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Good day, everyone. And welcome to the Lumentum Second Quarter Fiscal Year 2020 Financial Results Conference Call. As a reminder, today's call is being recorded for replay purposes through February 11, 2020. I would now like to turn the conference over to Mr. Jim Fanucchi of Darrow Associates. Mr. Fanucchi, please go ahead.
Thank you, Sharon. Welcome everyone to Lumentum's Second Quarter Fiscal 2020 Earnings Call. This is Jim Fanucchi from Darrow Associates, assisting Lumentum with its investor relations. And joining the call today from the Company's management team, we have Alan Lowe, President and Chief Executive Officer; Wajid Ali, Chief Financial Officer and Chris Coldren, Senior Vice President of Strategy and Corporate Development.
Today's call will include will include forward-looking statements, including statements regarding the markets in which we operate, including potential market sizes; market trends and our position in such markets trends and expectations for our products and technology, including product development and projected new product releases; purchasing trends and demands for our products; our expected financial performance, including our guidance, expenses, risks associated with potential disruption caused by the coronavirus, as well as statements regarding our business initiatives and the achievement of synergies following our acquisition of Oclaro.
These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations. Lumentum encourages you to review our most recent filings with the SEC, particularly the risk factors described in our filings with the Securities and Exchange Commission including the Company's quarterly report on Form 10-Q for the fiscal quarter ended December 28th, 2019 to be filed with the Securities and Exchange Commission later today. And Lumentum's 10-K for fiscal year 2019 ended on June 29th 2019.
The forward-looking statements provided during this call are based on Lumentum's reasonable beliefs and expectations as of today. Lumentum undertakes no obligation to update these statements, except as required by applicable law. Please also note, unless otherwise stated, all results and projections discussed in this call are non-GAAP. Non-GAAP financials are not be considered as a substitute for or superior to financials prepared in accordance with GAAP.
Lumentum's press release with the second quarter of fiscal 2020 results is available on its website at www.lumentum.com under the Investors section and includes additional details about our non-GAAP financial measures and a reconciliation between our historical GAAP and non-GAAP results. Lumentum's website also contains our latest SEC filings and supplementary slides relating to today's earnings release, and the Company encourages you to review these documents.
In addition, a recording of today's call will be available by 11:30 a.m. Pacific Time today on our website.
Now prior to handing the call to Alan, we wanted to provide an update on why NASDAQ halted the trading of the company’s stock yesterday aftermarket. The company discovered an employee’s computer pass where it had been compromised yesterday. As this employee had access to a portion of the financial information reported this morning, the company informed NASDAQ of the situation and they decided the halt trading until this information was made public. As of 8:00 AM Eastern Time this morning, trading had resumed.
Now I will turn the call over to Alan for his comments.
Thank you, Jim. Good morning, everyone. Second quarter performance was strong. We achieved new record revenue, gross margin and operating margin. This performance is the result of strong customer demand for our differentiated products, increasing levels of new and innovative products and an improving financial model due to increasing scale and acquisition synergies.
Looking to calendar year 2020, telecom, transport demand is now strengthening. We expect telecom transmission demand to continue to grow further.
We expect a significant expansion in the market for world-facing 3D sensing lasers and from a financial model improvement standpoint, we have made substantial progress, but we are not done yet attaining acquisition synergies and exiting the low margin products we have highlighted on prior calls.
We believe we have sustainable technology leadership positions that make us indispensible to the multiple diverse growing markets we serve today and into the future. We plan to continue to invest strongly in R&D and new product capabilities to extend both our technology and market leadership positions.
Now for further product line and market details. Second quarter revenue increased 2% sequentially and 23% year-on-year. The largest driver of sequential and year-over-year growth was telecom and datacom driven by strong customer demand. Telecom and datacom revenue was up 7% sequentially and 29% from the prior year.
Growth was driven by strong demand for our differentiated coherent telecom transmission products and high-speed laser transmitter chips for datacenter and 5G Fronthaul applications. The strong telecom and datacom transmission growth more than offset the decline we experienced in telecom transport revenue.
We are now seeing however, telecom transport demand increasing.
Demand was, and continues to be strong for our ACO modules and our DCO module volumes are ramping now. Demand exceeded our ability to supply across a range of products in the second quarter. Products impacted by supply constraints, included high-end ROADMs, coherent transmission components and modules, and laser transmitter chips.
We are working to improve supply of these products to meet strong customer demand. We continue to sell off remaining inventory and satisfied customer last time buyers for previously discussed discontinued low margin telecom and datacom products. We continue to expect revenue from these products to effectively decline to zero over the next couple of quarters.
However, we now expect the largest revenue decline from these discontinued products of approximately $10 million to $15 million to occur in the fourth quarter. We are optimistic about the long-term outlook for our telecom and datacom product lines due to expected long-term demand trends, our technology and product leadership positions, and improving industry dynamics.
Demand over the long run should be strong based on the continued strong growth expected in global networks and datacenter traffic and the optical infrastructure needed to support 5G wireless bandwidth. We are well positioned in the market with our industry-leading products and deep customer relationships.
