Finisar (FNSR) Q3 2018 Earnings Conference Call Transcript

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Finisar (NASDAQ: FNSR) Q3 2018 Earnings Conference CallMarch 8, 2018 5:00 p.m. ET

Contents:

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  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, ladies and gentlemen, and welcome to the Finisar Corporation announces third quarter results conference call. Just a quick reminder, today's call is being recorded. And now at this time, I'll turn things over to Michael Hurlston, CEO.

Michael Hurlston -- Chief Executive Officer

Thank you, Chantel, and good afternoon, everyone. We appreciate you taking the time to listen to our conference call today. A replay of the call should appear on our website within eight hours. And an audio replay will be available for two weeks following the call by dialing 1 (855) 859-2056 for domestic callers or 1 (404) 537-3046 -- 3406, sorry, for international callers and then following the prompts, enter conference ID 5898449.

I need to remind you that any forward-looking statements in today's discussion are subject to risks and uncertainties, which are discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from any forward-looking statements. In addition, the company assumes no obligations to update any forward-looking information presented. Unless otherwise indicated, all results discussed are on a non-GAAP basis.

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A complete reconciliation of our GAAP to non-GAAP results may be found in our earnings press release and in the Investor Relations Section of our website. We have prepared some slides for today's earnings call. You can view them by connecting to the Investor Relations page of our website at finisar.com, click on Investors, then scroll down to Webcast Archives and click. You'll see a listing for today's third quarter 2018 earnings call.

Before discussing our quarterly results, I want to take a moment to say that it's an honor for me to join Finisar, and I'm excited to be part of such a great company. In the last few weeks, I have the opportunity to meet many of our employees and customers, and it's clear that we have world-class technologies, products, and talents. Our customers clearly value what we do and appreciate the close partnerships that we have with them. I hope to bring some of my consumer-electronics experience to the company as we expand into new segments and opportunities.

I also want to thank Jerry Rawls for having the vision to start Finisar 30 years ago and leading this company to become the world's largest optical component supplier. It would not have been possible without Jerry's leadership. On behalf of our Board of Directors and all of the Finisar employees, I would like to thank Jerry and wishing the best in his retirement. Finally, we are looking forward to the upcoming Optical Fiber Conference, and we'll have some exciting new products to showcase next week.

Now I'll let Kurt review the numbers. Kurt?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Thanks, Michael. Overall revenues for the third fiscal quarter grew to $332.4 million from $332.2 million in the second quarter. Sale of datacom products increased by $9.5 million or 3.7% compared to the second quarter of fiscal 2018. Primarily this was from strong demand of record revenues in our third fiscal quarter from 100-gig QSFP28 transceivers for data center as well as higher revenue for our VCSEL arrays for 3D sensing.

This was offset by lower sales of our 40-gig QSFP and 100-gig CFP and CFP2 ethernet transceivers. Sales of telecom products decreased by $9.3 million or 12.3% compared to the second quarter of fiscal 2018, primarily driven by the impact of one month of the annual telecom price reductions and lower revenues from our Chinese OEM customers. In the second quarter, we had two 10% or greater customers. Our top 10 customers represented 63.3% of total revenues compared to 60.2% in the second quarter.

Non-GAAP gross margin was 28.6% compared to 30.3% in the second quarter of fiscal 2018, primarily due to unfavorable product mix, the impact of one month of the telecom price reductions and the non-cash impact of an increase in inventory reserves. Non-GAAP operating expenses were $72.4 million compared to $74.6 million in the second quarter. Non-GAAP operating income was $22.7 million or 6.8% of revenue compared to $25.9 million or 7.8% of revenue in the second quarter, primarily due to lower gross margins. Interest and other income was approximately $3 million in the quarter.

Non-GAAP income was $22.8 million or $0.20 per diluted share compared to $26.1 million or $0.23 in the second quarter, primarily due to lower gross margins and to higher non-GAAP taxes. Non-GAAP taxes for the third quarter were approximately $3 million. This increase of $0.8 million over the second quarter was primarily the result of an unrealized gain in China due to the weakening U.S. dollar relative to the Chinese renminbi.

This had an approximate $0.01 negative impact on our non-GAAP earnings per share. During the third quarter, for GAAP purposes, we had a onetime approximately $42 million non-cash tax expense as the result of the Tax Cuts and Jobs Act passed in December 2017. Non-GAAP tax rate for the fiscal fourth quarter is expected to be approximately 11%. The non-GAAP tax rate for fiscal '19 is expected to be approximately 11% to 13%.

Average diluted shares for the third quarter for non-GAAP purposes totaled 115.7 million. Average diluted shares are expected to be approximately 116 million in the fourth fiscal quarter. Capital expenditures excluding Sherman taxes were approximately $38.6 million from the third quarter. In addition, during the quarter, we spent approximately $20.2 million related to the purchase of an approximately 700,000 square-foot facility in Sherman, Texas.

