In the information economy, electronic devices are the basis of almost everything we do. This includes communication, as well as various other activities such as sensing, taking action and much more. A company dedicated to the production of some of the components that go into these end products is Lumentum Fund (NASDAQ: LITE). Despite somewhat mixed results due to the COVID-19 pandemic, this company has performed incredibly well over the years. Its current fiscal year 2023 in particular should be particularly positive. Add to that the fact that the company’s stock looks attractively priced, both on an absolute basis and relative to similar companies, and I think that’s an appropriate buying prospect at this time.
A niche player in electronic devices
Lumentum Holdings’ management team describes the company as a leading provider of dedicated optics and photonics products to service customers who act as OEMs (original equipment manufacturers). These OEMs often use the products created by Lumentum Holdings for the production of their own products that ultimately address end market applications. An example provided by the company is its fiber optic components that network equipment manufacturers assemble into communication network systems. These systems, in turn, are then sold to network service providers, carriers, or other companies with their own networks. Another example is the company’s laser products. These are often integrated into the tools that its customers manufacture, products that are then used for manufacturing processes. Similarly, 3D sensing components produced by the company include diode lasers which are sold to manufacturers of consumer electronics for mobile phones, personal computing, gaming and other related businesses.
To better understand Lumentum Holdings, we need to dig into the two major operating segments it has. The first of these is called the OpComms segment. This particular unit of the business is, by far, the larger of the two, accounting for 93% of the company’s revenue and 93.5% of its profit. It focuses on customers in the telecommunications, data communications, consumer and industrial markets. The company sells a wide variety of different products in this category, including those useful for the transmission and transport of video, audio, data, etc. over fiber optic cables. The segment is also responsible for the production of diode laser products, with the laser light sources produced by the company being integrated into 3D sensing cameras for various applications. These applications can include biometric identification, computational photography, virtual and augmented reality, and more. It should be noted that the largest customer in this segment in 2021 was Apple (AAPL), a company that accounted for 30.2% of the company’s overall revenue.
The company’s other segment is remarkably smaller, accounting for just 7% of revenue and 6.5% of profit last year. This is the laser segment. According to management, the products it sells through this segment serve customers in a wide variety of markets and applications, ranging from sheet metal processing to general manufacturing to biotechnology, and more. Specific OEM applications include semiconductor, fiber, diode, and diode-pumped gas lasers. It also produces high-powered, ultra-fast lasers for the industrial and scientific markets. And on top of that, the segment sells various components and subsystems ranging in power from watts to kilowatts that include different wavelengths like ultraviolet, visible, and infrared.
Over the past few years, the management has done a very good job of increasing the company’s turnover and results. Revenue fell from $1.25 billion in the company’s fiscal year 2018 to $1.74 billion at the end of its fiscal year 2021. Then, for fiscal year 2022, sales fell slightly to $1.71 billion. The drop in sales came even as the company’s Lasers segment saw a 59% increase in revenue. It was impacted by a 6.3% drop in the OpComms segment. However, this decline should be short-lived. Indeed, for its 2023 fiscal year, management expects revenue of between $2.10 billion and $2.25 billion. Much of this is expected to be due to the company’s acquisition of NeoPhotonics, a purchase that was completed just after the company’s 2022 fiscal year-end. The transaction price was $918 million in total.
While revenues have increased in recent years, profitability has generally followed. Net income, to be clear, has been quite volatile, ranging from a low of negative $37.9 million to a high of $397.3 million over the past five years. In 2022, net profits amounted to $198.9 million. Other measures of profitability have been more consistent. Operating cash flow, for example, has steadily increased year over year, from $85 million in 2018 to $738.7 million last year. EBITDA was nearly as constant, a metric that rose from $320.2 million in 2018 to $621 million in 2021 before dropping slightly to $608.6 million last year. Interestingly, the company’s profitability issues came even as its gross margins fell from 44.9% to 46%. The problem therefore stemmed from several different factors. For starters, selling, general and administrative expenses have increased even at a time when revenues have fallen. As a percentage of sales, this metric fell from 13.9% to 15.5%, while research and development costs fell from 12.3% of sales to 12.9%. But more significant was the fact that the company received a merger termination fee of $207.5 million in its 2021 fiscal year, any move that temporarily increased profitability abnormally. Despite the company’s declining profitability, management announced a billion-dollar share buyback program earlier this year. It’s a great way to restore shareholder value. And on top of that, the company expects to ultimately realize $50 million in cost savings associated with its aforementioned acquisition. But it will take up to 24 months from the closing of the purchase.
Looking to fiscal 2023, management expects earnings per share to be between $6 and $7. At the midpoint, that translates to a net profit of $464.8 million. The company didn’t provide any guidance on other measures of profitability, except to say its operating margins are expected to be between 24% and 26%. Running the numbers, I was able to make a rough estimate of operating cash flow for FY 2023 of around $827.7 million, while my EBITDA estimate was $933.7. millions of dollars. Using these numbers, I calculated that the company is trading at a futures price on an earnings multiple of 13.5. These numbers are all lower than what the data would look like if we were to use 2022 results for the business. The forward price to operating cash flow multiple is 7.6 and the EV to EBITDA multiple is expected to be 7. Note that the enterprise value of the business involved a scenario in which I withdrew the $918 million from the company’s cash to cover the acquisition. that was made after the end of the financial year. I also assumed that convertible notes will remain debt for the foreseeable future.
As part of my analysis, I also compared the company to five other companies. On a price-earnings basis, these companies ranged from a low of 18.6 to a high of 232.8. Three of the four companies that had a positive multiple were cheaper than Lumentum Holdings. Using the price/operating cash flow approach, the range was between 5.9 and 99.8, with only one of the five companies cheaper than our outlook. And when it comes to the EV to EBITDA approach, the range was between 12.7 and 53.7. In this scenario, our target is the cheapest of the bunch.
|Company||Prizes / Earnings||Price / Operating Cash||EV / EBITDA|
|Ciena Corporation (CIEN)||20.4||22.2||13.8|
|Viavi Solutions (VIAV)||232.8||20.0||14.4|
|Juniper Networks (JNPR)||25.2||53.6||15.1|
|Viasat (VSAT)||N / A||5.9||12.7|
Taking all the data into the equation, Lumentum Holdings strikes me as an interesting company that will likely continue to do well. Assuming current performance holds, the company looks pretty cheap and that includes compared to other similar companies. For this reason, I have decided to classify the company as a “Buy”, reflecting my belief that it will likely outperform the market for the foreseeable future.