Our next-generation products are critical to the global customer base and include a range of high-performance DCO transmission modules and underlying highly integrated components including those at 400 G and above; high baud rate indium phosphide components including those for 800 G transmission; contingent with M-by-N and high port count twin ROADMs where we are qualified or in advanced design phases across all major customer platforms; and high-performance laser transmitter chips, most notably, our EML transmitters.
These enable next-generation 400 G and higher speed datacenter architectures and next-generation wireless front haul and access solutions. After significant M&A in the optical space over the past few years, industry dynamics are improving. We expect these dynamics to continue to improve and to compound over time.
Looking to the third quarter, Telecom and Datacom demand strength should offset typically seasonal factors. Our industrial and consumer product lines were down 15% sequentially, but up 20% relative to the prior year.
The smaller than anticipated sequential decline was due to strong customer demand for 3D sensing-enabled products. Year-on-year growth was also driven by customers incorporating 3D sensing in a higher percentage of their product offerings compared to last year.
We expect - that we expect the 3D sensing market will grow significantly over the next couple of years as 3D sensing is incorporated in more consumer products in both user and world-facing applications, including computational photography and augmented and virtual reality.
Our R&D teams are very busy working with a broad range of customers on their future generations of 3D sensing needs including for new products coming later this year and next, as well as for products several years away.
We are well-positioned to grow in this market and our experience is a valuable advantage that is proven difficult for our competitors to replicate.
Looking to our third quarter, our guidance contemplates 3D sensing declining more than 20% due to normal seasonality and customer demand. But we expect 3D sensing to be up year-on-year. Over the past year, 3D sensing has penetrated deeper into customers’ product portfolios including increasing need for world-facing applications. We expect this trend to continue.
Now on to lasers. Second quarter lasers revenue increased to $48.4 million. During the second quarter, we started shipping our new PicoBlade 3 ultrafast laser for micro-machining applications. This product addresses OLED display processing, 5G antenna fabrication, and advanced via hole drilling and print circuit boards.
These applications are all expected to see significant market growth in the coming years. Over the long run, because of our investments in unique new products and technologies like the PicoBlade 3, we believe we have good opportunities for growth driven by new product introductions in addition to market growth. In the third quarter, we expect laser revenue to be down a bit due to the customer seasonality.
Throughout my remarks, I've highlighted long-term trends that make our products, products and technology increasingly critical to the markets in which we participate. I’ve also highlighted the progress we have made towards our strategic and financial goals.
Over the past several years, we have made significant investments in new products, markets, design wins and M&A. We believe these investments and the long-term trend in our markets position us well for the future.
Before handing it over to Wajid, some comments on the tragic and evolving coronavirus outbreak. First, our thoughts are with all those affected. Second, our top priority is protecting the health and safety of our employees. We have restricted employee travel into and out of the affected regions and we are reducing our participation in large group events with strong international attendance such as certain tradeshows.
In our factory in Shenzhen, China employees have been impacted by travel restrictions and the extended Lunar New Year Holiday imposed by the Chinese government. For some of our products, the supply of externally purchased material is being impacted. The situation is obviously very fluid, but we are in close contact with our factory in China, impacted suppliers, as well as our customers.
Wajid will discuss the impact of the coronavirus on our third quarter financial guidance. I will now hand it over to Wajid.
Thank you, Alan. Good morning everyone. I am pleased to be discussing our strong second quarter results. Net revenue for the second quarter was $457.8 million, which was up 2% sequentially and 23% year-on-year.
GAAP gross margin for the second quarter was 41.3%, GAAP operating margin was 16.3% and GAAP diluted net income per share was $0.63. Second quarter non-GAAP gross margin was 47.4%, which was about 160 basis points sequentially and 730 basis points year-on-year. The higher gross margin was primarily driven by improvements in telecom and datacom margins, as well as acquisition synergies.
Non-GAAP operating margin for the second quarter was 28.8%, which was up 150 basis points sequentially and 680 basis points year-on-year. Non-GAAP operating expenses totaled $84.8 million or 18.5% of revenue. SG&A expense was $38 million, R&D expense was $46.8 million.
Second quarter non-GAAP net Income was $119.4 million. This includes $0.6 million of net interest and other expense and $12 million of tax expense. Non-GAAP diluted net income per share was $1.53 based on a fully diluted share count of 78 million. We had very strong cash flows in the second quarter. Cash flow from operations was $162 million.
We also took a series of actions impacting our capital structure during the quarter. We repaid in full the term loan that we took on in connection with the Oclaro acquisition. We sold 1.05 billion of new convertible notes due in 2026 and we repurchased $200 million of our common stock in connection with the note offering.
These actions, along with the strong cash generation from the company's normal business operations resulted in an end-of-quarter cash and short-term investments balance of $1.3 billion.
And now an update on synergies. On our call in August 2019, having achieved our initial $60 million target, we increased our annual runrate synergy target by $40 million to $100 million. Through the second quarter of fiscal 2020, we have achieved approximately half of the incremental $40 million of synergies and we have also identified an additional $10 million.
