The I/O Fund has been looking closely at the networking stack to position for 2025 due to the increased demand from the expanding role that optical networking will play in artificial intelligence clusters.
Lumentum is a strong candidate within the networking stack as the company supplies components for datacom transceivers and optical interconnects. We recently covered a close competitor Coherent, who is quite similar in terms of its products. As discussed in the Coherent writeup, transceivers and optical interconnects convert electrical signals into optical signals for fiber optic networks within the data center. Traditionally, optical links have been used for compute and storage servers, yet AI/ML servers are driving an increase in demand.
AI models are driving an exponential increase in compute requirements, meanwhile the scaling of workloads is limited by the existing network. Although GPUs and AI accelerators capture the headlines, as we move into 2025, hyperscalers will become equally as focused (if not more so) on networking capabilities as GPUs and ASICs are reaching the upper limit of what networking components and interconnects are capable of.
In response, transceiver speeds have been increasing, as traditionally, the highest data rates ranged from 100G to 200G to 400G. AI servers are driving a market for 800G data rates, which are shipping in production now, and 1.6T rates, which are shipping in 2025. These interconnects help to meet demand for high-speed, low-power data transmission in data centers. Over the coming year, a transition to 200G lane speeds for 800G and 1.6T single-mode optics and InP (indium phosphide) laser transmitters will cause some of these little-known suppliers to reach a critical inflection point in revenue, margins and cash.
The high-speed optical transceiver market is expected to grow at a 30% CAGR to exceed $10B between now and 2028. Notably, discussions from Lumentum’s management team points toward a more noticeable inflection in the second half of 2025 due to EML-related products being capacity constrained, yet we think it’s prudent to start tracking these companies now in an effort to be early.
Optical Networking Components for 800G and 1.6T Transceiver Applications:
Lumentum’s cloud and networking segment inflected in the September quarter with 11% QoQ growth and more sequential growth expected in the December quarter. This was driven by silicon-based optical and photonic products, such as lasers, optical and datacom transceivers, and 400G and 800G optical modules.
About a year ago, Lumentum acquired a company called Cloud Light for its 800G transceivers. At time of acquisition, over half of Cloud Light’s $200M in revenue was from 800G modules, resulting in a doubling of Lumentum’s cloud data center infrastructure revenue.
The acquisition allowed Lumentum to add Cloud Light’s SR transceiver to the 100G VSCELs to potentially supply 800G transceivers to Nvidia. Following the acquisition, Lumentum is expected to become a supplier to Nvidia in early 2025 pending a qualification process with the Thailand facility.
An analyst pointed out the growth in the AI-related segment is forecast to be about 20% QoQ, from $282.3 million this quarter with an additional $55 million in sequential growth guided. The CEO stated it was from a mix of datacom chips and datacom modules although datacom chips will see bigger growth in the coming quarters: “I'd say Datacom chip growth is not a lot until the next couple of quarters because the capacity comes in increments in chunks.”
200G EML Datacom Transceivers:
Transceiver technologies that Lumentum provides include VSCELs, CW lasers for silicon photonics and EML-based lasers. Of these, the 200G EMLs are what is expected to drive the H2 2025 inflection. Management stated in the August earnings call that the 200G lane speeds in the 1.6T optical transceivers “play to our strengths” and that “we anticipate being a key laser supplier in initial 1.6T transceiver deployments as we ramp up 200G EMLs later this fiscal year.”
Electro-absorption modulated lasers (EMLs) enable 200G per lane transmission, which is enabling the 1.6TBps data rates for AI servers. As pointed out in last week’s analysis, EMLs were traditionally used by telecom customers, yet became attractive for AI servers due to meeting the 200G per second speeds necessary for 1.6T optical modules to support AI models. These are called single mode optics, made of Indium Phosphide, which has been used instead of silicon for long-haul networking due being a superior choice for optical functions, such as enabling the laser, modulator, photodetector and amplifier. InP is more expensive at the component level as four EMLs are needed compared to two lower-cost CW lasers for silicon photonics modules, yet this difference at the component level can be made up for in data centers as InP reduces power consumption.
