Rising LED Competition And AI Cyclicality Will Pressure Long Term Earnings Potential

Catalysts

About Dialight

Dialight designs and manufactures industrial LED lighting and signal components for hazardous and mission critical environments.

What are the underlying business or industry changes driving this perspective?

• Rising competition from well capitalized industrial lighting peers that are increasingly focused on LED is likely to erode Dialight's pricing power in hazardous and MRO oriented markets. This may cap future revenue growth and constrain gross margin expansion.
• Customer delays and volatility in large capital projects linked to commodity tariffs and broader macro uncertainty may prove structural rather than temporary. This could limit the ability to deliver the targeted 3 to 5 percent top line growth and operating leverage.
• Growing dependence on high margin indicator and components demand tied to data centers and AI introduces cyclicality and concentration risk. Any slowdown in that build out could quickly pressure group revenue mix, gross margins and earnings.
• The transformation benefits from SKU rationalization, cost cutting and working capital release are already driving a large share of the current margin and cash flow improvement. This leaves less incremental self help upside to justify a premium valuation as these effects annualize.
• Ambitious long term targets for 45 percent gross margin, mid teens EBITDA margin and 25 percent plus return on assets assume sustained investment in R&D and sales capability. Any need to reinstate higher CapEx or opex to keep pace with technology and specification requirements could dilute net margins and delay earnings growth.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Dialight's revenue will grow by 2.3% annually over the next 3 years.
• Analysts assume that profit margins will increase from 4.0% today to 5.3% in 3 years time.
• Analysts expect earnings to reach $10.2 million (and earnings per share of $0.23) by about December 2028, up from $7.2 million today.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 19.4x on those 2028 earnings, down from 24.0x today. This future PE is greater than the current PE for the GB Electrical industry at 17.2x.
• Analysts expect the number of shares outstanding to grow by 0.29% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.34%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The multi year transformation plan has already shifted the group from losses to a sixfold increase in operating profit, with continued annualization of cost savings expected through at least 2027. This could underpin structurally higher earnings and net margins over the long term.
• Management is targeting a return to historical performance levels, including 45 percent gross margin, mid teens EBITDA margin and 25 percent plus return on assets. Early progress, such as a 10 percentage point gross margin improvement and a run rate 17 percent return on capital, suggests long term profitability and earnings could surprise to the upside.
• Secular growth in data centers and AI is already driving 20 percent growth in the high margin components business. A strategic shift from harvest to active investment in this segment could support sustained revenue expansion and a richer gross margin mix.
• The company maintains a strong, entrenched position in hazardous industrial LED lighting with a recognized brand, low warranty claims and a 10 year product guarantee. As capital project uncertainty eases, Dialight could capture higher value projects that lift revenue, gross margins and overall earnings.
• Ongoing working capital optimization, rapid inventory reduction and the elimination of legacy liabilities such as the Sanmina settlement and defined benefit schemes are structurally improving the balance sheet. This in turn may lower interest costs, boost free cash flow and support higher long term equity valuation.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of £2.8 for Dialight based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $192.1 million, earnings will come to $10.2 million, and it would be trading on a PE ratio of 19.4x, assuming you use a discount rate of 9.3%.
  
• Given the current share price of £3.24, the analyst price target of £2.8 is 15.7% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.