Goldman Sachs analyst Rod Hall recently raised Lumentum (LITE, Financial) – the manufacturer of optical components for networking and 3D sensing for smartphones – from hold to buy, citing 3D sensing demand. "We note that Lumentum's 3D sensing business is robust and gaining pace and the Lasers business is seeing strong demand," wrote Hall.
Hall said that the Street is underestimating the iPhone and iPad-related 3D sensing opportunity; Lumentum is a key supplier of 3-D sensing components for Apple (AAPL, Financial). It is worth mentioning that Lumentum generated 25% of its revenue from sales to Apple during the first quarter of 2018 as opposed to less than 10% during the same quarter last year. The market is unmoved though as the stock is down 5% since the analyst upgrade.
Lumentum continues to trend downwards. Why?
Lumentum is down 25% since touching an all time high of $73 towards the end of its first fiscal quarter of 2018. Despite strong first quarter performance – beating earnings per share consensus by 7 cents a share – Lumentum’s stock is under pressure. A number of developments including cautious commentary from investment bank B. Riley FBR, poor sales of iPhone X and a ban on ZTE from the U.S. government potentially contributed to the downward pressure on Lumentum.
B. Riley FBR's Dave Kang raised his concerns regarding the weakening of demand in China after visiting the optical communication conference back in March. The commentary had put pressure on the optoelectronics players including Lumentum. Furthermore, the decline in iPhone sales also took a toll on the optical component player. Apple registered a 1.1 million drop in number of iPhones sold during 2017, according to Gartner.
Moreover, the barring of U.S. suppliers from selling to ZTE was also a contributing factor for investors to shy away from Lumentum during the last few months. More recently, Nikkei Asian Review reported that Apple is potentially reducing 20% of its supply orders, which reflected bad on Lumentum as the company generated more than a quarter of its revenue from Apple during the nine months ended March 2018.Â
Headwinds seem to be short lived
Most of the negative developments are either short term or overplayed. For instance, Kang was cautious on optoelectronics demand from China but still held a buy target for Lumentum. This means that Lumentum is going to weather the storm despite weak demand from China.
Regarding the ZTE ban, Lumentum generates less than 10% of its revenue from the second largest network equipment provider of China. The demand for network components isn’t expected to dry up as network service providers can shift to Huawei and Nokia (NOK, Financial) for cutting-edge products. All in all, the ban on ZTE is not a material concern for Lumentum. Furthermore, the ban on ZTE isn’t set in stone as two U.S. senators recently urged President Trump to lift the ban.
To review, negative developments surrounding Lumentum are short lived. The company is set to benefit from 3-D sensing market. The 3D sensor market is set to grow at a CAGR of 26.5% during 2016 to 2022. More than 1 billion phones will feature facial recognition, according to a report from Counterpoint Research. Moreover, Lumentum’s success is also evident from its quarterly results. Revenue grew 21.5% year-over-year to reach $946 million during the nine months ended March 2018.
In effect, the dip in the stock price of California-based Lumentum is a buying opportunity for investors as the company is keeping a high growth profile and is exposed to a major 3D sensing opportunity on the consumer side.
The stock is also cheaply priced, thanks to the downward trend of late. Lumentum is trading at 12 times 2019 earnings consensus while earnings are set to grow 18.5% per year during the next five years. The economic added approach to valuation also reveals that the stock is trading at a discount to its fair value. EVA valuation based on 10% per-year earnings growth during the next five years and 1% terminal growth reveals an upside of 32%.
Takeaways
- Goldman Sachs is right in upgrading Lumentum as the stock holds favorable 3D sensing opportunity in smartphones and is trading at a discount.
- ZTE ban is immaterial for the top line of Lumentum as the company generates less than 10% revenue from the network equipment provider.
- The adoption of facial recognition will add to the top line of Lumentum going forward.
- The only risk for Lumentum in the 3D sensing market is the potential for smartphone OEMs to discard facial recognition in favor on another technology.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