Lumentum is already a lead supplier for 100G EML transceivers, and is setting up to be in pole position for the 200G EML transceivers. Per the November earnings call: “our 100G EMLs are currently shipping in high volumes to a wide range of optical transceiver suppliers for use in leading edge single-mode 400G and more importantly, 800G optical transceivers. These customers are now designing our 200G EMLs into their next generation of transceivers, positioning us well for the upcoming transition to 200G per lane.”
200G per Lane to Ramp in 2025
Management is optimistic in capturing the transition to 200G lane speeds that is expected to drive the importance of single-mode optics and indium phosphide laser transmitters. The company’s indium phosphide 100G EMLs (Externally-Modulated Lasers) are being shipped and used in leading single-mode 400G and 800G optical transceivers. These customers are now designing the company’s 200G EMLs into their next generation of transceivers.
Management provided a few clues as to when to expect an impact in their revenue growth from the 200G per lane datacom transceivers. For the upcoming quarter, datacom transceiver shipments are expected to increase QoQ and will continue to grow throughout the calendar year 2025.
Regarding the timing, it was stated: “And so we're going to participate at the component level, as I talked about in the script, with our 200-gig EMLs and that ramps really more towards the summer of next year. But we're in the qualification stages today and have received volume orders today as our capacity is quite constrained. But I'd say that by the end of next calendar year, 1.6T should be ramping in a significant way.”
There was some talk about pricing power on EMLs, with management stating: “I think that we're justified in looking at price optimization on EMLs is one area that we are looking at and have implemented some strategic pricing for those products.”
EML Fully Subscribed in 2025:
In the August earnings call, it was stated the Indium Phosphide capacity is fully subscribed “to at least the end of calendar 2025. And therefore, we can only meet this demand by growing capacity.”
To increase capacity, the company is investing in wafer fab facilities, with $43 million spent in FQ4. In Q1, $74 million was invested in Capex “primarily driven by investments in high-speed transceiver capacity additions at our Thailand manufacturing site as well as indium phosphide wafer production capacity.”
Due to strong demand, the company is working to increase the EML production capacity by 40% in Q4 FY2025 compared to the same period last year, and then implied higher capacity growth the following year (beginning in June) – reference Q&A transcript below.
The company’s Datacom transceiver capacity expansion in Thailand is progressing well. The first production line is operational and management expects to complete additional phases in the next 18 months to meet the strong demand. These expansions are part of the company’s plan to expand facilities outside China.
Future Transceiver Technologies:
Looking further out into 2026, Lumentum is working on higher speed optical links, including 400G per lane, and new architectures, such as co-packaged optics requiring ultra-high power lasers. Specifically, the company’s experience in InP long haul transceivers is being tapped as AI servers scale out, especially since InP reduces power consumption compared to silicon.
Optical Switching:
Optical switches are a new kind of switch for AI clusters that handles the switching optically instead of using transceivers to convert photons to electrons, and back again. There are many competitors within optical switching, with heavyweights Broadcom and Arista coming to mind, yet Lumentum believes their MEMS-Based technology can set them apart. Although the discussion around MEMS can get quite technical, the idea is that Lumentum is a smaller, (potentially) key supplier for customers putting optical circuit switches into their data centers. Another use case for using Lumentum is to rearchitect or write software to enable the optical circuit switching.
According to the most recent earnings call, Lumentum has “already shipped evaluation units to customers who have provided overwhelmingly positive feedback on our performance.” It was also stated that “more meaningful growth will probably be in calendar 2026” for the optical switching circuit products.
Data Center Interconnects:
For long-distance transmission, Lumentum offers tunable lasers for data center interconnects (DCIs). These transmissions are traditionally used for telecom purposes and can range up to hundreds of kilometers, yet are now seeing demand for data center buildouts. Per the call: “we're seeing dramatic strength in anything ZR, anything to connect data centers as data centers are being built out, and that can take the form of ZR modules. But given our share of tunable lasers that go into ZRs, that's where we're going to see a dramatic pickup in the telecom side.”
