MACOM Technology Solutions Holdings, Inc.

Welcome to MACOM's third fiscal quarter 2021 conference call. This call is being recorded today, Thursday, July 29th, 2021. At this time, all participants are on a listen-only mode. I will now turn the call to Mr. Steve Ferranti, MACOM's Vice President of Strategic Initiatives and Investor Relations. Mr. Ferranti, please go ahead.

Thank you, Olivia. Good morning. Good morning. and welcome to our conference call to discuss MACOM's financial results for the third fiscal quarter of 2021. 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 can result in those differences, we refer you to MACOM's filings with the SEC. Management statements on this call will also 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 8K, which was filed with the SEC today. And with that, I'll turn over the call to Steve Daly, President and CEO of MACOM.

Thank you and good morning. 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 third quarter fiscal year 2021 results. When Jack is finished, I will provide revenue and earnings guidance for the fourth fiscal quarter, and then we will be happy to take some questions. Revenue for our third fiscal quarter was $152.6 million, and adjusted EPS was 57 cents per diluted share. We are pleased to achieve 60.3% gross margin and 28.7% operating margin. We believe that our culture of continuous improvement along with our disciplined financial management and investment in developing differentiated products will support further gains in market share as well as improved profitability in the quarters and years ahead. Our Q3 book-to-bill ratio was 1.3 to 1, and our turns business was approximately 16% of our total revenue. We believe our strong Q3 bookings reflect market share gains as well as the current industry trend of customers placing orders well in advance of demand due to continued supply concerns. As most are aware, the semiconductor industry and our business are currently being challenged on multiple fronts. We see exceptionally high utilization levels at many of our wafer foundry suppliers, which results in extended ordering lead times. Second, we see pockets of component shortages due to manufacturing capacity limitations. This is especially true with certain package and PCB technologies. And third, we are once again seeing COVID-19 cause operational disruptions across Southeast Asia. where many of our assembly and test suppliers are located. Our operations, planning, and logistics teams are doing an excellent job managing these issues and working to meet customer commitments. We believe we can meet our near-term targets. However, given the deteriorating situation I just noted, we do see a higher execution risk profile in Q4 when compared to last quarter. Our fiscal Q3 revenue by end market was generally as expected and included industrial and defense at 71.4 million, telecom at 48 million, and data center at 33.3 million. IND was down 1% sequentially, telecom was up 14% sequentially, and data center was down 8% sequentially. For the first three quarters of FY21, IND was up 40%, data center up 27.6%, and telecom down 8%. Our industrial and defense end market performed well in Q3, with only a modest sequential decline following two quarters of strong double-digit growth. Demand is being driven by industrial applications, including test and measurement in medical systems, along with continued traction in various U.S. defense programs. Our strategy of developing compelling and more innovative products is opening up new opportunities for us across our existing industrial and aerospace and defense customer base. Additionally, we continue to make progress in our campaign to better leverage our entire portfolio within the IND market. We seek opportunities that will create a diverse, sustainable, and profitable business in the IND space based on our differentiated product lines, including RF power, millimeter wave mimics, high-speed data ICs, and optical components. We will also begin evaluating select subsystem opportunities to further leverage our IC and system knowledge. Our telecom and market revenue was up in Q3, driven by a modest increase in 5G product shipments. along with increased product shipments in PON, cable TV, and SATCOM markets. I'll note that over the last month, we've been tracking the 5G awards to support the next phase of China's domestic 5G network deployments. As a reminder, Macom has a comprehensive 5G solution portfolio, which supports coherent metro long-haul and front-haul optical hardware, as well as a suite of RF products used within the radio base station. The specific opportunities for MACOM vary depending on the base station configuration, regional frequency bands, and details of the network architecture being deployed. For example, within China, 5G deployments at 2.1 and 2.6 gigahertz typically utilize 25G front-haul links, and deployments at 700 megahertz typically utilize 10G front-haul links. In aggregate, we believe 5G represents a large secular growth trend for MACOM over the next few years as the worldwide demand for improved connectivity at higher data rates grows. We also expect contribution from 10G PON, cable TV infrastructure, and SATCOM, primarily driven by strong end market dynamics, new product introductions, and market share gains. Our data center and market revenue was down in Q3. As expected, traction with our new 200G and 400G products and gains in international 25G and 100G deployments was offset by a decrease in demand for our 100G products. We believe the 100G slowdown is related to inventory consumption at our largest customer. In fact, we believe 100G volumes will remain healthy for the foreseeable future and we continue to secure new design wins within the 100G segment. Long term, we are confident in our data center growth prospects with our leading CDR, driver, and TIA product portfolio, and with our strategy to expand into new applications, such as active copper cables, which is an emerging and very high volume, short reach, typically less than three meters, 400G and 800G data center segment. At this year's Optical Fiber Conference, we announced the availability of a two-chip analog PAM4 solution for 200G and 400G modules and active optical cable applications within the data center. This is our second-generation product for 200G and 400G PAM4 applications, and this chipset solution provides customers an alternative to DSP-based solutions with lower power consumption, lower latency, lower cost, and utilizes a smaller footprint. We believe this chipset is ideal for short-reach applications within the data center. Notably, in May, one of the three projects approved by OIF, or the Optical Inter-Networking Forum, is a project for linear interface directly from the server switch ASIC to the optical front-end module. effectively eliminating the DSP component from the optical module and moving the functionality into the switch ASIC. This interface was proposed by several leading cloud service providers, IC, optics, and IP vendors to enable a low-cost, lower-power, lower-latency solution for next-generation interconnects. MACOM is working to bring to market IC solutions for this effort. And the OIF's project aligns well with MACOM's technology roadmap to achieve 100G per lane analog solutions. Next, I would like to provide a progress report on various important topics. I am pleased to report the transfer of the Air Force Research Lab's 0.14 micron GAN on silicon carbide process into our Lowell wafer fab is on schedule. We have successfully completed front-side development, including the formation of the special T-gate structure using complex photoresist stack-ups and e-beam exposure technology. This effort is a top corporate priority, and our world-class team of dedicated process and device engineers in the FAB have been working around the clock to complete the transfer so we can bring this technology to market. As a reminder, this technology is ideally suited for very high frequency, very high power mimic products, and we are targeting aerospace and defense, test and instrumentation, and SATCOM markets. We believe that this process will establish MACOM as a major supplier of millimeter wave GAN mimics. Putting this process into production is the first step of our multi-prong millimeter wave GAN technology strategy. Recently, we received and are currently testing our first GAN on silicon devices from ST's wafer fab. We expect to receive additional samples over the next few months as ST works on process experiments and refinements. We believe we will need multiple iterations in order to achieve product success, and we continue to view this as a long-term and high-risk effort. Early in the quarter, we announced a new vendor relationship with Modelithics. Modelithics has set the gold standard in the RF and microwave industry for producing accurate device and product models that system engineers and designers can rely on when they simulate their designs. With Modelithics' support, we have released a series of device models on our new Macom pure carbide GAN products, which will aid our customers to accurately simulate their designs. Quick access to product samples and accurate models along with outstanding customer and application support will help ensure we win market share. Next, I'll highlight that our LightWave R&D team continues to make steady progress on the development of our 400G silicon photonic ICs. Investors should also view this effort as a long-term technology development with first products expected to be introduced late next fiscal year at the earliest. Our product introduction schedule is driven in part by the production readiness and the stability of the silicon photonic process we are using. We will continue to work with our foundry partner to perform producibility experiments and resolve technical issues as they emerge. And when the process is ready, we will release our designs to production. During fiscal Q3, we announced the production release of our new high-speed 25G and 50G DFB laser portfolio, following our successful completion of Telcordia qualification testing. The new laser platform, trademarked Clear Diamond Lasers, is based on MACOM's Etched Facet Technology, or EFT technology, and utilizes a new single-ridge design for enhanced performance and reliability. The portfolio includes over 50 laser products, which support multiple 5G infrastructure applications, including CWDM6, MWDM12, LWDM12, 50 gigabits PAM4, and 1310 BiDi. We are pleased to report that multiple customers have successfully finished their 5G module qualifications with our lasers, and we believe this will support revenue in the coming quarters. Looking forward... As the next generation data center and high performance compute architectures evolve, we are seeing growing interest in our high power CW lasers and our ability to produce CW laser arrays. Next generation architectures will inevitably increase the data throughput in a smaller form factor, which creates thermal challenges for the system, specifically the laser. MACOM's team is working on novel semiconductor and package technology to support these new laser array requirements, and we believe we have properly aligned our laser roadmap with industry needs. Our future financial performance is dependent on launching compelling new products. During Q3, we launched over 30 new products, and we remained on pace to release more products in fiscal 2021 compared to last fiscal year. We showcased many of these products at the International Microwave Symposium, or IMS, in Q3, where we successfully held many demo sessions with customers showcasing the breadth of Macom's technology. Investors should understand that our growth strategy includes further diversifying our business. This includes launching new product lines as well as further penetrating or entering adjacent markets, including the automotive market. In support of our automotive growth strategy, I am pleased to report we successfully completed a major milestone in our certification process in Q3, and we believe we are on schedule to be fully certified before the end of calendar 2021. This will open the door for customers to evaluate our LightWave, RF and Microwave, kilovolt capacitor, and high-speed analog technologies, which are ideal for automotive applications such as sensors, LIDAR, under-the-hood power management, and autonomous driving applications. Jack will now provide a more detailed review of our financial results.

