After my coverage of Lumentum Holdings (Nasdaq: Lite), I recommend a HOLD rating as I expect lower gross margins to negatively impact gross margins in the coming quarters.This post is to provide an update About my views on the business and the stock. I reiterate my Hold rating because I haven’t seen any improvement in the stock situation so far. In fact, management’s comments lead me to believe that things are worse than I initially expected.
LITE’s 4Q23 revenue was $371 million, just above the midpoint of the $350 million to $380 million guidance range. Meanwhile, gross margin was 36.7%, operating margin was 9.1%, and EPS was 0.59. While revenue did beat the midpoint of forecasts, I don’t see things improving (which is why I’m neutral on the stock).In fact, the result In Q4 2023, I am sure it will take more time and effort to digest customer inventory than I anticipated. The service providers are LITE customers and they have excess inventory which I didn’t take into account in my initial expectations. This means that there are two stages that need to be completed before LITE can benefit from the inventory normalization process. The current situation is actually in the hands of LITE, they can only bite the bullet and complete this process. As I said before, management has a poor track record when it comes to estimating inventory levels, so I wouldn’t be surprised if things are worse than they appear. This will only exacerbate concerns about the future trajectory of revenue and, more importantly, gross margin.
Management has also been historically inaccurate, as they don’t seem to be able to correctly predict how long it will take customers to correct excess inventory levels. For example, in the first quarter of 2023, management predicted that a datacom slowdown due to excess inventory at ICP customers would continue through the remainder of FY23, which was wrong. The same thing happened in China two years ago, and the glut of EML laser chips lasted much longer than expected. As such, I’m less confident in management’s assurances that the inventory issue will be resolved in 2023. – Jay Capital
However, LITE’s datacom business appears to be a bright spot due to growing demand from cloud provider customers for AI-based applications. LITE’s current foray into the AI industry stems from the sale of EML to transceiver manufacturers for the manufacture of 800 Gb transceivers. From what I can tell, the existence and growth potential of LITE is just beginning, as management is only just beginning to reintroduce additional resources and capabilities to serve this market. This momentum should start to show in the form of improved financial performance over the next few quarters. Going forward, LITE is also working on a VCSEL-based solution for short-range applications in AI-based architectures, which should be ready in 2CH24. VCSELs are expected to experience significant growth over the next few years as short-reach, multimode optical links gradually replace copper cables. So I think that gives LITE a lot of exposure in the AI space. That said, I don’t think this growth expectation is enough to overcome the uncertainty of the inventory glut situation.
Previously, I’ve shown potential upside if valuations return to 12.7x 2-year forward P/E (when it was trading at 10x 2-year forward P/E). Today, with a P/E ratio of 12, I no longer believe that to be the case. Using consensus estimates as a guide for expected earnings growth, I think any potential upside will clearly come from expectations for fiscal 2025 earnings performance. The consensus estimate for fiscal 2024 is a 23% decline in revenue, which I think is a reasonable assumption given the inventory situation. The question is, when will this all end? Current expectations are for a FY25 recovery, but note that no one really knows how bad things are, not even management got it wrong. I believe this uncertainty will keep the stock price range-bound until at least February 24, 2024, when we will have better information to assess the situation. Another negative is that even though I think the consensus is correct, the stock still appears to be trading at a reasonable valuation of 12 times 2Y forward earnings.
All in all, the LITE inventory overhang challenge remains, and the situation may be more severe than I initially expected. Because of this ongoing concern, my HOLD recommendation remains unchanged. While the outlook for LITE’s datacom business is bright, the uncertainty over excess inventory masks underlying growth. Valuations also appear to be adjusted for current conditions, with any material upside depending on expectations for FY2025 results. Given the unpredictability of the inventory issue, inventories are likely to remain range-bound until more clarity emerges (probably around the second half of 2024).