AI Data Center Optics And Indium Phosphide Capacity Will Drive Powerful Long Term Upside

Catalysts

About Coherent

Coherent develops and manufactures advanced photonic components, modules and materials that power high speed data, communications and industrial systems.

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

• AI data center build outs are driving an exceptional, multi year upgrade cycle in high speed optics, where Coherent's leadership in 800 gig and 1.6T transceivers and record long dated bookings provide visibility to accelerating revenue and earnings growth.
• The transition to higher speed architectures using indium phosphide based lasers and photodiodes, together with Coherent's first in the world 6 inch indium phosphide lines in Texas and Sweden, is expected to structurally lower unit costs and lift gross and operating margins as capacity doubles and scales further over time.
• Rapid adoption of new optical architectures such as linear pluggables, co packaged optics and advanced integrated VCSEL solutions positions Coherent to expand its content per AI server and per rack, supporting sustained double digit revenue growth and expanding gross profit dollars.
• Increasing optical density in both data center interconnect and traditional telecom networks, combined with Coherent's broad ZR and ZR+ portfolio and high value components, is set to grow mix rich communications revenue and improve overall corporate gross margin and EPS leverage.
• Emerging platforms like optical circuit switching and advanced thermal management materials for large scale AI infrastructure create new, high margin revenue streams that build on existing customer relationships and manufacturing know how, enhancing long term earnings power and return on invested capital.

Assumptions

This narrative explores a more optimistic perspective on Coherent compared to the consensus, based on a Fair Value that aligns with the bullish cohort of analysts. How have these above catalysts been quantified?

• The bullish analysts are assuming Coherent's revenue will grow by 15.9% annually over the next 3 years.
• The bullish analysts assume that profit margins will increase from 2.0% today to 15.1% in 3 years time.
• The bullish analysts expect earnings to reach $1.4 billion (and earnings per share of $9.39) by about December 2028, up from $118.3 million today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as $-255.0 million.
• In order for the above numbers to justify the price target of the more bullish analyst cohort, the company would need to trade at a PE ratio of 32.7x on those 2028 earnings, down from 254.3x today. This future PE is greater than the current PE for the US Electronic industry at 24.9x.
• The bullish analysts expect the number of shares outstanding to grow by 1.41% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.72%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• AI data center optics is experiencing exceptionally strong, multi year demand, but if hyperscaler spending cycles slow, deployment architectures shift away from Coherent's transceiver technologies or customers over order and later digest inventory, growth in 800 gig and 1.6T units could decelerate materially and pressure revenue and earnings growth.
• The strategy depends heavily on rapidly ramping 6 inch indium phosphide and expanding module capacity across multiple global sites. Execution missteps, yield degradation from higher volume, qualification delays, geopolitical disruptions in Malaysia or Vietnam, or supplier issues could constrain shipments and erode gross margin improvement and EPS leverage.
• Coherent is concentrating R&D and capital into a few high growth vectors like pluggable transceivers, CPO, OCS and advanced thermal materials. If industry standards evolve differently, competing optical architectures win share or key customer programs are canceled, the expected double digit growth and margin uplift could fail to materialize, weighing on long term revenue and operating margin.
• The communications and industrial businesses are benefiting from cyclical recovery and pricing optimization. However, macroeconomic weakness, renewed telecom capex cuts, tariff and regulatory uncertainty or customer resistance to further price increases could reverse recent gains and limit progress toward the greater than 42% gross margin target, directly impacting corporate gross margin and net earnings.
• Portfolio optimization, site exits and divestitures are improving the balance sheet and reported profitability. Yet if core remaining businesses underperform, restructuring savings fall short or additional noncore assets prove harder to sell at attractive prices, the company may be forced to slow debt reduction or increase spending, which would constrain net income growth and EPS expansion.

Valuation

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

• The assumed bullish price target for Coherent is $220.0, which represents up to two standard deviations above the consensus price target of $178.47. This valuation is based on what can be assumed as the expectations of Coherent's future earnings growth, profit margins and other risk factors from analysts on the bullish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $220.0, and the most bearish reporting a price target of just $113.0.
  
• In order for you to agree with the more bullish analyst cohort, you'd need to believe that by 2028, revenues will be $9.4 billion, earnings will come to $1.4 billion, and it would be trading on a PE ratio of 32.7x, assuming you use a discount rate of 8.7%.
  
• Given the current share price of $191.37, the analyst price target of $220.0 is 13.0% higher.
  
• 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.