief Financial Officer]

Thanks, Steve, and good afternoon, everyone. Our fiscal Q2 results demonstrate the continued improvement in the overall profitability and cash flow of the company. We posted sequential improvements in revenue, margins and adjusted earnings per share. We also reported another quarter of positive cash flow, exiting Q2 with our highest combined cash and short-term investment balances since the third fiscal quarter of 2017.

I would like to thank all MACOM employees for their dedication, not only in keeping our business operations functioning during this COVID-19 pandemic, but also supporting the growth in orders and revenue, as well as helping to manage our spending.

Revenue in the second fiscal quarter of 2020 was $126.4 million, up 6% sequentially. The sequential improvement was driven by positive trends in our Telecom and Data Center markets, including growth from early 5G deployments and strong demand in Data Center upgrades. Overall Industrial and Defense demand remains healthy, despite our anticipated modest sequential revenue decline.

On a year-over-year basis, revenue was down 2% from $128.5 million in the second fiscal quarter of 2019. Adjusted gross profit in Q2 was $68.9 million or 54.5% of revenue. Adjusted gross margin was up 100 basis points sequentially.

As we have discussed in the past, gross margin improvement remains a corporate priority for us. The team has done an excellent job of maintaining focus on our internal margin improvement initiatives in spite of the COVID-19 pandemic related operational challenges we face during Q2.

We believe these initiatives, which target cycle time improvement, scrap reduction and other operational efficiencies will continue to resolve is incremental gains in gross margin over the course of fiscal 2020 and beyond.

Total adjusted operating expense was $49.3 million, consisting of R&D expense of $31 million and SG&A expense of $18.3 million. Operating expenses were down $1.4 million sequentially. We will continue to balance investments in new product opportunities, while diligently managing our discretionary spending.

Adjusted operating income in the second quarter of $19.6 million, up $13 million in fiscal Q1, translating into 15.5% adjusted operating margin. We expect [Technical Difficulty] improving gross profits and stable operating expenses will provide continued operating leverage throughout the remainder of the fiscal year.

Depreciation expense for Q2 was $7.3 million and adjusted EBITDA was $26.9 million. Fiscal Q2 adjusted net interest expense was approximately $6.7 million, down around $900,000 from the first fiscal quarter of 2020. The decline was primarily driven by declining interest rates on our term loan. Looking ahead to fiscal Q3, we expect to see an incremental reduction of $500,000 in net interest expense, primarily from the full quarter benefit of lower interest rates.

Our non-GAAP adjusted income tax rate in fiscal Q2 continued at 8% and resulted in an expense of approximately $1 million. We expect our non-GAAP adjusted income tax rate to remain at 8% for the remainder of this fiscal year.

Fiscal Q2 adjusted net income was $11.9 million, compared to $4.9 million in fiscal Q1. Adjusted earnings per fully diluted share was $0.17 in fiscal Q2, utilizing a share count of $68.1 million fully diluted shares, compared to $0.07 of adjusted earnings per share in fiscal Q1.

Now moving on to cash flow and balance sheet items. Cash flow from operations came in at $25.3 million. Improvements in operating income and inventory management help to enable strong cash generation for the quarter.

CapEx totaled $4.8 million or 4% of revenue. Despite the lower capital spending, we continue to invest in priority programs. We continue to remain focused on achieving appropriate returns on capital that we deploy and we expect overall capital expenditures in fiscal 2020 to be well below our fiscal 2019 levels.

Free cash flow was $20.5 million for the second fiscal quarter and $33.4 million in Q1. These fiscal 2020 improvements in cash flow are result of revenue linearity, improved operating income, reduce CapEx and other working capital improvements. We believe the numerous structural changes we have made throughout the organization will continue to drive positive cash flow as we progressed through the second half of the fiscal year.

Accounts receivable was $53 million, up slightly from $52 million in Q1. Day sales outstanding were 38 days, down from 42 days in Q1. Inventories were just below $100 million at quarter-end, down approximately $7 million sequentially.

