LITE - Lumentum Holdings: An Odd Time For A Substantial Deal

2023-11-01 10:40:41 ET

Summary

• Lumentum Holdings Inc.'s acquisition attempt of Coherent sparked a bidding war in 2021, but they ultimately "lost" out to II-VI.
• Lumentum's organic growth has been unimpressive, with declining sales and earnings.
• The company made smaller acquisitions, including NeoPhotonics and Cloud Light, but its performance remains uncertain.

In January 2021, I offered some thoughts on Lumentum Holdings Inc. (LITE) after it announced a $5.7 billion deal for Coherent. I saw the long-term potential of the strategic deal, yet believed that a significant premium was offered, as history tells us that the offer was the start of a bidding war for Coherent, with II-VI, now renamed Coherent Corp. ( COHR ), eventually ending up acquiring Coherent.

While Lumentum was "saved" from making an expensive acquisition, the organic route has not been too impressive as well, with the company seeing headwinds in its end markets while making two smaller deals instead. Down 60% in nearly three years' time, the lower share price looks more appealing, but not appealing yet amidst lack of growth and very complicated and low realistic earnings here.

A Quick Recap

Early in 2021, Lumentum announced a $5.7 billion deal to acquire Coherent, as the (initial) 49% premium offered for the shares awarded the business a $1.9 billion premium. With multiple peers getting involved in the bidding race, the price for Coherent kept rising, and Lumentum dropped out of the bidding war.

Shares of Lumentum traded at $105 per share ahead of the deal announcement, granting Lumentum an $8.2 billion equity valuation with 78 million shares outstanding, or $7.7 billion if we factor in a pre-deal net cash position of around half a billion.

This valuation was based on a business which generated $1.8 billion in sales and some $700 million in EBITDA, based on the annualized first quarter numbers at the time. Adjusted earnings ran at $7 per share, while GAAP earnings came in at $3.50 per share, as adjusted for stock-based compensation expenses, earnings were trending at close to $6 per share.

A potential deal with Lumentum would add quite some leverage and as incremental interest expenses would eat the incremental profits of Coherent, albeit that this was set to be a strategic deal. Believing that a further selloff might create an opportunity, I failed to get involved with Lumentum, with shares in other players having sold off meaningfully over time.

Expectations Come Down

A $100 stock before the (failed) deal with Coherent fell to the $70 mark in the spring as investors feared the company´s involvement in the bidding war for Coherent. Shares actually rallied back to the $100 mark early in 2022, but shares fell to the $50 mark by the end of 2022 as valuations across the technology market were coming down. In fact, 2023 has been a tough year as well, with shares now down to $40 per share, after trading at lows of $35 in recent weeks.

In August 2021, Lumentum reported a 4% increase in 2021 sales to $1.73 billion. Adjusted earnings were reported at $6.31 per share, with GAAP earnings reported at $1.15 per share. In November, Lumentum announced a $918 million purchase of NeoPhotonics, having gone after other M&A targets after the deal with Coherent broke down, although that deal only closed in the summer of 2022.

In August 2022, Lumentum posted a 2% fall in 2022 sales to $1.71 billion with adjusted earnings reported at $6.05 per share, with GAAP earnings posted at $2.68 per share. While I am happy to adjust for an $85 million goodwill impairment charge, I am not willing to adjust for a $103 million in stock-based compensation expenses and $73 million in non-cash interest expenses, making realistic earnings likely come in around $3.50-$4.00 per share.

Forwarding to August of this year, Lumentum posted a 3% increase in 2023 sales to $1.77 billion, yet adjusted earnings fell from just over six dollar per share to $4.56 per share as the company actually posted a GAAP loss of $1.93 per share. No fewer than 13 adjustments were made between both earnings metrics, and while I am happy to add back amortization charges, realistic earnings were minimal if I do. Moreover, fourth quarter revenues of $371 million were weak, down 12% on the year, and trending only at about $1.4 billion per annum here.

In fact, first quarter sales for the first quarter of 2024 were only seen between $300 and $325 million, despite the contribution of the NeoPhotonics acquisition. Adjusted earnings were seen at $0.20-$0.35 per share, with realistic losses likely reported.

A New Deal

With much of the cash holdings used to buy back shares, which reduce the share count to 68 million shares, the market value of Lumentum has fallen to $2.72 billion. While the company has a net debt load of about $800 million, it is all convertible debt which carries low interest rates, the reason why the company actually reported interest income here despite a net debt position.

With a $3.5 billion enterprise valuation, the company now trades at a 2.5 times sales multiple based on the annualized guidance for the first quarter, trading at about 2 times annual sales in 2023.

Given the turmoil in the business, which carries debt, but actually has a positive carry on this, the timing for a substantial deal is a bit at odds, certainly as the business is seeing poor operating momentum.

On the final day of October, Lumentum announced a $750 million deal to acquire Cloud Light, a developer and manufacturer of optical modules used in cloud computing data center infrastructure. The deal is set to add about $200 million in sales, revealing that a near 4 times sales multiple was paid, but the deal should be accretive to non-GAAP earnings and improve its positioning.

The deal will double pro forma net debt to about $1.5 billion, although the positive carry on debt makes leverage perhaps more of a concern than one might think at first sight.

What Now?

Shares of Lumentum actually rose from $36 to $40 upon the deal announcement, adding about a quarter of a billion to the value of the firm. It is a bit too shortsighted to attribute this entirely to the deal, as the company provided an update to the first quarter results as well. Revenues of $317 million were seen just over the midpoint of the preliminary earnings guidance, as the same applies for earnings, alleviating most of the inventory concerns and potential reviving up the hopes for sequential revenue improvements.

The reality is that while it has been a lifesaver that Lumentum did not end up winning the bidding war for Coherent, its own performance has been utterly soft, with the company resorting to two other deals and reporting highly adjusted earnings metrics posted in the meantime.

Given all this, I am very cautious here on Lumentum Holdings Inc. stock given the perceived (lack of) quality of the business, as the earnings are simply too adjusted to give real comfort, despite a historical lower point in the share price and strategic deal.

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