Therefore, we expect to attain another $30 million in annual runrate synergies over the next three to four quarters bringing the total acquisition synergies to $110 million versus the prior forecast of $100 million.
Turning to segment details. Second quarter Optical Communications segment revenue at $409.4 million decreased 2% sequentially. Optical Communications segment gross margin at 48%, increased 190 basis points sequentially and 830 basis points year-on-year with a more favorable mix of products, improved Telecom and Datacom margins, and acquisition synergies.
Our Laser segment revenue at $48.4 million, increased 43% sequentially and was flat year-on-year. Second quarter Laser’s gross margins was 42.1%, flat quarter-on-quarter.
Turning now to our guidance for the third quarter. The projections we're providing today are also on a non-GAAP basis and are based on our assumptions as of today. Please note the guidance we are providing today incorporates an approximate $15 million to $20 million reduction in revenue at the midpoint and a wider than normal revenue range due to the coronavirus outbreak.
We project net revenue for the third quarter will be in the range of $400 million to $425 million. At the midpoint, this revenue projection includes Telecom and Datacom increasing sequentially. Industrial and consumer decreasing due to 3D sensor sensing customer seasonality and Commercial Lasers also decreasing, driven by customer seasonality.
Based on this, we project third-quarter operating margin to be in the range of 21% to 23% and diluted net income per share to be in the range of $1 to $1.17. These projections incorporate an approximate share count of 78 million and an estimated other income of $3 million.
This share count and other income projections incorporate the impact of both of our convertible notes, pay down of our term loan and share purchases made in December.
I want to note again that our guidance incorporates a $15 million to $20 million reduction in revenue at the midpoint due to the anticipated impacts of the coronavirus outbreak and as Alan highlighted earlier, the situation is fluid and evolving.
With that, I’ll turn the called back to Jim to start the Q&A session. Jim?
Thank you, Wajid. And I before I turning the call over to Sharon to start the question-and-answer session, I would like to ask everyone to please keep to one question and one follow-up. This should help us get to everyone before the end of our allotted time. Sharon, let’s begin the question-and-answer session.
[Operator Instructions] Your first question comes from Rod Hall with Goldman Sachs.
Yes. Hi guys. Thanks for the question and nice job on results here. I wanted to start off and see if you could talk about the $15 million to $20 million adjustment for the coronavirus and give us some idea maybe where that lands. Is it mainly 3D sensing? Or is it evenly spread across the segments? And any other color you could give us on the how that might impact things down through the P&L? And then I’ve got a follow-up.
Yes, Rod. Thanks for your question. This is Alan. The $15 million to $20 million in an estimate based on what we know today, both from a supply standpoint, as well as anticipated demand standpoint given some of our customers are also in affected areas. So, you know, we don't have the granularity to say, on the demand standpoint where it comes from, I will say that, because our factory in Shenzen is focused mainly on telecom transmission. From a supply standpoint, that’s primarily where the shortfall will come.
And Rod, as far as your question is related to the P&L, we've already incorporated the impact of the $15 million to $20 million in our operating margin and in our EPS guidance. So the $1 to $1.17 already includes the impact of the $15 million to 20 million adjustment that we noted in our script.
Okay. Thanks, Wajid, and Alan, as well. I wanted to follow-up with a question on Huawei, two things on that, one the UK's decision on Huawei, how does that impacts you? Do you anticipate any impact from that, positive or negative I guess?
And then also, just maybe an update on what you know your thinking in terms of recent administration comments regarding Huawei? Does that the change anything? Do you have any thoughts on when we might find out more just any update on that would be helpful.
Hey Rod. This is Chris. I would say, to both parts of the question, given our footprint in the customer base we’re largely agnostic to which of our customers wins business. So, whether in the UK, Huawei is restricted to a more limited portion of the network. We don't believe this is a significant change for us.
And then, in terms of understanding what the U.S. government is going to do here, I don't think we have any more insight that that what you can read in the general news or media. But we are monitoring the situation very closely.
Great. Okay. Thanks, guys. Appreciated.
Your next question comes from Alex Henderson with Needham.
Great. I wanted to see if I could delve into a little bit what your comments were around the ROADM side of the business. Obviously, you are seeing some constraints at the high-end of your production segment. But have you seen a change in the demand there? It sounded like, if I read what you were saying in your text that you are seeing a pickup in demand there.
And if you could tie that into, what’s your thinking around the coronavirus is that would be depreciated. Is corona going to result in a temporary demand hiatus on some supply? Or and then you get it back later in the year? Is it – how do you see that playing out over time assuming the virus has got the same traditional seasonality of all cold viruses i.e., as the weather changes it abates?
Yes. So, what we said, Alex was, if remember going into our second quarter, we said, we were seeing some telecom transport flattening out or softening and we saw that in the second quarter. And what we wanted to reiterate in the script was that, through the quarter, we saw a pickup in that demand across the board, but mostly on the high-end ROADMs as more and more of our customers are developing and designing systems around both our high port count twins, as well as our contentionless end-by-end.