Inventory turns improved 2.3 times during the second fiscal quarter. As Steve had mentioned, inventory management remains an area of emphasis and we see opportunities to continue to improve our inventory metrics going forward.

Overall, working capital was $103 million in fiscal Q2, down approximately $2.5 million sequentially. Cash, cash equivalents and short term investments were $221.5 million, up $11.5 million from fiscal Q1. As a reminder, our short-term investments are comprised of corporate bonds and commercial paper and are classified as held for sale.

Total long-term debt was $683 million inclusive of finance lease. Our long-term debt of $654 million is covenant light and has minimal annual principal repayments until its maturity in May, 2024. We also have an undrawn $160 million credit line available from November 2021.

It’s worth noting that our trailing 12 months EBITDA increase in Q2 for the first time since early fiscal 2019 nearly doubling sequentially. We believe that this trend of improving EBITDA should help to improve the leverage ratio of the company over time.

As we have discussed in the past, we remain confident in our liquidity position and believe the structural improvements we have made to increase our profitability and cash flow will provide us with sufficient financial options to execute our strategic objectives.

In summary, we feel Q2 was another quarter of solid financial performance and we are pleased with our progress. We also understand there is still much more for us to do in order to achieve our longer term objectives and believe that we will continue to build positive momentum across the business.

I will now turn the discussion back over to Steve.

[Steve Daly, President and CEO]

Thank you, Jack. MACOM expects revenue in Q3 ending July 3, 2020 to be in the range of $129 million to $133 million, adjusted gross margin is expected to be in the range of 54% to 56% and adjusted earnings per share is expected to be between $0.19 and $0.23 based on $68.5 million fully diluted shares.

Our Q3 revenue projections include expectations that are three end markets will grow sequentially. Specifically, we believe our revenue growth will be driven by the increase in Data Center traffic, 5G network deployments and increased demand for our RF and microwave products in defense applications. We are excited about the multiple growth opportunities in front of us and we are focused on execution and planning.

I would now like to ask the operator to take any questions.

[Operator]

Thank you. [Operator Instructions] Our first question comes from Harsh Kumar with Piper Sandler. Your line is now open.

[Harsh Kumar, Piper Sandler]

Yeah. Hey, guys. First of all, huge congratulations, there aren’t a whole lot of companies that are beating and then actually guiding up on sequential basis, so tremendous job. I had two quick questions. First of all, Steve, you talked about strengths in the June quarter rising from the March timeframe and you said all three end markets would go. I am just curious if you could give us some color just for modeling purposes whether one will outperform the other or where do you think you will get more traction based on your backlog?

[Steve Daly, President and CEO]

Thanks, Harsh. So we think that the Data Center will lead the growth going into the next quarter, probably a double-digit growth, strong double-digit growth, and then Telecom and I&D, I would say mid-single digits plus or minus a little bit.

[Harsh Kumar, Piper Sandler]

Okay. And then for my follow up, you guys have a bunch of strategic products in the pipeline. I believe for the rest of the year. We are hearing 10 GBaud [ph] is coming back in China in a strong way. I believe you guys were also working on a PAM-4 analog product and you might have referred to that in some of the demo information. I was curious if you could give us some idea of some of these critical products, are they still on track despite COVID and all that’s going on here in the world?

[Steve Daly, President and CEO]

Sure. So, I would say, generally speaking, our R&D team is doing a great job holding schedules, and continuing to move ahead and make reasonable results given the current situation. I will say that there have been some minor delays in terms of getting product tested in the labs, given the, social distancing and whatnot that we are practicing.

But generally speaking, we are on plan for where we want to be and where we want to go in terms of product development and product launches. And I will just highlight maybe as an example, we are well ahead of last year’s total product introductions even given the COVID-19 pandemic situation. So the team is really stepping up and doing a great job.

In terms of some of those strategic programs that you have talked about. You are correct. We do have quite a few of them whether it be some of our silicon photonic work that we are doing, some of our advanced laser work, some of our power amplifier process technology work that we are doing, as well as challenging our analog designers to design analog solutions at higher data rates.

