Lumentum lights up NeoPhotonics with $918M bid

Few companies are as important to modern-day society and yet as obscure to the layperson as Lumentum and NeoPhotonics. There is something arcane and magical about photonics, the science of conjuring and manipulating light in which the US firms specialize.

Used in consumer electronics, industrial manufacturing, medicine and high-speed communications, photonics components generated more than half a billion dollars in sales for Lumentum and NeoPhotonics between July and September.

Their importance in telecom has been underscored in recent years by US sanctions against Huawei and ZTE. Both the Chinese equipment makers had relied heavily on Lumentum and NeoPhotonics before restrictions made that difficult (although ZTE is no longer on the trade blacklist).

Until late last year, when sanctions kicked in, Huawei even ranked as NeoPhotonics' largest customer, spending $148.4 million on its products in 2020. For the Chinese duo, finding alternative suppliers would not be easy.

Figure 1: NeoPhotonics' share price ($) Source: Google Finance

For everyone else, shopping with Lumentum and NeoPhotonics will soon mean buying from the same store (barring any regulatory objections). This week, Lumentum stepped forward with a $918 million offer for its rival, to be funded through cash from the new entity's balance sheet.

Approved by the boards of both companies, that offer represented a 38.8% premium to NeoPhotonics' closing share price on November 3 and fueled the same percentage increase in its stock a day later. Lumentum's share price closed 1.76% higher after the takeover was announced.

The optics look good

Lumentum's main justification for splashing the cash – explained on a call with analysts yesterday – is NeoPhotonics' specific expertise in the 400G technology used in optical communications.

With that, said CEO Alan Lowe, Lumentum would be "creating an even better partner for our customers, adding a talented team of photonics experts and expanding our photonics toolkit with technologies widely applicable across many industries."

Lowe's estimate is that Lumentum's total addressable market is worth about $20 billion annually across a range of industries. Roughly half of that comes from optical components for communications applications, where NeoPhotonics is highly regarded.

"All of this highlights a significant opportunity to accelerate growth with the addition of NeoPhotonics," said Lowe.

Highly regarded it may be, but NeoPhotonics has been hit badly by the long-running US campaign against Huawei. Unable to sell most products to a company that was previously its biggest customer, it has suffered a 31% year-on-year drop in sales for the first nine months of this year, to about $210 million.

Over the same period, it swung from a small net profit of $7 million to a troubling net loss of $30 million. Shares dropped from a high of $16.34 in September 2016, before the US began chasing Huawei and ZTE, to a low of $3.89 in May 2019.

The components crunch affecting the entire global economy has been a more recent issue for both Lumentum and NeoPhotonics. Semiconductor shortages largely explain why the bigger and more diversified Lumentum saw its own revenues drop 1% for the recent quarter, to $448.4 million, compared with the year-earlier period. Thanks to lower cost of sales, it managed a 21% increase in net profit, to $81.5 million.

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The Lumemtum expectation, clearly, is that non-Huawei demand will eventually buoy sales at NeoPhotonics. It reckons the takeover will be immediately accretive to earnings per share when it closes – expected in the second half of next year – and says the tie-up will generate about $50 million in cost savings over the first 12 months.

Analysts look favorably on the deal, which follows Lumentum's $1.8 billion takeover of Oclaro, another optical components maker, in 2018. Michael Genovese of WestPark Capital said NeoPhotonics' tunable lasers and 400G technology "should allow Lumentum to continue the momentum from the Oclaro acquisition and maintain industry leadership in transmission products."

The only real concern is that competition authorities interfere. Richard Shannon, an analyst with Craig Hallum, points out that both companies have a position in "a fairly oligopolistic market" and that antitrust issues could arise.

Executives have downplayed that concern, insisting that technologies from Lumentum and NeoPhotonics are complementary.

"We wouldn't be going into this merger agreement if we weren't confident we would get through all the regulatory approvals," said Lowe yesterday.

Whatever regulators make of it, the deal will turn Lumentum into the industry's largest optical component supplier by revenues, according to Fahad Najam, an analyst with MKM Partners.

In the 400G sector alone, he estimates that NeoPhotonics has a 25% share and puts Lumentum's at slightly more than 10%. Lumentum was behind the curve in some 400G technologies, according to Najam, who thinks catching up with NeoPhotonics technologically would have cost it about $80 million in research and development expenses. More importantly, he says, it would have taken around two years.

Assuming the takeover does pass regulatory muster, it will mark the end of a consolidation era, says the MKM analyst. The industry would be left with just three prominent suppliers – II-VI, Molex (privately owned) and Lumentum. And across a range of important technologies, Lumentum would look hard to beat.

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— Iain Morris, International Editor, Light Reading