So, we are starting to see that really pick up across the board at all of our customers. And as far as the coronavirus impact on ROADM demand, I don't know that until our big customers come back from the break will know exactly what impact that will have. That said, I don't think we have a problem in demand for the high-end ROADMs.
And so, we are shipping as much as we can and I don't think that anything will impact that as we are adding more capacity over the next nine months.
And then if I could follow-up. So, looking at the Corona commentary, I assume you are taking into account the full impact of the holidays and the extension you are also – it sounds like you are taking into account some supply constraints.
Are you assuming that that stays – could you give us a sense of how long you expect that to stay within that guidance or whether you are assuming that there is some tempering of the damage over time within that projection. What’s the sensitivity to further extensions of delays or things of that sort versus the forecast assumptions?
Yes. So, Alex, maybe one of the differences with our factory in Shenzen to others is that, because of the very, very strong demand for coherent components and modules, we had a workforce working through the Chinese New Year at about 50% plus or minus a little bit. So those employees continued to work through the Lunar New Year as well as the existing week because they were in working and staying at the dorms and didn't – weren’t restricted by travel restrictions.
We have a good handle on where the other employees are and our guidance contemplates them not coming back immediately because of the travel restrictions, but coming back slowly over time. And so we’ve had to kind of estimate what we think that’s going to be and that’s where we came up with the $15 million to $20 million of impact. Did that answer your question?
Yes. That’s very helpful. Thank you very much.
Okay.
Next question comes from Blayne Curtis with Barclays.
Hey guys. This is Tom O'Malley on for Blayne Curtis. My first question is around 3D sensing. Obviously you have some big ramps coming up in the second half of this calendar year. Can you talk about what your expectations are for share? Has that changed recently? And how do you see yourselves competing in the second half? Are you any more or less well-positioned than you were, say, last quarter?
Well, I’d say that, we are going to continue to do what we need to do to satisfy our customer and give them no reason to want to buy from anyone else. And so, I think, having shipped 0.5 billion or more units with no field returns is a pretty compelling argument to continue to give us a very large share of the business.
I will say that that we do expect introduce new products in the coming months that I think push the technology a little further and give us strength in our differentiation over our competitors that then will give us again a high share of those new products for quite some time. So, I am pretty confident on our position and feel good about where we are now, as well as in the second half of the year.
Great. And then, on the telecom and datacom businesses, you are guiding them both, but that’s cumulatively. You are talking about how the Shenzen factory may be affected from a telecom transmission perspective. And then you’ve also talked about some businesses going away. I know that that's weighted toward the fourth quarter.
But can you talk about - are you able to offset both of those weaknesses in telecom, specifically? And is it just the ROADMs that are better there that you’ve described? Or is there anything else that’s kind of helping that grow?
Well, as I said in the script, we are on serious constrains in our ability to meet our customers’ demand for coherent components, ACO's and now DCOs. And so we are ramping those products as fast as we possibly can putting aside the coronavirus impact on our Shenzen factory. So I think, we are seeing growth in transmission.
We are seeing a strength coming back in transport and our datacom chips are growing very rapidly both in Q2, as well as expected throughout this year to support the 5G rollout, the datacenter buildout. And so, I think from that perspective, that’s why we said telecom datacom are going to offset what’s typically is a seasonally soft quarter in the March quarter.
Yes. And also just to make sure we are clear that not all of our telecom and datacom revenue is flowing through our factory in China. In fact our datacom chip revenue does not touch that factory and similarly a lot of our telecom transport is not flowing through that factory. So we do have significant portions of our revenue from a supply standpoint unimpacted by what’s going in China.
Thanks guys.
Your next question comes from Samik Chatterjee with J.P. Morgan.
Hey, thanks for taking the question. If I can just start off by following up on the earlier question about Huawei, I understand you mentioned that there is limited visibility at this time on the changes in terms of regulation from the government on that front.
But what you are really embedding in your guidance than related to revenue from the customer, I believe last quarter, you had mentioned you were expecting to see some slowdown from that customer. So, I just wanted to understand if that's played out as you expected? And are you expecting, kind of similar revenues or a pickup from that customer?
This is Chris. I would say things are playing out as expected. That customer was a significant customer for a lot of our products that are being discontinued. For example, the datacom modules, the historically we’re the largest customer.
And similarly, on some of the products that we supply where we do have competition that those products seem to be a little bit more impacted from a demand standpoint, whereas our high-end products, particularly the high-end ROADMs were seeing less slowing, if you will.
With that said obviously, it’s difficult to handicap what's going on with U.S. government et cetera and any changes that they may make to rules. I continue to point out that our manufacturing and supply chain is quite offshore when you have some manufacturing in the U.S. of some laser chips, but other than that in general, our manufacturing is quite offshore.
So, difficult to opine on what the impact of what people speculate changes what could be, but I think unless there is a complete change in strategy, i.e. the question of a ratcheting down percentage is in de minimis threshold. That’s something that unless there is a radical change in definition, wouldn’t be as impactful to us given our supply chain.