So there’s probably too much there to drill down on and to discuss in any level of detail. But I would say, generally speaking, we have a solid plan, we are executing to the plan, we are not updating any pivots per se on any of those strategic programs that I think you are referring to, so it’s really a steady progress at this stage.

[Operator]

Thank you. Our next question comes from Quinn Bolton with Needham. Your line is now open.

[Michelle Waller, Needham]

Hi, guys. It’s Michelle on for Quinn. Congrats on the quarter. I just had one question. In terms of, for 2Q, you mentioned that customers are pulling in inventory to prevent risk of future supply constraints. I am just wondering and maybe I missed this, but I assume you are saying that it’s going into the third quarter, I am just wondering is that more on Telecom side or Data Center side or both, or maybe you can give a little bit of color on which markets you are seeing that?

[Steve Daly, President and CEO]

Yeah. That’s fine. And maybe I will just give some general background and then, Jack, can quantify it for us. So, I have to say that, we have had some tremendous bookings over the past number of months. And so we actually believe the majority of this -- the vast majority of this is end market demand driven and only a small fraction is actually sort of overreacting and sort of panic buying due to the COVID situation.

I would say that the strength in the bookings is coming from Data Center and Telecom,, and then to a lesser degree, I & D. I will also highlight that our channel inventory is very healthy right now. We have been monitoring our channel partners and distributors and their inventories have been moving down over the past six months really by our design.

And so we are very pleased with the level of inventory in the channel. We see very strong bookings, which we believe are end demand driven. I will say we do see a bit of softness in Europe, if I were to call out any one territory or region that’s sort of softer than the others, it would certainly be across Europe. And Jack, I don’t know whether you want to quantify in terms of levels where we may think customers are buying a little bit ahead of demand.

[Jack Kober, Chief Financial Officer]

Yeah. So with regard to some of those types of orders, we don’t believe it’s significant. We do have active conversations with our customers to try and get an understanding of the ultimate end use demand or whether they are stocking these items. But if we were to quantify it’s probably less than 5%.

[Michelle Waller, Needham]

Okay. That’s helpful. And if I can actually just sneak another one in there, Huawei, I know you guys said that they had significantly declined after being placed on the trade restriction entity list. So just wondering though, did you see any sort of increase in the second quarter from off the first quarter or what the change if any at all in Huawei orders?

[Jack Kober, Chief Financial Officer]

Yeah. Thanks Michelle. So, in terms of Huawei and they have been out less than 10% customer for quite a few years now. As we have been stating in some of the prior discussions, their revenue has been declining for us over time, so really, really no meaningful change to that.

[Operator]

Thank you. Our next question comes from Tom O’Malley with Barclays Capital. Your line is now open.

[Tom O’Malley, Barclays Capital]

Hey, guys. Thanks for taking my question and congratulations on the strong results. I just wanted to start out with the guidance. You obviously are taking some consideration of some COVID impact. If you just take kind of the midpoint of what you described as double-digit growth in data center and then mid-single digits in telecom and industrial, you get a little bit above your range. Can you talk about where you are being cautious and what areas you think you are giving yourself a little bit of room to get back into the range that you are guiding?

[Steve Daly, President and CEO]

Yeah. So, I think, our ops team is working very closely with our sales organization to make sure that we come up with the most accurate guidance that we can give. I wouldn’t necessarily want to carve out anyone end market or customer or even product line. It’s really making sure that operations understands the any associated risks with the forecast for the third quarter.

Now, the good news is we have a very high backlog for the third quarter and we are already one month into the quarter. So, we are very comfortable with the supply chain risks that are sort of built into our guidance. And so we think we are doing all the right things in terms of planning. I will say that generally speaking the supply chain is recovering.

So in areas where we have started - maybe a month or two months ago where we were seeing impacts and shutdowns, we are seeing our suppliers come back online, that’s not only in Asia, but also across Europe and here in the U.S.