Three Hyperscaler Customers for 2025
Lumentum recently added a third hyperscaler customer for a total of three hyperscaler customers. According to the earnings call: “we expect to start shipping volume production against these new customer awards in the first half of calendar 2025, and they will ramp through the year, consistent with the revenue targets we set out previously.”
According to a Susquehanna analyst, this is the return of the primary CloudLight customer i.e., Google. This is in addition to the new customer added last quarter.
With that said, Lumentum is competing for the larger orders expected to be placed sometime in 2025: “And I think we're positioning ourselves very well. We're having the capacity in place, as I said, with clean rooms as well as equipment. So we're planning for success, but we still have to earn that. But that said, these are all very, very large customers that consume a lot of transceivers. And so getting in the door is step one and earning bigger share is really what we're striving to do now.”
FQ1 Revenue and 2025 Revenue Targets
This quarter, Lumentum reported QoQ growth in its primary AI-related segment, Cloud and Networking. Management also reiterated their goal of reaching quarterly revenue of $500 million by the end of the calendar year 2025 while expecting continued significant growth into 2026 and 2027.
The management team plans to achieve its goal of $500 million quarterly revenue from the current guide of $390 million for the December quarter by increasing the EML capacity by 40% by June, and tapping the transceivers and data center infrastructure opportunities discussed above. If the traditional telecom business recovers, the company is expected to reach their goal before the end of the year.
Chris Coldren, Senior VP, recently said at the Barclays conference that he feels a lot better about telecom, which is another positive catalyst as the company’s revenue has declined in the past due to the inventory corrections at its network equipment customers.
“So, I feel a lot better about telecom than we have been at least several quarters that we're starting to see things improve. And hopefully, history repeats as things tend to improve, then they tend to improve faster than you expect. And then when they get bad, they tend to get worse than you expect. And we'll let you know when that starts to happen, but it definitely feels good.”
- Q1 FY2025 revenue grew by 6.1% YoY to $336.9 million and set a new record for Datacom laser chip orders. The CEO, Alan Lowe, said in the earnings call, “In the first quarter, we exceeded the high end of our guidance for both revenue and earnings per share. We set a new record for Datacom laser chip orders, including 200-gig EML chips, reflecting strong demand from multiple customers, including an AI infrastructure customer.”
- Management has guided FQ2 revenue of $390 million, representing YoY growth of 6.3% and 15.8% QoQ growth at the midpoint. “As we previously forecasted, our datacom transceiver shipments are expected to increase sequentially this December quarter, and we expect our transceiver production to continue growing throughout calendar year 2025, driven by demand from multiple hyperscale cloud and AI customers.”
Looking further out, analysts expect FY2025 ending June revenue to grow 17% YoY to $1.59 billion and 28.4% YoY to $2.04 billion in FY2026.
Segments
Cloud and Networking
Q1 FY2025 Cloud and Networking revenue grew by 23% YoY and 11% QoQ to $282.3 million. Profit from this segment increased 13% sequentially and 13% YoY. Segment profit increased to 2.5 percentage points YoY to 12.9%.
Revenue accelerated from a decline of (-11.1%) YoY in FQ4. Management attributed the strong growth to setting “a new record for Datacom laser chip orders, including 200-gig EML chips, reflecting strong demand from multiple customers, including an AI infrastructure customer.”
Management expects strong sequential growth to continue in FQ2: “based on expanding cloud demand and improving trends in the broader networking market, we expect double-digit sequential revenue growth in the second quarter.” Per discussions in the Q&A portion of the call, the implied increase QoQ for FQ2 will be $50 million to $60 million or about 20% sequential growth versus the 15.3% guided QoQ growth for overall revenue.
Industrial Tech
Industrial Tech revenue declined by (-38%) YoY and up 2% QoQ to $54.6 million. Management expects FQ2 revenue “to be approximately flat sequentially due to an uptick in industrial lasers led by our ultrafast lasers, offset by a sequential decline in 3D sensing revenue.” Segment profit declined to 4% from 17.4% in the same period last year.