Got it. And if I can just follow up on the broader comment that you had in the press release about transport demand has been strengthening and you've talked about the ROADM strength as well. If you can give any color on, kind of which customers or geographies you are seeing is driving that? And how is that different from the drivers of the strength that you are seeing on the transmission side? And that will be helpful. Thank you.
Yes, well, as I said in the script, the high-end ROADMs and the contentionless end-by-end are broadly being deployed in new systems across the board. So I wouldn’t say that it's any particular customer nor what I comment if it were, just because I think we have a very broad footprint of customers and our ROADM leadership really puts us in a good place across the board.
Chris, do you have anything to add there?
No.
Okay. Thank you.
Next question comes from John Marchetti with Stifel.
Thanks very much. Just following up little bit on the transmission side. I was just curious, outside of some of the constraints that you have right now in ACO, DCO you had mentioned it in the prior call that that you are expecting that business to continue to build.
Just want to get a sense from your perspective, is that still the case if you are seeing that broadly across different geographies? And how you think about that transmission piece playing out here over the next several quarters?
Yes, and we continue to see strength in ACOs and we are in the midst of ramping our DCO product. But I think even underlying those products is our capability at the indium phosphide level for higher baud rates, components for products that are up to 800 Gigs. So we are seeing a broad range of customer demand for these enabling technologies from a component level through ACO and DCO’s broad based.
And then if I can just follow-up real quickly on the end-by-end commentary. I just wanted to make sure, historically I think that was primarily a product designed or shipping into Huawei and I just wanted to follow -up on your last comments that that is now shipping to multiple customers and not just to that one?
That is correct.
Thank you.
Next question comes from Simon Leopold with Raymond James.
Thank you for taking the question. I wanted to come back up on the coronavirus supply side of the question. I think you’ve moved a lot of operations out of China. So, maybe help us understand what portion of your production or headcount is based in China now?
And do you feel as if you have a competitive advantage, because the folks you can competing against maybe more exposed in terms of the supply side of this, in terms of having more staff in China? And then I’ve got a follow-up.
Sure. Well, we have approximately 1,000 people in China. Most of those are manufacturing people. And then outside of China, we have contract manufacturers that employ thousands of people on our behalf, as well as our own factory in Thailand. And so, over the last three years, we did move a substantial percentage of our production out of a contract manufacturer in Shenzen China.
Most of that went to our own factory, as well as into contract manufacturer in Thailand. So, those - those employees and contract manufacturers are not affected by the coronavirus except from the standpoint of any kind of sourcing of components and we’ve looked at the sourcing of those components that could come from China.
And we feel pretty comfortable that our Thailand contract manufacturer and our own operations will be minimally impacted by those sourcing of components coming from China. So I’d say, to answer your question, Yes I think we’re in a much better position than some of our competitors who are highly China manufacturing based.
Great. Thanks. And then, in terms of the follow-up, one of the things are rich that that we've all talked about for some time is the idea that Huawei in particular or Chinese OEMs in general become more vertically integrated.
And we have the impression that that might be accelerating and just want to get your sense whether you’ve seen evidence of this, particularly in an area like a lower-end ROADM type product or other aspects? Thanks.
Yes, I mean, I think, we are going to continue to focus on innovation and driving innovation and I think while, over the last five years, there has been a drive for our Chinese-based customers to be more independent. I think our continued push on innovation and new product introductions has kept us in a very, very good position with respect to those leading edge products.
Our participation at the low-end ROADMs in China is not that big as most of those deployments have shifted and the ASPs per unit are significantly higher on a twin high port count product or an end-by-end.
Yes, Simon, I would add to that. Our customers in China also compete on a global market and our customers or our customers’ customers demand the ultimate in performance capability and that's how we differentiate our products is around performance and capability.
And we do or have had and continue to have competitors in most of the products that we make and we feel that if we can continue to put distance between ourselves and our competitors, it’s pretty challenging for a customer, if you will, other than if they are willing to compromise performance or capability, which they would struggle to do on a global marketplace.
Great. Thanks for taking the questions.
Next question comes from George Notter with Jefferies.
Hi there. Thanks very much guys. I wanted to ask about the gross margins strength. I was really pretty surprised by her in the December quarter. Heard the comments about mix improvement as well as just trade up strength in datacom and telecom. But any more flavor you could give us for that optical gross margin strength? And then, how do you see gross margins going forward? Thanks.
Yes, no, I think, it’s Wajid here. I think you’ve captured it pretty well. Our gross margins came in a little bit better than we expected during the quarter, primarily because of the acquisition synergies continuing to flow through. As we noted in our script, we are expecting those acquisition synergies to continue through the calendar year 2020 and we’ve increased that number from $100 million to $110 million.
If you take a look at our operating margin guidance, which is really a flow down of our gross margin improvements for Q3. You can see that year-on-year, we are expecting to increase substantially despite the fact that our revenues are going to be down year-over-year because of the coronavirus situation. And so, we are continuing to expect to see improvements in telecom and datacom gross margins.
