Lumentum: The Path Gets A Bit Difficult From Here

| About: Lumentum Holdings (LITE)

Summary

Post-split, the company has performed well, but the improvement going forward may not be easy.

Most product groups are delivering muted growth and margins are coming under pressure, urging caution.

The capital spending continues at an elevated level, raising general concerns over cash flows.

Since late last year, Lumentum (NASDAQ:LITE) stock is up more than 70%, as the market cheered the decent performance and growth prospects offered by certain products. The split (JDS Uniphase) that was expected to help the independent company achieve better focus and operational efficiencies further fanned the investor excitement around the name. The result now is that the business, trading around 15 times next year's earnings with poor visibility, seems expensive and the expectations of decent double-digit growth are high.

Source: Lumentum

No doubt, there are some pockets of growth, products where the business is very well positioned, but the recent results seem to suggest that the edge or growth provided by those products are limited, while the business is facing increasing pricing and margin pressures, without any ease in investment spending.

From a macro standpoint, the company's high exposure to the APAC region, close to 60% of the total business, which was celebrated for a while, is becoming an issue, mostly due to uncertainty surrounding the Chinese economy and carrier spending, among other risks. The recent sanctions by the U.S. Department of Commerce on ZTE equipment may add another layer of investor caution around the sales from the Asian region, even though Lumentum's exposure to the company is negligible.

Caution warranted

The results, late last month, came out ahead of the midpoint of the guidance, which was a decent performance even though the numbers were impacted by an additional week in the quarter and the loss of manufacturing capacity in Asia due to the Chinese New Year holidays.

Below the headline numbers certain trends do urge caution. The optical communication business, which is close to 85% of the total mix, is growing at a single-digit rate, while the ASP (average selling prices) pressure is becoming evident. Compared to a typical ASP decline of about 3%, the ASP erosion experienced last quarter was around 6%. Within the mix, other than datacom, there are hardly any growth pockets, considering the revenues for telecom as well as industrial and consumer are growing at a mid-to-high single-digit rate. The laser revenue, close to 15% of the mix, is declining, even though gross margins for the business have improved this year due to cost reduction initiatives and a favorable product mix.

The non-TrueFlex products continue to slow down the overall growth of the ROADM revenues, even though TrueFlex products are growing nicely. The uncertainty related to the full-scale ROADM deployment in the metro network by the Chinese players continues. The weak fiber laser sales, which suffered from some production issues, continue to offset any benefit from the increased demand for solid-state lasers. The full-scale customer adoption of the fiber lasers with a new production process may only be after a thorough inspection by customers, possibly thousands of hours.

The capital expenditure is still at an elevated level. The current capital expenditure level of 13% of revenue is significantly higher than the historical investment levels of 4%-6% of revenue. No doubt, the increased investment is geared towards expanding capacity for products like 100G and ROADM products, where the company has been failing to cater to the increased demand, but the expected $25-$30 million of capital expenditure in the current quarter, after $30 million dollars of investment in the last quarter, is bound to scare some investors away, especially in light of the broader macroeconomic concerns.

Margins pressure is making the case even more difficult

The gross margins for the optical communications business declined by 90 basis points sequentially in the most recent quarter, partly due to the higher than usual ASP erosion, and the gross margins at the consolidated level also declined by 50 basis points sequentially.

The non-GAAP operating margin for the latest quarter also declined by 20 basis points sequentially, highlighting the limit of operating margin leverage in the model, but more importantly, the gap from the target 10% operating margin level is only widening. The next quarter's operating expense is expected to increase and any slowdown in the ramp of new products that tend to carry better margins may only worsen the situation on the margin front.

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