Lumentum has been on our radar for some time as the company supplies components for datacom transceivers and optical interconnects. Lumentum is a small-cap company with differentiated technology that has caught the attention of heavyweight NVIDIA. We’ve been closely monitoring Lumentum for roughly a year, waiting patiently for their EML lasers for 200G to ship, enabling 800G and 1.6T bandwidths. Any progress here should continue into 2026-2027 for 400G data lanes and 3.2T bandwidths. 

Optical interconnects help data centers accelerate data throughput between data centers and inside the data center between servers or racks, while reducing latency and power consumption. AI is driving cloud demand higher from the hyperscalers, leading to more data being created and processed, thus helping drive a need for these interconnects to meet demand for high-speed, low power data transmission in data centers. 

The company supplies three types of lasers for datacom transceivers: VSCELs, CW lasers for silicon photonics and EML-based lasers. Per our previous analysis, the 200G EMLs are what is expected to drive an inflection in 2025.  

In the most recent quarter, Lumentum reported their Cloud and Networking segment grew 18.3% YoY and 20.2% QoQ to $339.2 million. This caused total revenue to grow 9.7% yet total revenue is expected to accelerate to 46.6% and 43% in the second half of the year.  

More on Lumentum’s EML Lasers: 

EMLs were traditionally used by telecom customers, yet became attractive for AI servers due to meeting the 200G per second speeds necessary for 1.6T optical modules to support AI models. These are called single mode optics, made of Indium Phosphide, which has been used instead of silicon for long-haul networking due to being a superior choice for optical functions, such as enabling the laser, modulator, photodetector and amplifier.  

InP is more expensive at the component level as four EMLs are needed compared to two lower-cost CW lasers for silicon photonics modules, yet this difference at the component level can be made up for in data centers as InP reduces power consumption. 

In the December quarter, Lumentum stated they began shipping its 200G lane speed externally-modulated lasers (EMLs) to multiple customers. The Company stated they would increase its EML capacity by 40% YoY from June 2024 to June 2025, followed by another 40% increase by the end of calendar 2025 as its Thailand production accelerates – representing compounding growth in an 18-month time frame:   

“So, we're just overall the demand is outstripping even that 40% compounded twice in an 18 month period of time. We do have additional capacity expansion beyond the end of calendar '25 obviously and those are investments that we've made over the past several quarters that come online in calendar '25, which will give us increased capacity as well.” 

Lumentum’s indium phosphide 100G EMLs (Externally-Modulated Lasers) are being shipped and used in leading single-mode 400G and 800G optical transceivers. These customers are now designing the company’s 200G EMLs into their next generation of transceivers. Already being a lead supplier for 100G EML transceivers, the company is set up to be in pole position for the 200G EML transceivers. 

Per the most recent earnings call: “We achieved another record for EML unit shipments in Q2 and began delivering 200G lane speed EMLs to multiple customers.  

Based on the breadth of our 200G EML design wins, we expect to gain additional laser transmitter market share in the upcoming wave of 800G and 1.6T transceivers, utilizing the more efficient 200G EMLs for AI applications. Complementing our EMLs are our new 200G lens integrated photodetector arrays, which adds to our content opportunity in next generation 800G and 1.6T transceivers as well as strengthens our vertical integration strategy for our own cloud modules.” 

Specifically, the company’s experience in InP long haul transceivers is being tapped as AI servers scale, especially since InP reduces power consumption compared to silicon. Lumentum is also working on higher speed optical links, including 400G per lane. This means more data, fewer lanes if you compare it to 200G per lane. This is important especially as data centers will eventually move not only to 1.6 terabits per second (1.6T) (4X400G or 8X200G) but also 3.2T (8X400G).  

Management also stated the new 200G lens integrated photodetector arrays “adds to our content opportunity in next generation 800G and 1.6T transceivers.” 

Lumentum’s Co-Packaged Optics Opportunity for High Power Lasers:  

Silicon photonics are the only viable choice for rack-to-rack and across the data center due to the need for high bandwidth and lower power at high speeds. There is also low-loss over long distances with optical fiber, which refers to preserving the original signal, whereas copper sees signal degradation over longer distances.  

Where there is a debate and an important shift occurring is in the networking between chips and inside the rack. We’ve recently covered the benefits of co-packaged optics as a replacement for pluggable transceivers when networking between chips. At 800G and 1.6T speeds, the electrical signals over power circuit boards (PCBs) run too hot, are power hungry and create loss for the signal. The overall goal is to move the optics closer in proximity to overcome scaling issues when increasing electrical speed. 

Nvidia stated that by replacing pluggable optics with silicon photonics on the package, it can “deliver 3.5x more power efficiency, 63x greater signal integrity, 10x better network resiliency at scale and 1.3x faster deployment compared with traditional methods.”  

Nvidia VP Ian Buck stated at GTC that the CPO switches help reduce power consumption by eliminating the need for external lasers and pluggable transceivers to achieve a significant reduction in power from 39 watts to 9 watts. Buck explained that this “gives you that benefit from going from 39 watts of power down to only 9 watts of power for the same number of ports, and that's huge. It doesn't sound like 39 sounds a lot. But if you get 400,000 GPUs in an AI supercomputer, there's like 24 megawatts of lasers like so that's a lot of laser light that could be optimized and made more efficient.” 