And some of that is being driven by the new products that we have coming out which are giving us higher standard margins on our products, but some of it is also because of the continued expectation of acquisition synergies to flow through over the next three or four quarters.
The one item just drawing on what Alan said earlier, the continued strength in 3D sensing that we are expecting to see over calendar year 2020 should also provide us with a nice boost to gross margins as we enter the back half of calendar 2020. So we are looking forward to that.
Yes, and just one thing.
Got it. And then…
Sorry, sorry, George. The $10 million to $15 million drop of legacy low-margin products going away in Q4, that should also help. Those are very core margins. That was with Huawei.
Got it. Okay. And then, through the M&A synergies coming in Shenzen, was that part of the story here in March or do they still kind of flow in on a more sort of ratable basis as you progress this? How should we think about that?
Yes, so, I mean, some of it is flowing through and you will see some of it in March and that’s why we’ve been able to guide the operating margins that we have. But you’ll see a nice chunk come in our first fiscal quarter of 2021 and then flow through to the December quarter in fiscal 2021 as well.
Okay. Thank you.
Next question comes from Michael Genovese with MKM Partners
Thanks a lot. As we think about 3D sensing seasonality for the year, obviously, you’ve given March guidance. But, is there a reason should we think about normal seasonality this year? Or is there a reason to thinking June either an earlier start to programs on existing customers as they do world-facing or new programs, new customers? Is there any reason to think that June should be better than seasonally normal?
I don’t think that there is anything that would be material different with respect to seasonality in the June quarter.
Okay.
And we see – we saw pickup in the June quarter from new products last year and that usually starts late in the quarter and I don’t see any reason to expect it to be any different this year.
Okay. Got it. And as we look at the March guidance, that you’ve given for 3D sensing, and as we sort of try to compare it with the main customer that we know about and what we think about their units. Is there any reason that you’d be materially different, ASPs or market share or inventory or would we think that these numbers should actually line up the customer numbers with your numbers?
Well, I think, Mike, we highlighted in the prepared remarks where we thought the 3D sensing revenue would be at least from a quarter-on-quarter change. So I think that incorporates all of those questions that you’ve asked.
Okay. I appreciate it. Thanks.
Next question comes from Tejas Venkatesh with UBS.
Thank you. I wonder if you could comment on the inventory situation at Huawei and broadly in China.
Well, I think, it’s hard a hard to know exactly what's going on with inventories. But I’d say that, the majority of our revenue that are going into our leading customers in China are for very differentiated products, in particular high-end ROADMs, twin high-end ROADMs, end-by-end ROADMs where - but competition is far behind us.
And so, I think, given that we are constrained in our ability to meet what they are asking for gives me confidence that there is not a warehouse full of high-end ROADMs. I’d say that the rest of the products whether it’s more competitors, we are not selling a lot of those things and in fact, as Chris mentioned, we’re getting out of the datacom module business and winding that down in the next several months. And so, we’re not so concerned about those types of products.
Thank you. And as a follow-up, what was android 3D sensing revenue in the December quarter? And how are you thinking about the next few quarters? Thank you.
Yes, we're not going to continue to break out android revenue. Obviously, we have a large customer driving the vast majority of our revenue and so that - in providing that we would be disclosing confidential information. I think from the trajectory standpoint, we’re certainly seeing android funnel building up as more customers incorporate 3D sensing in more models.
There has been a little bit of a sort of hits to the android market with obviously Huawei being a major customer or major smartphone supplier and therefore a major customer of 3D sensing lasers. And with their inability to get things like Google apps and challenges around the android operating system due to the current restrictions, we believe their volumes of high-end smartphones sold out outside of China are more limited and that’s muted some of the growth that we had previously anticipated in android.
But with that said, the customers are lining up, particularly around the world-facing capability for computational photography and more or less saying that’s just a feature of their new dual, triple and quad cameras moving forward.
And I think, over the next 12 to 24 months is also a time period where augmented reality, virtual reality applications are potentially going to emerge more visibly for consumer devices and that will give other motivation to android suppliers to adopt 3D Sensing.
Next question comes from Meta Marshall with Morgan Stanley.
Great. Thanks. Maybe just one clarification and one question. On the clarifications, should other incremental synergies that you guys are talking about be kind of 30 that are remaining, should that mostly be in gross margins or should we expect some of that in OpEx?
And then for my question, coronavirus aside on kind of the supply constrained products, how much incremental capacity could you be adding kind of on a quarter-on-quarter basis? Or should we be thinking of incremental capacity that could be added? Thanks.
Yes, so on the synergies question, it will be in our gross margins. We’re seeing most of the benefits coming through in our cost of sales, as our operations team has been able to continuously beat every target that we put in front of them. So - so what we should see that in the gross margins primarily flowing through.
Our operating expenses – we are continuing to invest heavily in R&D, especially with the growth that Alan talked about earlier and within our transmission product lines. And so, some of it will be reinvested back in there. As far as your question on coronavirus, Alan, did you want to take that?