This new site will be used to expand our manufacturing capacity for VCSELs using 6-inch wafers. Construction continues on the third building of our Wuxi manufacturing's site. We expect construction of this building will be completed in the second half of calendar 2018. Capital expenditures, excluding Sherman, for the fourth quarter are estimated to be $45 million, of which approximately $8 million is related to the construction and fit out of the third Wuxi manufacturing building.

In addition, for Sherman, for the uplift of the building and additional equipment, we expect capital expenditures of approximately $55 million in the fourth quarter. We excluded from our non-GAAP results a number of charges or benefits were either non-cash or considered outside of our core ongoing operating results. These totaled $78.5 million of charges last quarter. If you include all these items as required under GAAP, we generated net positive $55.7 million or $0.49 per diluted share compared to net income of 5.8 -- $5.9 million or $0.05 per diluted share in the second quarter.

That concludes my comments, and I'll turn it back to Michael.

Michael Hurlston -- Chief Executive Officer

Thanks, Kurt. We expect revenues for our fourth fiscal quarter of 2018 to be in the range of $300 million to $320 million. The expected decline in revenues compared to the prior quarter is driven primarily by lower demand for our VCSEL arrays, lower revenues from 40-gig datacom transceivers and lower telecom revenue, driven primarily by the full 3-month impact of the telecom price reductions that Kurt spoke to earlier. We expect fourth quarter non-GAAP gross margins to be approximately 27% to 28% as a result of the impact of lower revenue levels and the full three months of the annual telecom price negotiation, which typically take effect on January 1.

We expect operating expenses to be relatively flat, and non-GAAP operating margins are expected to be approximately 4%. Non-GAAP earnings per diluted share are expected to be in the range of $0.09 to $0.15 per share. While our third quarter financial performance is disappointing and the outlook for the industry in the next few quarters expected to be challenging, I'm optimistic that we can ultimately improve our financial results through a combination of improved execution and a healthier demand environment. We are currently reviewing all aspects on how we do business in the markets we participate in.

I expect that I'll be able to share with you all a complete vision of our plans for the company in our next earnings call in June. While I believe the near term will remain challenging for the industry, this type of environment often creates exciting opportunities. In addition, I believe we can ultimately restore the company's gross and operating margins back to historic levels over time. With that, I'm going to turn it back over to Chantel and open it up for questions.

Chantel?--------------------------------

Questions and Answers:

Operator

[Operator's Instructions] Your first question comes from Joseph Wolf with Barclays. Your line is open.

Joseph Wolf -- Barclays

Thank you very much for taking my question, and welcome, Michael. I guess, given the margin profile in the guidance, I'm wondering if you could point any bright spots in telecom if there are any comments on the ROADM business or the qualification of all of your products in U.S. Metro or things we could point to as positive. And then any commentary we could have on overall datacom pricing and the impact that, that is having on gross margin?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, I'll start with your last part of your question first and maybe then I'll turn it over to Michael to talk about some of the new products on the telecom side. Certainly, as we know, last calendar year, we were largely in a constrained environment in our 100-gig QSFP28 product line, and as we talked about in the past, it has relatively benign pricing environment. I think given now that there's more of an equilibrium between supply and demand, we are definitely seeing stronger price erosion and competition as it relates to that 100-gig QSFP28 product line.

Michael Hurlston -- Chief Executive Officer

And let me add a little bit, Kurt. I'd say in general, the telecom environments has been pressed by these price reductions that we talked about that we saw beginning in the calendar year. We do expect some improvement in the back half of the year, primarily coming from our WSS product line. We expect some uplift in the Chinese market, and we should see some improvement there.

Joseph Wolf -- Barclays

OK. And then just one last question on gross margin. If you take a look at all the CAPEX for the new facility and you consider some sort of timing toward the end of this year or early next year, should there be an up -- how quickly will that translate into an uptick in gross margin overall?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, I think ultimately, uptick in gross margin, especially as it relates to the Sherman facility, is going to come down to volume and yields. And so there will be a ramp period, of course. But as we've said before, we expect our VCSEL arrays for 3D sensing to be margin accretive for our company. But we got to get Sherman up and running and like I said, it's highly volume and yield dependent.

Joseph Wolf -- Barclays

OK. Thanks, Kurt and Michael.

Operator

Your next question comes from the line of Troy Jensen with Piper Jaffray. Your line is open.

Troy Jensen -- Piper Jaffray

Hey, thanks for taking my question. I'm looking forward to working with you, Michael. Quick question on Telco, if we can dive into that a little bit more. I mean, most of the competitors in the space here have been reporting strength in the telco business and understanding that one-month telco pricing erosion.

But can you talk about -- did the ROADMs grow sequentially? Did the ACO qualifications start to ramp? Any more color would be great.

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Sure. So I think WSS, in general, was actually flat to down a little bit. We had a strong quarter in WSS the prior quarter. In terms of -- I think your second part of your question was the CFP2 ACO, we haven't really seen an uptick in that yet.

As we had mentioned last quarter, we did get qualifications done with a key customer. However, I think as Jerry mentioned on the last call, we believe that customer has some inventory. And so we're really not going to see the benefit of that until fiscal '19.