While Lumentum may see some decline in its pluggable optics transceiver business as the industry shifts, it is also well-positioned to benefit from the transition. The company is a key supplier of high-power lasers required for co-packaged optics (CPO), which could offset near-term losses. Taken together, the impact should be at the onset net neutral — with (potentially significant) upside over time from growing demand for EML lasers, the transition to 200G and 400G per lane, plus optical switching (see below). 

Regarding CPOs, here is what was stated on the most recent call: “But I'd also highlight for Lumentum a little bit of a unique situation where we're more modest share on transceivers today and share gaining, if you will, over time. So even if there is some cannibalization in the mid to long-term, we don't think it impacts our transceiver opportunity and creates an expanded opportunity for high power lasers.” 

Nearly a year ago, Lumentum announced an ultra-high output power 1310 nm DFB laser in beta, stating it was designed to reduce the “required number of lasers” while boosting efficiency and reliability in large scale AI/ML infrastructure. 

It was also shared that Lumentum is shipping preproduction volumes now related to CPOs: 

 ‘As part of one collaboration, we began shipping preproduction volumes of our unique ultra-high power lasers to an AI infrastructure customer for a proprietary interconnect solution in Q2 and have received follow-on orders as well as excellent feedback on the product's performance. This is a very exciting opportunity.” 

It was later teased out on the earnings call that 2026 could be a big year for Lumentum’s high power laser: “I would say preproduction volume with forecasts for more meaningful volume throughout calendar '25 and then real extremely high volume in calendar '26. So, feedback is very positive. The performance is very unique and the line width that we produce with the laser is superior to anything in the market.”

CPO (with Switch ASIC) + Optical Switch + GPU Clusters = The Future of Scale Up AI Systems 

Optical switches are a new kind of switch for AI clusters that handles the switching optically instead of using transceivers to convert photons to electrons, and back again. Optical switching and CPOs work together to allow for more flexibility for reconfigurations, to reduce energy and complexity while also increasing bandwidth. 

There are many competitors within optical switching, with heavyweights Broadcom and Arista coming to mind, yet Lumentum believes their MEMS-Based technology can set them apart. Although the discussion around MEMS can get quite technical, the idea is that Lumentum is a smaller, (potentially) key supplier for customers putting optical circuit switches into their data centers. Another use case for using Lumentum is to rearchitect or write software to enable the optical circuit switching. 

According to a previous earnings call, Lumentum has “already shipped evaluation units to customers who have provided overwhelmingly positive feedback on our performance.” It was also stated that “more meaningful growth will probably be in calendar 2026” for the optical switching circuit products. 

Partner for Nvidia’s Silicon Photonics & Marvell 400G per Lane

Nvidia recently announced 1.6 terabits per second port switches at GTC “to deliver 3.5x energy savings and 10x resilience in AI factories.” Lumentum was named as a partner, among others in the industry.  

This analysis has covered some of Lumentum’s unique advantages and why they would be chosen as a partner, such as: 

• At the forefront of increasing bandwidths, from data rates of 400G, 800G, and the upcoming 1.6T 
• At the forefront of faster data pipelines, from 100G per lane (today), 200G per lane (ramping now and into H2 2025), and 400G per lane (into 2026 and beyond) 
• Indium Phosphide lasers are more expensive due to volumes at the component level compared to silicon — yet is made up for in data centers as InP reduces power consumption. InP also offers higher signal integrity. 
• 1310nm DFB lasers are high power lasers that enable the transition to co-packaged optics.

Last month, Lumentum announced an InP DFB-MZI optical transmitter in partnership with Marvell to demonstrate 400G-per-lane PAM4. The long acronym refers to a laser-modulator combo — specifically, a DFB laser integrated with a compact Mach-Zehnder (MZI) modulator. This was paired with Marvell’s 400G PAM4 DSP, which operates at 225 Gbaud and enables the high-speed signaling needed to reach 400G per lane. 

The result is a high-performance, power-efficient optical transmitter that outperforms traditional silicon photonics — “particularly in applications where signal integrity and efficiency are critical,” per the press release. The InP DFB-MZI platform sets the stage for architectures expanding to 1.6T and 3.2T bandwidth, which is in the near future, up from the 800G modules in production today. 

Lumentum is Supply Constrained; Building Capacity 

Lumentum’s demand far exceeds supply, including indium phosphide supply and components such as CW lasers. 

The company is expanding its transceiver manufacturing capacity through the construction of a three-story facility and cleanroom in Thailand, which complements existing production lines. The first floor is completed and ready for tool installation.  

As stated, Lumentum began shipping its 200G lane speed externally-modulated lasers (EMLs) to multiple customers in Q2 F2025. The Company aims to increase its EML capacity by 40% YoY from June 2024 to June 2025, followed by another 40% increase by the end of 2025 as its Thailand production accelerates.   

