2023-12-20 12:21:49 ET

Summary

• I revised my rating for Lumentum Holdings from neutral to buy as I am positive about the potential of the Cloud Light Technology acquisition.
• The acquisition of CLT has significantly improved Lumentum's growth trajectory and competitive position.
• The high-speed transceiver market, particularly in the AI-related data center infrastructure, offers growth potential for Lumentum.

Summary

I'm following up on my coverage of Lumentum Holdings (LITE), where I previously recommended a hold rating as the inventory situation did not see any improvements at all. Management comments back then were also painted with a very uncertain outlook. This post is to provide an update on my thoughts on the business and stock. I am revising my rating from neutral to buy on the idea that LITE will be able to close its Cloud Light Technology acquisition as planned. I believe this acquisition has significantly altered LITE's near-term growth trajectory and long-term competitive position. It has also improved the stock equity story, deserving a positive valuation re-rating.

Investment thesis

LITE reported its 1Q24 earnings in early November, and just to recap a little, revenue came in at $318 million, which was slightly above management pre-announced expectations of $317 million. On the other hand, gross margins came in at 34.9%, slightly below consensus expectation of 35.8%. However, EBIT margin saw 3.3%, beating consensus by 50bps. Normalized EPS came in at $0.35. Given that earnings were already pre-released, I don't think there was any surprise for the market.

What was interesting and also the focus of this post was the acquisition of Cloud Light Technology [CLT]. The acquisition has a price tag of $750 million and a valuation of 3.8x LTM revenue. This might look expensive considering LITE was trading at only 2x LTM revenue; however, I view this acquisition very favorably, which just might be what LITE needed at this point-a catalyst to drive the stock up. From a business perspective, this acquisition broadens LITE's exposure beyond photonic chips and into the datacom optical transceiver market. For background, LITE made a strategic decision to concentrate on the higher-margin optical sub-component market, which led to the sale of its transceiver business in early 2019. The results from the divestiture were immediate, as the gross margin inflected to a high of 30%, followed by a further increase to 40%+. Valuation followed through, re-rating from high single-digits to mid-teens forward PE multiples. As such, it might seem weird that LITE is pivoting back to producing lower-margin transceivers.

I note that there are fundamental differences relative to the transceiver business related to LITE back then, and I think it has a lot of strategic value. For instance, LITE is going to focus on higher-data-rate transceivers for hyperscalers. CLT provides LITE with the capabilities to stay competitive, as more than half of CLT's revenues are from 800G AI-related products. With CLT, the growth trajectory of LITE has also been altered significantly. Since hyperscalers are rapidly deploying AI datacenter infrastructure, my growth expectations for LITE have been significantly improved. This is a very attractive end-market that has a market size of $2 billion and is expected to grow more than 30% CAGR to more than $10 billion by 2028. Previously, LITE could only address a subset of the TAM using photonic chips; now, it can address the entire TAM (i.e., growth potential expanded significantly). To illustrate the immediate impact of CLT on LITE's financials, suppose $200 million of CLT revenue (almost all derived from 400G or higher speed transceiver sales) continues to grow at more than 30%; this represents a 4% uplift in growth to LITE FY23 growth instantly. I would also note that the growth is very likely to come through, as the growth constraint is not demand. Growth is constrained by capacity ( AI data center buildout), and given the nature of these buildouts (long buildout periods and planned in advance), I'd say the near-term growth rates of CLT are pretty much locked in.

Third-party research also estimates that total revenue from sales of high-speed transceivers utilized within data centers will grow from $2.4 billion in 2023 to more than $10 billion in 2028, a five-year compound annual growth rate of more than 30%. 1Q24 earnings results call

LITE's long-term competitive position has also improved. In my opinion, the introduction of AI will speed up the development and rollout of next-generation optical equipment. The implication is that demand is going to continue growing at breakneck speed, and at some point, the ability to meet demand is going to be a key differentiating factor between suppliers. Hence, the acquisition of CLT effectively vertically integrated LITE, as CLT has its own manufacturing automation system (including packaging, assembly, and testing).

There might be some investors that are worried about the post-acquisition impact on the financials (i.e., growth slows down or margin deteriorates, etc.). I note this is not a major issue. CLT is a business that is growing very profitably. As of LTM, CLT had over $200 million in revenues and is growing in excess of 30% with a mid-teens EBIT margin. As such, the acquisition is immediately accretive. In fact, I believe the acquisition will drive a sustained positive valuation re-rating (forward PE already re-rated to 20x as of today) as it improves the equity story of LITE. LITE now has higher growth, more margin expansion potential, and provides investors with an avenue to ride on the AI trend.

Valuation

Own calculation

My target price for LITE, based on my model, is $75.79. To keep my optimism aligned with the market, I am using consensus estimates for my model. Consensus is estimating a continuous decline in FY24, which I think is fair as the previous inventory correction issue is still undergoing and should end in FY24. Note that I previously modeled a 23% decline in FY24; a key part of the 600 bps delta is the inclusion of CLT financials. As for FY25, growth is going to see major acceleration due to industry fundamental improvements (as I mentioned previously). Growth expectations are 900 bps higher today because of CLT's strong growth. As I mentioned above, I believe LITE is going to trade a higher multiple from here on because of its higher growth profile and exposure to AI. I draw precedent from Fabrinet (FN), which saw its valuation increase from an all-time high of 21.5x when it saw wins in the AI field .

Risk

The acquisition of CLT has been announced but not closed. If the deal fails to materialize, my entire bullish thesis will be dismissed, since I think LITE is going to see a major valuation reversion from the current 20x to the mid-teens (where it was trading before the deal announcement). Multiple reversions themselves are already a 25% negative return. Consensus reducing their estimates could further drive the downside in the stock.

Conclusion

To conclude the post, I am revising my hold rating to a buy rating as I am very positive about the CLT acquisition. I believe this acquisition has altered LITE growth trajectory and competitive position. This strategic move broadens LITE's market exposure and positions it favorably in the high-speed transceiver domain, particularly catering to the fast-growing AI-related data center infrastructure end-market. Despite the transformative potential, the pending acquisition poses a substantial risk.

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