In an increasingly connected world, industrial lasers and photonics hold a lot of promise. Modern networking systems and devices make use of these technologies, and Lumentum (LITE -0.66%) and II-VI (COHR 0.93%) have done well in recent years as a result -- even though demand from some customers may be drying up this year. Shares of both companies have pulled back as of late, so investors may be wondering which would be the better choice to buy now.
Mind the cyclical business
As technology component manufacturers, Lumentum and II-VI have highly cyclical businesses that are sensitive to customer demand. But while 2020 has been a total mess for the economy overall, networking sales did well through the first half of the year as many organizations scrambled to update their operations to adapt to shelter-in-place orders and work-from-home requirements.
However, telecom and networking supplier giant Ciena (CIEN 0.40%) recently revealed it is experiencing a sharp slowdown during the second half of the year. As Lumentum and II-VI both provided their latest quarterly updates earlier than Ciena, it's possible they had less visibility on future demand when they reported. As a result, both stocks are well off of recent highs, with Lumentum down 6% year to date and II-VI up 12%. But with market caps of just $5.6 billion and $3.9 billion respectively, both of these component makers are still relatively small and could have much room to grow in the decade ahead.
Plenty of use for laser technology
That's because, unlike Ciena, both Lumentum and II-VI produce components related to lasers and photonics for more than just the telecom industry (although that is still their largest end-market). It's true that the deployment of 5G mobile networks during the last couple of years has boosted results for both companies.
There's also an ever-increasing demand for new data centers and improvements to existing ones as the use of cloud computing expands. Advanced manufacturing techniques also make use of both companies' wares. And as the performance of devices gets more advanced, photonics and related tech has been finding its way out of telecom, networking, and data centers and into things like cars, smartphones, AR/VR headsets, and other industrial and consumer electronics gadgets.
But the photonics industry is fragmented and has many players. Why should investors be focused on Lumentum and II-VI in particular? Both are still small, but financially strong enough that they've been able to consolidate market share for themselves. At the end of 2018, Lumentum acquired former peer Oclaro for $1.8 billion, and II-VI nearly doubled its revenue with the purchase of Finisar in summer 2019 for $1.9 billion.
More than a year removed from both deals, it's Lumentum that is generating by far the better free cash flow (revenue less cash operating and capital expenses) -- even though II-VI is now the larger outfit. II-VI may be able to squeeze more free cash flow out of its new assets in the coming quarters, but for now, Lumentum generates a better bottom line.
Additionally, Lumentum has a stronger balance sheet. At the end of June, it had $1.55 billion in cash, equivalents, and short-term investments on the books, and $1.12 billion in convertible debt. By comparison, II-VI had $567 million in cash, equivalents, and investments and $2.26 billion in debt. As for valuation, Lumentum trades for just 13.4 times trailing 12-month free cash flow to 20.9 for II-VI -- making Lumentum the relative value here.
The better buy is?
While demand from communications end-markets may be headed for a rough patch in the next few quarters, the stress being put on the internet and organizations' networks due to the pandemic should keep longer-term demand for photonics headed north. And new uses for Lumentum's and II-VI's components in industrial and consumer devices are creating additional fast-growing end-markets for these two manufacturers.
I'm not currently a buyer of either of these stocks given the immediate-term uncertainty, but Lumentum's better profit margins, stronger financial position, and relative value mean it gets my nod as the better buy of the two.