AI Data Center Overcapacity Will Pressure Margins And Undermine Long Term Profitability

Catalysts

About Coherent

Coherent supplies photonic components, modules and materials that enable high speed optical connectivity and advanced industrial applications.

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

• The rapid build out of AI data centers and high speed cloud networks risks creating a classic over investment cycle. In this scenario, Coherent’s newly doubled indium phosphide and module capacity could collide with slower hyperscaler capex in a few years, pressuring revenue growth and utilization driven gross margins.
• Customer road maps that now extend through 2028 may encourage aggressive commitments around 800 gig and 1.6T transceivers. However, any architectural shift toward lower cost or alternative interconnect technologies could leave Coherent with stranded capacity and weaker pricing power, compressing earnings.
• The push toward larger wafer sizes and vertically integrated laser production improves unit costs today. At the same time, it concentrates manufacturing and technology risk in a few fabs, so a yield setback, qualification delay or geopolitical disruption at these sites could quickly reverse recent margin gains and dent profitability.
• Expanding production footprints in Malaysia, Vietnam, Texas and Sweden to serve AI networking and telecom demand introduces higher fixed overhead. As a result, even a modest slowdown in orders across data center and communications would magnify operating deleverage and weigh on operating margins.
• OCS platforms and advanced thermal management materials are being scaled for a much larger market. If adoption in AI data centers and DCI networks falls short of internal expectations, Coherent could face low return on these growth investments and slower improvement in both revenue mix and net margins.

Assumptions

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

• The bearish analysts are assuming Coherent's revenue will grow by 11.6% annually over the next 3 years.
• The bearish analysts are not forecasting that Coherent will become profitable in next 3 years. To represent the Analyst Price Target as a Future PE Valuation we will estimate Coherent's profit margin will increase from 2.0% to the average US Electronic industry of 8.8% in 3 years.
• If Coherent's profit margin were to converge on the industry average, you could expect earnings to reach $735.0 million (and earnings per share of $4.48) by about December 2028, up from $118.3 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $1.4 billion in earnings, and the most bearish expecting $-251.6 million.
• 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 32.7x on those 2028 earnings, down from 263.8x today. This future PE is greater than the current PE for the US Electronic industry at 25.4x.
• The bearish 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 8.73%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Exceptionally strong and broad based demand for AI data center optics, ZR and ZR plus DCI products and traditional telecom has produced record bookings and multi year customer forecasts that now extend out to 2028. This could sustain double digit revenue growth much longer than expected and support a higher share price through stronger earnings visibility and operating leverage.
• The rapid ramp of 6 inch indium phosphide capacity across two sites with yields already exceeding mature 3 inch lines, together with laser and module cost reductions of more than half per chip, provides a structural gross margin tailwind. This could push margins toward or above the 42% target, lifting net margins and earnings rather than compressing them.
• Portfolio optimization, including the sale of lower margin Aerospace and Defense and the Munich products division, alongside exiting 23 sites and focusing investment on Datacenter and Communications, may continue to enhance mix and asset efficiency. This could drive higher corporate gross margin, operating margin and return on invested capital, which would be supportive for earnings and valuation multiples.
• New growth vectors such as 1.6T pluggable transceivers, co packaged optics, optical circuit switch platforms with a potential multi billion dollar addressable market and advanced thermal management materials for AI data centers could create incremental, high margin revenue streams. These may accelerate long term revenue and EPS growth beyond conservative expectations.
• Disciplined capital allocation with over four hundred million dollars of debt repaid, leverage reduced to 1.7 times, refinancing at lower interest rates and planned further deleveraging from additional divestiture proceeds strengthens the balance sheet and reduces interest expense. This can support higher net income, more resilient earnings and a premium valuation multiple over time.

Valuation

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

• The assumed bearish price target for Coherent is $114.02, which represents up to two standard deviations below the consensus price target of $174.53. 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 more bearish 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 bearish analyst cohort, you'd need to believe that by 2028, revenues will be $8.4 billion, earnings will come to $735.0 million, 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 $198.5, the analyst price target of $114.02 is 74.1% 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.