Are the Bulls Right About Lumentum's Future?

Lumentum's (LITE 2.57%) stock plunged to a 52-week low last November after the optical components maker slashed its second-quarter guidance on lower laser diode orders from one of its top customers, most likely Apple (AAPL -0.24%). However, the numbers rebounded more than 30% this year as Wall Street turned bullish on the beaten-down stock.

In March, JPMorgan analyst Samik Chatterjee upgraded the stock to "Overweight," stating that it had lower concerns about its "customer concentration with Apple" after the stabilization of iPhone shipments, which could drive the market's "focus back to strong fundamentals in the core business."

Image source: Getty Images.

Morgan Stanley's Meta Marshall also upgraded the stock to "Overweight," stating that the stock "presents more opportunity for upside" as it recognizes synergies from its takeover of Oclaro. Jefferies analyst George Notter, who has a "Buy" rating on Lumentum, noted that the company was approaching a "turning point" and that its shares were "significantly undervalued."

All of the analysts who cover Lumentum are currently bullish on the stock. Investors should always take analysts' ratings with a grain of salt and do their own homework, but are these bulls right about Lumentum's future?

Understanding Lumentum's business

Last quarter, 87% of Lumentum's revenue came from its optical communications products, which include network upgrade components and the diodes that power the iPhone's 3D-sensing cameras. The remaining 13% came from sales of laser components.

In the second half of calendar 2018, Lumentum's sales growth accelerated on robust demand for its optical components in network upgrades, rebounding sales in China, and the rise of 3D-sensing technologies. It also benefited from easy comparisons to the previous year, which saw a cyclical slowdown in demand for optical components.

The bulls were also optimistic about Lumentum's takeover of Oclaro, which closed last December. Lumentum expects the acquisition to be immediately accretive to its non-GAAP EPS, generate more than $60 million in run-rate synergies within 12 to 24 months, and broaden its portfolio and R&D capabilities.

Image source: Getty Images.

Unfortunately, Lumentum's guidance cut in November spooked the bulls, and its second-quarter numbers (which included Oclaro's results for the first time) weren't pretty:

YOY = year-over-year growth. Source: Lumentum quarterly reports.

Lumentum's revenue decline was disappointing, especially after Oclaro contributed $29.6 million to its sales at the tail end of the quarter. The drop was mainly attributed to a 10% annual decline in its optical revenues, which was caused by the aforementioned drop in 3D-sensing orders and softer demand for its datacom products.

Lumentum's gross and operating margins also contracted annually and sequentially as it generated less revenue from the higher-margin industrial and consumer markets:

Source: Lumentum Q2 report.

For the third quarter, Lumentum expects its revenue to rise 44% to 50% annually as it includes its first full quarter of Oclaro's sales. It expects its operating margin to fall sequentially (but remain stable annually) to 16% to 18% and for its non-GAAP EPS to rise 9% annually at the midpoint.

Growth forecasts, valuations, and catalysts

Lumentum didn't provide any guidance for the full year, but analysts expect its revenue and earnings to rise 28% and 9%, respectively. That recovery is expected to continue into fiscal 2020 with 26% sales growth and 21% earnings growth.

At $57, Lumentum trades at 14 times this year's earnings and 11 times next year's earnings, which are low valuations relative to its longer-term growth potential.

Lumentum still has other irons in the fire besides Oclaro. It expects more smartphone makers to add 3D-sensing features to their devices, driverless cars to boost demand for its 3D-sensing and LIDAR components, and customers across multiple industries to increase orders for its ROADMs (reconfigurable optical add-drop multiplexers) as they upgrade their networks.

Looking further ahead, the ramp-up of 5G technologies worldwide and the growth of the IoT (Internet of Things) market should generate healthy long-term demand for its fiber-optic components.

The bulls could be right

Lumentum is a cyclical stock, and multiple catalysts could revive the "supercycle" in fiber-optic upgrades again. It won't happen overnight, but Lumentum's takeover of Oclaro will boost its revenues, broaden its portfolio, and generate synergies until that happens. I think Lumentum is finally approaching an inflection point, and investors who buy the stock today could be well rewarded over the next few years.