Troy Jensen -- Piper Jaffray

And Kurt, a follow-up for you here, can you just talk about when you guys on load the Sherman facility, I mean, what do you think happens to the gross margin profile? When would that impact the model? Will you non-GAAP that out of the estimates?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

I'm sorry, when you said we unload the facility?

Troy Jensen -- Piper Jaffray

No, when you on load, when the facility comes on and there's no revenues but expenses. Can you just talk about what the gross and operating margins will look like?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Sure. So I think, again, we had this quarter as it related to Sherman approximately about $600k of expenses. And I think if you look the non-GAAP -- GAAP/non-GAAP reconciliation, we excluded that from the results. So we're going to be incurring start-up costs before we get to commercial production in Sherman, and we are non-GAAP-ing those out and that amounted to, in this quarter, a small amount of only $600k.

But those expenses are definitely going to ramp significantly as we get closer and closer to getting that facility up and running and ultimately, going into commercial production.

Troy Jensen -- Piper Jaffray

Got it. Last question, I'll cede the floor. Can you let us know who have any VCSEL design wins for tablets?

Michael Hurlston -- Chief Executive Officer

We can't comment around specific design wins. I think -- we're obviously optimistic about the space, and we see quite a bit of opportunity. And I think the number of opportunity is increasing. But to get into where the opportunities are with which customers is probably not appropriate.

Troy Jensen -- Piper Jaffray

Understood. I'll see you guys next week.

Operator

Our next question comes from Patrick Newton with Stifel.

Patrick Newton -- Stifel

Yeah, good afternoon, Michael and Kurt. Thank you for taking my question. Welcome to the team, Michael. First one, Kurt is to, I guess, ask some gross margin questions at different way, maybe a 2-part question.

Number one is, could you help us understand how big of a headwind the 3D sensing business is currently, given the Allen facility. I'm guessing it's staff up for larger ramp than perhaps you saw. And then, I guess, secondly, you've had pretty good line of sight on intermediate-term margin trends in the past, given kind of a pipeline of new product introductions or ways that you thought mix could change. And I guess, is there anything that you see in the pipeline that could improve your mix a few quarters out? Or should we read the commentary from Michael saying that there's some softness in the intermediate term to mean that margins could kind of stand the sub-30s range for multi-quarter period?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Yes. I guess, to take the first part of your question, certainly, we're not producing and selling as many VCSEL arrays as we'd like at this point in time. And like we said and I think Michael said, we're working on our yields. They're not where we would like them to be.

So obviously, as we continue to make progress there both from a production perspective but from a demand perspective, then that should be helpful to us. I think in the second part of the question, I do think, again, the pricing environment is definitely more challenging than it was last year, especially on the datacom. And so that is kind of a headwinds for this business right now. So I'd say we never give more than one-quarter guidance as you know very well, either on revenue or on margins.

But certainly, I think the near term appears challenging, but we are optimistic in the back half, things will start to improve both in terms of, hopefully, some revenue on the core business but also additional VCSEL business.

Yes.

Patrick Newton -- Stifel

OK. And then, Michael, I find it pretty interesting that you spent more than the last 15 years of your life in the semiconductor company that was pioneered in shifting to the fabless model and also very aggressive with M&A, and now you're the CEO of an optical company that has its roots solidly tied to vertical integration in an industry that nearly all participants believes requires consolidation. So I know you've only been at the helm for less than a quarter, but I'd appreciate your thoughts on how you're thinking about an outsourced model versus vertical integration and what your view is on the need and potential for consolidation in the industry in Finisar's rule?

Michael Hurlston -- Chief Executive Officer

Yes, Patrick, I read the comments from last quarter, and it look liked you were throwing your hat in the ring for this job. So you would have been excellent at this. I think in both comments, first, with respect to the vertical integration. As I said, what's going on right now is really I'm reviewing all aspects of the business and trying to apply some of what we did have in outsourced model and look at this through a new lens.

I would say at this point, everything's on the table. And I think in the asymptote in a lot of the businesses the vertical integration strategy absolutely makes sense, but we're looking at everything at this point. And then I think relative to mergers and acquisitions, as you said it's probably too early to comment in any specific. I do think that there are challenges here and that you've got a number of companies who are supplying components to Chinese vendors and other vendors are able to put together modules, and that presents a challenge to really do significant roll ups.

But we're looking at everything. And as we said in the remarks, we're definitely going to come back in June with some more specifics in terms of what our longer-term plans are.

Patrick Newton -- Stifel

Great. Thank you for taking the questions and good luck on the quarter.

Michael Hurlston -- Chief Executive Officer

Thanks, Patrick.

Operator

Your next question comes from the line of Alex Henderson with Needham & Company. Your line is open.

Alex Henderson -- Needham & Co.

Thanks. A couple of questions, first off, on the pricing side of the equation. I know you guys had said the pricing was fairly stable in the back half of calendar '17, and that you're now starting to see heavy price erosion now. But isn't that simply a function of the way you've contracted the prices over the course of the last year as opposed to keeping track of market prices? In other words, if you had been marking the market prices over the last two or three quarters, I think the prices came down quite hard in the back half of last year and may have -- maybe not declining as much as you're seeing now.

