What You Should Know About Lumentum's Acquisition of Oclaro

Lumentum Holdings inc. (LITE, Financial), a provider of optics and photonics products for networking, agreed to acquire Oclaro Inc. (OCLR, Financial) for the domination of telecom infrastructure and data center markets, along with tapping into the 3-D sensing market. The benefits of the deal seem skewed toward the existing Lumentum investors. Nonetheless, Oclaro's investors can still benefit from holding on too their newly acquired position in Lumentum.

About the deal

At market close on March 28, Oclaro was valued at $9.54 per share, or $1.8 billion. According to the terms of the deal, Lumentum will buy all of Oclaro's outstanding shares for $5.60 in cash and 0.0636 shares per share. Oclaro shareholders are expected to have a 16% share in the combined entity. Lumentem is using the cash balance from the combined company, and $550 million in debt, to settle the cash portion of the deal.

What does that mean for Oclaro's investors?

Oclaro was an attractive opportunity at 10.7 times forward earnings when I last wrote about it. Thanks to the acquisition, Oclaro has moved past the relative price target based on the EVA valuation. Shareholders are getting paid 18.63 times 2018 earnings for the stock. So the question for Oclaro investors now is whether it is worth holding onto Lumentum going forward. Let’s explore.

The positives

Consolidation seems to be a positive development given the reduction in the number of companies on the market, which will potentially lead to margin improvements. Several players, including Applied Optoelectronics Inc. (AAOI, Financial), Finisar Corp. (FNSR, Financial) and NeoPhotonics Corp. (NPNT, Financial), are already competing in the market. Cost synergies will also add to the company's bottom line.

The deal is expected to save more than $60 million per year for Lumentum. Furthermore, the company expects to benefit from 3-D sensing demand going forward. The acquisition of Oclaro is also expected to add to the company's fabrication capacity, which will help Lumentum meet demand.

On a conference call, Lumentum CEO Alan Lowe commented on the company's fabrication capacity:

“We’re pretty excited about adding this fab capability ... to be able to tackle the really huge pipeline of 3D sensing designs that we’ve got in front of us,” he said.

Moreover, Lumentum is trading at around 18 times forward earnings, suggesting the stock is not expensive on a relative basis for Oclaro investors, who are getting almost the same per-dollar added to the company's bottom line.

The negatives

One unfavorable aspect of the deal is Oclaro investors are getting only a 35% share in the combined company (assuming re-invested cash proceeds). It is also expected to contribute more than 40% toward the company's operating income. Oclaro could have gotten a better deal given the company's strong margin profile.

Profit margin for Oclaro was high as compared to Lumentum. During 2017, Oclaro registered an operating margin of 22% while Lumentum managed to post 17%. It is worth mentioning that a law firm is weighing the possibility of litigation that the deal is not in the best interest of shareholders.

Regardless, the deal-breaker for most of Oclaro’s shareholders is the relative valuation. Most of the shareholders who were attracted to its cheap valuation won’t see much value in holding Lumentum going forward.

Oclaro was trading at 15 times forward earnings before the deal was announced. Lumentum, on the other hand, is trading in excess of 18 times forward earnings. Moreover, Lumentum's margin profile is weaker, which may result in investors cashing out.Â

What’s the thesis for Lumentum?

There’s a case for holding on to Lumentum amid higher margins and cost savings due to consolidation. Moreover, the 3-D sensing market will potentially add to the company's top line going forward. The 3-D sensing market is projected to grow at a compound annual rate of 26.5%, reaching $5.46 billion by 2022. Lumentum provided the 3-D sensing laser chips for Microsoft’s (MSFT, Financial) Kinect, which is indicative of the company’s strong footing in the consumer market. Overall, the potential for cost synergies along with pricing benefits and opportunities in 3-D sensing are some reasons to be bullish on Lumentum.

Further, economic value added-based valuation measures reveal the stock is not expensive if the assumptions hold.

Assumptions

Earnings are expected to grow 10% annually from 2020 to 2023. Note, analysts are projecting earnings growth of approximately 18% per year over the next five years. No growth is assumed in perpetuity. Cost of equity is assumed to grow in line with earnings. The capital asset pricing model is used to calculate cost of equity.

The valuation reveals an upside of around 15% for Lumentum based on the assumptions stated above. Note this valuation does not take into account the margin benefit that will be realized from acquiring Oclaro. The stock also doesn’t appear to be expensive based on the PEG ratio. Although Lumentum is trading at 18 times forward earnings, 18% per annum growth is also expected over the next five years. Overall, Lumentum does not appear to be an expensive stock.

Final thoughts

The acquisition-related compensation is not ideal for Oclaro investors, yet holding on to Lumentum isn’t the worst option. The company is poised for growth over the next several years amid networking, data center and 3-D sensing exposure. However, Oclaro's investors could have gotten a better deal. On the other hand, it is a sweet deal for Lumentum investors given the company's high margins. Lumentum has a lot to offer in terms of data center and 3-D sensor growth at a reasonable price.

Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.