Battle Of The Apple Suppliers

The upcoming new Apple iPhones look like they could become a blockbuster.

While by no means guaranteed, any inclusion, especially a new one of the phones (or all of them) could significantly impact suppliers.

Here, we look at two potential suppliers which could significantly benefit from an inclusion of '3D sensing' in the upcoming iPhones.

We also formulate some thoughts on which one of these is the better buy.

(below is excerpt taken from linked article on comparison of FINISAR versus LUMENTUM)

We turn to our two 3D hopefuls, optic networking companies, Finisar and Lumentum.

Finisar

It's rather curious that where other suppliers, and even potential suppliers for the new iPhone, see a raft of bullish analysts rejoicing, quite the opposite has happened for Finisar. This company was downgraded on a possible delay of the iPhone (or some of them).

The Finisar product that could benefit materially from being included into the upcoming iPhones is a VCSEL, a vertical-cavity surface-emitting laser diode; this is used for 3D sensing (enabling stuff like facial recognition, gesture control and augmented reality).

Now, the funny thing is, we refer to the quote above from Drexel's analyst who argued that the reason for the delay (of the top-end version of the iPhone 8) which is supposed to have "3-D sensing" and other whiz-bang features.

Now, The Benchmark Company's Mark Miller argues that this is bad for Finisar, as the company and another one, Lumentum Holdings, have more rising on the laser diodes this year. The delay will benefit yet another potential supplier II-IV as it gives the company time to ramp up.

This is more than a little curious; in fact, we think it's mostly nonsense:

• The delay isn't material as it's a rumor and it's a matter of weeks
• Production isn't delayed, that's still ramping up this year
• The cause of the delay is supposedly the inclusion of the laser diodes, that should be a positive
• As witnessed above, there are some that argue the numbers will be much bigger compared to the previous iPhones

When Finisar first mentioned it was moving into the laser diode market, analysts reacted favorably, with several upgrades. During its Q3CC, management argued the following:

Finally, during the third quarter, we shipped many thousands of our high-powered VCSEL arrays for 3D sensing. We are continuing to add manufacturing capacity in anticipation of strong demand from this application in the second half of calendar year 2017.

When asked during that CC whether it was hampered by capacity and manufacturing on 4-inch wafers, management argued the following (our emphasis):

We are adding capacity, we're hiring people, we're adding equipment,we are increasing our capacity very dramatically. It is true that we manufacture on 4-inch wafers. We think our yields are higher on 4-inch wafers than they would be if we were processing 6-inch wafers. And so we made a very conscious decision to stick with, 4-inch. VCSEL wafers are very thin and very fragile.

Can the earlier optimism suddenly die down because Apple might be a little late just to actually have time to include these laser diodes?

Lumentum

Lumentum shares also reacted positively on the laser diode speculation when the CEO mentioned the emerging market opportunity on the Q2CC.

Both companies have been enthusiastic about the new opportunity in these laser diodes (not only in mobile, but computing, industrial, and automotive applications as well. Both are raking up capacity and production.

So, the market is wider than just the upcoming iPhones, but landing its business would certainly make a rather big difference, given the potential numbers involved.

That Q2 was a good quarter for Lumentum anyway, from the PR:

"We achieved record revenue of $265.0 million, growing 21% year over year," said Alan Lowe, president and CEO. "Strong growth in new product revenue, particularly 100G Datacom, which was up 124% sequentially and more than 500% year over year, drove operating margin to a new record high of 14.7%."

While its 100G datacom business is zooming ahead (and still constraint, so it can't even meet all demand, especially that from the hyperscale data centers). However, it's still not a big part of its overall business (overall datacom revenue makes up 18.1% of revenues) which is mostly dependent on the telecom sector (61.5% of revenue), which faced some issues, like end-of-life products.

It had some interesting things to say on the CC about 3D sensing:

 

We shipped our first revenue into what we believe could be a high volume mobile device application. We are very encouraged by the progress and key milestones achieved today on this application.

I'd say that it's not just one mobile device manufacturer that we're working with in sampling, it's multiple. So I would have to give away any of their secrets and as we start including meaningful revenue in our guidance, we'll talk more and more about it, but suffice it to say that the milestones that we achieved over the last six months increased my confidence in our ability to make 3D sensing a meaningful part of our business as we look forward.

the market is multiple times bigger than the connect business and could imagine quarters of 100 plus million dollars type of marketplace growing to over $1 billion I would expect as we get into multiple mobile devices and multiple customers with mobile devices. So I'd say that every indication is that it's a huge growth driver for us.

So, basically, it is very close to a design win, has sampled to multiple potential customers (mobile OEMs), and the market opportunity is really large. On top of that, it has another market opportunity with these products in automotive, but that's still a couple of years out in terms of generating significant revenue.

Which one is the better bet?

The companies are fairly comparable as its bread and butter business is optical networking gear. However, there is a significant difference in valuation with Finisar going for 2x sales and 1.95 times book value, compared to Lumentum's 3x sales and 5.5 times book value.

Lumentum isn't really growing significantly faster:

Its 100GB products did, growing over 500% on the year versus a 'mere' 110% for Finisar, but that's about it for Lumentum.

The stock price divergence occurred in February in favor of Lumentum, which rose considerably more, and the subsequent fall was considerably less.

Given the divergence of earnings per share, this actually seems curious:

Of course, part of this is that Lumentum enjoyed a Q2 11% earnings surprise, while Finisar's earnings disappointed on a few temporary issues (as we explained here). And while Lumentum's non-GAAP operating margin reached a record of 14.7%, it still trails Finisar's 17%.

And operating margin is going to fall back a bit, given its Q3 outlook:

For the fiscal third quarter of 2017, the Company expects net revenue to be in the range of $250 million to $265 million, non-GAAP operating margin to be 12.5% to 14.0%, and non-GAAP diluted earnings per share to be $0.46 to $0.54 per share, based on approximately 63.0 million shares outstanding on a fully diluted basis.

More importantly, like Finisar, Lumentum also guides EPS lower for Q3 (Q2 non-GAAP EPS came in at $0.57). So, we don't actually see all that much difference here either.

Conclusion

There is a significant valuation gap between Finisar and Lumentum, and we struggle to find a rational explanation for that, given the fact that this gap has grown significantly the past quarter. Finisar has enjoyed more of a profit jump, and enjoys higher margins compared to Lumentum.

Finisar suffered an earnings miss in its latest quarter whilst guiding also lower for the upcoming one; the issues are mostly temporal and seasonal. Whilst Lumentum beat earnings in its latest quarter, it is also guided lower for the next with both operating margins and earnings guided considerably below Q2.

Both companies could benefit from the rumored inclusion in the high-end upcoming Apple iPhone. Both companies are significantly ramping up their laser diode capacity and production and winning a slot in an iPhone would constitute a big win for both.

While the upcoming iPhone is a big prize, let's not forget that it isn't the only one, and the 3D sensing market constitutes a big new opportunity for both, with or without Apple, as automotive will follow mobile phones in the not-so-distant future.

It's somewhat curious that both stocks reacted so negatively to rumors about a possible delay (running in weeks, not months), given that the outlook for these new iPhones are so bullish. A couple of weeks should not make much of a difference and is temporal anyway.

We prefer Finisar on valuation as it's considerably cheaper for which we find little reason. It's the leading optic networking stock with 15% market share (Lumentum is number 2 with 9%). The shares are also significantly oversold.

Disclosure: I am/we are long FNSR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.