Can you talk about the discrepancy between market prices and your prices, those two alternative trajectories?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, I think as we talked about in the last couple of calls, I think our team did a great job in the second half of the calendar year, kind of optimizing margins and revenue based on the fact that we were definitely still in a constrained environment, which I think is the point that you're getting to, Alex. But you're correct, as supplies equaled demand and we've reached more of an equilibrium, and we're definitely seeing more price erosion now. How that's comparing to the price erosion, our competitors are seeing, given the fact that maybe they started to see the price erosion impact themselves sooner, I can't really comment on. But certainly, as we talked about, I do feel like we're definitely seeing more now.

And I do think we did a good job, especially in the second half of last year, kind of optimizing things, given we were constrained, but that's no longer the case at this point.

Alex Henderson -- Needham & Co.

Alright. On a separate subject, I know you guys don't want to quantify the 3D sensing, but I think you've talked about capacity at the existing plant being up in the 20 million plus range. It sounds like you're running at less than half capacity here in -- may be in the January quarter, but at least in the April quarter. Is that the right way to think about that sort of generic ballpark of where you're running here?

Michael Hurlston -- Chief Executive Officer

Yes. I think, Alex, you are right. We don't really want to go through the numbers and we haven't broken those out historically. I think your capacity estimate is close to accurate.

I'd say, based on where we are with customer demand and based on where we are in the yield curve, I think you could see us much as maybe 25 million of capacity out of the Allen facility. But I generally I'd say, 20 million to 25 million is kind of the right range.

Alex Henderson -- Needham & Co.

OK. So are we absorbing significant amount of costs because of underutilization of that facility? Is that part of the gross margin pressure? And if so, how much of a pressure does that represent?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, again, I think I would say two things. First of all, this industry has or some of the applications where the 3D sensing VCSELs go to tend to have some sort of seasonality to it. And so I think you are starting to see and our competitors are seeing some of that seasonality as it comes to a revenue perspective. I think that being said, we are -- or continue to build some volume to get ready for what we hope is increased demand, driven by product cycles in the second half of the year.

But you're right, I think we are not producing as much as we are capable of, and part of that is yield and part of that is obviously, the demand isn't at where we would like it to be. But we do still feel very bullish about our position in this industry and our customer interactions and do feel bullish about what will happen in the second half of the year.

Alex Henderson -- Needham & Co.

Is it reasonable to think that if you are anticipating a very strong demand in say the October, January quarters, that you might build $30 million or $40 million, $50 million worth of inventory in anticipation of that during the lull period? Or is it unlikely that you would want to do that, take that risk on?

Michael Hurlston -- Chief Executive Officer

Again, I don't want to quantify. But certainly, I think that the expectation would be that we would be able to build ahead. So certainly, our plan is that we are going to load the fab up as much as we can, as Kurt said, "taking yield and customer demand profile into account." But I certainly think that you can expect us to build ahead as appropriate.

Alex Henderson -- Needham & Co.

That's helpful. One last question and I'll cede the floor. A lot of discussions about CWDM4 undermining LR. You guys don't usually talk about the things in the context of the distance parameters.

But could you talk a little bit about your exposure within the LR space? As clearly there's an extension of CWDM4 past the 2- kilometer range into the 10-plus range, which is undermining the higher price points of the traditional LR market?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, I think what I really want to say is what we said last quarter is, you're definitely seeing on kind of an overall basis the shift from LR4 to CWDM4 and the variance -- the various variance of CWDM4. So I would say that trend continues, we talked about how margins were less than expected, one of the reasons why was an unfavorable product mix, and we certainly saw meaningfully less LR4 revenue this quarter and significant growth in CWDM4. But I'm not going to get into all the different variants of each of those products. But the trend, you are correct, the trend is continuing where there's more CWDM4 and that's growing where we saw last quarter, at least less LR4.

Operator

[Operator's Instructions] Your next question comes from the line of Doug Clark with Goldman Sachs. Your line is open.

Doug Clark -- Goldman Sachs

Hi, thanks for taking my question. Michael, welcome. First one is piggybacking off of that inventory comment. Kurt, inventories continue to climb in the balance sheet.

I'm wondering if that is directly attributable to 3D sensing, other products as well? And just how you think about inventory management broadly?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Yes. Inventory is much higher than we would likely it to be. Honestly, our inventory turns were not where we would like them to be. I don't think that -- I don't think I could -- some that obviously, is attributable to our Allen facility, but it's broader than that.

I think a lot of it has to do with some of the product transitions that are going on as well. So as you see, certain products continue to grow strongly like CWDM4, but you've got other products like CFP or CFP2 ethernet that are dropping off faster than expected. And so there is a bit of an inventory hangover that we have, and I think that's going to take multiple quarters to work through. And it's going to be highly dependent on getting revenue growing again and, hopefully, growing with the products that we have the inventory for.

So we're working hard on that issue. It's not where we would like it to be. But at the same time, I think operations is one of our strong suits and so I'm sure we will work through this inventory overhang.