I will say by the way from a supply chain point of view, we effectively had no interruptions from our third-party wafer foundries. So the good news is we were able to receive the materials that we needed. Our fab remained completely operational.

So from a raw material point of view, we are in a very good position to service not only the third quarter, but also beyond. So I think we are -- I think our guidance is as accurate as we can make it given all these different moving parts.

[Thomas O’Malley]

Great. And then just a quick follow-up, you mentioned that Huawei revenue was going up, but you are also seeing a sequential growth in telecom. Clearly, there is a number of tenders that are coming out in China right now for optical builds. Where are you seeing the sequential growth in telecom? Is that U.S. based or are you participating in the Chinese ramps elsewhere outside of Huawei?

[Steve Daly, President and CEO]

Yeah. So I would say that it’s primarily 5G driven and the majority of that activity is China based. And then as you drill down and look at the OEMs and their customers and their suppliers, we try to service as many as we can. I wouldn’t want to call out any one particular OEM in terms of our position as it relates to optical infrastructure.

I think the key point here is, we are seeing more opportunities. The volumes are going up. We have very compelling technology for 5G front-haul and mid-haul, for analog solutions, laser solutions, detector solutions that I talked about.

So we actually have a very strong product set for the 5G rollout on the optical side, which is what you were referring to. So I think it’s really more than just anyone customer driving our demand. We see lots of demand from lots of customers.

[Operator]

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

[Richard Shannon, Craig-Hallum]

Well, great. Thanks for taking my questions as well. Steve in your prepared remarks, you talked about finding my notes here. You talked about some market share gains, and I think you are referring to both data center and telecom. Can give us more detail on where that’s coming from, which products in geographies or customers if that’s relevant to?

[Steve Daly, President and CEO]

Absolutely, so I probably start with our diode product. So we are - our team within our diode business unit has really been doing a very nice job, picking up business that previously we may have been losing. There is a renewed effort to drive growth in our Industrial and Defense end markets, which means taking our existing technologies, repackaging, re-pricing in some instances screening.

So that is certainly an area where I see market share gains. Typically there are competitors in the technology area are weaker than us. So it’s our goal to continue to put pressure on these smaller and weaker competitors and win that business.

In terms of the other areas I would probably also highlight our HPA or high-performance analog team is doing a very good job winning business, not only with 100G analog solutions and picking up new customers, but also going into adjacent markets.

A part of our strategy will be to expand beyond the Data Center and beyond Telecom with some of our high-performance analog design capability and so we are starting to see new opportunities and win business and go after business that may be a year or two years ago, we wouldn’t have gone after.

And then the last thing I will add is, I just want to emphasize that 5G architecture really plays to MACOM strengths with the very large optical piece of that network. And this is an area where a year ago, two years ago, we had no business. So the fact that there is a large optical component there is going to drive our growth in the months and quarters ahead and that includes by the way not only the front-haul piece, but also the mid-haul piece.

[Richard Shannon, Craig-Hallum]

Okay. Thanks for that. Steve. A follow on question, I guess, kind of following the end of your response here to the Telecom market, you have talked about 5G mostly within that segments. And I guess from the other comments it would be a relatively small piece of the Telecom from a dollar point of view. So how do we reconcile the rather small concentration or an exposure there with your fairly strong growth both in March and June quarters here. Is 5G driving most of that or is there also some benefit coming from PON and back-haul and in other things like that?

[Steve Daly, President and CEO]

So I would say that there is - this quarter and going into next quarter, less growth on the PON side, and it’s more on the 5G side. We did have actually some significant growth going from Q4 to Q1 this year and now we are seeing that growth continue. I think it was just two quarters ago or three quarters ago, the Telecom market was below $40 million, and this quarter we are above $50 million. So we would like to growth, we like the steady business and the diverse type of business that the 5G market is bringing to us.

I will highlight that there are areas of bright spots. Of course, there is also areas where we need to do a lot of work, including on the RF boards within the 5G radios themselves. It’s very competitive market.

