Lumentum: Surging Demand Meets Supply Constraints

Summary

• Demand for most of the company's products is booming due to secular tailwinds. However, supply constraints and uncertainty about mobile phone demand are short-term negatives.
• Despite declining revenue as a result of these supply constraints, which will continue into Q4, financial performance was stellar, mostly on acquisition synergies.
• Given the amount of cash the company produces even with some temporary headwinds, the shares are very reasonably priced.

We hold Lumentum (NASDAQ:LITE) in our SHU portfolio already for quite some time as we bought 200 shares at $45.70 at the end of 2017. We argued in our last article that while the company was booming, we saw little room for immediate upside and that's how it played out.

While revenues have been boosted by the acquisition of Oclaro, operationally things have improved considerably:

Data by YCharts

There have been operational wobbles as you can see, largely the result of a fall in Chinese demand and the (GAAP) acquisition cost.

However, the company is executing beautifully, and all its end markets (bar the industrial lasers) are booming. On the other hand, even without the economic impact of Covid-19, the company was already supply constraint, and these constraints have become much worse as a result of the pandemic.

Covid-19

There are quite a number of ways the pandemic has affected the company:

• In Q3, the Shenzhen and Thailand facilities suffered from supply shortages.
• In Malaysia, production was halted for several weeks since March 16.
• The efficiencies of waver production facilities in the US, Japan and the UK were all impacted by social distancing.
• The company hasn't laid off or furloughed employees.
• While these restrictions are easing, Q4 guidance is nevertheless significantly reduced by 20% or $90M at midpoint, just over half of this is due to supply constraints and the rest due to reduced consumer (VCSELs) and industrial (laser) demand.

Basically, the company is supply constraint on most key product lines, which is unfortunate as demand is almost invariably booming. However, there are also positive takeaways:

• The pandemic is accelerating the shift towards digital and virtual approaches (entertainment, healthcare, meeting, education, commerce, etc.) which require bandwidth.
• The pandemic is putting financial strain on smaller, less financially healthy competitors, allowing Lumentum to increase its market leadership position as it is maintaining its investments in R&D.

Indeed, the company has introduced new products in March based on the strength of its indium phosphide and gallium arsenide capabilities. In addition, from the Q3CC:

We have a range of new products. We are ready to ramp in the second half of the calendar year, including additional world-facing designs that we expect will increase the penetration of world-facing 3D sensing or LiDAR enabled cameras. It is too early to quantify with confidence, any impact consumer volumes, or the timing of new programs due to COVID-19, but we are very closely monitoring the situation.

Q3 results

From the 10-Q:

Telecom and datacom supply constraints resulted in a 6% revenue decline with telecom transport revenue flat. Datacom chip demand rose 20% sequentially on strong cloud and 5G demand.

Industrial and consumer (VCSELs) products were down on seasonality of the latter, but up 40% y/y as more customers are incorporating face and world-facing 3D sensing into more models.

The company is winding down its lithium nitrate production, which was still $10M in Q3, but will decline to almost zero over the next two quarters.

Guidance

From the earnings PR:

Lumentum expects the following for the fiscal fourth quarter 2020:

• Net revenue in the range of $325 million to $365 million
• Non-GAAP operating margin of 18% to 21%
• Non-GAAP diluted earnings per share of $0.70 to $0.90
• Estimated fourth quarter impact from COVID-19 is a reduction in revenue of more than $90 million and a reduction in non-GAAP diluted earnings per share of more than $0.50

Pandemic impact still very substantial, from the Q3CC:

Telecom datacom demand remains robust and strong bookings continue. However, we expect telecom and datacom revenue growth to be limited by COVID-19 related supply constraints. Supply constraints and telecom transmission in Malaysia are improving, but we are not at 100% output yet. We won't be able to satisfy them more than $100 million of current backlog we have for these products, until the second half of the calendar year.

Both telecom transport and datacom chip revenue will be up in Q4, the latter on strong cloud data center and 5G demand, but limited by the company's fab capacity. 3D sensing demand will be down 40%+ on expected consumer demand fall for smartphone, as well as supply issues.

Demand for fiber lasers, tied to industrial demand, will decline further, and this is only partially offset by rising demand for solid state lasers, resulting in Q4 laser revenue to decline by another 20% or so. But next fiscal year looks to be better (Q3CC):

But I'd say that we probably as we enter into July and August we should be back to near normal from what I can tell.

Margins

Data by YCharts

With the absorption of Oclaro and the beginning of a new up-cycle in the industry, margins have recovered strongly last year. Non-GAAP margin is substantially higher at 45.5%, one of the highest in the business. From the Q3CC:

Year on year in the third quarter, we achieved, 650 and 720 basis points of improvement in non GAAP gross and operating margins respectively. And more than a 37% improvement in non GAAP EPS, despite revenue being down 7%.

That's quite an achievement, much of it on the back of the synergies from the Oclaro acquisition.

Cash

This is what we want to see as investors:

Data by YCharts

It's a really tremendous graph which is the consequence of combining secular tailwinds, market-leading products and disciplined financial execution (Q3CC):

Through the third quarter of fiscal 2020, we completed actions that will result in approximately $100 million of annual expense synergies. As a reminder, we are targeting a total of $110 million in annual run rates acquisition synergies with the remaining $10 million to be attained over the next few quarters.

And the company executed some transactions to improve the balance sheet (Q3CC):

On capital structure, as you are aware, in the second quarter, we issued $1.05 billion in convertible debt, paid off our acquisition related term loan and repurchased $200 million of our stock.

Data by YCharts

Share-based compensation has risen quite a bit, but not nearly as much as free cash flow, and it is 4% or so of revenue; we've seen far worse.

Valuation

Data by YCharts

Analysts expect this (fiscal) year's EPS to come in at $5.04 and rising to $5.42 next year. The sector used to be rather cyclical and P/E ratios therefore less useful as a gauge.

However, with the consolidation in the industry and what seem to be more secular trends in demand for bandwidth, pulled by 5G and ongoing digitalization and virtualization, as well as the 3D sensing revolution, we think the stock has become much less cyclical.

With respect to that, we don't think the 14 earnings multiple is overly onerous, and as the graph above shows, on an EBITDA basis, the stock is cheaper than it has been for a couple of years.

Risks

We see two main risks for the company:

• A resurgence of the pandemic, leading to new pressure on production facilities.
• An escalation of geopolitical tensions between China and the US leading to new constraints on supplying Chinese customers or even a wholesale balkanization of the tech world. For instance, revenue from Huawei was $60M in Q2 (it declined 20% in Q3 already).

Conclusion

The situation is fairly straightforward. We think better times are ahead for the company as:

• The pandemic is accelerating the demand for bandwidth, reinforcing a secular trend that has other drivers like the move to the cloud, CTV, 5G, IoT and the like.
• As a result, most of the company's end markets are booming.
• The industry is less cyclical after a wave of consolidation.
• The supply constraints that are depressing Q3 and Q4 results are receding to the background in Q1 and Q2 of FY2021.
• Despite the temporary headwinds, the company is performing very strongly from a financial perspective due to acquisition synergies and shedding older product lines.
• The strong balance sheet enables the company to widen its lead over competitors.

From a valuation vantage point, we see no reason why the shares could not move substantially higher either, and we expect that to happen in the rest of the year, unless some of the above-mentioned risks manifest themselves.

Analyst’s Disclosure: I am/we are long LITE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.