In Q2, the Company invested $65 million in capex to expand cleanroom capacity and increase equipment capacity for InP wafer production to support EML chip manufacturing at its Thailand site. Lumentum has also been invested in expanding its indium phosphide (InP) wafer fabrication facilities, which are critical for producing high-speed lasers like the EMLs used in transceivers.  

CEO Lowe reiterated this in the Q2 F2025 conference call: 

“We're still on track to what we've been saying, which was 40% or higher growth from the June quarter of calendar '24 to the June quarter of calendar '25 and then another 40% by the end of calendar '25. So, that's for all 100 gig and 200 gig. I think we were in our prepared remarks, we talked about being overall supply constrained, not 200 gig because we can start a 200 gig wafer or a 100 gig wafer just the same. So, we're just overall the demand is outstripping even that 40% compounded twice in an 18-month period of time… Our wafer fab expansion plans to enable higher volumes of EMLs and other indium phosphide lasers and photodetectors continues to be on track. We still anticipate that demand for our EML chips will continue to exceed supply, at least into calendar year 2026. We are experiencing strengthening demand for our DCI products as well as long haul transmission and transport solutions.” 

A Note on China Exposure 

Interestingly, Lumentum does not have as much exposure to China whereas most supply chain troubles right now are due to sourcing in this problematic geo-political zone  

This was stated on the last call: 

“We have some production that happens in China and then those components are integrated into bigger components, bigger products at our Thailand facility. And then most of the shipments happen from Thailand, even if they are to the US or to Mexico as well. And then much of the growth that we're seeing is shipments that are coming from Japan as well as from Caswell for the transmission products that we have. So because of that, at least in the short to mid-term, unless policy changes, happen at a government level, we're not expecting much of an impact.” 

This was also stated in the introduction: 

“Second, we are scaling capacity for our highly differentiated laser transmitter chips in our indium phosphide wafer fabs and optical circuit switch and transceiver production capacity in our proven factories outside of China to meet the rising demand.” 

Quite a lot has changed in terms of policy at the government level since the last earnings call. The overall commentary regarding China reliance being minimal on the supply chain side may be true — but tariffs could upend enough of the supply chain to affect Lumentum’s customers (and overall demand). 

Also, despite not relying on manufacturing in China, Lumentum reported Hong Kong as a major customer in the 10-Q at 19% of revenue for LITE, second to United States. Geo-political tensions should cause China/HK to source domestically either voluntarily or through blacklists.  

Source: Lumentum’s 10-QLumentum’s 10-Q 

Telecom Problematic End Market yet DCIs are a Bright Spot 

There has been a steep inventory correction in telecom that has led to substantial revenue decline and significant margin erosion, presenting a major fundamental headwind for data center growth to overcome. However, data center interconnects (DCIs) are helping to drive the turnaround in this otherwise problematic end market.  

Lumentum offers tunable laser and coherent pluggable transceivers for data center interconnects (DCIs). These long-distance data transmissions are traditionally used for telecom purposes and can range up to hundreds of kilometers yet are now seeing demand for data center buildouts.  

In April 2025, Lumentum announced the sampling of new 400/800G ZR+ L-band pluggable transceivers and the general availability of its 800G ZR+ C-band module. The L-band modules effectively double the usable wavelength range and available fiber capacity. By expanding into both C-band and L-band spectrums, Lumentum’s transceivers enable increased fiber capacity, and are able to serve AI and cloud-based applications. These pluggable modules reduce overall system complexity and cost.   

Regarding DCIs, per the previous earnings call: “we're seeing dramatic strength in anything ZR, anything to connect data centers as data centers are being built out, and that can take the form of ZR modules. But given our share of tunable lasers that go into ZRs, that's where we're going to see a dramatic pickup in the telecom side.” 

The most recent update from management is that demand remains very, very strong: “And so the data center interconnect and the networks that are interconnecting these data centers is showing very, very strong demand. And so DCIs and the components as well as ROADMs amplifiers and longer haul coherent transmission connecting further apart data centers is very strong.” 

Revenue Growth Poised to Accelerate  

Q2 FY25 revenue grew by 9.65% YoY and 19.37% QoQ to $402.2 million, driven by strength in its Cloud and Networking segment, beating estimates by 2.87%. 

• Management guided Q3 revenue between $410 million to $425 million, with a midpoint of $417.5 million for 13.9% growth. 
• Analysts expect revenue to grow 46.6% in the June quarter to $452 million and 43% YoY in the September quarter to $481.9 million in Q1 F2026. 
• Management also reaffirmed its commitment to reaching quarterly revenue of $500 million by the end of calendar year 2025, driven by improving trends with its networking equipment manufacturing customers. 

Segments: 

Cloud and Networking Drives Revenue and Margins

In the most recent quarter, Cloud and Networking grew 18.3% YoY and 20.2% QoQ to $339.2 million with management stating they saw “sequential increases in nearly all of our Cloud and Networking product lines.” Cloud and Networking segment profit grew 16.2% for an increase of 330 basis points sequentially and an increase of 610 basis points year-on-year on higher revenue. This segment includes optical transceivers, the datacom chips/lasers that go into optical modules (EMLs, VSCELs, CW lasers, etc) and telecom/data center interconnects. 