Today, we support the market successfully with front-end modules and high power switches, but we have a lot of work to do on the power amplifiers side. So that’s an area where we are behind and we do need to do a lot of work there and we recognize that. And so we are going to build that into our strategy as we move ahead.

[Operator]

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

[Harlan Sur, JPMorgan]

Good afternoon, guys, and good job on the quarterly execution on strongest margin performance. If I look at the March quarter results and June quarter guidance, your incremental gross margins on the incremental revenue growth is falling through at about 70%. Historically, it’s been about 60% to 65%. So pretty strong step up. Is that more a function of mix or is that a combination of mix and the manufacturing efficiencies driving lower costs and going forward? Is this how we should think about the gross margin contribution on revenue growth?

[Jack Kober, Chief Financial Officer]

Yeah. This is Jack. So in terms of that step up that we are seeing going from Q2 to our Q3 guide, there is a number of different elements that come into play there, obviously, the increase on the top line helps in terms of the overall gross margin step up that we are showing here in the quarter.

There has been a number of initiatives that we have been working throughout the company that are ultimately driving that sequential margin improvement that you have been seeing over the past couple of quarters and this is the next natural step in our progression from a guidance range perspective.

So I mean it’s going to be a kind of a step-by-step process as we continue to work through things and continue to execute along these initiatives that we have that are ultimately improving the margins and the mix is a big piece of how that can come into play in terms of the margin?

[Harlan Sur, JPMorgan]

Okay. Great. Thanks for the insights there. And then on the product side, I know you mentioned some of this in the prepared remarks, but on the 5G sort of mid-haul, back-haul depending on the distance that we are hearing customers they are using a 100 gig, they are using 200 gig for some cases they are using coherent and then in Data Centers, as you mentioned, you have customers making yearly transitions, 200 and 400 gig using 25-gigabaud, 60-gigabaud. Hard drivers in TIA and PAM-4 DSP, these new PAM-4 opportunities potentially pulls in your PAM-4 DSP in addition to your Chiari and drivers, are you guys seeing the adoption of DSP based devices in 5G, and do you have design wins on both 200 gig 5G and 200 gig Data Center and also 400 gig for Data Center, and if so like when would we expect to kind of see that the tangible to the revenue growth here?

[Jack Kober, Chief Financial Officer]

Okay. So I am going to try to address all of those points, but if I miss some, help me. Just when I think about front-haul, I think about 25 gig link. When I think about mid-haul, I think about 50 gig link. So that’s our starting point. So when we think about the products that we can front-haul were specifically referring to clock and data recovery circuits, TIAs and drivers.

We want to introduce 25 DSP lasers and that’s something that we talked about in the script. That’s something we are demonstrating and it’s a product line that we are sampling customers. When we think about 50G links now, different module form factors. We believe we have a product called PRISM 50, which is essentially a PAM-4 DSP. It’s a cousin of our PRISM project that we have been working on. It’s in R&D.

We don’t have any design wins, but it’s working quite nicely in this application and so we demonstrated that just a few months ago with our lead customers and lead prospects, let’s say, and we are gaining interest in traction.

On the mid-haul piece, I would also add that the TIAs are generally very high-end TIAs, and I would argue that, MACOM today has the best TIA in the market. We are winning market share there as a result of that.

The last item is the driver for mid-haul and so that’s another area, again, new revenue and new interest on this product line. So that’s a very concise review of front-haul and mid-haul, when you go into the data. Did you have a question on that?

[Steve Daly, President and CEO]

No. You are right. That was very concise. Thank you. And then I just wanted to, I think you, mentioned, the Data Center in 400G and I can tell you that there’s parallels. So we are today supporting 400G and 200G applications with our TIAs, as well as our 56-gigabaud drivers, okay? And so those would be supporting 200 and 400. And just, if you think about the different reaches, those go all the way from short reach or SR all the way up to long reach LR.