Thank you, Steve, and good morning to everyone. We established additional financial records for the company during the third fiscal quarter ended July 2, 2021, with adjusted gross margins exceeding 60% and adjusted operating margin over 28%. We also continued our sequential revenue and earnings per share growth. We are very proud of the hard work, dedication, and focus from the entire MACOM team, which has resulted in the establishment of these records. Revenue for the third quarter was $152.6 million, up 1.4% quarter over quarter. The sequential improvement in revenue was driven by increases in the telecom end market, partially offset by a modest decline in the data center and industrial and defense end markets. On a geographic basis, approximately 46% of both our fiscal Q3 and fiscal year-to-date 2021 revenue was from domestic customers. This represents an increase from the approximate 43% of sales to domestic customers during last year's nine-month year-to-date period. Our Q4 guidance implies we are on track for an estimated 14% revenue growth in fiscal year 2021, and our business trends continue to appear strong, looking forward to our September 4th fiscal quarter of 2021. As Steve highlighted earlier, we are currently facing a higher number of business risks and challenges. However, we believe our guidance and outlook for our 4th fiscal quarter take these challenges into consideration. Adjusted gross profit in fiscal Q3 was $92 million, or 60.3% of revenue, up 110 basis points sequentially. We are excited to have exceeded the 60% adjusted gross margin level and view this as a key accomplishment for the company. The improvement in adjusted gross margin underscores our continuous improvement efforts across the business. Looking ahead into Q4, we see opportunities to further improve our gross margins. Total adjusted operating expense was $48.1 million, consisting of R&D expense of $30.3 million and SG&A expense of $17.8 million. Total operating expenses were sequentially up $800,000 from fiscal Q2 levels. We continue to invest in new product development and other growth opportunities for the company, while carefully managing our discretionary spending. Adjusted operating income in fiscal Q3 was $43.9 million, up from $41.8 million in fiscal Q2. Adjusted operating margin was 28.7% for fiscal Q3, sequentially up from 27.8% in Q2. As noted earlier, this adjusted operating margin represents a new record for MACOM since we went public back in 2012. We expect a combination of top-line growth, expanding gross margins, and or stable operating expenses to provide the opportunity for continued increases to operating leverage in the fourth quarter of fiscal 2021 and into fiscal year 22. Depreciation expense for fiscal Q3 was $5.8 million and adjusted EBITDA was $49.7 million. Trailing 12-month adjusted EBITDA increased again in our fiscal third quarter to $182 million as compared to $169 million for fiscal Q2. Adjusted net interest expense for fiscal Q3 was $1.4 million, down $2.5 million from fiscal Q2. Interest expense benefited from a full quarter of lower interest expense after our $100 million debt pay down in Q2 and the lower 0.25% interest rate associated with our new $450 million convertible notes. Our adjusted income tax rate in fiscal Q3 was 5% in line with our expectations and resulted in an expense of approximately $2.1 million. Our cash tax payments were $700,000 for the quarter. We expect our adjusted income tax rate to remain at 5% for the remainder of fiscal 2021. Fiscal Q3 adjusted net income was $40.3 million compared to $36.1 million in fiscal Q2. Adjusted earnings per fully diluted share was $0.57, utilizing a share count of 70.9 million shares compared to $0.51 of adjusted earnings per share in fiscal Q2. Now, moving to balance sheet and cash flow items. Our Q3 accounts receivable balance was $71.6 million, up slightly from $68.3 million in fiscal Q2. As a result, day sales outstanding were 43 days. Inventories were $83.5 million at quarter end, down $1 million sequentially. Inventory turns remained at 2.9 times during the third fiscal quarter. We remain focused on inventory management and believe our current inventory levels and production capabilities along with product we have on order or held at our suppliers, will support our growth targets. Our fiscal Q3 cash flow from operations was approximately $45 million, primarily driven by improvements in operating profit. Cash flow from operations was up $16.9 million sequentially and $10.8 million from the same quarter in the prior year. Cash flow from operations represented around 100% of our fiscal year-to-date adjusted net income. This is in line with our expectation for cash flow from operations to run at a comparable amount of non-GAAP net income over time. Capital expenditures totaled $5.6 million for fiscal Q3. The increase in CapEx in Q3 was primarily attributable to additional investments in our FABs as well as R&D infrastructure. Free cash flow was $39.3 million for the third fiscal quarter, up sequentially from $23.5 million. Cash equivalents and short-term investments for the third fiscal quarter were $309 million, up $41 million from fiscal Q2, and up $44 million versus the same quarter in the prior year. As a reminder, during our second fiscal quarter in March, we utilized $100 million of our available cash to pay down a portion of our outstanding term loans. Over the past few years, we've been working to make improvements to our return on invested capital metrics and expect to continue making additional improvements in the future. Lastly, I will note that with the improvement in trailing 12-month EBITDA, we exit the third quarter with a net leverage ratio of around 1.9 times and gross leverage of 3.3 times, down from 2.3 and 3.5 times respectively in the fiscal second quarter. These leverage calculations include $79.7 million of convertible notes classified as equity, as well as $29.4 million of financing leases. We are pleased with our financial performance to date and look forward to making additional improvements to the business and the opportunity to establish new records as we move forward into our fourth fiscal quarter and beyond. Before turning it back to Steve, I would like to note that over the past six months, we have been engaging with stockholders and other stakeholders to discuss topics to help define some of our environmental, social, and governance goals. This week, we published our initial ESG report, which can be found in the Investors section of our MACOM website. The publication of our ESG report is an important step toward enhancing our ESG practices and disclosures. I will now turn the discussion back over to Steve. Thank you, Jack.