Previously, in the September quarter, the segment saw a meaningful inflection with growth of 23% YoY and 11% QoQ. Next quarter, management stated they expect the segment to increase by $25 million QoQ, which would represent growth of 7.3% QoQ – not quite as high as the previous quarter yet it’s been clearly noted in our previous analysis that H2 would be the bigger ramp. Our analysis on delayed Nvidia suppliers also connects some dots on this particular timing for Lumentum. 

According to management commentary, the company shipped record EML units with datacom transceivers shipping to their largest hyperscaler customer and volume production shipments to a new customer.  

The company stated they expect to increase their market share: 

 “Based on the breadth of our 200G EML design wins, we expect to gain additional laser transmitter market share in the upcoming wave of 800G and 1.6T transceivers, utilizing the more efficient 200G EMLs for AI applications. Complementing our EMLs are our new 200G lens integrated photodetector arrays, which adds to our content opportunity in next generation 800G and 1.6T transceivers as well as strengthens our vertical integration strategy for our own cloud modules.” 

Industrial Tech Continues to Contract 

Q2 F2024 Industrial Tech revenue fell (21.4%) YoY and grew 15.4% QoQ to $63 million. The sequential increase was driven by higher industrial laser shipments, partially offset by lower 3D sensing shipments. 

Next quarter, management expects revenues to decline sequentially by $10 million, driven by declines in both commercial lasers and 3D sensing. 

Adj. Margins Bottomed Out and Accelerating  

GAAP Gross margin was 24.7% with adjusted gross margin at 32.3%. Per management, company gross margins will “sequentially increase as manufacturing utilization improves as well as an increase in Datacom laser shipments.” 

• GAAP operating margin was (12.8%) for operating losses of ($51.6) million. 
• Adjusted operating margins rose to 7.9% compared to 3% last quarter. It’s expected to further expand to 10% at the midpoint this quarter. 
• GAAP net margin was (15.1%) for net losses of $61 million 
• GAAP adjusted net margin was 7.46% for adjusted profits of $30 million 

Adj. EPS Returns to Growth and Accelerates Quickly 

Q2 FY25 adj. EPS improved to $0.42, beating consensus estimates by 16.97%. Management guided Q3 F2025 adj. EPS between $0.47 to $0.53, with a midpoint of $0.53. There is outsized growth in EPS from the rebound on small numbers: 

• Analysts expect Q4 adj. EPS to grow 957.38% to $0.63  
• Q1 is expected to see 332.24% to $0.78 

The difference between GAAP and non-GAAP operating margin is due to the stock-based compensation expenses and amortization of acquired intangibles.  

Elevated Capex Spend in Thailand Manufacturing Site Pressuring Free Cash Flow 

Q2 FY25 operating cash flow was $24.3 million or 6.1% of revenue. The Company spent $74 million capex in Q1 FY25 and $64 million in Q2, resulting in sequential negative free cash flow.  

Free cash flow in Q2 was ($15.9 million) or -4% of revenue.   The Company closed the quarter with $896.7 million in cash and cash equivalents and $2.47 billion in debt. This puts the debt-to-equity ratio at 2.75 due to high capex spending — which is high and not ideal in this environment. However, if Lumentum can prove the capex will quickly be converted to revenue, it may become a non-issue by this time next year.  

Lumentum spent $64 million in capex for expanding cleanroom capacity at the Thailand manufacturing site and increasing equipment capacity for indium phosphate wafer production to support EML chip manufacturing. 

Valuation  

Lumentum trades at a forward price-earnings (P/E) of 31.3 and a current PE ratio of 143 (although this looks drastic given the weak bottom line the company is rebounding from). 

The price/sales (P/S) ratio is 2.6 and forward P/S is 2.3. The five-year average P/S ratio is 3.2 

These valuations do not reflect an AI story should Lumentum catch the AI bid (in a bull market) the valuation could be 5-6. This may not be in the near-term given tariff related concerns, weak semiconductor sector performance and Nasdaq entering a bear market officially following the (20%) decline. However, looking into the second half of the year, should conditions improve, Lumentum is capable of trading higher. 

Q&A from Earnings Call 

Yield/Supply Issues are Limiting Growth 

According to the earnings call, the Cloud and Networking segment is expected to increase by $25 million yet the company has “demand that far surpasses that.” Management went on to explain: “we could have probably seen a double-digit increase sequentially quarter-over-quarter had we not had some of those supply chain shortages.” 

It was later more specifically called out as yield issues on the transceiver side, with this comment being in context of the lower margin: “So, yes, so during the quarter, we had some yield issues related to new product ramps within our Transceiver business. That probably was a headwind of anywhere from 100 to 150 basis points.” 