And so that revenue today is small. These are relatively new products just gaining traction. It’s not - those products are not what’s driving the growth today, but they will if we go out in time, okay, if we are successful.

So I hope I have answered your questions, but I do think that you are asking the right question and I think the -- all of these products that we are talking about are relatively new and I think MACOM is a leader in this area.

[Harlan Sur, JPMorgan]

Yeah. No. Thank you very much for the insights there. Just one more question if I may. So on the Industrial and Defense business, as you improved the portfolio, I think, much of your portfolio includes catalog product still. So as the new development pipeline focused on multipurpose dials, multipurpose high-performance analog and mimic products, the kind of continuing to build out the catalog business or are you targeting more application specific products for the various sub segments within I&D?

[Steve Daly, President and CEO]

So it’s a little bit of both and it’s resource dependent, opportunity dependent and we want to be -- so we want to have our own product plan where we want to raise the bar in terms of performance in the market. So that’s an internal plan.

And we always supplement those activities with custom design work, whether it’s a diode, a mimic, this is we want to be very friendly to our A&D [ph] customers and we embrace that work. And again, I think this is a change of strategy. We want to do custom mimic design work for all the major U.S. defense OEMs, and we are going to make sure that MACOM is at the table, looking at the latest specs and bidding very aggressively to win that business, because this is right in our wheelhouse. This is what we do very, very well. And I&D is, as you know, our AR largest revenue segment, but it’s also the largest end market, so tremendous opportunities there.

[Operator]

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

[Tore Svanberg, Stifel]

Yes. Thank you, Steve and Jack and congratulations on this tremendous turnaround. First question, and maybe this is a bit counterintuitive, but obviously there is a lot of questions about inventory build in the midst of a downturn. But as you talk to your customers, could we actually be seeing something completely different meaning if you think about Data Center 5G, our customers actually may be pulling in some of those deployments, maybe even accelerating them somewhat?

[Steve Daly, President and CEO]

It’s very possible, Tore, and this is a question we are asking as well as we look at the strong bookings. And so as Jack alluded to in some of his comments, when we see large orders coming in, we do a lot of investigative work to understand what’s behind this, our customers placing orders because they have one new business or are they getting ahead of expected future business, and so I think that it’s a hard question to answer, but I think it is possible. Yes.

[Tore Svanberg, Stifel]

Very good. And maybe I - my perception is wrong here, but I think you mentioned some new products for testing measurements. Could that be kind of like the fourth leg of the stool here and if not as it’s still going to be embedded in any of the three categories?

[Steve Daly, President and CEO]

It’s an interesting question also, so I would say that our typical business in Industrial and Defense and specifically testing measurement, which is a sub-market in that category. The order sizes are generally smaller than say some of the large high volume sockets that we have been talking about over the past few minutes.

So I would say that this is building out the base and it’s something that will be done over time, as opposed to let’s say a fast ramp, okay? So this is -- we look at our industrial and defense business and if you go back two years, it’s been flat and we recognize that as a problem.

And so the fix will be to design more products for the lead defense OEMs, screen products, repackage products and do a better job of going after the accounts from a sales point of view. And so there is a big opportunity there, moving the needle and the I&D end market. It’s a slow process. So I would temper expectations in terms of high growth in this area.

[Operator]

Thank you. Our next question comes from Tom Diffely with D.A. Davidson. Your line is now open.

[Tom Diffely, D.A. Davidson]

Yes. Good afternoon. I am kind of following on the -- I was hoping to get a little bit of your thoughts on exposure and the outlook for specifically the industrial markets. You mentioned you didn’t have much auto exposure. I am curious on the other industrial markets with the exposures?

[Steve Daly, President and CEO]

I would say that this is the one market that we are most concerned about. We have a lot of customers across Europe that are in the industrial sector and so we have seen a slowdown in bookings and whatnot.

I think over the past two to three quarters it’s been relatively stable, but we are seeing a weakness not only over the past month, but maybe the last two months things have started to slow down. So the markets that would be in that area would be, for example, folks that are building test instrumentation, people that are building even medical equipment. For example, we provide essentially very unique products for MRIs and we have seen a bit of a slow down there.

