Photonics Risks And Cloud Consolidation Will Erode Margins

Key Takeaways

• Heavy dependence on a few large cloud customers creates significant revenue risk if key relationships weaken or industry pricing power shifts.
  
• Rapid technological innovation and market commoditization threaten Lumentum's leadership and ability to sustain margins in core photonics products.
  
• Strong demand for advanced optical networking and disciplined execution in high-margin products position Lumentum for sustained revenue growth and expanding profitability amid accelerating AI and cloud adoption.

Catalysts

Manufactures and sells optical and photonic products in the Americas, the Asia-Pacific, Europe, the Middle East, and Africa.

• Lumentum remains heavily dependent on a narrow set of large customers in the hyperscale and cloud segment, creating a significant revenue concentration risk; should any major contract be lost or orders slow, overall revenue and earnings could face sharp declines despite current growth.
  
• The company's ability to maintain leadership in advanced photonics and laser markets is threatened by rapid innovation cycles; if Lumentum fails to keep pace with rivals in new generations of photonic integration or is outflanked by better-resourced competitors in integrated or silicon photonics, future revenue growth could stall as existing products become obsolete.
  
• Industry consolidation among cloud and telecom customers is likely to drive down average selling prices over time, especially as bargaining power shifts to a few large buyers, which will compress net margins even as Lumentum invests heavily to expand capacity.
  
• Although Lumentum is expanding manufacturing capacity in both Japan and Thailand, growing reliance on a global supply chain and potential escalation of trade barriers or environmental regulations could increase operational costs, introduce unpredictable tariffs, and pressure gross margins over the medium to long term.
  
• The ongoing commoditization of optical components, fueled by aggressive competition and emerging low-cost suppliers, will make it difficult for Lumentum to sustain pricing power, putting long-term profitability at risk as margins erode across core product lines.

Lumentum Holdings Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Lumentum Holdings compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Lumentum Holdings's revenue will grow by 18.1% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 1.6% today to 10.1% in 3 years time.
• The bearish analysts expect earnings to reach $273.1 million (and earnings per share of $3.55) by about August 2028, up from $25.9 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 34.2x on those 2028 earnings, down from 322.1x today. This future PE is greater than the current PE for the US Communications industry at 25.5x.
• Analysts expect the number of shares outstanding to grow by 1.75% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.62%, as per the Simply Wall St company report.

Lumentum Holdings Future Earnings Per Share Growth

Risks

• Rapid secular growth in AI and cloud computing is driving dramatic increases in demand for optical networking hardware, with Lumentum repeatedly highlighting multi-billion dollar addressable markets emerging over the next five years, which could significantly boost future revenues, margins, and earnings.
  
• Lumentum maintains clear technological leadership and high customer switching costs in advanced components like EMLs and high-powered lasers, allowing for pricing power and capacity-led growth; management notes supply constraints and sold-out production, suggesting potential for above-trend profit margin expansion as capacity ramps.
  
• The company has strong visibility and multi-quarter order commitments from major hyperscale cloud customers, and its ability to layer new products such as 200G and 1.6T components on top of a robust 100G base is likely to result in sustained revenue growth in the near and medium term.
  
• Segment expansion into higher-margin, differentiated products like optical circuit switches (OCS) and co-packaged optics (CPO), which are both experiencing accelerating customer adoption, is positioned to be significantly accretive to company-wide operating margins and net income in the next couple of years.
  
• Management is executing a disciplined portfolio strategy with ongoing cost reduction and manufacturing capacity investments, projecting quarterly revenue records and incremental gross margin improvement that could push profit margins toward or above 40% as scaling and operating leverage are realized.

Valuation

• The assumed bearish price target for Lumentum Holdings is $99.82, which represents two standard deviations below the consensus price target of $136.78. This valuation is based on what can be assumed as the expectations of Lumentum Holdings's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $165.0, and the most bearish reporting a price target of just $83.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $2.7 billion, earnings will come to $273.1 million, and it would be trading on a PE ratio of 34.2x, assuming you use a discount rate of 8.6%.
  
• Given the current share price of $119.34, the bearish analyst price target of $99.82 is 19.6% lower. Despite analysts expecting the underlying buisness 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.