Well, I think that question was really setting aside the coronavirus the capacity growth on constrained products, I’d say on the biggest area for opportunity in my mind – well, two areas, is our datacom chip revenue that grew substantially quarter-on-quarter last quarter, but was still constrained.
I can imagine adding 50% to that capacity over the next four to six quarters and we are taking action to do that by adding capacity in our fab in Japan, moving equipment from our San Jose fab to our Japan fab and things like that that will give us that incremental capacity.
I’d say the other big areas on the telecom transmission as we shift to DCO modules, average selling price per unit is substantially higher than a ACO module given that we have DSP in it. So, that’s one dynamic.
But we are ramping up capacity there. We're also having to increase our capacity in our UK wafer fab that supplies all these photonic integrated circuit chips or our coherent components and modules. I hate to give a number on that, but I could imagine a year-and-a-half from now having 50% increase to revenue and telecom transmission. So, I think that the vectors are lining up and demand is very strong.
Great. Thanks, Chris.
Next question comes from Troy Jensen with Piper Sandler.
Hey. How are you doing? First off congrats on really good results. Your team did a great job on the operating margins too.
Thanks, Troy.
Hey. So I guess, and just on that point, just talk about the stability of the operating margins here. I mean, what you guys reported here in the December quarter is pretty impressive right, 28% 29%. Just think about the longer term model you got at least cost synergies coming in, you got a mix of products. What do you think operating margins look like in coming quarters?
Yes. Hi there, Troy. It’s – I’ll start off. It’s Wajid here. So, what we talked about over the last couple of quarters is our goal is to improve our operating margins year-over-year and so we’ve been able to do that fiscal Q1. We clearly and I did that in fiscal Q2 and if you take a look at our guidance for fiscal Q3 I think last year, we were under 18% on operating margins and now we are guiding 21% to 23% on lower revenues.
And so, our operating margin trajectory is going as planned. A lot of it is because we’re being quite disciplined from a synergy standpoint, but when you hear capacity constraints, that also means that we’re being quite disciplined from a pricing standpoint as well. And our general managers are doing a fantastic job of balancing that with customer requesting customer requirements.
In addition to that, Alan mentioned earlier that we’re putting in place capacity to increase supply for telecom transmission products, as well as datacom chip products. And so, because we’ve got so much leverage in our model, even though we’re continuing to expect to invest in R&D with that revenue leverage, we should see operating margins improve.
And then, last thing is, as we look into the back half of calendar 2020 with increasing content that we are seeing on 3D sensing and the margins you can expect on world-facing products. We expect to see operating margins benefit from that as well. So, like Alan said, everything is lining up and we’re doing our best to execute to it. Alan?
Great. I guess, and my hope is that you guys can continue these year-over-year growth in the first half of next year - next fiscal year, you start to approach 30% model, but I know you won’t touch on that. But maybe just for my follow-up then, just can you hit on industrial lasers, any hopes in that – the fiber laser business starting to pick up more?
Yes, I mean, as you know, the fiber laser pricing is pretty aggressive really due to aggressiveness of the Chinese suppliers that are putting pressure across the board on fiber lasers. That said, we do supply a very large percentage of those customers with the fiber laser chips that fuel those engines and you can imagine those are at semiconductor type margins.
And so, we are going to continue to do that. I’d say that that there is a lot of new product introductions coming, as I mentioned the PicoBlade 3 entering new applications for us in ultrafast cutting of OIDs and the 5G antennas, as well as printed circuit board via drilling. And so, we are going to continue to invest in new products and lasers, new fiber laser platforms that drive our cost to the point where we need it to be to keep up with the competition or actually exceed the competition.
So, I think we are seeing ups and downs because we have a pretty concentrated customer base. But as we enter into these new markets and new applications, our customer base should broaden and we should see long-term growth.
Perfect. Keep up the good work Alan.
Thanks, Troy.
Next question comes from Richard Shannon with Craig-Hallum.
Well, hi guys. Thanks for taking my question. Maybe a question for Alan on the overall optical environment here. You just raised a convert, got a nice balance sheet here. You’ve closed a nice acquisition of Oclaro. Wondering what your views are on further industry consolidation specifically in Lumentum's participation in that? Do you expect continue looking for acquisitions and potentially large ones?
Okay. I think we always look for acquisitions that provide shareholder value. I think the challenge with some of those are that you have to have a willing seller at the right price and we are going to continue to have a funnel of targets that we look at all the time. And when we reach agreement with one of them, we will let you know.
But I think that the industry is getting healthier. The dynamics are much healthier with a lot of the acquisitions that have already taken place. But I do think that there is still more to come that will even make the dynamics of the industry more healthy.
And I think, Richard something you brought up is participate in the benefit of it, not only can we participate in the benefits by acquiring companies and integrating and achieving the synergies as we’ve done. But also by being a bystander and others consolidating in the industry, everybody benefits from being there being fewer players competing for the customer opportunities.
