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Oclaro, Inc. (NASDAQ:OCLR)

Q4 2014 Earnings Conference Call

August 13, 2014 05:00 PM ET

Executives

Greg Dougherty - CEO

Pete Mangan - CFO

Jim Fanucchi - Darrow Associates

Analysts

Alex Henderson - Needham & Company

Dave Kang - B. Riley & Co.

Patrick Newton - Stifel, Nicolaus & Company

Natarajan 'Subu' Subrahmanyan - The Juda Group

*

Operator

Good afternoon and welcome to the Oclaro Fourth Quarter and Fiscal Year 2014 Financial Results Conference Call. As a reminder, this conference call is being recorded for replay purposes through August 27, 2014.

At this time, I'd like to turn the call over to Mr. Jim Fanucchi of Darrow Associates. Please go ahead, sir.

Jim Fanucchi

Thank you, operator, and thanks to all of you for joining us. Our speakers today are CEO Greg Dougherty and CFO Pete Mangan.

Statements about management’s future expectations, plans or prospects of Oclaro and its business, including statements about future financial targets and financial guidance, Oclaro's plans for future operations together with the assumptions underlying these statements constitute forward-looking statements for the purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, statements concerning financial targets and expectations and progress towards Oclaro's target business model, including financial guidance for the fiscal quarter ending September 27, 2014. Regarding revenue, non-GAAP gross margin and adjusted EBITDA, the status of Oclaro's restructuring plan, market interest in Oclaro's 100G products, the pending acquisition of Ushio Opto, Oclaro's industrial and consumer business and Oclaro’s future financial performance and operating prospect.

There are a number of important factors that could cause actual results or events to differ materially from those indicated by such forward-looking statements including the risk factors described in Oclaro's most recent Annual Report on Form 10-K, most recent quarterly report on Form 10-Q, recent Form 8-Ks and other documents we periodically file with the SEC.

The forward-looking statements discussed today represent Oclaro's current views as of the date of this conference call and subsequent events and developments may cause Oclaro's views to change. Accordingly, actual results may differ materially from those indicated by these forward-looking statements. Oclaro does not intend and is not required to update any forward-looking statement as a result of future developments.

In addition, today, we will be discussing non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP and should not be considered as a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A table that outlines the reconciliation between the non-GAAP financial measures to GAAP financial measures together with a discussion of their usefulness and limitation is included in today's earnings press release, which we have filed with the SEC, and I refer investors to this release. In addition, we’ve provided a supplemental slide deck in the Investor Section of our Web site.

I’d now like to turn the call over to Greg.

Greg Dougherty

Thanks, Jim, and thank you everyone for joining the call. Today we’re reporting both our fourth quarter and full-year fiscal 2014 financial results. I’m very pleased that our results continue to validate the aggressive actions we’ve taken to focus and streamline the Company, regain industry leadership and establish financial stability.

During today’s call, I’ll report on our performance over the past year and reflect on our Q4 results. Pete will take you through our numbers, as well as our improved break even model and our guidance. While our work is not over, we’ve substantially transformed the Company over the past nine months.

As you remember, one-year-ago we were facing significant financial challenges. Since then we’ve accomplished quite a bit. First, to fund our recovery we successfully sold assets with -- which allowed us to pay off our debt and to kick off our restructuring plan that we rolled out last November. That plan called for us to lower our cost structure by reducing the number of our sites, reducing our headcount, correcting many broken processes and essentially beginning to operate as one Oclaro.

Secondly, we committed to continuing to invest strongly in R&D and focus our resources on the large 100G markets for Telecom and Datacom. Our execution of this turnaround plan has resulted in the following accomplishments to date. We paid off all of our bank debt and are now essentially debt free and ended our fiscal year 2014 with over $100 million in cash.

We reduced our annual operating expenses by $26 million and improved our adjusted EBITDA by $38 million. By the end of Q2 this year, we expect to have only 8 major sites, down from the 20 that we had one year-ago. We also will have reduced the number of our fab from six to three in this timeframe.

Our headcount, which was about 2,900 one year-ago, will be approaching 1,200 when the sale of our industrial and consumer business closes which we expect to occur by the end of Q2. Following the sale of our I&C business, we will be solely focused on optical communication with the main thrust of our R&D on the large and high growth markets for 100G.

Our focus has allowed us to successfully introduce and ramp up production of our client side CFP2 transceiver. We believe that we’re currently the market leader in single-mode 100G products for client side. We intend to leverage this success into the emerging single-mode data center opportunities.

We also have begun shipping samples of our coherent CFP2 to several key customers for line-side application. This is another area where we’re in a market leadership position. We also committed to transforming the culture of Oclaro to be more customer driven, to deliver on our commitments and to be more accountable. While we’ve not been 100% successful, we’re proud of our results which show a much healthier Oclaro that is well positioned for the future.

For the recently concluded fourth quarter, our results were in line with our expectations and showed good improvement over the prior quarter. Our revenues for the quarter were $95.9 million, mainly driven by the continued growth of our high-speed products. Our gross margin performance of 14% was up quarter-over-quarter by 200 basis points, despite another quarter where we had higher than usual cost of sales as we continue to fix historical business process issues.