This isn’t exactly surprising given the clear commentary around capex and the need to increase capacity. It was also later stated the supply issues should ease by the June quarter:  

“To your second question, we're gating our module customers’ ability to grow their Transceiver business by the lack of worldwide indium phosphide for EMLs and CW lasers, quite frankly, we're having challenges actually getting enough CW lasers for our own transceivers. So that is actually impacting us on the short-term this quarter, hope to have that resolved in the June quarter. “ 

With even further questioning, it was revealed that hermetic packaging is also creating supply shortages, which refers to sealed enclosures that protect optical components. 

“But the worldwide shortage of things like hermetic packages is creating a challenge for the kinds of volumes that our customers are looking for especially in coherent components and narrow line with lasers. And so, if we have those packages and we could get them more readily, we could grow, as Wajid said, double-digits quarter-on-quarter. It is going to hamper us in both the March quarter as well as the June quarter, and we're working diligently to minimize that impact in the June quarter, but the March quarter is what it is because we need those deliveries now in order to turn products for the quarter and we have a limited supply and ability to get that for example.” 

Hyperscaler Customers 

In the most recent quarter, the 10-Q states that three customers accounted for 16%, 14% and 11% of total revenue with two customers accounting for gross accounts receivable.  

• In the prior quarter, two customers accounted for 15% and 12% of revenue, respectively.  
• When comparing to the quarter a year ago, there were three customers at 19%, 13% and 11% of total revenue.  

Management provided the following color in regard to how the ramp is going with the three customers: 

“In Q2, Datacom transceiver revenue grew sequentially as expected, driven by an increase in shipments to our largest cloud hyperscale customer and the start of volume production shipments to one of our new customers we highlighted on prior calls. 

We continue qualification work with the other new customers and expect to start initial volume production during the fourth quarter continuing to ramp through the first half of fiscal '26. Transceiver manufacturing capacity expansion is also progressing as planned.” 

During the call, there was a Q&A exchange that drilled deeper into a potential fourth customer: 

“Ananda Baruah:  

 “On the new ramping customer, can you give us some sense of time frame when you think that it hits run rate and or any context around what run rate I know this is probably kind of somewhat project based, but when you think it hits run rate, what time frame? And then the second one is sounds like this year, calendar year '25, you're not going to run into sort of congestion between your EML chips and your own transceivers since they're largely SiPho (silicon photonics) based right now.”  

Lowe:  

 “As far as the new customer reaching run rate, I'd say that's going to take some time. So don't be raising your projections for that customer. But as I said earlier, we're qualifying a second product there that should come on by the end of the calendar year. So, I'd say around the end of the calendar year, we should be in full motion with that customer. And then as we talked about in the script, the third customer start production in fiscal Q4 and really hit run rate, I'd say, by the fall time. So, September, October. That product is scheduled to ramp significantly faster. So that's the ramp color.”  

Conclusion: 

Lumentum is a small-cap company with differentiated technology that has caught the attention of heavyweight NVIDIA. We’ve been closely monitoring Lumentum for roughly a year, waiting patiently for their EML lasers for 200G to ship, enabling 800G and 1.6T bandwidths. Any progress here should continue into 2026-2027 for 400G data lanes and 3.2T bandwidths. 

Their indium phosphide (InP) laser technology offers significant power efficiency advantages over traditional silicon photonics. This is increasingly important as power consumption becomes a central concern in scaling AI data centers. Lumentum’s collaboration with NVIDIA, integrating their high-efficiency lasers into NVIDIA’s Spectrum-X and Quantum-X photonics networking switches, is a nod towards the EML lasers and their ultra high power lasers for CPOs playing a critical role in future architectures. 

With that said, Lumentum is in the high risk bucket due to being a small cap. The stock requires speculation as to when a shift in fundamentals will occur. To date, we have seen an inflection for one quarter, yet we need more evidence before an inflection becomes a meaningful trend. The sharp acceleration provided for in analyst consensus in H2 could wane if supply chain troubles trickle down and result in slower sourcing for AI systems.  

Ultimately, it’s well worth our time to earmark companies like Lumentum and identify potential entry targets.  

The I/O Fund recently launched our new Discovery tier which surfaces new ideas the I/O Fund does not own yet at a pace of 30-40 new stocks per year. Coverage will include AI hardware, AI software, crypto and more, from a leading tech portfolio. new Discovery tier which surfaces new ideas the I/O Fund does not own yet at a pace of 30-40 new stocks per year. Coverage will include AI hardware, AI software, crypto and more, from a leading tech portfolio.  

Sample research we published in March and April:   

• Key supplier to TSMC’s new high-growth platform called Compact Universal Photonic Engine (COUPE)  
• Nuclear and natural gas supplier for AI data centers   
• A breakdown of the risks and opportunities for the biggest IPO in the AI sector

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

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• Core Scientific: Hypergrowth with 21X AI Segment Growth Potential
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We recently covered Big Tech’s massive capex plans for 2024, with Microsoft, Meta, Amazon and Alphabet likely spending close to or upwards of $200 billion this year, and signaling a high likelihood of increasing capex in 2025. These spending plans are primarily for AI infrastructure, and while a majority of this spend is likely flowing to GPU leader Nvidia and then downstream to AI servers from Super Micro and Dell, the data center networking component shouldn’t be overlooked.