So the good news is there is lots of customers but the business level at any one customers is at a relatively low level, so we are not too concerned about it. And as I highlighted in my remarks, we have no automotive or consumer electronic exposure and those are the parts of the semi-industry that have been hit the hardest with Coronavirus.

[Tom Diffely, D.A. Davidson]

Okay. I appreciate that. And then just a quick modeling question. You have been using an 8% tax rate. Does that change over time if data centers and these other segments become a bigger piece of the pie?

[Steve Daly, President and CEO]

At this stage, Tom 8% is where we are looking for the remainder of the year from a tax rate -- from non-GAAP tax rate perspective.

[Operator]

Thank you. Our next question comes from Tim Savageaux with Northland Capital Markets. Your line is now open.

[Steve Daly, President and CEO]

Hi, Tim.

[Tim Savageaux, Northland Capital Markets]

Hi. Good afternoon. Sorry, about that, and I will add my congrats. Questions back on the Telecom side. You were looking for high single-digit growth, I guess, leading mid-to-high, for 2Q ended up around 13%. And I wonder if you could talk about what surprised you to the upside there. I know you have mentioned 5G front-haul, mid-haul as a driver. You were seeing strength there previously. So if you look at -- fiscal Q2 in particular, looking across your 5G related markets, maybe just channel and optical transport or PON [ph], can you talk about where the upside was in the quarter. And I have a follow-up?

[Steve Daly, President and CEO]

Yeah. So, I am not sure. I would say that we were surprised by the results for Q2 in any of our markets. They behaved fairly in line with what we were signaling on our last call, where in fact we had signaled that I&D would be down this quarter, which it was.

So in terms of the areas where we saw strength again, it was the front-haul market, which is 25G modules essentially. And I would also sort of maybe add on top of that, we had some strong business with some of our metro long-haul products. So that’s sort of similar end application, right? So I would probably call out those two items as the ones that really drove the upside?

[Tim Savageaux, Northland Capital Markets]

Great. And to follow up on that, you mentioned a couple quarters ago you are under $40 million in telecom now you will be at least with your guidance maybe into the close to the mid-50s. If you look at that kind of growth over that time period, I wonder if you can kind of segment it along the same lines in terms of end market or application drivers. Should we assume that the bulk of that the majority is a 5G front-haul and mid-haul driven more. Are there any -- should we look at it basically as the same way you just described the episode drivers for Q2. Is there anything else going on there if you look over that longer time period?

[Steve Daly, President and CEO]

Yeah. So that the telecom category is actually a large category for us, so it includes the more than just 5G, it includes access to all a whole variety of wireless and applications. So it would be a fair amount of work to kind of go down that list of sort of takes and puts. It includes VoIP as well, which has been a legacy business that we have had.

So I wouldn’t necessarily want to call out any one of the sub-markets. I will say that some of our most exciting technology that we are developing including the laser technology, the analog solutions, the power products including power switches and power amplifiers for this end market are compelling products.

And so we are pleased with the growth. We recognize we have a lot of work to do. We recognize that we are still below some of the prior year peaks in this area, especially when 2.5GPON was running. So we recognize we have a lot of work to do in this area.

[Tim Savageaux, Northland Capital Markets]

Thanks very much.

[Operator]

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

[Mark Lipacis, Jefferies]

Hi. Thanks for taking my question. The Department of Commerce introduced some new export control actions. It looks like it’s targeted at a military area to prevent acquisition of technologies under surveillance used pretended for military end uses. I am wondering if you guys had a chance to look at that yet and if you had any view of that, if that might impact you? And then separately related given all the focus on China, can you give us a sense of what percent of your products are actually consumed in China? Thank you.

[Steve Daly, President and CEO]

Sure. So we are aware of the new BIS announcement that came out I think on Tuesday. Jack and I have both been briefed by our internal counsel, as well as our trade compliance folks to understand that the details of that.