We continue to work towards standardizing our processes and moving toward operating as a single integrated company. We further reduced our operating expenses by over a $1 million and our adjusted EBITDA of negative $9.4 million represents an improvement of about $3 million over the previous quarter. This was a $13 million improvement over the same quarter last year.

During the recent quarter, our 40G and 100G portfolio continue to perform well and represented over 50% of the Company’s revenue. We saw meaningful growth in both the client and line-side of the 100G business. Longer term, we expect to see solid growth from 100G coherent products for transmission and from the conversion of data centers to single-mode fiber and to 100G data rates.

We continue to invest substantially in R&D in these areas and are strongly positioned technically in both. We further establish ourselves as a market leader in 100G client side products with our CFP and CFP2. We also believe that the coherent CFP2, our emerging flagship product will serve as a growth engine for us in many years to come.

In Q4, we shipped our first coherent CFP2 product to several key customers. The system test results of these customers have been very good and have reinforced our first to market position and our technical differentiation. Results show the customers will be able to use coherent CFP2 for both metro and long haul applications.

While the CFP2 is expected to be our flagship product, it is based on a platform approach that allows our customers to buy either a CFP2 pluggable module or the discrete transmit and receive components or system architectures utilizing embedded optics configuration. This platform approach leverages our indium phosphide photonic integrated circuit, which allow for small sized, lower power consumption and offer excellent performance.

As discussed in previous calls, our new pilot production line is up and running in the U.K. We will be building and shipping products from it next quarter. We believe that the market for the coherent CFP2 will be in the hundreds of millions of dollars within about two years. And we expect to be well positioned to capture a significant share of this growing market.

Our lithium niobate modulators had a strong quarter as shipments of our 100G coherent modulators increased by a factor or three compared to the third quarter. We have very strong backlog for Q1 and Q2, as demand is currently outstripping our ability to supply. Because of this, we’ve made significant capital investments to increase our capacity. We expect the results to be a doubling of our 100G modulator capacity by December.

Q4 was also the first quarter in which we saw revenue for our 100G coherent micro-ITLA. While we did not ramp this quickly as we had planned, we expect to see continued growth as again we have much more demand than we can shift. We expect to see our micro-ITLA product revenue grow by a factor of three in Q1 and yet again by another 150% to 200% in Q2.

On the client side, we believe that we’re the market leader in supplying single-mode 100G products to go into routers and data centers. We saw growth of 30% in Q4, particularly driven by China based demand. We believe the demand for CFP form factor for client side has peaked and we will see it decline some over the next few quarters as customers gradually transition for the new CFP2 form factor. The good news is that we have a strong market position with our CFP2 as well. And this is for both single and dual rate application.

Overall, on the 100G client, we expect Chinese demand to slowdown a bit in Q1 and pick up again in Q2 with the next anticipated infrastructure projects from the leading service providers there. We are continuing to invest in next generation high-speed DFB lasers, receivers, and advanced packaging to address the market needs for the conversion of data centers to 100G and single-mode fiber.

With the conversion from CFP to CFP2, our high-end router customers are now ramping quickly to install higher density port counts. To add more data center expertise to the Company, we hired Adam Carter, formerly Cisco’s General Manager of the transceiver module group as our Chief Commercial officer.

In addition to other roles, Adam will be in charge of both sales and strategy for Oclaro. We believe that Adam joining us is a clear signal that Oclaro is well positioned to be a very successful player in the data center space.

We continue to refine our manufacturing strategy. Given our focus on a 100G and the steep growth we expect, we’ve made the decision that we will no longer move and/or re-qualify anymore of our 10G indium phosphide project -- products to our contract manufacturing partners. This will allow our CM to focus on helping us with the expected steep production ramp of our 100G products. The impact of this decision was a one-time restructuring charge in the recent quarter of about $3 million.

Finally, last week we announced the signing of a definitive agreement to sell our Japan based industrial and consumer business to Ushio. The I&C business primarily manufacturers red and violet laser diodes used in medical, measuring, printing, and display applications.

The operations being divested, employ approximately 80 people, primarily located in Komoro, Japan. The sale of the I&C business is another key move in our turnaround plan as it has limited synergies with the rest of our business. It also adds a fair amount of complexity to the organization as it has different customers, different sales channels, market and technologies.

Another key reason for divesting the business is that it has a semiconductor laser fab that needed to be relocated after the expiration of our lease in early 2016. We had estimated that the cost to move the fab into our Sagamihara fab in Japan would have been around $10 million.

In addition to the cost, it would have created a significant distraction to some of our key laser personnel in our Datacom division in Japan. Instead, we will now be able to keep our Japan team focused on 100G modules for data center application.

The cash proceeds of this divestiture also will help further strengthen our balance sheet and enable our continued investment in R&D for Oclaro’s future. We expect this deal to close in the second quarter.

While this is a good move for Oclaro, I’m also happy to say that I believe that Ushio will be a perfect fit for our Komoro team. And our I&C customers will benefit from the increased focus on the markets being served.