MACOM expects revenue in the fiscal Q4 ending October 1, 2021, to be in the range of $153 to $157 million. Adjusted gross margin is expected to be in the range of 59.5 to 61.5%. And adjusted earnings per share is expected to be between 56 and 60 cents based on 71.3 million fully diluted shares. In fiscal Q4, we expect industrial and defense to be up slightly and data center and telecom to be relatively flat. As I've noted, we maintain a long-term perspective on executing our strategy. We are confident that we can continue to improve our financials and take market share in the months and years ahead. I would now like to ask the operator to take any questions.

Thank you. Ladies and gentlemen, to ask a question, please press the star then the one key on your touchtone telephone. To withdraw your question, please press the pound key. In the consideration of time, we ask that you please limit yourself to one question and one follow-up. Please stand by while we compile the Q&A roster. And our first question coming from the line of Tom O'Malley from Barclays. Your line is open.

Hey, guys. Good morning, and thanks for taking my questions, and congrats on the nice results. I just wanted to dive into the fourth quarter. You highlighted on the call that you're seeing or using a little bit more conservatism in the guidance. Can you talk about where you're seeing some of the stresses on the fourth quarter? Is it really supply related? And if it is supply related, could you talk about the different end markets that you're seeing that in just to give us a better feel of what's going on to the next quarter?

Sure. So good morning, Tom. I would say the main areas that we see issues associated with supply relate to different PCB technologies that we use with some of our networking products. That is really the area where we're most focused. And then on the margin, we're seeing some interruption with some of our OSAT suppliers, specifically in Malaysia, where we're seeing some of our suppliers do temporary shutdowns. I would say those are really the two main issues that we're focused on. So I just want to highlight that these considerations, as well as others, are factored into our guidance for Q4. And as you know, we really went through a similar type situation at the beginning of COVID when there was a high degree of uncertainty with supply chains, with customer interactions and whatnot. So I think the team is certainly capable of handling the new set of challenges this quarter.

Great, thanks. And then my follow-up is really on the Clear Diamond product portfolio. You saw a really strong quarter in telecom in June. I was curious, was there a contribution from the laser platform in the quarter? And can you talk about the opportunities that that platform brings you in the 5G market as we move into September and December, just given the fact that you now have more products that you can sell into that market? Can you talk about what the financial impact could look like from adding that to the portfolio?