Our initial assessment is that it really won’t impact our business. A lot of the categories in the additional restrictions that are being put into place at first review don’t look like they are going to impact us. So -- but we are aware of that and to the extent that we need to make adjustments to any of our procedures or policies, we will certainly do that.

In terms of our exposure to China, I think, our last output on that number was -- it’s running in the low 30% range from a shift to perspective. So low 30s.

[Mark Lipacis, Jefferies]

Right. That’s shifted. Do you have -- and do you have a sense of what the consumption is any chance?

[Steve Daly, President and CEO]

Unfortunately at this stage we -- it’s a tough one to figure out in terms of it’s being consumed internally there versus re-exported.

[Mark Lipacis, Jefferies]

Got you.

[Operator]

Thank you. Our next question comes from C.J. Muse with Evercore. Your line is now open.

[C.J. Muse, Evercore]

Yeah. Good afternoon. Thanks for squeezing me in. You talked earlier in the call, but winning share TIAs, and curious, how big of a market do you think that is. Can you share with us how accretive that is the margins? And then, I guess, interestingly, does the market share shift there, enable you to bundle other components and did you get kind of double the win because of it?

[Steve Daly, President and CEO]

So, probably be difficult for me to explain the margin question -- to answer the margin question. We don’t typically breakout gross margins by product line, and today it’s a small piece of our revenue. So it’s really not accretive at this stage.

In terms of the bundling piece, we want to provide the customer value on a part by part basis, and oftentimes when you bundle two parts and force a customer to buy something, they would really not want to buy. It -- you get a blow back effect.

Our go-to-market strategy is to put the best products out there that we can have a very compelling price and whether they buy our TIA or our laser diode or our CDR, we want to provide a very professional approach to make sure that they pick the parts they want and they are not penalized if they don’t buy all of it, let’s say. So we really don’t practice the bundling the way you have sort of are described.

In terms of the size of the market, I am sure if I gave you a number it would probably be incorrect. So I want to shy away from that.

[C.J. Muse, Evercore]

Okay. That’s helpful. And if I could just follow up, in terms of kind of this new world with COVID and hopefully it doesn’t last that long, but how are you thinking about cash that you want to have on hand today, and therefore, how do we think about the pay down of debt as your cash level exceeds that perhaps new level? Thank you.

[Steve Daly, President and CEO]

Great question. Jack, do you want to maybe start with that?

[Jack Kober, Chief Financial Officer]

Yeah. So C.J., obviously, we have done quite a bit of modeling going back over to the summer of 2019 time period and there’s a fair amount of modeling that we have put together some upside, some downside as we work our way through it. So to some extent we have had a head start on the modeling aspects and what a potential downturn might look like, and how that might impact us.

But where we stand today, we are fairly confident in our liquidity position and the cash balances that we have. So we are looking to keep our heads down and keep moving forward. We feel like the additional improvements we have made in the profitability and the cash flow generation will provide us with quite a few options as we go forward from liquidity standpoint.

[Steve Daly, President and CEO]

Yeah. And I will just add to that, it’s kind of interesting if you look back over the past period of times. We just delivered the lowest OpEx in 14 quarters. We delivered better gross margins and for all of our fiscal ‘18 and ‘19. So the team has done a great job there and our operating income as a percentage of total revenue is I think better than what we have done over the past 10 quarters.

So it’s really as Jack said doing the things that we are doing to prepare for uncertainty and to build a strong business regardless of COVID or losing a main customer or a main market, or having a competitor come in, we run a very diversified solid business that our goal is to make it a business that is very strong and I think the employees that make on we are doing a fantastic job to that end.

[Operator]

Thank you. This concludes the question-and-answer session. I would now like to turn the call back over to Steve Daly for closing remarks.

[Steve Daly, President and CEO]

Thank you. In closing, Jack and I would like to thank our employees for their extraordinary efforts and accomplishments during the past quarter. Thank you and good evening.

[Operator]

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may not disconnect.