With that, I’d like to turn the call over to Pete. Pete?

Pete Mangan

Thanks, Greg. As Greg noted earlier, the financial performance for the June quarter was in line with guidance and our non-GAAP operating results improved quarter-to-quarter. I’ll start by providing a few key points about fiscal year 2014, the third quarter and then close with the guidance for the first quarter.

Starting with our fiscal 2014 performance, revenues were $391 million, down 3% from the prior year reported sales. However, due to a growing mix of higher speed Datacom product and lower manufacturing overheads resulting from our restructuring plan, our non-GAAP gross margin increased by $19 million or 520 basis points, to 14% from the prior year.

Below the line, also a result of our restructuring plan, we reduced operating expenses by $26 million or 17% from the prior year. Together our non-GAAP operating performance improved $45 million or 38% year-to-year.

While we’re proud of our substantial year-over-year improvement, we recognize the need to keep driving to deliver further improvement in our financial performance in 2015 and further minimize and/or eliminate our operating cash burn.

Now turning to the fourth quarter results. For Q4, net revenues of $95.9 million, were essentially flat with the prior quarter. Within our revenue mix, sales of our 40G and above products increased 11% from the prior quarter, led by strong gains in our 100G Datacom and lithium niobate modulator product. This was offset by a decline in sales of 10G and below products of 10%.

From an end market perspective, sales of our products used in Datacom applications increased by 10% sequentially. While Telecom related products declined approximately 8% due to product exit. As a result, both Datacom and Telecom each contributed 46% of revenues in the quarter.

In total, our 40G and above products contributed 51%, 10G and lower comprised 41%, and industrial and consumer accounted for the balance of 8% of our revenue. In the June quarter, we had three customers, each contributing greater than 10% of total revenues. Coriant remained our largest customer with 24% of total revenues, Huawei 13% and Cisco 11%.

Additionally, our top 10 customers contributed 82% of our revenues and regional sales showed Americas of 29%, China 28%, Europe 23%, Southeast Asia 14% and Japan 6%.

Our non-GAAP gross margins increased to 14.1% in Q4 compared to 12.3% in the prior quarter. For Q4, while we had stronger revenue mix due to higher sales of a 100G Datacom product, the gross margin increase was muted due to higher E&O reserves of approximately 400 basis points when compared to our historical level. As a result, rather than being in position to report gross margins of 18%, we reported gross margins of 14%.

Our non-GAAP operating expenses further reduced in the June quarter to $27.8 million, down 5% or $1.4 million from the prior quarter. This level of operating expenses represents a 28% reduction from the first quarter of 2014, and has significantly reduced our breakeven point going forward. With the higher gross margins and lower operating expenses, our non-GAAP operating loss was $14.3 million, and improved 18% from the March quarter.

Our adjusted EBITDA in the fourth quarter was a negative $9.4 million which was an improvement of $3 million sequentially. Our GAAP net loss was $24 million or $0.23 per share compared to $22.9 million or $0.22 per share in the prior quarter. Included in the Q4 GAAP net loss was $5.8 million of restructuring, mostly related to the closure and reduction in our manufacturing footprint.

Now turning to the balance sheet, our cash position remains strong. Cash including restricted cash was $104.1 million representing a decrease of $18.2 million in the quarter. The decline resulted from a working capital drain of $10.3 million, with accounts payable down as expected and an adjusted EBITDA loss of $9.4 million.

Other significant balance sheet items in Q4 included accounts receivable of $82.9 million or 79 days of sale, which was up from 72 days last quarter. Inventory of $71.1 million or 79 days declined by 10 days versus the last quarter, however, primarily due to reserves taken in the quarter and products sold to contract manufacturers. Accounts payable and accrued expenses decreased by 10% in the quarter to $122.7 million.

That completes the review of the fourth quarter and fiscal 2014 results. Before discussing the guidance for the first quarter, let me provide an update on our expected fiscal year 2015 cash flows.

On outflows, number one, regarding restructuring in the past three quarters, we’ve incurred $16 million of our $20 million to $25 million plan. We now expect the balance of the $4 million to $9 million to be spread out over the remainder of fiscal 2015.

Number two, our CapEx and cap lease needs are approximately $5 million per quarter and number three, we continue to fund our adjusted EBITDA losses until we will achieve breakeven, which I will comment further on in a minute.

Cash inflows are projected to include the following. Number one, approximately $18.5 million from our pending I&C divestiture with $16 million to be paid at closing and approximately $2.5 million paid six months later. This transaction is expected to close in the December quarter.

Number two, also we expect to receive at calendar year-end the remaining $10 million holdback related to the asset sales from last year. Additionally, we have a $40 million working capital line of credit which we do not expect to draw on in fiscal 2015.

As a final note on the I&C divestiture, on a carved out basis, this business contributed $29 million of sales, 50% gross margins and approximately $8 million of positive adjusted EBITDA in fiscal year 2014. Anticipating the completion of this transaction, we’d like to update our adjusted EBITDA breakeven model and timeline.