Yes. So the Clear Diamond Laser portfolio has not started to contribute at a meaningful level to our revenues. We'll start to see very modest contributions in Q4, but that product portfolio and the growth we'll see from primarily the 5G end market will happen in our fiscal 22, so really next year. We did set a goal of starting production before the end of our fiscal year, and we're happy that we hit that goal The uptick that you saw in Q3 with regards to the telecom market has more to do with some growth in PON as well as cable infrastructure. We did see a little bit of legacy, what I'll call 5G front-haul and mid-haul business contributing. And then we had a very good quarter in the SATCOM end market. And I'll just highlight one other market that we really haven't spoken about a lot, and that has to do with broadcast video, where consumers continuing to see increased demand and really a comeback with some of our customers in this end market. And so this is an area where we have actually a fairly broad product line of cable drivers. We have reclocking devices, equalizers, and even cross-point switches. And so we are seeing that the broadcast end market, which is typically TV studios or sort of prosumer end markets where you have professional level video equipment running at roughly 12 gigabits speeds, you know, seeing increasing demands due to all the different streaming that we're seeing across the globe. So the telecom market really grew as a result of a lot of different factors. It was not specifically 5G, but really had contributions from a lot of different end markets. And then just sort of coming back again to your question about the clear diamond laser portfolio. So, you know, we believe as the dam breaks, as people begin to use our lasers, they will start to use them in 5G applications. But we do expect some of our customers, which also service the data center, to begin module qualifications for their data center customers. And we're seeing that. And so that gives us confidence that next year and going into our fiscal 23, that we'll start to see laser revenue for CWDM4 specifically. So a real good story there on the lasers. We've been very conservative with our revenue expectations with this portfolio this fiscal year. But as we look into next year, we are seeing some really nice growth opportunities.

And our next question coming from the line of Harsh Kumar with Piper Sandler. Your line is open.

Yeah. Hey, Steve. Good morning. Jack, good morning. First of all, congratulations, guys. Very consistent, steady results, and we appreciate it. I had two questions as well. Steve, first one for you. Your gross margin keeps going up, you know, which is a great, great thing to have. Great thing to have happen. But it's not easy, and we want to understand, I guess – how you were able to turn the wheel just every quarter a little bit more and get more out of the gross margins. And I ask that because a lot of the businesses at your revenue scale come to sort of a halt around this point in the gross margin and are not able to do it. So I'm curious, where do you think these margins can go, one, and then also what are some of the things maybe that you're doing that are turning the wheel here?

Sure. Sure. And I think you're exactly right. As your gross margins increase, it becomes more difficult to add on top of that. And I'd first like to just comment that the work that we've done over the past two years is really a result of all different parts of MACOM supporting this effort. Purchasing, sales, operations, quality, the business units, the way we're looking at pricing. We've established what we call a sales operations organization that is very focused on optimizing pricing. So there's been a lot of holistic work done over the past two years, which has allowed us to incrementally improve the gross margins. We also set, about a year ago, a corporate priority to look at some of our highest volume products running through our FAB And we were putting effort in to improve the overall yields associated with those high volume products. And so you're starting to see some of those products shine through with better margins. And quite frankly, we expect that to continue as we go into next fiscal year. When you ask about, you know, where can this go? My answer would be when we look at our peer group, our named peer group, which if you add up their revenue, it's about $43 billion of revenue. And you look at some of the leaders within that space, they have margins significantly higher than ours. We actually size our SAM to be approximately $5 billion. And so our goal is to pick product lines and pick technologies that we believe will command higher than corporate average gross margins. And that's really the mantra that we're pushing down onto our different business units. So it's really about positioning the company in an area where you have a competitive advantage and you can create stronger pricing. We can't say as we sit here today what that peak number will be. I don't have a short answer for you on that. I think the good news is we do expect in the near term to continue to see incremental improvement. We think we're doing all the right things as it relates to internal execution as well as picking new product lines that will be accretive to the gross margins. But there's also another piece. We have two fabs. We want to make sure these fabs are running at optimal utilization. And so we don't want investors to think that every single product we're selling has 60.3% gross margin. We like to go after high volume business and enjoy the absorption that you get when you run high volume wafers through your fab. So it's a bit of a mix. Jack, I don't know whether you want to add to that to help

Just to build upon that, we take a look at this from a holistic perspective and also take a longer-term perspective in terms of improving the overall profitability of the business. The gross margin improvements that we've seen where we set another record here this quarter is something that we're very proud of. but we're also looking at the overall operating margins of the business and making sure that is sustainable for a longer-term time period. And it's really just the sustaining aspect of many of the different things that we're doing to make sure that we don't just focus on one thing one quarter and then jump to something else the next quarter. We want to make sure we're continually building upon the successes and the improvements that we've made, which is helping to drive that improvement that we've seen from quarter to quarter.

Thank you for that, Keller. Steve, one more for you. Question on growth. So you're on a cadence of kind of like call it 2 million sequential growth a quarter, but as you talked about in your script, there's a lot of stuff in the works. There's the lasers coming out, analog PEM4, et cetera, et cetera. Your commentary was sort of limited to your fiscal analysis. which is a lot of that will hit past that. But let's just say I ask you to look out next year, which includes the December quarter when a lot of this stuff starts to hit. How do you, could you paint a picture for us in terms of growth for fiscal 22 that includes a lot of your new products versus where you are now?

Sure. I'll try to answer that question as best I can. So I think it, Let's take a step back for a minute. So if you look at Macom's growth rate between 2010 and 2020, it's about a 7.5% CAGR for the first 10 years, let's say, that Macom was a public company. If we look out over the next five years to 2025, so going from 2020 to 2025, roughly five years, If we were to get to a billion dollars, we would require about a 13.5% CAGR, and that would get us to a billion dollars of revenue. And as I said earlier, we are moving into a neighborhood where we have larger competitors that have large, multi-hundred million dollar product areas that are very attractive. And as we look at positioning the company, we'll be going after different product lines that, as we just talked about, will have higher gross margins. So we have a long-term strategy, and as we think about our business and we think about what is the right growth rate, I think it's somewhere between our historical first 10 years of 7.5% and somewhere between a reasonable number that would get us to a billion dollars of revenue in a reasonable amount of time. Now, if I look at our end market dynamics, and if I just go back over the past two years, and I look at the data center peak revenue, the IND peak revenue and the telecom peak revenue for the best quarters over the past two years and add it all up, you get to about $175 million of revenue on a quarterly basis, which is about a $700 million run rate. So if all the stars align, you can start to see numbers like that come together. The hard part is to understand when that will happen, the timing of how it happens, and the stars don't always align. So we can't forecast with accuracy, but I can tell you that we have a long-term plan to capture more of the SAM that we're in. We are engaging, by the way, with more Tier 1 customers. And I'll highlight, by the way, even within the color of our business, As we look at our business this past quarter, we have fewer, greater than 10% customers. I think a year ago we had three. This quarter we have one. We have more diversity within the customer base. Our top 10 customers, I think a year ago, were about 61% of our revenue. Today they're 51% of our revenue. So you have a business that's more diversified. It's growing at a reasonable rate. I think Jack mentioned our year-over-year growth year-to-date is 14%. And so when we think about next year, we think about executing and making sure that we win more than our fair share of the market. But we want to come short of talking about what our targets are for next year. We haven't come to that number internally yet. We generally put our AOPs together. in the late August, early September timeframe right before our fiscal year. And so I think the short answer is we'll try to provide a bit of color on our next earnings call about what might happen in fiscal 22, but we do want to be very cautious. This is a very dynamic industry where you don't always have long-term visibility.