Doug Clark -- Goldman Sachs

OK, that's helpful. And then 2-part question on VCSELs and 3D sensing. There was a quote or comment from a member of the Finisar team talking about the Sherman facility being production ready in October. I'm curious if that is initial volumes, full production? Or if you could just give a little bit of an updated timeline three months after last quarter of where you think Sherman will be and when it will be fully available? And then also you mentioned $55 million in related CAPEX in the April quarter, can you give us any sense for how long and how high CAPEX will be on a that Sherman facility over the next several quarters?

Michael Hurlston -- Chief Executive Officer

Doug, let me take the first part of the question. I think that it's certainly we said before that our intention is to have the Sherman facility online in the second half of the year. Our target is sometime in the fall, I think that's a reasonable expectation. And -- but I think a lot depends on -- again, our ability to ramp things are certainly some unknowns between now and then.

So our goal is to have it online in that time frame and it remains to be seen, whether we can do it. We're charging as hard as we can to that date. I'll let Kurt handle the second part of the question.

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Yes. So in terms of the building and the building uplift and kind of what I'd say is the first phase of capacity expansion in Sherman, I think our total, we estimate it to be about $150 million. So approximately $50 million of which is the building, which we bought this past quarter, plus the uplift of the building. And then the rest is equipment.

We spent $20 million last quarter as I mentioned, expect to spend about $55 million this quarter. I'd say probably another $55 million the next quarter and the remainder of the following quarter. But the exact timing obviously, is a little hard to predict. But it's $150 million -- is our best estimate at this time for this initial phase.

Doug Clark -- Goldman Sachs

OK. Great. Thanks for the detail, guys.

Operator

Your next question comes from a line of Simon Leopold with Raymond James. Your line is open.

Simon Leopold -- Raymond James

Right. Michael, welcome to the team. . I wanted to start up by getting an update on your view on the annual price negotiations? We generally talk about the sector range of annual decreases of 10% to 15%. Could you let us know how the negotiations played out for you?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Sure. And again for clarification, you're talking about the annual telecom price negotiations. And I think as we said on the last call, it was at the higher end of the 10% to 15% range, not that surprising, given the demand environment on the telecom side right now. But absolutely, it's kind of closer to that higher end of the range.

But there's always -- it's highly dependent on product and highly dependent on customer.

Simon Leopold -- Raymond James

And could you update us on your thoughts on the China market? How material was China demand in the quarter you just reported? And what are your current expectations for order improvement coming from the Chinese market?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

So China was -- our Chinese OEMs were down a little bit last quarter. And I would say our outlook is still uncertain there. I think as Michael mentioned, we do expect to see toward to the kind of the second halfa pickup on the WSS side as it relates to domestic deployments and WSS. But I still think, things remain uncertain, as usual, anything related to China.

Simon Leopold -- Raymond James

Because I think on the last call, I believe Jerry suggested that China might not recover until calendar '19. Some of your peers have suggested a second half calendar '18 improvement. I want to get a better understanding why your view might be different than theirs.

Michael Hurlston -- Chief Executive Officer

Yes. I mean, it's hard to comment on what other people are saying. But I think in general, our environment is uncertain as it's been. And so I think it's hard for anybody to call what's going on in China.

China's extremely tough as you know. And our best visibility is around the WSS product where we're seeing some strength, but generally, the picture remains uncertain.

Simon Leopold -- Raymond James

And one last one, I'd like to check in on where you are in terms of the direct web scale sales. I think you had a pretty decent percent. If I recall, roughly 15% of sales into that vertical last quarter. I wanted to check in to see how that was going in the current quarter and your outlook?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Sure. So I do think -- it depends obviously if you're talking about percent of datacom versus percent of overall revenue. But I do think as we kind of bucketized this typically on the datacom side, it's well north of 20% of our revenue is on the Web 2.0 side, if you want to call it that. I think as you look into calendar '18, we surely expect that business from a unit perspective to continue to grow.

And I think the question just becomes what is the pricing environment like and how much does that offset the unit growth? So I think there's still some uncertainty there about that. But obviously, from a unit perspective, that's a very still very much a growing business. And I think what we're trying to do is expand that customer's set. So obviously, it's been concentrated for a while under a handful of players that everybody can name.

But you're starting to see additional players or opportunities as it relates to Web 2.0 that we are pursuing.

Simon Leopold -- Raymond James

Great. Thanks for taking my questions. We'll see you next week.

Operator

Your next question comes from the line from Mike Genovese with MKM partners. Your line is open.

Michael Genovese -- MKM Partners

Yeah, thanks very much. I think last quarter, you guys said that between Allen and Sherman, if you look out some number of quarters into the future, it should be about $100 million in capacity for 3D sensing per quarter. Is that still a good number? When we expect to get there? And when do we think demand will require that much for a quarter?

Michael Hurlston -- Chief Executive Officer

Yes, let me try to address that. I mean, I think the whole operation sort of comes in multiple phases. I would say, as we initially bring Sherman on, I wouldn't expect more than $50 million to $60 million of revenue capacity out of the Sherman facility. I think we can certainly in the first phase build Sherman to a capacity of $80 million plus.

