I believe that Lumentum Holdings (NASDAQ: Lite(b) shows signs of a company unable to scale operations. The company offers significant important products that are widely used, but the company represents a significant customer and management concentration risk a team that is ineffective in allocating capital. This is evident in the company’s inability to transform from peer group-leading free cash flow margins to relevant shareholder value.
Lumentum Holdings’ (LITE) business is optical distribution and photonics through its Optical Communications (OpComms) and Commercial Lasers businesses.
opComms consists of many components, modules, and subsystems that provide access to local, metro (infectious), long-haul (city-to-city and international), and subsea (underwater) carrier networks. Commercial Lasers serves customers in the sheet metal processing, general manufacturing, biotechnology, graphics and imaging, remote sensing, and precision machining industries (PCB drilling, wafer singling, glass cutting, and solar cell scribing).
For almost all commercial and government networks, Lumentum provides optical components and subsystems. Lumentum’s commercial lasers enable cutting-edge manufacturing techniques and a wide range of applications, such as next-generation 3D sensing.
The first segment is called “OpComms” (Operational Communications). This division represents 88.67% of the company’s total sales. The consumer electronics, industrial and telecommunications industries are the target markets for this segment. The company sells numerous solutions that allow the transmission and transport of video, audio, data and other media using fiber optic lines. In addition to producing diode laser devices, this division is responsible for producing laser light sources incorporated into 3D sensing cameras for use in a range of sectors. Many applications are realizable, including biometric identification, computational photography, virtual and augmented reality, and more.
The Laser segment contributed 11.33% to the total revenue. This segment continues to grow and management has noted a strategic shift towards allocating more capital to this sector. According to the corporation, the markets and applications served by this division’s products include sheet metal processing, general manufacturing, and biotechnology. OEM uses include gas lasers, diode lasers, fiber lasers, and diode-pumped solid-state lasers. In addition, it is an extremely fast and powerful laser manufacturer used in both industry and research. In addition, the company offers a wide range of subsystems and components with outputs from a few watts to several kilowatts and a spectrum of wavelengths that include ultraviolet, visible and infrared light. You can find these outputs and wavelengths in the company’s vast product portfolio.
The company continued to allocate capital to acquisitions in an attempt to capitalize on the significant declines in company valuations. The most recent of these acquisitions is Ipg Photonics Corp, a company that manufactures fiber lasers, amplifiers, and laser systems. The deal closed on August 15, 2022 and was noted as an ongoing effort to expand the company’s offerings.
These acquisitions enable us to accelerate long-term technology trends in advanced networking hardware in adjacent markets and to increase our share of the growing telecommunications infrastructure market. Since closing these acquisitions, we have even greater confidence in achieving our goals.
Alan Lowe, Chief Executive
Financial Position of the Company
The company’s operating margin has been reduced from 17.5% to 11.5% as a result of the negative impact of inflation on the company’s profitability. This indicates a lack of operating leverage and is the reason for the negative stock price movements in 2022. Although LITE is not alone in its fight against inflation, investors need to allocate capital to management teams that can achieve effective operating leverage performance during periods of inflation. This is a result of the empirically sticky nature of inflation and its permanent effects (paywall warning – source article).
Despite being below historical averages, the effective multiple paid by investors has not fallen significantly in line with the market, and in the case of EV/EBIT, it continues to increase. This divergence between fundamentals and price is indicative of significant downside risk.
In recent months, the company’s return on equity has continued to decline significantly, and DuPoint Analysis allows us to identify the contributing factors. As shown in the table below, the decline in pre-tax margin to almost a third of the previous level contributed significantly to the decline in ROE. As previously stated, this reduction is directly related to the reduction in operating profits. Although it could be argued that the increase in the tax rate is a factor in the growth of ROE, this increase is small compared to the significant reduction in pre-tax margins. Even more alarmingly, as equity leverage increased by 28% over the same period of time, ROE continues to fall. Keeping leverage at 1.8x would result in a return on equity of 5.4%, a 20% decrease.
As indicated above, LITE does not trade at a discount to its historical self; always shows similar characteristics compared to a peer group. The sharp increase in the EV/EBIT multiple was caused by the company’s significant increase in debt and decrease in operating income. The significant premium compared to its peer group in terms of price to earnings and enterprise value to operating profit reflects management’s inability to generate shareholder value from above-average free cash flow margins. This difference between FCF margin and fundamental valuation multiples represents a management red flag for capital allocation decisions.
Customer Concentration Risk
Lumentum has a small customer base in certain industries, including 3D sensing and commercial lasers. If the company fails to acquire more customers, there is a significant risk of a decline in revenue. However, Lumentum notes a lack of momentum in other areas where it has a presence, such as 3D sensing and industrial lasers. If the company is unable to acquire new customers, its revenue is likely to drop significantly. The loss of even a handful of customers can have a devastating impact on the company’s bottom line. Apple (AAPL) was the company’s largest customer in 2021, contributing over 25% of revenue.
I believe the company’s financial condition indicates a fundamental lack of growth potential. In the context of slowing economic growth in the countries where LITE does business, this is clear. In addition to the company’s fundamental issues, there is a significant risk of customer concentration during a period when customers (businesses) are trying to reduce costs. While it’s clear that LITE offerings may not be where companies turn when trying to cut costs, mega cap companies like Apple are known for bringing functions in-house to save a small amount of money on production costs over time. I don’t think LITE is a viable investment opportunity.