Is Lumentum’s Weak Outlook a Red Flag?

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Apple (NASDAQ: AAPL) supplier Lumentum Holdings (NASDAQ: LITE) has started 2018 with a bang. The optical components specialist's second-quarter results for fiscal 2018 blew past estimates thanks to the use of its vertical-cavity surface-emitting laser (VCSEL) 3D-sensing technology in powering the iPhone X's Face ID feature.

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What happened?

Lumentum received a big boost from Apple during the quarter that ended in December as Cupertino raced to meet booming demand for the iPhone X. In fact, according to Apple CEO Tim Cook, the most expensive iPhone in its lineup was also the best-selling model every week since launch.

Lumentum was one of the companies that helped Apple overcome the initial production bottlenecks. When rival optical components supplier Finisar (NASDAQ: FNSR) failed to satisfy Apple's need for the laser dot projector hardware needed for the iPhone X, Lumentum stepped in. Not surprisingly, the latter's revenue jumped almost 53% year over year during the recently reported quarter.

Its gross margin expanded 8% while operating margin increased a whopping 13.6%. This led to a huge jump in the company's net income, which increased to $204.5 million during the quarter as compared to $11.6 million in the prior-year period.

A closer look at the tempered guidance

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Not surprisingly, investors and Wall Street decided to overlook Lumentum's muted March quarter guidance. The company expects adjusted earnings between $0.65 and $0.80 per share for the quarter on revenue between $280 million and $305 million. Consensus estimates originally called for $323 million in revenue, but Lumentum blamed seasonality for a sequential drop in 3D-sensing chip demand.

This is a consistent pattern seen across the Apple supply chain. The likes of Skyworks Solutions and Qorvo, which rely on Apple for a sizable portion of their revenue, have also issued muted guidance numbers for the current quarter. It's not surprising, as Apple tones down iPhone manufacturing after the holiday quarter to set itself up for a new device later this year.

As it turns out, a few Apple suppliers are calling for a 10% drop in component orders during the current quarter, which is in line with seasonal trends seen last year as well. But Lumentum's business is set to grow despite the drop in iPhone X production.

The midpoint of its revenue guidance suggests 14% growth in revenue over the same period last year. Meanwhile, earnings will jump substantially from $0.49 per share last year even if Lumentum manages to hit the lower end of its adjusted earnings-per-share range.

Lumentum is looking forward to a huge ramp in demand for VCSEL chips in the second half of the year, so it is investing in additional manufacturing capacity. The company estimates that its revenue from 3D-sensing chips could double in the second half of 2018 as compared to the prior-year period, and this fanned investor excitement.

But investors need to be cautious as a recent development could dampen Lumentum's ambitions.

Should Apple's Finisar investment worry Lumentum?

Apple was initially struggling to boost iPhone X production because of a short supply of components needed to make Face ID work. This played in Lumentum's favor when it became the sole supplier of related hardware to Apple, as mentioned earlier.

But Apple decided that it won't depend on just one supplier for Face ID components, so it gave Lumentum rival Finisar a $390 million advance in December last year. Finisar will use the money from Apple to configure a 700,000-square-foot facility in Sherman, Texas, to produce VCSEL arrays.

Lumentum will lose its sole-supplier status. Still, the company remains upbeat about its 3D-sensing prospects this year, as shown above. This could be because of Apple's rumored move to deploy Face ID across more of its devices, such as the iPad, as well as in all three of its iPhones slated for this year with this feature.

Moreover, Lumentum management clearly stated in the latest earnings conference call that it needs to "start producing earlier in the June quarter to be able to meet the really massive expected ramp in the second half of the year." So, the application of Face ID could expand across more devices in Apple's ecosystem this year, offering plenty of room for both Finisar and Lumentum to coexist in Apple's supply chain.

All in all, Lumentum investors were right to ignore the company's lukewarm guidance because it will get back up to speed soon enough and win big from the proliferation of Face ID.

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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple and Skyworks Solutions. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.