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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