But I don't think, at least in that initial phase, I don't think $100 million is the right number. I think in the asymptote as we go out some distance in time and build on some multiple phases, I think then you can see the $100 million. But certainly, in the initial phase, I wouldn't think about $100 million being a right number

Michael Genovese -- MKM Partners

Do you have anything to share on demand trends? I mean, obviously, seasonality right now things are looking good for that product. But if we go out into the strong part of the cycle for the next build from the customer, hiring some to meet demand then?

Michael Hurlston -- Chief Executive Officer

Yes. I think, again, it's hard to comment on the overall business. But I think as we look at the 3D sensing business, as Kurt said, in the back half of the calendar year, we certainly expect a significant pickup in demand and shipments. I think a reasonable expectation is that the first part of the cycles will be shipping out of the Allen facility, and then we'll be looking to transition to Sherman as soon as possible.

Michael Genovese -- MKM Partners

Just a couple more from me. First, do you have any recent qualifications for ROADM WSS either with U.S. customers or Chinese customers recently to report?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Yes. So the update there is that we don't have any recent stuff as it relates to the line card. We've actually decided to stop some of our line card development activities recently, just given the fact that it's taken -- took this longer to try to get qualified than expected and the key customer already had two sources. So the answer is we don't have any new line card activities or WSS activities to report on.

Michael Hurlston -- Chief Executive Officer

Yes. Mike, I would say just to add, follow up on what Kurt said, I think in general per my initial remarks, I think line cards is an area that we're taking specific attention to. As Kurt said, we have made decisions to stop some activity there. We'll be reviewing all of that as we go forward and seeing how we could best fit into that customer set.

Michael Genovese -- MKM Partners

Great. OK. Last question from me, just -- if we just assume or -- hypothetically, if overall demand in China, they were clearly building a lot more networks, metro, provincial, et cetera, and clearly the demand environment in China would strengthen, which is obviously, hypothetical at this point, what specific products would you be participating in and would you expect to turn out for you? I mean, I'm sure you're going to say ROADM, but is there anything else besides that, that you would expect to get stronger if the Chinese demand turned up?

Michael Hurlston -- Chief Executive Officer

Yes, I mean, I think we obviously, play with the Chinese OEMs across the portfolio, and I think our relationships with the key customers has been strong. We've obviously, as Kurt talked to, we've historically -- as the run-up happened in 2017, we saw a tremendous amount of benefit, I think again the hypothetical is that market rationalizes and heats up, we would expect to see good share there and given our relationships across the customer set, I think we would fair well.

Michael Genovese -- MKM Partners

Thanks very much.

Operator

Your next question comes from the line of Mark Kelleher with D.A. Davidson. Your line is open.

Mark Kelleher -- D.A Davidson

Great. Thanks for taking the questions. Michael, let me extend my welcome as well. In the past, you've indicated, you've given us some general insight into the QSFP28 revenue growth, may be sequential or year-over-year.

Is there any more insight. You can give into that level of growth?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

I think what we said last quarter was that in our fiscal Q2, we have done something in the ballpark of $100 million that quarter and that we expected to grow approximately in the $15 million range in this quarter. And I'd say, we're approximate -- we lived up to the expectations there. I think as we look forward to Q4, as I mentioned, we expect unit growth to continue. But given some of the price erosion that we're seeing, whether or not that leads to revenue growth, is to be determined.

Mark Kelleher -- D.A Davidson

OK, great. That's great insight. Is there an ability as the market shifts to CWDM4, is there ability within your manufacturing process to help the gross margins? Can you squeeze improved gross margins out of improved facility, manufacturing?

Michael Hurlston -- Chief Executive Officer

I would say this that on CWDM4, we have a number of different products in the pipeline that held the costs. It's obviously, a key focus because as Kurt said, it's something that we see being important not just now but in the future quarters. So from a development standpoint costs is a huge focus, and we're certainly working on cost reductions on the basic product. To your point always the manufacturing cost is the focus and squeezing every penny we can out of the factories is a key issue.

So I would expect to see improvement on both vectors.

Mark Kelleher -- D.A Davidson

OK. Great. That's all I have. Thanks.

Operator

Your next question comes from the line of James Kisner with Loop Capital Markets. Your line is open.

James Kisner -- Jefferies

Welcome, Michael. So I just wanted to talk about 40-gig and 10-gig for a second. So you've given us a lot of help on 100-gig and you pointed the 40-gig being weak. And actually, it was different than one of your data-center-focused competitors saw, but, I mean, it sounded like -- it seemed to you like 40-gig is now kind of rolling over, should we expect it to kind of rapidly decline? Or is it kind of basing here at the current level, I sort of seeing pressure on 10-gig? I'm just also kind of wondering if indeed this will sort of keep rolling off, I mean, are you confident that datacom is going to be growing sequentially through the year or at least directionally driven by the ramp of CWM4?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Yes. I'd say, first of all, I am not exactly sure what competitor you're talking about. But I think our Q2 40- gig was actually pretty healthy relative to some of our competitors. So maybe they had a bit of a bounce.