Our next question coming from Delana Quinn-Bolton. with New Hammond Company, Yolanda Sullivan.

Hey, guys. I'll echo the congratulations, especially on the 60% plus gross margins. Steve, I wanted to start with the market for telecom, particularly 5G. It sounds like 5G wasn't really a contributor to the telecom growth in the June quarter. We now have the next round of China tenders. North America has completed the C-band and auction and, you know, looking to deploy late this year. Can you give us a sense? Are you starting to see better traction in 5G as you look into September and December quarters? And if so, are there offsets from some of the other product areas you highlighted in telecom that might decline sequentially that, you know, potentially offset an uptick in 5G as you look into September and beyond? Yes.

And so we absolutely are continuing to see secular growth in 5G. That continues. And there is absolutely a tremendous growth opportunity for Macon because, as everybody knows, we support 5G networks on the optical side, whether it's front-haul equipment or metro long-haul equipment, as well as on the radio board. We typically have success with the higher frequency, higher data rate, and higher power applications. As you've highlighted, some of the tenders that have been released in China are specific around a 700 megahertz band. There's about 480,000 base stations announced, and those contracts have been awarded to the different base station manufacturers. I think that there are some opportunities within the 700 megahertz band, but we actually get more excited about the 2.1, 2.6, and as you highlighted, the C-band frequencies of around 3.5 gigahertz for the U.S. market. So there is a tremendous growth opportunity here. I would also add that we are seeing more opportunities with ORAN as it expands and becomes more accepted, let's say. And so that's a tremendous growth opportunity for us there. In terms of looking into the fourth quarter to your question about sort of what's going up and what's going down, I think that the 5G front haul quarter over quarter will probably be flat to slightly down, mainly due to inventory channel issues. I think we have good channel inventory levels, and I think that will be worked down in the fourth quarter. I do see that our microwave business is picking up, our diode business is picking up in the fourth quarter. So, you know, overall, I think Q4 will be very solid.

Great. And I wanted to ask a follow-up on the laser opportunity. You know, great to hear that you're already passing qualification at multiple module vendors, but wondering if you might be able to give us either a total TAM opportunity for 5G front-hole or mid-hole lasers and data center lasers, or maybe a content per module in the front-hole and the data center? I mean, are we talking 50 cents to a dollar? Are we talking multiple dollars of content in those applications?

Yes. So we probably don't necessarily want to talk about ASPs or our target SAM with that that level of detail. In terms of the laser volume, I'll sort of just comment that when we look at some of our competitors, we see them selling 30, $40 million of lasers per year, and we have multiple competitors doing that. And so our goal is to capture that market share. We will first start with 5G, as we've talked about in the past. There's multiple different wavelengths that are necessary when we add up all of those different wavelengths. You're over 50 different wavelengths. We think we have a competitive advantage because we're offering customers a full suite of products. But I would say that the overall dollar content investors should recognize that it will start at a small level and it will grow over time. But we don't want to call out revenue on our laser product line specifically. I think that's just a little too sensitive.

And our next question coming from the line of Harlan Sir with J.P. Morgan. Your line is open.

Hi. Good morning. Great job on the quarterly execution and strong margins. Given the strong demand environment, tight supply, both wafers and assembly and tests, I know you had an estimated unfulfilled backlog of around 5 million for the June quarter. Since then, it looks like the demand profile is getting stronger as you move into the second half of this calendar year. Then you've got the COVID-19-related risk. kind of layered on top of that, orders were strong. So does the team anticipate that the unfilled backlog number actually going up here in the September quarter and our lead times up quarter over quarter as well? And then more importantly, as you look at the capacity expansion plans, your outsourced partners expansion plans, when does the team expect supply demand situation to kind of normalize?

A great set of questions, and I'll take some of them and maybe Jack can finish answering. So generally speaking, the lead times have increased quarter over quarter, which was one of your questions. We don't have clear visibility as to when all of these constraints will clear. It will definitely be sometime at least six months from now is the way we look at it. In terms of our backlog, we are absolutely delighted that we had a 1.3 to 1 book to build. It was actually one of our strongest booking quarters in the history of the company. A significant amount of that is scheduled out over time, and so we look at that strong booking number and sort of break it into two categories. One, customers coming in under the normal behavior, especially some of our larger customers placing long lead orders for large I&D contracts. And then the second are the customers that are very concerned about supply and they just want to get their parts on order and they're placing orders ahead of demand. And so, and I would say that, you know, that piece is going to be, you know, the piece where there's ordering ahead of demand, we're talking maybe two, three quarters ahead of of when they actually need the products. The last thing I'll mention, and then I'll turn it over to Jack, is that we do have an advantage where we have two of our own fabs, and we're able to be very quick to service unforecasted demand. And so that is an advantage right now, and we are seeing customers come to us on certain product lines where they're not able to get fulfillment from their current supplier, and they're looking to make them. So we are being a bit opportunistic to win business away from our competitors that are not able to supply products. And we'll work hard to make sure that we take the business now when we can. Jack, did you want to comment about the unfilled backlog? Sure.