Our revised model indicate that $100 million of revenue -- $100 million in revenue, 20% gross margins, and 25% operating expenses, we will achieve adjusted EBITDA breakeven. Given the sale of the I&C business and our near-term top line prospects, we currently expect to reach this milestone in the September quarter of calendar year 2015.

In closing, the guidance for the first quarter of fiscal 2015 which includes a full quarter of industrial and consumer business is as follows. Revenues in the range of $83 million to $91 million, non-GAAP gross margins in the range of 12% and 16%, adjusted EBITDA in the range of negative $13 million to negative $9 million.

This concludes our financial update. I’ll now turn the call back to Greg for his closing remarks.

Greg Dougherty

Thanks, Pete. First and foremost I’m confident that we will continue to deliver improvements in our financial results through fiscal 2015 compared to fiscal 2014. As is evident in our much improved financial performance compared to a year-ago, the decisions that we’ve made and the actions that we’ve taken have made Oclaro a simpler, but stronger and more focused company.

We’ve a much lower cost structure. We’ve growing strong demand for our new 100G product. We have solid customer relationship and a strong market position for our CFP2 products in both client and line side applications.

However as Pete indicated, in the near term we expect a slow start to the fiscal year due to the decline in demand for our 10G and 40G legacy products. This is a decline that we had previously projected. Our new 100G products will continue to ramp and become an even larger revenue contributor in the coming quarters overtaking the legacy product revenue roll off around mid-calendar year in 2015.

Through our actions this past year to rebuild, revitalize and focus the company, we’re on a much stronger financial foundation and have a healthy new product pipeline. And now that we are completely focused on the optical communications market, our strategy is clear to be a leading innovator and provider of 100G solutions for lining client side application.

I must remind you that a turnaround is not something that happens over night and without some pain. While we did not progress as much as I would have liked, I’m very impressed with the achievements of the performance of the Oclaro team and what has essentially been in the nine months.

I’m fortunate to work with such an outstanding team, and I once again thank them all for their effort. I look forward to reporting our continued progress in the quarters ahead.

With that, I will turn it back to the operator to begin the Q&A. Operator.

Question-and-Answer-Session

Operator

Thank you. (Operator Instructions) And the first question comes from Alex Henderson with Needham & Company.

Alex Henderson - Needham & Company

Hi, guys.

Greg Dougherty

Hi, Alex.

Alex Henderson - Needham & Company

So, let me just get a couple of things straightened out. I wasn’t sure I completely caught. The EBITDA guidance for the upcoming quarter was what again?

Pete Mangan

Negative $9 million to negative $13 million.

Alex Henderson - Needham & Company

And when you give the $81 million to $91 million, just to be clear that does or does not include the discontinued operations from the sale?

Pete Mangan

It includes the full quarter Alex of the company.

Alex Henderson - Needham & Company

It includes -- so how much is that of that revenue?

Pete Mangan

Roughly $8 million and you can see it on the PowerPoint slide we have on revenue by product group that’s noted as industrial consumer, so its $7.7 million.

Greg Dougherty

Alex, it’s been running at about the seven point high number, so close to $8 million for the last several quarters. But the guidance was $83 million to $91 million, not $81 million to $91 million.

Alex Henderson - Needham & Company

$83 million to $91 million, right.

Greg Dougherty

Yes.

Alex Henderson - Needham & Company

That’s what I had written down.

Greg Dougherty

Okay.

Alex Henderson - Needham & Company

So, you’ve given guidance here of $100 million in revenues, 20% gross margin, 25% OpEx gives you EBITDA breakeven. What level of revenue do you need to get to actual earnings breakeven?

Pete Mangan

So, earnings breakeven on a GAAP base?

Alex Henderson - Needham & Company

No, non-GAAP.

Pete Mangan

On an non-GAAP base would be approximately $105 million, $110 million.

Alex Henderson - Needham & Company

Okay. And I assume that, that is a higher gross margin, because obviously something is got to change.

Pete Mangan

That’s right. So, it’s similar to what we talked about before from an operating breakeven perspective the further improvement would come through gross margins going from 20% to 25% and operating expenses remaining at 25%. And so, the path will be through the middle line and the top line.

Alex Henderson - Needham & Company

So, just to put some time line around that. If you’re saying you’re going to hit this initial model that you hit EBITDA breakeven by the middle of the year next year. Is it reasonable to think that you could, by the end of the year get to breakeven on earnings basis or is that five points of gross margin expansion, too much to target over that window? I know that’s quite a ways out. Granularity is certainly not intended to be something we’re holding you to, just trying to get some sense of the plan.

Pete Mangan

Yes, Alex we believe with our new coherent 100G product that the revenue and margin profile of that can drive the company through the 20% gross margin and beyond driving both the top line to cover more expenses as well as generate more significant gross margins.

Alex Henderson - Needham & Company

And would the OpEx start to flatten out when you hit $100 million, and if that happens, there are straight leverage on that? How should I be thinking about that?