But 40-gig was definitely down this quarter, and we expect it to continue to be down over time. We've always said as supply and demand reached equilibrium for 100-gig QSFP28, that we'd expect 40-gig to start to fall off. And I think it's falling off as we expected when we reached equilibrium. So it's definitely one of the reasons as we listed earlier that we're going to see a revenue decline, expect to see a revenue decline this quarter.

James Kisner -- Jefferies

What's happening with 10-gig? Is that more stable with enterprise buying? Or what is that look like?

Michael Hurlston -- Chief Executive Officer

10-gig has stabilized some, I'd say it's -- So I think it's relatively flat last quarter. I think it will be flat to maybe slightly down this quarter. But it's definitely stabilized versus we saw pretty severe, I'd say 10-gig degradation at the beginning of calendar '17. And I think that was part of which, as Jerry said a couple of quarters ago, was related to some of the Web 2.0s that we're still using some 10-gig that we're moving off of it.

But I'd say for kind of the enterprise as you call it, it's stable, where you expect, of course, 10- gig to decline over time just like all legacy products, too, and, ultimately, for people to deploy the newer products. But it's been more stable lately.

James Kisner -- Jefferies

OK. And just related here, just to go back to LR4 for QSFP28. I mean, it seems like there's definitely headwinds on LR4. I'm wondering is that going to keep going down, going forward as well, so you're pretty much in datacom? But other than X3 Sensing pretty much relying on CWM4 to kind of carry the ball for you completely? Or is LR4 kind of stabilizing? Can you put a finer point on LR4s?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, certainly, CWDM is the growth engine. And as we said, we expect the units of that to continue to grow and be the big growth engine for the webscale and the hyperscale guys. I think in terms of when does LR4 reach some sort of asymptote, I'm not ready to predict that yet. So we certainly in the last couple of quarters have seen decline in LR4.

And I expect some further declines this quarter. But there's definitely a market for LR4. But certainly, all the growth that we're seeing is on CWDM4 side.

James Kisner -- Jefferies

OK. Just last one, it seems that you don't have that much China exposure anymore, except with maybe ROADMs ramping here at some point. But there have been comments from China, I think every companies have been asking this during earnings season about the comments on them called the bidding domestic industry -- component industry. And I'm just wondering how you're thinking about that as you're planning your strategy and thinking about the impact in your business?

Michael Hurlston -- Chief Executive Officer

Yes. I mean, I think the goal for us is to stay ahead. I think the Chinese if they end up coming in any meaningful way historically in almost any business, it's been on the trailing edge and optimizing around cost. I think our forte has been being at the leading edge and being out in front relative to new standards, and new speeds.

And so that's where we want to be. I think even in the face of increased Chinese competition if, in fact, materializes, I think we'll be in pretty good shape.

Operator

[Operator Instructions] Your next question comes from the line of Tim Savageaux with Northland Securities. Your line is open.

Tim Savageaux -- Northland Securities

Hi, good afternoon. Couple of questions from me. I wanted to go back to comments on capacity in Sherman. Was that $50 million to $60 million, is that Sherman only or Sherman plus Allen as Sherman begins to ramp? Just to clarify that.

Michael Hurlston -- Chief Executive Officer

I think the key to understand is that we -- at some point, and that point is not yet clear, our intention is to consolidate Sherman and Allen. I think the number that I just related, the $50 million to $60 million, would be the Sherman number, but I think to think about your models, I don't think that we're going to run simultaneously for very long in Sherman and Allen.

Tim Savageaux -- Northland Securities

Understood. So we should think about that as kind of a total capacity type number. As you look at the demand side of the equation, Michael, given your background and successfully supplying both the Android and iOS side of the house. I'm wondering if you have any commentary on what you're seeing from a demand standpoint on the Android side? And whether that figures into your capacity planning and idea of the served market opportunity out there?

Michael Hurlston -- Chief Executive Officer

Yes. I think we're early yet with the Android customers. I mean, certainly, everybody is talking about 3D sensing, and I think the world of opportunity is significant. We are working on a variety of technologies and to be able to go serve different customers.

And given our engagement so far, I'm optimistic that we're going to see volume both from additional phone manufacturers as well as from segments like automotive. So we're continuing to make progress in the customer base and developing technologies I think that will be a good marriage between their needs and what we could produce.

Tim Savageaux -- Northland Securities

OK. And to finish up on 3D and I do want to follow up. I mean, would you say as you kind of join the company and assess the situation that ramping Sherman would be your no.1 priority as CEO of Finisar at this point in time?

Michael Hurlston -- Chief Executive Officer

We've got a lot of priorities, there's no question. I think there's a great number of opportunities. I think our 3D sensing opportunity is certainly something that we're going to focus on. I'd say, in general, it's a great opportunity as I said both for what we have on our plates and what we expect to add.

So that is a very big focus of the company and of mine.

Tim Savageaux -- Northland Securities

Got it. And just to follow up on the numbers a little bit. As you guide to Q4 talking about roughly $20 million, $22 million sequential decline, Kurt, I think you called out three drivers there or Michael, maybe you did, 3D sensing, 40-gig, in telecom, I wonder if you might be able to wait those drivers with regard to their contribution to that sequential decline? Should we think of those as being about equal or some...

