Lumentum Holdings (NASDAQ:LITE) gained a lot of attention last year thanks to its vertical-cavity surface-emitting laser (VCSEL) technology that's used to enable augmented reality (AR) applications by way of 3D sensing. The optical components specialist was in the running to supply the laser dot projector hardware to Apple (NASDAQ:AAPL) for the iPhone X's Face ID feature, and it managed to steal a march over rivals by becoming the sole supplier of the hardware to Cupertino.
Not surprisingly, Lumentum expects big revenue gains as Apple ramps up iPhone production, giving investors a good reason to buy into the stock.
But the company is facing weakness in its traditional business of supplying optical components to telecom customers in China. This weakness weighed on Lumentum's last quarterly report as its revenue and margins dropped on a year-over-year basis, a potential red flag for investors.
Augmented reality will be Lumentum's trump card
Lumentum's December quarter guidance suggests that its revenue will rise almost 36% year over year at the midpoint. This is a remarkable turnaround for a company whose revenue was declining last year.
Lumentum's Apple contract is the biggest reason behind this massive top-line jump, as it received $300 million worth of 3D sensing orders within a span of just six months from April to September. This amounts to 30% of the revenue generated by the chipmaker over the past year, indicating that its VCSEL technology is bringing a substantial amount of new business.
More importantly, Lumentum believes that its 3D sensing revenue will remain strong in 2018. This isn't surprising as Apple will reportedly increase iPhone X production by an estimated 45% during the first quarter of 2018 as compared to potential production of 25 million to 27 million units during the current quarter.
Lumentum is well prepared for an increase in iPhone builds thanks to a rapid ramp-up in VCSEL capacity. It has increased its VCSEL production capacity by 25% to 30% in just one quarter. The company is reportedly going to add one more supplier of VCSEL wafers to its roster in a bid to expand capacity, in a bid to defend its sole-supplier status at Apple as rival Finisar (NASDAQ:LITE) faces production bottlenecks.
More importantly, Lumentum's VCSEL capacity expansion means that it can take advantage of the secular growth in this space. It is projected that VCSEL parts could generate $14 billion in revenue by 2020 as compared to just $1.5 billion in 2017, driven by the adoption of the 3D sensing technology by Android smartphone makers.
VCSEL technology is set to be a long-term growth driver for Lumentum, but will it be enough to outpace the weakness in the core business?
Telecom is a sore point
Weak optical component demand out of China and North America has hurt Lumentum's top line in recent quarters, as telecom companies have been reducing inventory levels. The weak demand has also triggered a fall in pricing, which has negatively impacted Lumentum's margin profile.
Last quarter, Lumentum's gross margin fell 3.5% year over year while operating margin was down 5.4%. Such massive margin decline has been triggered by a 22% drop in fiber deployments in China, as well as the completion of LTE (long-term evolution) network rollouts in other countries.
The market is expected to pick up the pace from 2018 on the back of a recent tender from China Mobile that's set to build new networks in the country in 2018. However, the component orders in the latest two tenders are half the size of what China Mobile had called for in the 2015 tender, indicating that the demand slowdown could continue.
As a result, any unit growth in optical component demand is likely to be offset by weak pricing, so Lumentum's margin erosion could continue. This is a red flag that could keep investors from betting on Lumentum despite its strong momentum in the 3D sensing space.
The Foolish takeaway
Investors shouldn't ignore that the success of its VCSEL chips will lead to impressive earnings growth. Lumentum's December quarter guidance indicates that its earnings will increase to $1.15 per share at the midpoint as compared to just $0.57 a share in the prior-year period.
What's more, analysts expect the company to clock earnings growth of 18.5% a year for the next five years despite the optical component headwinds. This looks achievable if Lumentum's 3D sensing business gains critical mass, helping it offset the weakness in the telecom market. Lumentum could be a good bet for investors in search of a 3D sensing play, provided they can be comfortable with the weakness in the telecom business.
Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.