Greg Dougherty

Yes, I think you should be thinking about straight leverage with one exception that we will continue to invest in R&D at about the current levels. We’re not looking to starve the R&D line. But the G&A and marketing and sales will pretty much flat line other than just nominal growth.

Alex Henderson - Needham & Company

Okay. Come back to the industry conditions, obviously the legacy stuff is falling off that’s a planned process. But could you talk about the general market conditions independent of your company specific fundamentals, but rather on a more broad industry view of what you think is going on in terms of aggregate demand and Datacom and Telecom and China versus the U.S. versus Europe? Thanks.

Greg Dougherty

Sure. I think if we look at Datacom, if I break it into three segment 10, 40 and 100 is three segments, we continue to think that 10-gig is still growing in terms of units, but the price erosion has basically flat lined the revenue component of that, but we still see that as a healthy and growing market. 40-gig we think continues to grow. Of course it’s mostly multi-mode and that’s an area we don’t like, so we don’t see any of the growth there. The 100-gig has been quite strong, and we’re doing quite well there as we mentioned in the call. There is some variability based on some of the China deployment. And as service providers come out with new bid or new installs then that’s been, we then see that go up and down the couple of few million a quarter. So, we had a very good last quarter. We mentioned in the call it will come down a bit in China this quarter to 100G with the Datacom products, but it will come back up we think in the second quarter.

Alex Henderson - Needham & Company

If I could just ask a question on that comment, the 10-gig price erosion, is that just simply a matter of the premium that had been in the field between OEM prices and Web 2.0 prices collapsing to OEM levels and therefore stabilizing at the OEM level or is there some other dynamic in that?

Greg Dougherty

I think that it’s partially that, it’s partially that there is a lot of supply out there. I think there’s a lot of pressure from Chinese suppliers coming in that has helped drive it down.

Alex Henderson - Needham & Company

Okay. Thank you.

Greg Dougherty

Sure. And Telecom the 100G side we see is very strong. We have -- we’re doing quite well in Europe, North America and China. I would say we probably are somewhat conservative on our planning numbers for China because we think that there might be some overbuying and so we’re being very cautious as we look at that market. I think as some of the customers jockey for positions to try and control capacity. So, but the 100G market continues to grow very, very well. The CFP2 that we showed at OFC, we did start sampling in the quarter, and the customers I think are pretty impressed. It’s now playing with several different DSPs and the performance is outstanding with the variety of DSPs which was one of the questions that I think a lot of our customers had. The interoperability aspect and we’re feeling very good about that now.

Alex Henderson - Needham & Company

Just if I could ask one question on that, is that plugging into the DSP or is the DSP being pre-fabbed at your production locations with them supplying into. It’s just an interface?

Greg Dougherty

Yes, we have an analog output limiting amp or liner amplification coming out and interfacing with the DSP that in some cases are industry DSPs, and in some cases they are proprietary DSPs that our customers have designed.

Alex Henderson - Needham & Company

Got it. And then this is the 40-gig coherent, non-coherent erosion, can you talk about that piece?

Greg Dougherty

So, as we mentioned we started the roll-down last quarter. And it continues into this quarter and next and we are working and trying to sort out definitively what type of profile it will have in the calendar year 2015, but we have a good handle on where it is for the next two quarters. Basically we have commitments for the next two quarters. But its definitely part of our revenue plan that we talked about at the last conference call was it rolling down.

Alex Henderson - Needham & Company

One last question, then I’ll cede the floor. The margin on that 40-gig product that’s rolling off, is it above average or -- how do we think about that impacting the [ph] [market]?

Greg Dougherty

It’s hard to be below average, but yes it’s above average.

Alex Henderson - Needham & Company

Okay. Thank you.

Operator

And we’ll take the next question from Dave Kang with B. Riley.

Dave Kang - B. Riley & Co.

Thank you. Good afternoon.

Greg Dougherty

Hi, Dave.

Dave Kang - B. Riley & Co.

Just first of all a couple of numbers. Can I get the depreciation, amortization and CapEx, what they were?

Pete Mangan

Yes, the depreciation for the quarter was around $5 million, and the CapEx was around $3 million.

Dave Kang - B. Riley & Co.

Okay. And is that going to kind of stay at that level or?

Pete Mangan

Yes, the depreciation will stay at that level. The guidance we gave on the cash flows was CapEx and cap lease around $5 million a quarter.

Dave Kang - B. Riley & Co.

Right. And then just going back to on the 40G, so I was wondering if you can just provide what those number were in the 40G as well as Telecom 10G, I guess that’s expected to come off. And regarding your guide, it looks like the midpoint implies about $9 million sequential decline, and you mentioned 40G as well as the 10G legacy. Is that pretty much all of that or just trying to understand the mix and can we -- should we expect other business to be flat or up? Any kind of comments will be helpful.