Arista Networks is a major supplier to Meta, and provided upbeat guidance this quarter. Lumentum, an optical and photonics components manufacturer did, as well, signaling an important opportunity for revenue growth from the data center. Management said they are “making excellent progress on the huge opportunities the long-term demand for data center photonics creates for us, driven by the exponentially increasing compute requirements of artificial intelligence, machine learning, and advanced data centers.”

Lumentum is in the high-risk bucket due to being a small cap, and because it requires speculation as to when a shift in fundamentals will occur. The stock will be reserved for the Advanced tier’s momentum portfolio for now, until we see more fundamental strength. This means technical analysis plays a primary role. We will close the position quickly (as soon as one day) if the setup fails. Or, we will hold for many months and increase its allocation if we see the stock shift to meet more of our criteria.

Background on Optical Interconnects

Optical interconnects help data centers accelerate data throughput between data centers, inside the data center between servers or racks, while reducing latency and power consumption. AI is driving cloud demand higher from the hyperscalers, leading to more data being created and processed, thus helping drive a need for these interconnects to meet demand for high-speed, low power data transmission in data centers.

It’s no secret that Big Tech is investing tens of billions in expanding and building physical data center infrastructure over the next five to ten years – just in May, AWS, Google and Microsoft announced tens of billions in investments to expand data center infrastructure globally, which we covered here. These continuous investments in physical infrastructure will not only require GPUs, but also other networking and optical components.

Lumentum’s management has been bullish on the data center optical component market for some time, saying in August 2023 that the “data center optical component market is projected to grow sharply over the next 4 to 5 years to accommodate the increased traffic associated with AI as customers employ ever higher bandwidth interconnects between racks within racks in between servers and storage. We also believe that Datacom VCSEL growth will be meaningful in the next several years as copper is replaced by short-reach multimode optical links.”

As a result, management is eyeing a rather quick ascent to $500 million in quarterly revenue by the end of next year, up 60% from Q4’s projected $302.5 million, while also expecting its cloud business to transform into a multi-billion dollar opportunity in the longer term.

Financials Suffering from Sharp Inventory Correction

Though Lumentum’s management expressed optimism on the longer-term potential of AI-driven data center revenue growth in its recent fiscal Q3 earnings call, the steep inventory correction in telecom has led to a substantial revenue decline and significant margin erosion, presenting a major fundamental headwind for data center growth to overcome.

Management noted in August 2023 that they were “facing significant headwinds as both our direct and end customers actively work to reduce their elevated inventory levels,” and estimated the correction to last through 2023 with shipments “well below end-market demand.” Lumentum reiterated in November 2023 that they were continuing to ship below end market demand.

This created a sharp revenue decline in barely a year and a half — from peak to trough (in six quarters from Q2 FY23 to Q4 FY24’s estimates), TTM revenue has fallen more than (26%).

Telecom Headwinds are Late to Clear

TTM (trailing twelve months) revenues peaked in fiscal Q2 2023 at $1.83 billion, and are now projected to sit at $1.35 billion based on Q4’s guidance. This telecom softness has continued to weigh on results with the inventory correction lasting longer than expected. Lumentum said in its Q3 earnings call in early May 2024 that “revenue will continue to be burdened by telecom customer inventory challenges. The pace of telco carrier spending has slowed more than previously anticipated. Because we continue to ship below end market demand, customer inventory of our products is decreasing, indicating that we are getting closer to the end of this lower demand phase in our industry.”

Once the inventory correction clears, revenue headwinds should subside, though there are lingering doubts about when exactly these issues will clear up, given that we’re now two quarters later than previously anticipated.

Fiscal Q3 Earnings Overview:

Turning to fiscal Q3, Lumentum reported revenue of $366.5 million, down (4.4%) YoY and flat QoQ. Management guided for $290 million to $315 million in fiscal Q4, representing a YoY decline of (18.4%) at the midpoint, far below the $331 million consensus estimate and suggesting its revenue recovery may not be out of the woods until after fiscal Q1 2025 (Sept 2024 quarter).

Margins have rapidly eroded, weighing on Lumentum’s bottom line. TTM gross margin was 20.4%, down from 36.4% a year ago and down from a peak of 46.0% in June 2022. Fiscal Q3’s gross margin of 16.2% suggests the decline in margins is not over yet.

Operating margin has fallen to (22.3%), down from 1.1% a year ago and 17.7% in the June 2022 quarter. Fiscal Q3’s operating margin was (31.3%), and Q4’s guided range points to operating margins declining again.

This is a pretty significant erosion in Lumentum’s operating margin that can’t be fixed solely via cost cuts; in order to drive operating margin to positive, revenue growth will need to rebound alongside improvements in gross margin, most likely back to 30% and higher.

Because of the revenue slump and margin weakness, Lumentum has burned through a substantial bit of cash, reporting $871 million in cash and equivalents in fiscal Q3, down from $1.67B a year ago and $1.22 billion last quarter. The QoQ decrease was primarily due to $323 million in debt repayment in Q3, as operating cash flow was only thinly negative, at ($7 million).