Margins
The company’s margins are recovering helped by cost controls. The management has set an ambitious goal to achieve an adjusted operating margin of 17% to 20% when the company’s quarterly revenue surpasses $600 million. Management plans to reach the target by better capacity utilization, cost controls, and synergies from prior acquisitions.
Looking further ahead to next year, management expects gross margins to increase while operating margins will come under pressure from increased R&D investments: “we’ll see gross margins tick up sequentially through the fiscal year, but we'll — it will be muted a little bit from an operating margin standpoint because of the increased R&D investment we're making just given the amount of customer pull we have.”
The overhead expenses are also expected to increase in the next couple of quarters due to additional capacities being added. These investments are expected to yield benefits in the middle of this year as production ramps up. The Street can be especially margin-sensitive with hardware companies, and thus, this is important to keep track of:
“No, it does have a little bit of overhead impact [to add capacity] because we're building out in our Thailand facility as we move more of our production of transceivers to Thailand. And so as we move that up and ramp that up, there will be a couple of quarters of overhead expenses associated with that. And so that's already contemplated in the sequential increases in margins. But then as that volume ramps up in the middle part of next calendar year, we'll be able to see the benefit of that moving through the quarter. So we'll explain more about that as the quarters happen, but thank you for asking about that.”
- Q1 FY2025 gross margin was 23.1% compared to 24.1% in the same period last year. Adjusted gross margin was 32.8% in both the periods. Management expects gross margins to improve sequentially throughout FY2025. “In future quarters, we anticipate company gross margins will sequentially increase as manufacturing utilization improves due to an improving telecom outlook as well as an increase in Datacom laser shipments.”
- Operating margin was (-24.5%) compared to (-25.4%) in the same period last year. Adjusted operating margin improved to 3% from 0.60% in the same period last year. The difference between GAAP and non-GAAP operating margin is due to the stock-based compensation expenses and amortization of acquired intangibles. Management expects the adjusted operating margin to improve to 6.5% in FQ2.
- Net margin was (-24.5%) or (-$82.4 million) compared to (-21.4%) or (-$67.9 million) in the same period last year. Adjusted net margin was 3.6% or $12.2 million compared to 5.1% or $16.1 million in the same period last year.
- Adjusted EBITDA was $37 million or 11% of revenue compared to $34.6 million or 10.9% in the same period last year.
EPS
The EPS is expected to rebound in the coming quarters, with adjusted EPS expected to almost double sequentially in the next quarter. Note the very strong, incoming rebound on adjusted EPS below.
- FQ1 adjusted EPS came in at $0.18, beating consensus estimates by 48.1%, helped by operating leverage and cost controls.
- Analysts expect FQ2 adjusted EPS to grow 9.6% YoY to $0.35 and 46% YoY to $0.42 in FQ3.
- Looking further out, analysts expect the adjusted EPS for FY2025 ending June to grow 56% YoY to $1.58 and 134.5% YoY to $3.70 in FY2026.
Cash Flow and Balance Sheet
The cash flows are improving, driven by the recovery in revenue. With management targeting an adjusted operating margin of 17% to 20% once quarterly revenue surpasses $600 million, cash flow generation should further strengthen in the coming quarters.
- Q1 FY2025 operating cash flow was $39.6 million or 11.8% of revenue compared to (-$2.3 million) or (-0.7%) of revenue in the same period last year.
- Free cash outflow was (-$34.5 million) or (-10.2%) of revenue compared to (-$63.1 million) or (-19.9%) of revenue in the same period last year. The company has been investing due to the strong demand for AI. The company’s CEO, Alan Lowe, said in the earnings call, “In Q1, we invested $74 million in CapEx, primarily driven by investments in high-speed transceiver capacity additions at our Thailand manufacturing site as well as indium phosphide wafer production capacity.”
- The company has cash & short-term investments of $916.1 million and debt of $2.58 billion compared to $887 million and $2.5 billion at the end of FQ4.