Pete Mangan

So, Dave I’ll just sort of start and Greg can add in here. Looking at the quarter we had in June and the midpoint of the guidance you would say it’s down $9 million. There’s a couple of different ways to look at it. Clearly there is the 40G coherent AT&T business rolling off -- I’m sorry it’s not coherent it’s the line card business for AT&T, that’s in element of it. There’s some legacy, Datacom that’s rolling off. If we look at the splits on Telecom and Datacom. Telecom is more or less flat quarter-to-quarter, and the roll off is more related -- the decline is more related to Datacom with the 10G legacy being a piece. And as Greg had indicated in his script, we had a great quarter 30% growth on the 100G but believe we will have sort of an Ebb & Flow China being soft in this quarter but they’ll come back as the infrastructure. That would be the color I would say on the top line. I think embedded in your question was sort of going to gross margins as well in mix. The color, I could give you there would be, if you started with 14 points of margin, take the comment on E&O reserves of 400 basis points and you start from 18. Then what I would suggest is, there is about two points of loss in the quarter given the top line and the weaker mix of the 40G business and the Datacom 100G both contribute about a point. So, that puts us sort of back in that midpoint of guidance of 12% to 16%.

Dave Kang - B. Riley & Co.

Got it. The reason I’m asking about this the mix is because obviously 40G will continue to come off. So, at the end of this quarter -- at the end of September quarter how much do you think you’ll have as far as 40G is concerned? Because obviously Korea naturally went up -- and went up in the fourth quarter.

Pete Mangan

Yes, so the 40G line card business and of course we don’t guide other than the Q1. The 40G line card business we have model rolling down as we talked about. We are seeing very good growth at 100G, 100G coherent products or a combination of Micro-iTLA, lithium niobate modulator and we will start to see a little bit of revenue at the back end of this year for the CSP2 analog. In addition to that something that we’re also seeing a fair amount of demand for Tunable 10-gig transceivers.

Dave Kang - B. Riley & Co.

[Ph] [TSFE]?

Pete Mangan

Yes, exactly.

Dave Kang - B. Riley & Co.

Okay.

Pete Mangan

And so, we are seeing good demand there which is also helping bolster the Telecom side. And we also, we’re seeing some 40G coherent deployments in terms of the Verizon network that we’re also applying into.

Dave Kang - B. Riley & Co.

Got it. And then you talked about capacity being constraint, so I guess, you’re planning to double by when, did you just say December?

Pete Mangan

So, lithium niobate modulators for a 100 gigabits we grew by a factor of three from the March quarter to the June quarter. We invested and this is part of why our CapEx is going to be going up. We have invested, and we’ll continue to invest to increase the capacity there. We will double the new capacity by December within the next four, five months.

Dave Kang - B. Riley & Co.

Got it. But I was wondering if you can just provide any ballparks, are we talking of 100G modulators being what, like 10% of revenues or any color there?

Pete Mangan

We don’t break it out that way Dave, sorry.

Dave Kang - B. Riley & Co.

Okay, that’s fine. And then just lastly, just a little bit more on the -- just the overall market condition. Obviously yesterday one of your competitors talked about especially the North American market being a little bit challenging at least for the next couple of quarters and actually Cisco said sort of the same thing earlier. I mean, what are your customer’s telling you as far as the December quarter is concerned. I know that you don’t give guide, but any kind of a color what to expect in the December quarter?

Pete Mangan

Well, its customer-by-customer, market-by-market. I mean for customers that buy our 100-gig product lines we can't ship enough, and so it kind of cuts that way.

Dave Kang - B. Riley & Co.

Okay. Well, what about other stuff?

Pete Mangan

Well, I mean -- I think similarly we predicted 40G line card business to continue to roll down. We expected that our 10G legacy business is going down, but some of that is painful but strategic decisions that we’ve made in terms of not chasing price in with products that aren’t profitable for us.

Dave Kang - B. Riley & Co.

Got it. All right. Thank you.

Pete Mangan

Sure.

Operator

Next will be Patrick Newton with Stifel.

Patrick Newton - Stifel, Nicolaus & Company

Hi, good afternoon Greg and Pete. Thank you for taking my question.

Pete Mangan

Hi, Patrick.

Patrick Newton - Stifel, Nicolaus & Company

One quick clarification, did you say your industrial and consumer business had gross margins of 50% or 15%?

Pete Mangan

50%.

Patrick Newton - Stifel, Nicolaus & Company

Okay, that’s what I thought, I heard it little bit higher than I would have thought. All right, so and then I know that Dave and Alex asked this several different ways, but on the guide down of $9 million at the midpoint you talked about legacy products, you talked about the Datacom, you talked about 40G line card, but could you comment on whether 100G CFP is likely to be down sequentially given kind of an expected pausing for CFP2?

Pete Mangan

So, the answer to that is, it will be based upon some of the demand that we have in China.

Patrick Newton - Stifel, Nicolaus & Company

Okay. And then just on this one down business in general, I know you’re hesitant to give us exact revenue, but to give us a level set of an expectation on a go forward basis, can you help maybe basket together what the legacy Datacom, the 40G line card et cetera is as a percent of revenue that’s bleeding off over the next three to four quarters.

Pete Mangan

I’m not sure we want to do that, but maybe another way to talk about it is that, we do think that the backend of this calendar year is kind of our bottom and the crossover in terms of the ramping of the new products with the others coming down will start to allow us to grow as we look forward. And I think, I mentioned in my script that by the middle of next year that should be clearly evident.