However, total long-term debt is $2.52 billion, raising the likelihood of a capital raise down the line to smooth out any issues with a shrinking cash balance while working to expand production capacity.

Management Quite Optimistic About Data Center Revenue Growth

Lumentum is quite optimistic about the data center opportunities that are arising from Big Tech spending tens of billions on data center infrastructure.

Nvidia’s earnings shed clarity on why Big Tech is investing in the data center at break-neck speeds: CEO Jensen Huang said that “Everybody is anxious to get their infrastructure online. And the reason for that is because they're saving money and making money, and they would like to do that as soon as possible.”

He further explained that Big Tech and other AI firms “need to make money today. They want to save money today. And time is really, really valuable to them. Let me give you an example of time being really valuable, why this idea of standing up a data center instantaneously is so valuable and getting this thing called time to train is so valuable. The reason for that is because the next company who reaches the next major plateau gets to announce a groundbreaking AI. And the second one after that gets to announce something that's 0.3% better. And so the question is, do you want to be repeatedly the company delivering groundbreaking AI or the company delivering 0.3% better? And that's the reason why this race, as in all technology races, the race is so important.”

Lumentum believes that this AI-fueled boom in physical data centers will help drive the next leg higher for its cloud segment. Management said in February 2024 that they expected “revenue from data center transceivers to temporarily dip in the June and September quarters, and then grow significantly through the end of the year and into calendar year '25,” as they work to build out leading-edge transceiver manufacturing capacity in Thailand.

This ties in to a more optimistic view on 2025, with management eyeing exiting the year at a $2B+ annualized revenue run rate, up from $1.35 billion based on Q4’s guidance. Here’s what management said:

“To summarize, the combination of explosive growth in cloud data center and AI-driven demand, our customer traction and capacity additions for new data center products and strong early demand for our new telecom products makes me confident and bullish about calendar 2025. We expect significant growth next calendar year as our investments in new data center products and manufacturing capacity this year translates into significant new revenues. This, combined with the telecom industry inventory correction abating, makes the outlook for calendar 2025 and beyond very promising. We have multiple cloud customer engagements which will drive meaningful revenue growth and drive total company quarterly revenue to exceed $500 million exiting calendar 2025. Additionally, we expect that significant growth will continue into 2026 and 2027. We are working on several significant opportunities today that we expect will propel our cloud business into a multi-billion dollar annual run rate business in the coming years.” We expect significant growth next calendar year as our investments in new data center products and manufacturing capacity this year translates into significant new revenues. This, combined with the telecom industry inventory correction abating, makes the outlook for calendar 2025 and beyond very promising. We have multiple cloud customer engagements which will drive meaningful revenue growth and drive total company quarterly revenue to exceed $500 million exiting calendar 2025. Additionally, we expect that significant growth will continue into 2026 and 2027. We are working on several significant opportunities today that we expect will propel our cloud business into a multi-billion dollar annual run rate business in the coming years.”

CEO Alan Lowe doubled down on this, saying “we would certainly be disappointed if we don't more than double our datacom business by then from today's or from the Q3 run rate.”we would certainly be disappointed if we don't more than double our datacom business by then from today's or from the Q3 run rate.”

Given the billions committed to data center infrastructure from Big Tech over the course of the next 3 to 5 years, there certainly is room for Lumentum to capture such growth, stemming from an increasing need to transmit data in and in between data centers. However, one risk arises here, in that Lumentum is walking a tightrope in working to simultaneously expand production capacity and meet demand without missing the mark.

Management said that “a lot of this incremental capacity is really new customers and diversified customers, both in the cloud space as well as the AI infrastructure space. And so, the challenge is it's a chicken and egg thing in that if you don't have the floor space and capacity, you're not going to get the orders. And … if you have the orders and you don't have the floor space, you're not going to be able to perform. So, we're working hand in hand with our customers to make sure that we're pulling the trigger at the right time to not have too much capacity, but at the same time to build confidence that we're making the investments on behalf of them and the growth that they see in calendar 2025 and beyond.”And so, the challenge is it's a chicken and egg thing in that if you don't have the floor space and capacity, you're not going to get the orders. And … if you have the orders and you don't have the floor space, you're not going to be able to perform. So, we're working hand in hand with our customers to make sure that we're pulling the trigger at the right time to not have too much capacity, but at the same time to build confidence that we're making the investments on behalf of them and the growth that they see in calendar 2025 and beyond.”

This is critical to note, not only because it is new customers and new capacity coming online, but also because it can be quite difficult to perfectly align supply and demand in a fast-moving market.

A Look at Cloud & Networking Revenue

Lumentum’s Cloud and Networking revenue was $313.8 million in Q3, up 9.5% QoQ and 7.1% YoY, with management saying the growth was driven by data center demand and its Cloud Light acquisition two quarters ago.

Cloud and networking revenue has grown sequentially since fiscal Q1, but management’s guidance calls for a sequential decline, including ~$40 million reduction from softer telecom demand, to ~$247.5 million in fiscal Q4. In order to reach management’s goal of exiting calendar 2025 with $500 million plus in quarterly revenue, Cloud and Networking revenue would likely need to grow upwards of 70% to $425 million or above.