The question? I guess just to build upon some of the things you had talked about, Steve, with the improvements that we've seen in orders and the improved visibility we have, one of the numbers that we also report on is our turns business or orders that received and and shipped out in the quarter that number we've been working very hard to make sure we we are driving that number down to a much lower number than where we could have been a couple of years ago so that allows allows us some additional visibility and and to work with our suppliers and our customers to make sure we're meeting their requirements when needed there's there's a lot of moving pieces as there is in every quarter in terms of things moving around, and we deal with that on a regular basis, and our operational teams do a good job managing that. But in terms of putting a number on it, it's something that we're not looking to do at this stage because it's going to be evolving. We're fairly early on in the quarter at this stage, so to understand what the current impact is going to be to the current quarter at this stage, it would just be too premature at this point.

Great. Thank you for the insights there, and It's interesting, you talked about the opportunities in ORAN and VRAN, and we know the virtualization of the radio access network, or RAN, is a big focus area for operators, right, because it provides strong economic benefit, both from a CAPEX and OPEX perspective. So I'm curious to know, how does MACOM benefit from the move to ORAN and VRAN over the next few years as the service providers continue to virtualize their networks?

Well, ORAN opens up the market to new entrants. So we see new companies coming into the market, and the barrier of entry for a company like Macom to get in and to work with these customers and consume all the oxygen in the room, so to speak, with our solutions is there. And so we're taking advantage of that due to the – let's say lower barrier of entry where you might have a traditional telecom company that has their go-to vendors and they're focused on them and they're entrenched. Because O-RAN is opening up the field, we see new opportunities and we're being very aggressive to go after them. The other benefit is that it's also more of an international platform and it's going to bring less China exposure. And so we're seeing European and North American companies really driving O-RAN. And so there's some benefits on the margin with regards to that as well. In terms of the product sets, they're very similar. The overall architectures of the radios and the requirements are quite similar. So to the extent that we have competitive parts where we can win the day, we'll do that. But I think that the big... opportunity for MACOM is the lower barrier of entry to engage customers.

Our next question coming from the line of Chris Castle with Raymond James. Your line is open.

Yes, thank you. Good morning. A question on the data center segment. And you saw a good acceleration around the middle of last year and since then we've been kind of bouncing around these revenue levels. I know that some data center customers were digesting some inventory, you know, toward the end of last year. I guess, could you give us a little more color about what's going on within the customers of that segment and what's the catalyst for moving the data center numbers higher? Is that more about your own product cycles or is that, more about your customers normalizing.

Sure. And maybe I'll start with the back half of your question regarding what will MACOM's catalyst for growth be within this market. There's really about 10 different items that I think are important for investors to understand. First, today's business is primarily 100G CWDM4. And historically, that business has been very concentrated on one major customer that had a significant part of the market. And what we're seeing today is that customers' volumes have come down year over year and plateauing. And so when we think about our growth strategy, we are looking to win new designs of 100G CWDM4 at other customers, many of which are international customers. So that, number one, provides a very interesting growth opportunity for us. The second is we're starting to get design wins for our 200G short-reach chips, primarily TIAs and drivers. And these chips are used generally with competitors' DSPs. So we are now working with multiple companies companies that produce their own DSPs, and they're selecting Macom's, Driver, and TIA because these are the best chips in the industry. And we're having very good success there, and we're agnostic as to which DSP our customers select. And that's been a very successful program that we started about a year ago. The third item I'll highlight is while there are many 200G DSP-based solutions where we sell the Driver and the TIA, We also believe for certain short-reach applications, it should be an analog solution. And so what we actually want to do is bump the DSP, and we want to provide our 200G combo chips. And we announced those combo chips at this year's OFC. And these combo chips basically are a Vixel driver in CDR and a TIA in CDR. And with these two chips, you do not need a DSP. We're very excited about that. These chips have just entered the market. The fourth item I'll highlight is really our 400G product. So we have a very competitive TIA and driver for DR4, basically, and also we have a version that's suitable for DR1. And we're getting very strong traction there, and we are seeing the volumes grow exponentially if we look back over the last two years. we are seeing exponential growth with our 400G products. And that includes the TIA and sort of just starting now is our 400G driver. And then we talked about, and I mentioned this on the prepared remarks, that we are entering the active copper cable segment within the data center. And we have a chip today. It's been sampled for the past six months. We are seeing very strong customer adoption. We are starting to get pilot orders in the tens of thousands of pieces from multiple customers, and we are confident we will have success as we go into next year. The last items I'll add are, of course, we do have 100 GPM4 GSP in production, steady business there. It's looking like it will start to grow going into next year in terms of volumes. And the lasers, we believe the lasers will start to come on towards the end of next year and the following year. When you add all these things up, even if we take our lead customer and we model their revenues as being flat to down, we actually do see growth coming out of the data center segment. Even with the offset of the connectivity declines that we talked about on the last conference call where we mentioned year over year, we expected a $15 million decline with our connectivity business, which is primarily data centers. So when you put all that together, we think we're doing the right things. We have a very strong strategy. I talked about some of the trends also in the industry where the industry wants to look at what we call direct drive at the higher data rates, which will eliminate the DSP and move that functionality into the switch. When you ask about, well, what are the customer trends, I would say that we are not a good bellwether of the industry. The fact that one of our customers is going up or down doesn't necessarily reflect what's going on in the broader industry. I can say that there is definitely a move from NRZ to PAM4, and we are going to make sure that we have sufficient tips to cover that. Then the last item I'll mention, we are starting to see more and more traction in China with our chips being sold into the data center there at data rates between 2500 and 200G. we have a very strong sales force within China, and I think we're starting to win market share there. So I think I said on the last call that we did expect to exceed our peak watermark in the data center, which was roughly 45 million. The question is per quarter, and the question is the timing of that. We're not sure it will happen next year, but we think we're on a good path in doing all the right things.

Great. That's extremely helpful, so thanks for that. As a follow-up question on 5G, understand what's happening with China with the deployments down at 700 megahertz, but the U.S. deployments are at higher frequencies, so therefore, you know, I guess we'd expect that there's more content opportunity for you in the U.S. You know, I guess we're expecting, you know, some of that, some of those deployments to kind of start toward the end of this year, beginning of next year. Is that when Macom starts to see some benefit, some stronger benefit from the 5G market? Could you give some more color there, please?