Patrick Newton - Stifel, Nicolaus & Company

Okay. So, if I take backend of calendar year as the bottom, if I take 100G should offset the roll off of legacy by like you said mid fiscal ’15. I would interpret that to mean that we should see another sequential step down in revenue in the December quarter excluding the impact of your I&C sale, is that fair?

Pete Mangan

No, I wouldn’t go there yet. But it is the, we’re in the transitional period between new products coming on and legacy products going off.

Greg Dougherty

Yes, I think that you also -- there were a couple of other points that we mentioned Patrick that we expected that the China 100G CFP2 business to pick up again in the December quarter. We also mentioned that we will ship 150% to 200% more Micro-iTLAs in the December quarter, and that we will ship twice what we shipped last quarter in lithium niobate modulators. You will see a lot of pick up there.

Patrick Newton - Stifel, Nicolaus & Company

So, tell me, what is this basis of the micro-iTLA just so we have an idea of what type of uptick we’re looking at?

Greg Dougherty

Well, last quarter was our first quarter with revenues, but it was fairly small.

Patrick Newton - Stifel, Nicolaus & Company

So even 150% to 200% pick up, so you’re saying that it will grow by factor of three in the September quarter, and then another 150% to 300% in the December quarter and therefore be …

Greg Dougherty

Yes.

Patrick Newton - Stifel, Nicolaus & Company

Okay, so a little bit more meaningful. And then that commentary on the CFP2 China is a perfect segue into, what are your thoughts on pricing on the CFP2 relative to the CFP and do you have enough confidence that the volume growth in the CFP2 will be enough to offset pricing erosion?

Greg Dougherty

It’s a great question, and I would say we do have -- I think we have enough confidence in the possibilities for CFP2 volumes.

Patrick Newton - Stifel, Nicolaus & Company

And then does that require you to have any share gains resulting from that or if you just held share constant that would be enough just based on volumes?

Greg Dougherty

We’re always driving for share gains, but right now I think we’re in a one and number two position and I would probably then just say number one on CFP2.

Patrick Newton - Stifel, Nicolaus & Company

Okay. And then sticking to the CFP2 you talked about a platform approach, you talked about being used in both metro and long-haul, and I love your comment or your thoughts on timing of the 100G metro ramp or any thoughts by geography. And you did have a competitor yesterday that said, that they’re not thinking late 2015.

Greg Dougherty

Yes, I would say that -- our answer on the metro market is the same as we gave a couple of quarters ago which was 2016 as in terms of meaningful the beginning of some real revenue, 100G coherent in the metro. I would probably still stick with that whether it’s late 2015 early 2016. So, I think we’re saying the same thing. The nice thing about the CFP2 is the fact that we’ve integrated a tunable laser and an indium phosphide modulator in this tiny package and it’s capable of not just doing the 300 or 600 kilometers, but much beyond that. So it’s the same part that can do both metro and long-haul.

Patrick Newton - Stifel, Nicolaus & Company

Great. And then, I guess just last one on Korean strength I think you answered this kind of with Dave’s question a little bit, but up 15% sequentially can you just talk us through the puts and takes of what's driving the strength there?

Greg Dougherty

Sure. We do a lot more with Koreans than the 40G line cards. And so, we have other products both from ex-Tellabs and ex-NSN that run the gamut of Tunable CFP, CFP2 for client side, 10-gig tunable, 40-gig coherent, just this (indiscernible) of products there, and then now we’re starting to work with them on some of their newer 100G platforms.

Patrick Newton - Stifel, Nicolaus & Company

Great. Thank you very much for taking my questions.

Greg Dougherty

Sure. Take care, Patrick.

Operator

And the next question comes from Subu Subrahmanyan with Juda Group.

Natarajan 'Subu' Subrahmanyan - The Juda Group

Thank you. I had two question. I guess the first question Greg, if you think about the September guidance and exclude the I&C business we’re looking at a base of about $80 million which you’re hoping is going to be about $120 million -- or a $100 million, I should say 25% higher by in the next four quarters. And I’m just curious if you could talk about what are the puts and takes to get you there? What are the bigger piece growth drivers clearly 100G, if you talk about in Telecom, Datacom, when CFP2 coherent becomes meaningful. The other question is related to the 40G and the legacy 10G. Is there any way to quantify it or give us a sense of where stops being a drag. I know you said second half of this year, by December quarter do you think that bottoms, give us some sense of size on that.

Greg Dougherty

On the first question, in term of growth it takes a few different forms. But we have the growth coming from on the Telecom, the coherent CFP2 that we’ve been talking about. I do expect that to have meaningful revenue in calendar year ’15. So, we do see that picking up nicely. And that should feel a fair amount of growth because the market for that is fairly significant, and I think its going to be here very quickly. We are also continuing to supply Micro-iTLAs and lithium niobate into standard line cards and things like that, and that is really picking up for us. And remember we basically had no share in that business six months ago. So, that’s one end. On the Datacom -- that we’re expecting high growth. On the Datacom side, the CFP, CFP2 product line we expected to continue to do quite well. We are obviously working on CFP4 and QSFP28, and we see that having revenue for us in calendar year of 2015 as well. We also -- we don’t really have any meaningful revenue yet, but the Tunable SFP+ which by the way unlike our competitor, ours actually is in the SFP+ two form factor and operates at 85 degree C. We do expect to start seeing some nice revenue from that coming also in 2015.