Kurt Adzema -- Chief Financial Officer and Executive Vice President

I would say, they are in the same ballpark, but I would say there are also probably ordered sequentially. So I think probably the first would be on the VCSEL side and the second would be 40-gig and the third would be telecom. But they're all roughly in the same ballpark, I'd say.

Operator

Your next question comes from the line of Richard Shannon with Craig Hallum. Your line is open.

Richard Shannon -- Craig-Hallum

Thanks for taking my question. Maybe I'll focus on the 3D sensing topic, Michael, and you're -- the last responses that you're talking about 3D sensing outside of the mobile space you mentioned automotive. Maybe I'll ask it just more broadly non-mobile there, what kind of opportunities in terms of size and timing do you see that happening for you and for the industry?

Michael Hurlston -- Chief Executive Officer

Yes. I think it's hard to size because I think everybody's looking at it generically right now. I think if you look at automotive in specific, I think you're looking at really 2020 before you'd see anything of any significance in that space. It's still hard to size because we just don't know what models people are thinking about and how deeply they adopt it in the portfolio.

On the Android phone side, again, I think it's a little bit hard to say when those start kicking in. I think it will certainly be earlier than automotive. But the size is again hard to say because the depth of and of the model stock into which the 3D sensing appears is still a little bit of a question.

Richard Shannon -- Craig-Hallum

OK, that makes sense. Follow-up question from me on gross margins. Kurt, historically, you've had a gap between your datacom and your telecom product lines as you've defined them. You talked about some significant pricing pressure in the datacom side and really this question excludes the impact of 3D sensing.

How much have those gross margins contracted over the last couple of quarters or Android going forward, you see those two numbers coming closer together?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Well, I guess what I would say is, first of all, I do think it's highly dependent on customer and product mix, right? So inside of telecom, you've got plenty of products that are above our corporate average, plenty below, same thing on the datacom side. And there has not been a huge gap, I'd say between datacom and telecom on average. But if you look at our business, it's 80% datacom, I think, the last quarter. So I think you can look at roughly our overall -- what happened to our overall gross margins and kind of extrapolate what's happening on the datacom side.

But there isn't -- on an aggregated basis, there isn't a huge difference between those two at this point.

Richard Shannon -- Craig-Hallum

OK. Fair enough. That's all the questions for me. Thank you.

Operator

Your next question comes from the line of Dave Kang with B. Riley, FBR. Your line is open.

Dave Kang -- B. Riley FBR

Thank you. Good afternoon. Just questions on 3D S. First of all, I believe you guys were working on just the larger chip before.

Are you trying to work on both larger chip as well as smaller chip?

Michael Hurlston -- Chief Executive Officer

Yes. Dave, I think it's hard for us to comment on what we're going to work on from a roadmap perspective. At least as far as I'm aware of, we have not delineated different products out there. But I would say, again, certainly we're -- we are working on variety of different things for customers both in the consumer segment and automotive.

But to be more specific than that, I'd be reluctant to talk about that.

Dave Kang -- B. Riley FBR

What about -- you talked about Android customers, but my understanding is that they will be at least some of them prefer edge meters. So do you guys have edge meters? And if not, when do you plan to have edge meters?

Michael Hurlston -- Chief Executive Officer

I think that the environment is uncertain. There's a lot of different technologies that the Android customers are considering, and we're working on all the things that the Android customers are taking a look at. To spin it down specifically to edge meters, I think it would be premature. But certainly, we hope to engage the customers, and we think we have the right technologies to do that.

Dave Kang -- B. Riley FBR

Got it. And lastly, on just WSS, what's your current run rate right now?

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Dave, as you know, we're not going to give out that number. But I think, in general, we've talked about, it's been, unfortunately, it's got a little bit of lumpy, but it's been a relatively flat market for us. So I think that's all about I'm going to say.

Dave Kang -- B. Riley FBR

Got it. Thank you.

Operator

That is all the time we have. I will now turn the call back over to Michael.

Michael Hurlston -- Chief Executive Officer

Thank you, Chantel, and thank you to everybody for joining the call. We certainly appreciate your time and attendance, and we hope you'll have a great day. And we look forward to you joining us again in three months. Thank you.

Operator

This concludes today's conference call. You may now disconnect.

Duration: 62 minutes

Call Participants:

Michael Hurlston -- Chief Executive Officer

Kurt Adzema -- Chief Financial Officer and Executive Vice President

Joseph Wolf -- Barclays

Troy Jensen -- Piper Jaffray

Patrick Newton -- Stifel

Alex Henderson -- Needham & Co.

Doug Clark -- Goldman Sachs

Simon Leopold -- Raymond James

Michael Genovese -- MKM Partners

Michael Genovese -- MKM Partners

Mark Kelleher -- D.A Davidson

James Kisner -- Jefferies

Tim Savageaux -- Northland Securities

Richard Shannon -- Craig-Hallum

Dave Kang -- B. Riley FBR

Dave Kang -- B. Riley FBR

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