Earnings Call Q&A:
EMLs are Capacity Constrained
EML production capacity was the hot topic on the earnings call, with the discussions revealing quite a bit about Lumentum’s strategy as the company attempts to compete against companies like Coherent/Innolight, Eoptolink, and others. Essentially, the company is buying CW lasers while reserving capacity for EML production in-house.
Reserving capacity for EMLs:
Here is what was stated regarding why Lumentum is looking for more H2 2025 strength in both EML lasers and the company’s strategy when approaching limited capacity with what they can build in-house:
“So, we use a lot of CW lasers, not EML lasers yet in the products that we're shipping and released today. So we can buy those CW lasers externally or we can use our very critical EML capacity to add those CW lasers into our products.
We've done the math. There's a lot of good CW laser suppliers. It makes more sense for us to buy those CW lasers and free up that EML capacity to ship to our customers than it would be to convert that EML capacity to CW lasers, for example. So that's one of the things that's pushing off that integration of CW lasers into our products until the second half.
I'd say that we are working on EML-based designs, and those will come to market in the second half of the calendar year. We have to get qualified and go through that. But today, most of the products that we're producing are silicon photonic-based using CW lasers from our strategic supplier partners to keep that EML capacity for our customers.”
–End Quote
1.6T Transceivers Driving Demand for EMLs:
Lumentum’s call is decisively focused on EMLs compared to more broad product discussions on the VSCELs or CW lasers that Coherent’s call covers. When asked why EML is so critical to Lumentum’s strategy, the management team responded with:
“And I'd add that the real performance advantage of EML starts to come in as we talk about 1.6T and future generations of higher performance 1.6T. So, our natural road map also aligns with using more vertical integration where the technologies are much more differentiated at those speeds.” There was also a follow-up: “And as Chris said, a lot of the new next generation of 1.6T likes EMLs better, especially as you get into multi-wavelengths where EMLs can really play a key role there. So yes, we're absolutely going to do that. It probably makes more sense in the second half of the calendar year as we get into these more advanced 1.6T products.
And then we have next-generation 200-gig EMLs, which are really going to differentiate us from our competitors. And I think that really gives us the ability to drive incremental differentiation at the transceiver level and drive higher gross margins.”
It was also stated during this discussion that the goal is to increase EML production capacity by 40% between June of 2024 and June of 2025. There was a question as to why not increase it 100%, to which management relented they would increase by that much, if they could: “So a very good question. If I had the ability to add 100% between now and June, I would do it.”
Most importantly, management hinted there would be more than 40% capacity increases after June, pointing toward wafer capacity for EMLs coming online in Japan: “And so I think we're going to do well in the second half of the calendar year on that. But we are adding capacity beyond the 40% for sure after the June quarter. We're not sitting idle for sure.”
EMLs will Not Ship until Later this Year:
Quick note to say the 11% sequential growth last quarter and the expected 20% growth this quarter in the cloud and networking segment is not coming from EMLs yet.
Per the discussions: “And so these, in general, are transceivers that won't have our EMLs at initial launch, if you will, because these have been in development and designed over the past year or so.
Obviously, these accounts have other opportunities to Alan's point, as we succeed and execute with them, not only will there be more share, but there will be more SKUs and other types of transceivers where we can introduce more of our own content.”
Expanding Outside of China
There were discussions around China with management stating “we’re as tariff-free as you can get with respect to our future,” citing manufacturing in the United States, U.K., Thailand and Japan. Similar to Coherent, Lumentum sees this as a tailwind.
“And with our U.S. headquarter and manufacturing outside of China, I think there's a compelling reason for customers to come our way. So we expect to not only grow our datacom module business and EML chip business, but gain significant share through the next coming years.”
Conclusion:
It’s important to emphasize that it’s not clear who will win the networking wars, yet we think given our detailed process of tracking earnings reports for material inflections, combined with technicals that allow us to reduce risk while tracking breakouts, that we will be able to carefully add the correct winners to our portfolio for 2025.
To hear more on how we plan to position this year, plan to join me for a one-hour special webinar for Q1 2025 on January 14th at 4:30 pm EST.
That’s a wrap for 2024! Thank you for an amazing year, we look forward to continued outperformance in 2025.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
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