Why Lumentum Holdings Is a Risky Bet Despite iPhone Gains

Lumentum Holdings (NASDAQ: LITE) has set the stock market on fire this year as anticipation that it might win big with Apple's latest-generation iPhones fueled its rise. The optical components specialist has been touted to supply 3D sensing chips for enabling augmented reality applications in the Cupertino company's latest device.

Now that Apple has launched its new devices and equipped the premium iPhone X with features such as Face ID and Animoji, which are made possible by 3D sensing chips, Lumentum investors should be a happy lot. After all, the company has received $200 million worth of orders for its 3D sensing chips within the last six months, mostly from a single customer.

By comparison, Lumentum had just $5 million in 3D sensing revenue during its last reported quarter, which means that it is on track to record windfall gains from Apple's latest flagship. But investors shouldn't remain fixated on this single design win, as Lumentum's iPhone success could be short-lived.

Apple might not be a long-term catalyst

Lumentum's orders for 3D sensing chips will definitely give the company a short-term boost as it accounts for a substantial 20% of the $1 billion in revenue generated in the just-concluded fiscal year. But it's questionable that the company can sustain this momentum over a longer time period for two reasons.

First, Lumentum isn't the sole supplier of 3D sensing chips to Cupertino. It competes with the likes of Finisar and German supplier AMS for this spot. What's more, Lumentum's supply constraints for 3D sensing chips mean that it won't be able to take advantage of rival Finisar's production issues, so its order growth will take a hit when the latter's production comes online later this year.

Therefore, Lumentum's upside from Apple seems limited to its production capacity. Though the company is currently busy ramping up its capabilities, investors shouldn't forget that stronger output at any of its rivals will hurt its order book.

The second problem is the pricing of the augmented reality-enabled iPhone X. With a base price of $999, it remains to be seen if this flagship device will do well outside of North America. Given that Chinese manufacturers such as Huawei are providing cutting-edge features at a much lower price, the premium iPhone's success in price-sensitive markets is far from guaranteed.

So, it won't be surprising if Lumentum's iPhone gains are limited to just a few quarters.

The core business is struggling

Lumentum hit the $1 billion revenue mark in the latest fiscal quarter, thanks to strong demand for its 100G transceivers and 3D sensing products. But cracks have started appearing in Lumentum's optical components business, as its fourth-quarter results indicate.

The company's revenue dropped almost 8% year over year during the fiscal fourth quarter. Additionally, Lumentum's gross margin declined 120 basis points as it struggled with weak demand for its telecom products in China. The company expects telecom softness to continue in the current quarter as telecom customers won't be buying any new inventory.

In fact, optical component demand in China could drop 30% to 40% this quarter as compared to its level in the beginning of the year, according to MKM Partners. Eventual inventory restocking will definitely drive volumes, but the prices of telecom products have already taken a hit because of weak demand. So, the optical component market might remain under pressure since the domino effect of weak pricing and demand could carry into 2018.

Furthermore, Lumentum is trading at a rich valuation. Its price-to-sales ratio of 3.5 is double the industry average, but a declining top line and shrinking margins don't justify this expensive multiple. Therefore, investors might want to look elsewhere despite Lumentum's potential gains from the new iPhone, because the bigger picture doesn't look rosy.

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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has a disclosure policy.