Okay. Fair enough. Thanks. My follow-up question is on 3D sensing, specifically on the - kind of the pricing dynamics you expect going forward throughout this year. Your discussion on previous questions around competition. So, just you don’t see a big change in that environment. So, are you expecting pricing curves kind of being similar at least like-for-like basis this year that you’ve seen in past years?
Well, I mean, I think, we continue to focus on driving our cost down to satisfy our customers’ desired need for lower cost solutions especially as they add more content per phone or per device I’d say. And so, we are focused on maintaining our gross margins in that business and we’re confident that continuing to come down on the price curve and cost curve will allow us to continue to have a huge share of that market and happy customers.
And so, as the gross margins that we need. So, I think from that perspective, I think as we refresh the products and we're expecting a pretty good refresh on all the products, most of the products I should say, this coming year, we have an opportunity for pricing to not have gone through three years of price reductions. And so, I think from that perspective, we are pretty comfortable with where we are from a gross margin standpoint.
Okay. Fair enough. Thanks for taking my questions.
Operator
Next question comes from Tim Savageaux with Northland Capital.
Hi, good morning and congrats on the results. I have initial question on the demand front and maybe a sort of quick follow-up on gross margins. And from a demand perspective, but to kind of get your thoughts on what appears to be almost historically strong telecom datacom demand. It looks like ex the impact of the virus you might be guiding up mid, maybe even high-single-digits in a normally seasonally down quarter historically, in the March quarter.
We’ve seen that before and have a very strong surge in China in back a few years ago. But I wonder if you could characterize what's driving that and whether it is kind of a 5G-driven demand strength out of China or to what extent your own share gains or perhaps the new normal that you previously referenced from an ASP standpoint are driving what looks to be pretty extraordinarily strong demand in telecom and datacom.
Yes, I would say that, we have a competitive advantage with respect to a lot of our products and technologies that that drive demand. And in particular, if you look at our datacom chip business, we have an enabling technology with our EMLs to really drive next-generation product introductions that 400G for datacenters.
So I think we are seeing a lot of strength in hyperscale datacenter growth and we’re in the early stages of 5G demand using similar type of technology in chips. And so, I’d say we’re in the front-end of that. But the demand across the board is quite strong on datacom chips. On the telecom side.
Again I think it’s a differentiation standpoint and our ROADMs are – we have a huge lead in technology and product on that. And in our transmission side, we’re enabling customers to produce 800 Gig transmission - coherent transmission with the enabling technology at our photonic integrated circuit level.
So, I think that’s what’s driving a lot of the demand and having the leadership that we had on ACOs and now, hopefully on DCOs in the coming years will drive incremental growth in our telecom transmission business.
Yes, I think Alan.
Thanks and - sorry.
Alan, hit the nail in the head and summarized it well. It’s strong market, fewer competitors and very differentiated products. All three of the two - are all three compounded positively.
Sounds like a decent environment. And to follow-up on the datacom chip, maybe that was the real surprise driving gross margins maybe a little bit better than you expected, but a lot better than I expected maybe 300, 400 basis points with Optical com margins looking to get into the mid-40s here. Would it be fair to characterize as datacom device drivers is sort of key to that and as you look forward into at least some growth even with the virus impacts in the March quarter.
From a mix standpoint or any others, is there reason to believe those margins would decline sequentially in Optical com or is most of the sequential gross margin decline a result of lower 3D sensing volumes and margins?
So, let me start up and then Alan can jump in. So historically we've seen a seasonal decline in both revenues and gross and operating margins going from our fiscal Q2 to fiscal Q3. And just a reminder, last year, our operating margins for fiscal Q3 were under 18%. And so, that normal seasonality does give us normal gross and operating margins come down, because we have a pretty substantial manufacturing infrastructure that we’ve got to support. And so revenue levels do matter.
We’ve provided guidance from March to the best of our ability. But what you’ve heard from Alan is that, we’ve got a number of tailwinds that are working in our favor. Obviously, the datacom chips being on supply constraints and that’s investing in more capacity because we see demand there is giving us a tailwind.
3DS going into the back half of the year. That’s giving us a tailwind. We’ve got acquisition synergies that are flowing through all of calendar year 2020 and then, we’ve got top-line growth in transmission that’s going to give us leverage on the top-line and allow us to have better operating margins as the calendar year flows through.
So, we've got everything working in our favor in order to help us improve gross margins and resulting operating margins. I mentioned earlier that we are investing a little bit more in R&D especially in transmission business. But that shouldn't be so much that it offsets that the leverage and the tailwinds we see in datacom, 3DS, as well as acquisition synergies.
So, where it’s going to be in March? We've guided to. But what we see for the balance of calendar year 2020, I think you've kind of all you need to help you with your model.
Thanks.
We have reached the end of the allotted time. I will now turn the call back over to Mr. Alan Lowe.
Great. Thank you, operator. We regularly discuss our business and investor events. These events are listed on our website in the Investor Relations section and are regularly updated. This concludes our call for today. We’d like to thank everyone for attending and we look forward to speaking with you again in another few months. Thank you.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.