So the short answer is yes. The higher frequency, 3.4 to 3.7, does provide us opportunities. I think this is also the platform where we may start to see our first design wins for our power amplifier product line. argon and silicon carbide products primarily, whether it be a massive MIMO or a macro architecture. We have compelling product today that is very interesting to many different customers. I'll also highlight that we have very strong front-end modules, or FEMs, on the RF side for the higher frequencies as well. So I think your question is right on, that as... As you start to see deployments in the U.S., we should see MACOM seeing an advantage there.

Our next question coming from the line of Vivek Arya with Bank of America. Your line is open.

Thanks for taking my question. I actually had two quick ones. First, you mentioned there are some supply headwinds that are having an impact on your Q4. I was hoping if you could help us quantify how much of a headwind is And importantly, is that demand you can recover over the next several quarters?

Yeah, so as Jack highlighted, we really want to step away from sort of quantifying the exact amount that we're not able to ship. I know we did that a quarter ago, but as Jack highlighted, we're early in the quarter. There's a lot of different moving parts, and we just sort of want to step away from that. In terms of will we be able to roll that demand into future quarters, the answer is yes, we will. We are not losing business. We are rescheduling business. And so we're working with our major customers that are being impacted. We have certainly, if not daily, we're having weekly calls with some major customers to make sure that we support them. Our operations team, our logistics team, and our supply chain management team is really doing a nice job managing and making sure that our customers have the best information we can give them. As I highlighted also, this is really an industry-wide issue, and MACOM is not immune to some of these factors. We have, and I will emphasize this again, we have built in and hedged our guidance based on the higher risk profile. So we'd like investors to be confident that the guidance we're giving is is following the same methodology that we've done in the past.

Got it. Thanks. And a quick follow-up. Your industrial and defense sales are now running close to 50%, right, year on year. I realize that that's off of somewhat easier comparison, but how would you characterize the sustainability of this business? Thank you.

Yes, I think that growth rate is not sustainable. And typically, you would expect lower growth rates from a large, slow-moving market like defense. However, we are, with our changing strategies of really focusing on this market, cross-selling all the different product lines, we are actually driving very reasonable growth. But we don't want investors to expect you know, sort of $10 or $20 million sequential growth on a quarterly basis going into next year. It's more likely to slow down, plateau, and then after running at a certain plateau level, it will start to grow again. That's what our expectation would be. We do have a very strong backlog of IND business. We have multi-year contracts as well that we're working on. And as we are bringing on some of our GAN on silicon carbide, products, we are seeing opportunities that, quite frankly, we hadn't seen in the last two to three years. So we're very excited about that. We think long-term, IND will be, it will remain the largest segment for us. And I've said this before, I'll just highlight that. When we think about the RF power market, we think it's evenly split between telecom and industrial and defense. And so that really excites us. We think this is a very large market. It should bring really nice growth opportunities to Macom, especially when we introduce our millimeter wave GaN on silicon carbide mimics. So customers are already very excited about that. Here in the US domestically, there's one, maybe two companies that are the entrenched suppliers of this technology. And we are very confident that we can step into the market and win market share.

Our next question, coming from the line of CJ Muse with Evercore, your line is open.

Yeah, good morning. Thank you for taking the question. I guess, Steve, first question, you know, you typically choose your words carefully, particularly timing as well. So, you know, your increased disclosure around automotive definitely piqued my interest. So, Could you expand on your go-to-market strategy there, and at what point should that start to have a meaningful impact to your overall business?

Sure. So we started or really refreshed our automotive strategy about a year ago, and we set a target to ensure that the company was automotive certified or TS certified, and so we We actually went through an audit this past quarter. We effectively passed the audit with a few action items to close, which will close in the next few weeks, and we would expect full certification by year end. So what that will allow us to do is really engage the Tier 1 OEMs, align technology roadmaps, understand the requirements that they may have, and then we can begin developing the chips for their requirements if we don't already have them. The areas that we will focus on, as I highlighted in my script, are LiDAR-type applications, which have a combination of LightWave and optoelectrical high data rate chips, which is right in our wheelhouse, especially for what we call our high-performance analog business unit. We're looking at in-cabin applications. We're looking at sort of advanced driver assistance navigation systems that might require LiDAR. as well as there's more and more Ethernet connectivity throughout the car. And as everybody knows, this is a strength of MACOM. So, you know, it's a target-rich environment, as we say. It will be a long-term strategy. We would not expect to have material revenue next year or probably not even the year after. This is a long-term growth strategy. What I can tell you is that we have tremendous interest from major customers today across our portfolio, and so we intend to fully maximize the growth opportunity here. We like the automotive business because when you're designed in, it's typically sole source. You're seeing multi-year manufacturing cycles, and once you're in, you can build and go wider and start to bring on new product lines. The one technology that I will highlight that I think we're seeing interest in from the automotive industry is our kilovolt cap product line, mainly because this is a semiconductor-based capacitor that can handle 300 degrees C environments, which is necessary in some applications within automotive. So we are excited to really promote that technology to the automotive industry. whether it's under the hood or whether it's for electric vehicle type applications. Very helpful.

And quick follow-up. It looks like we're going to get an infrastructure bill passed. Have you thought about the implications to your business and what kind of upside that might drive? Thank you.

So, yeah. We're aware of the CHIPS Act. I'll start with that. I haven't been watching the news recently regarding some of the things running through Congress, but I will highlight on the CHIP Act where there will be dollars allocated to the semiconductor industry. We do have a strategy to work with different government agencies that support the semiconductor industry and make sure that they understand that MECOM has a long list of needs, and we're looking for investment and support from the government so that we can expand and modernize some of our facilities. And so that is a priority for the company. We are working with one lobbyist right now. We plan on expanding that, and we look at this effort as really a multi-year effort where perhaps one or two years from now we might see some funding for special projects associated with the growth and the development of Maycom.

Our next question coming from the line up, Carol Ackerman with Colin. Your line is open.

