Lumentum Holdings: Inventory Situation Is Worse Than Expected (NASDAQ:LITE)

Summary

Following my coverage of Lumentum Holdings (NASDAQ:LITE), I recommended a hold rating due to my expectation that gross margins would be negatively impacted by lower gross margins in the coming quarters. This post is to provide an update on my thoughts on the business and stock. I reiterate my hold rating, as I don’t see any improvements in the inventory situation so far. In fact, the comments made by management led me to believe the situation was worse than I had initially expected.

Investment thesis

LITE’s revenue for 4Q23 was $371 million, which was slightly higher than the $350 million to $380 million guidance range’s midpoint. Meanwhile, gross margins came in at 36.7%, operating margins at 9.1%, and EPS at 0.59. While revenue did exceed the midpoint of projections, I do not believe the situation has improved (which is why I remained neutral on the stock). In fact, the results of 4Q23 convinced me that the time and effort required to digest customer inventory would be greater than I had anticipated. The service providers, who are LITE’s customers, have surplus stock, which I failed to account for in my original expectation. Which means there are two stages to clear before LITE will benefit from the stock normalization process. The current situation is literally in the hands of LITE, where they simply have to bite the bullet and sit through this process. As I’ve said before, management’s track record in estimating inventory levels is poor, so I wouldn’t be surprised if things are worse than they seem. This only serves to heighten concerns about the future trajectory of both revenue and, more importantly, gross margin.

Management has also historically been inaccurate as they seem to not be able to correctly predict how long it will take for customers to correct their excess inventory levels. For instance, in 1Q23, management’s forecast that the Datacom slowdown caused by excess inventory among ICP customers would continue for the rest of FY23 was incorrect. The same thing happened in China two years ago with an EML laser chip oversupply that lasted many more quarters than anticipated. Therefore, I lack confidence in management’s assurance that this inventory problem will be resolved by CY23. – Jay Capital

However, LITE’s Datacom business appears to be a bright spot, driven by rising demand associated with AI-based applications among cloud provider customers. LITE’s current involvement in the AI industry stems from the sale of EMLs to transceiver manufacturers for use in making 800 gigabit transceivers. From what I can tell, LITE’s presence and growth potential are just getting started, as management has only just begun re-introducing additional resources and capacity to serve this market. This momentum should begin to materialize in the form of improved financial results within the next few quarters. Looking ahead, LITE is also working on a VCSEL-based solution for short-range applications in AI-based architectures, and it should be ready in 2CH24. As short-range, multi-mode optical links gradually replace copper, VCSELs are expected to experience significant growth over the next few years. As such, I think this gives great exposure to LITE in the AI space. That said, I don’t think this growth expectation is sufficient to overcome the uncertainty with regards to the inventory overstock situation.

Valuation

Previously, I showed the potential upside if valuation goes back to 12.7x 2Y forward earnings, when it was trading at 10x 2Y forward earnings. With the multiple trading at 12x today, I no longer believe this is the case. Using consensus estimates as a guide for expected earnings growth, I think it is apparent that any potential upside will come from expectations of FY25 earnings performance. The consensus is expecting revenue to decline by 23% in FY24, which I see as a fair assumption considering the inventory situation. The problem is, when will this end? The current expectation is for a FY25 recovery, but note that nobody really knows how bad the situation is-even management got it wrong. I believe this uncertainty is something that will keep the stock price range bound until at least 2FH24, when we will have better information to assess the situation. Another negative point is that even if I assume consensus is right, the stock seems to be fairly valued at 12x 2Y forward PE.

Conclusion

In conclusion, LITE inventory overstock challenge persists, and the situation might be more dire than what I initially anticipated. My recommendation to hold remains unchanged due to this ongoing concern. While LITE’s Datacom business shows promise, the uncertainty surrounding inventory overstock overshadows potential growth. The valuation also appears to have adjusted to the current circumstances, and any substantial upside hinges on expectations for FY25 performance. Given the unpredictability of the inventory issue, the stock might remain range-bound until better clarity emerges, likely around 2H24.