Natarajan 'Subu' Subrahmanyan - The Juda Group

And on Datacom it sounds like it’s more of an ongoing market growth story because you’re already a leader in that 100-gig client side module market. In Telecom it’s a combination of market growth and share gain, is that fair?

Greg Dougherty

I think that’s fair with the one caveat that, I think as we’ve said last year at this time, this call in September maybe last year, but that we had not really been working on the Web 2.0 customers and really looking at datacenter and the emerging customers. We have put some nice focus on that, and I do think that there is some market expansion as we look at those type of customers. I mentioned in the call that, a part of the reason where our optimism is validated in Adam joining us. With Adam on board, number one, he knows that space much better than the rest of the us around the table here. But also well connected with the technology that we have and also what can win big in that area, and we’re feeling pretty good about that. So we’re expecting to be a bigger player in data center as it shifts to single-mode fiber. We are not obviously a player in the multi-mode game there, but as it shifts to single-mode fiber and with these mega data centers in terms of transmission from the edge, they are areas that we play nicely with in terms of our tunable laser capability in terms of our signal knowledge expertise, in terms of really understanding the nuances of PAM-4 and other type of methods. So we’re feeling pretty good about expanding in that realm as that market shifts to single-mode fiber.

Natarajan 'Subu' Subrahmanyan - The Juda Group

Got it. And the 40 gig and the legacy Datacom is that also indium phosphide base, is it [ph] [pixel] base your legacy Datacom business?

Greg Dougherty

Yes, we don’t do [ph] [pixel] based product really. So it’s some of the old indium phosphide base 10 gig stuff. And I think we go back to (indiscernible) and all of those of kind of package configurations so.

Natarajan 'Subu' Subrahmanyan - The Juda Group

I’m just wondering if that’s -- you get a sense of that bottoms out in the December timeframe, is there kind of an ongoing drag from that? Is there anyway to quantify that business?

Greg Dougherty

Well, I don’t think it’s a drag, right. It’s just the question of how much is left and what the revenue stream is. So its just -- we see it rolling down and as we’ve said even going back about three calls ago, that it was going to take a while for our new products to come up and up the ramp, both in terms of acceptance, but also the growth of our own capacity and so I think we’re kind of seeing the end there, the crossover point around now, so.

Natarajan 'Subu' Subrahmanyan - The Juda Group

Understood. And this question was asked earlier I thought I could take another stab at it. If you don’t look at kind of your customer specific and product specific, can you just broadly comment on Datacom and Telecom trends? How do you view market trends in the Datacom and Telecom market as they’ve evolved over the last couple of quarters?

Greg Dougherty

It’s hard to -- it’s hard not to be clouded by our own situation. I mean, we -- I think in the last call we were pretty positive about Telecom with the exception of the fact that our line card business basically took a pretty significant unexpected hit. We are still seeing strong demand on Telecom and we feel pretty good about that in part because of our share gain though. In Datacom, again, I think that the 10 and 40 are very healthy. I think 100 is coming on strong, but that’s the one we’re most exposed to.

Natarajan 'Subu' Subrahmanyan - The Juda Group

Understood. Thank you.

Greg Dougherty

Thanks, Subu.

Operator

Next question comes from Alex Henderson with Needham & Company.

Alex Henderson - Needham & Company

Yes, thanks. If I could just sneak one last one in since it’s a little bit off the standard path. Since you brought this guy over from Cisco, it would be really interesting to know what your read is now that he is over here on the C pack products and if there is any read on whether C pack technology is getting uptake in Cisco’s customer base or whether that proprietary kind of architecture that they’re trying to rollout is being highly resisted by their customer base. So obviously, that doesn’t directly impact you, but it is an important piece of the overall data center environment. So if you guys have any thoughts on that or have a read on that we would love to get any insight.

Greg Dougherty

Alex, my only comment would be that, that something that we don’t discuss with Adam, because that’s part of the works that he did at Cisco. So yes, we’re -- we haven’t gone there.

Alex Henderson - Needham & Company

Well, can’t blame a guy for trying.

Greg Dougherty

It was a good question and if you get Adam drunk maybe you never know, but …

Alex Henderson - Needham & Company

What does he like to drink? I will meet him at the bar. Okay, guys. Thank you.

Greg Dougherty

Thanks, Alex.

Operator

And that does conclude the question-and-answer session. Mr. Fanucchi, I’ll now turn the conference back over to you for any additional or closing remarks.

Jim Fanucchi

Okay, great. Thank you everyone for joining us today. We look forward to speaking with you again when we report our first quarter 2015 financial results. Have a good day.

Operator

Thank you. That does conclude today’s conference. Thank you for your participation today.

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