Hey, good morning, guys. This is Eddie for Carl. Most of my questions were answered, but a few quarters ago, you indicated that STMicro would be installing tools to support manufacturing of 6-inch GAN on silicon wafers. Can you please provide an update on your progress there? Thanks.

Yes, thank you. So we are just now receiving samples from ST. So just to remind everybody, one of the big delays with this program was moving certain dedicated equipment into ST's wafer fab and then qualifying that equipment. Those actions have been completed. So that allowed ST to effectively run a wafer end-to-end within their FAB. They've been doing that. They have provided MACOM samples just this past quarter, and we've been running through a series of tests with those first samples and providing feedback to ST. This is part of the process which will become iterative and will take time. So as I highlighted in my script, we do view this as a long-term process high risk technology transfer program. And in the meantime, we are focused on winning RF power business using GaN on silicon carbide. And when and if the GaN on silicon technology is ready for high volume production, we will absolutely insert it. We do believe there are certain applications where GaN on silicon makes a lot of sense. So no major updates other than that. I view this as a long-term project.

Thanks. And another one, your sales through distribution are modest, but some peers across the supply chain have spoken about OEMs and resellers and restocking inventory where possible in order to avert any future supply shortages in the second half. I'm curious if you are seeing that customer experience activity across your data center and communication infrastructure market? Thank you.

Thank you. So I'm not sure that I can comment on the trends that you highlighted there, but maybe I'll say a few words about our sales channel. So one of our areas of focus has been to further develop and expand and strengthen our sales organization, especially across Europe, as a priority. And so we've been doing that. We've been hiring country managers. We've been hiring new representatives, manufacturers' representatives across Europe. We've been supplementing our team here in the U.S. as well. And we also have embarked on a strategy where we want to do more direct business with our major customers and do less business through distribution. And that has been a bit of a trend that we've had over the past year. So our strategy, our go-to-market strategy, is really relying on our direct sales force and applications force, as well as our business units to have direct engagement. And we also believe that these direct engagements actually help during this period of supply shortage, because now we have direct discussions with our customers about their long-term needs, and we can build that into our plan effectively. So generally speaking, our sales force year over year is a lot stronger. I think this time next year, it will be even stronger. And over time, we will, as a company, be less dependent on distribution.

Our next question coming from Delana, Richard Shannon with Greg Hallam. You want to jump in?

Hi, guys. Just one question for me. I had a couple other questions earlier in the call regarding growth, and Steve, you haven't quantified them, and I certainly understand your reticence to do that. Maybe I'll kind of attack it from a different angle here, which is if you look at your top-line growth over the next one to two years, what do you see as the biggest dollar contribution drivers to that by product line or market, you know,

Sure. Thank you for the question. So we have six different business units, as everybody knows. We call them business units. They're really engineering technology centers. Our larger business units are high-performance analog and our diode areas, and then some of our smaller ones include RF power and even LightWave. And so when we step back and we look at... Growth rates, of course, we would expect RF power and light wave and even connectivity to have the highest growth rates given they're small relative to the overall size of MAINCOM. And we would expect the larger groups to grow at a more rational rate. We don't necessarily want to call out any one product line that might be our most successful or sort of an end application that will drive growth. That's sensitive information. But what I can say is we have a very detailed product plan, bottoms-up plan. We've been looking very carefully at our growth forecasts over the next one to two years. In fact, this past July, we updated our five-year strategic plan. And so we have fresh numbers and we have updated plans and activities to support our growth. So I think we're doing all the right things. But ultimately, what we deliver for growth, we'll really have to wait and see. It's very difficult to forecast We have a lot of exciting technologies that we're bringing to market. We have a lot of exciting technologies we haven't talked about publicly that we'll bring to market and we'll announce in the next one to two years. But I'll just say at a high level, one of the things we're doing, I think, well, is we're expanding our SAM with the new product lines and the new technologies that we're now bringing to market. And that is exciting and should bring a new color of revenue to Macom over the next one to two years.

Okay, great. We look forward to hearing about those. That was all my questions. Thanks, Steve.

Our next question coming from the line of Tori Spender with Stiefel. Stiefel, your line is open.

Yes, thank you. First question, Steve, you gave a list of six, seven things that are driving your data center growth, but you also said in your preparatory remarks that you were working on some subsystem level opportunities in data center. Could you just elaborate on that, please?

Yes. So I think the subsystem comment was not directly targeted at the data center. And so maybe I should clarify that. What I was referring to there is as we engage customers in different end markets, we want to make sure that we leverage our system knowledge capability to the greatest extent we can. And if in certain instances it means the customer is better off if we take the pen on the design of that subsystem, we want to do that, and we want to support them in that area. That is most likely going to happen in industrial and defense end markets where customers want to really lean on our chip-level technology and to design a system that based on customized chips for their application. That would more typically be RF and microwave, as well as hardened optical applications where the customers require domestic manufacturing capability. I don't envision, and of course we will not be building modules for the data center as an example, and most likely not for anything within the telecom space per se. An area that we'll focus on is building out and gaining market share where it makes sense inside the industrial and defense markets.

Yeah, thanks for clarifying that. And as my follow-up, and just to make sure I'm clear on this, so the main capacity constraints right now are at the back end, You know, your own FABs, I mean, I assume they're running pretty high, but I know you're also adding some capacity. And what's the current mix between inside versus outsourced on the front end?

So you're correct to say that we are having constraints on the back end, which is typically assembly and test, let's say, or package technology associated with assembly. But we also are seeing extended lead times with our external foundries, and so that is, of course, impacting us as well. And so I don't want you to think it's just the back end. It's also we're working with extended lead times with our FAB partners in some instances, not all instances. In terms of the mix within internal FAB versus external FAB, Jack, I don't believe we've disclosed that. Is that right? That's correct. So I don't think we would be able to make a comment there, Tori.

I am showing no further questions at this time. I would now like to turn the conference back to Mr. Daly for any closing remarks.

Thank you. In closing, we'd like to thank our employees for their outstanding contributions during the quarter. Thank you very much.

Ladies and gentlemen, that's our conference for today. Thank you for your participation. You may now disconnect.