Despite Optimism, Analysts Not Convinced of Growth

Despite management’s expressed optimism and explicit statements about reaching $500 million plus in quarterly revenue by the end of 2025, analysts aren’t convinced of this growth.

Current consensus estimates call for revenue of $489 million in the Dec 2025 quarter, just over 2% below management’s target, with the lowest estimate below $475 million, more than 5% below management’s target. Revenue growth also is not expected to return to double-digits until the June 2025 quarter, with estimates pointing to a nearly 40 percentage point acceleration from 6.8% to 45.6% growth.

In addition, revenue revisions are downward, signaling eroding confidence in the turnaround story.  FY25’s revenue estimate of $1.51 billion has been revised (9.1%) lower over the past 3 months, while adjusted EPS of $1.67 has been revised (29.7%) lower, suggesting margin headwinds are expected to remain. The upcoming September and December quarters (fiscal Q1 and Q2 2025) have both seen revenue revised more than (13%) lower.

The doubts here about reaching and surpassing these revenue targets likely arises from a combination of factors – persisting softness in telecom weakness for multiple quarters more than anticipated, the tightrope walk for bringing capacity online to book new orders, and in general the six quarter-plus time frame between now and then. These types of revenue accelerations brought about by AI are what the Street has been rewarding recently, especially in hardware and data center players, hence why we’re tracking Lumentum and adding it to our momentum watchlist.

Valuation

Because of the top-line growth headwinds at the moment, Lumentum is trading at a discounted top-line valuation relative to its historical average since its IPO. Shares have traded at an average 2.9x PS multiple, as low as 1x around IPO and more recently 1.5x in October 2023, and as high as 5x in early 2021. Shares are currently trading at approximately 2.2x PS, and 2.3x forward PS due to the revenue declines we’re seeing.

Lumentum’s bottom line valuation is much more stretched, trading at 46.6x adjusted EPS for fiscal 2024, with adjusted EPS projected to decline (77%) this fiscal year due to the margin erosion we previously discussed. However, analysts forecast EPS to rebound quite rapidly in the back half of fiscal 2025 and continue this growth in 2026, with shares trading at an estimated 12.1x adjusted EPS for 2026.

Margins will be the first tell-tale sign of the pace and timing of this EPS rebound and growth, but the current pace of acceleration is attractive should Lumentum be able to hit or exceed analyst estimates.

As you can see, mid-2025 is currently the estimated time for Lumentum to see its rebound. This may seem far off, yet we are building our pipeline now for 2025 potentials and this is one we will continue to watch for when fundamentals and technicals align.

Competitors

Lumentum has a strong competitor in Marvell, with analysts seeing Marvell in “pole position” in the optical space with Inphi. Marvell reported over $1 billion in data center optics revenue in fiscal 2024, and projects electro-optics revenue to surpass $1 billion this year.

Marvell reported $816 million in data center revenue in Q1, up 87% YoY, driven by cloud AI, cloud infrastructure, and electro-optics. Management projected this “robust growth to continue from AI with the expected ramp in our cloud, custom AI programs to augment our substantial base of electro-optics revenue, which we expect will remain correlated to accelerator shipments.”

Electro-optics is expected to be a $1B+ business for Marvell this year, explaining that “from a full year perspective, the way to think about it, maybe some additional color would be, we talked about a floor of $1.5 billion for AI revenue for Marvell for this fiscal year with about 2/3 in electro-optics and a third in custom.” For more context, Marvell’s exit rate in Q4 was “well north of $200 million. And the bulk of that, as we said, was in optics.” Management also provided some clues that electro-optics growth will mirror the pace of AI accelerator growth, from 50% to 100% YoY. This growth is likely outpacing Lumentum’s growth, where management sees 60% growth form $300 million to $500 million over six quarters.

Conclusion

Lumentum has caught our attention as a potential beneficiary of AI capex spending from Big Tech, and while the majority of Big Tech’s budgets will be allocated to GPUs from Nvidia, physical data center infrastructure buildouts will require both AI servers and racks, and networking and optical components.

Lumentum’s management is eyeing data center demand to help drive a push to $500 million plus in quarterly revenues, or nearly new record levels, by the end of calendar 2025, though analysts aren’t fully convinced of the story, with estimates below management’s explicitly stated targets. The telecom inventory correction continues to weigh on revenues while margins have eroded substantially, providing two near-term headwinds to top line and bottom line growth, though forecasts point to strong accelerations in early calendar 2025.

We continue to watch Marvell for similar reasons, which is that telecom headwinds may subside while electro-optics and AI data center growth powers forward in the medium-term. Marvell is a stock we’ve owned in the past with coverage dating back to 2019, covered the Inphi acquisition, and various other reports found here. There is also a potential CXL memory catalyst, described here.back to 2019, covered the Inphi acquisition, and various other reports found here. There is also a potential CXL memory catalyst, described here.

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• Baidu: An Emerging China-AI Momentum Play