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Stock Strategist Industry Reports

3 New Communications Equipment Firms Under Coverage

Though none of them have developed a moat, one does look undervalued at current prices.

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We recently launched coverage of three communications equipment makers:  Finisar (FNSR),  Lumentum Holdings (LITE), and  Viavi Solutions (VIAV). None have an economic moat, in our view. Finisar appears to be undervalued, trading 28% below our fair value estimate, while Lumentum is trading at a 16% premium and Viavi looks about fairly valued.

Finisar is the largest optical component maker with close to one third of industry sales, by our estimates, and second-place Lumentum holds domain expertise in optical communications components that face robust demand. However, these firms have not demonstrated an ability to earn excess returns on capital, thanks to customers’ sporadic purchasing patterns and a fragmented market structure. Although 3-D sensing in consumer electronics could provide a windfall in revenue, the laser diode business is quickly becoming crowded in anticipation of upcoming demand, and we don't think Finisar or Lumentum can carve out an economic moat here.

Finisar sells into two submarkets, telecommunications and data communications; the latter includes networking equipment and parts for data center interconnects and cloud deployment. Lumentum’s optical communication business accounts for over 80% of total sales; it sells optical components in networking equipment. These markets benefit from broadband network upgrade initiatives in China and the U.S. and secular growth in enterprise cloud and retail colocation services.

However, we believe Finisar’s and Lumentum’s ability to develop a sustainable competitive advantage is limited by a couple of structural forces in the optical industry. The industry is very fragmented, with a dozen small- and medium-size players that compete fiercely with each other for large original-equipment manufacturer contracts and have relatively low profitability. OEMs have greater negotiation power with fiber-optic suppliers and work hard to eradicate lockup risks by demanding components to be interchangeable and modularizing designs. Technological leads among optical vendors are often short-lived and fade by commercial deployment. Operating scale does not necessarily translate into a substantial cost advantage for either company, as small peers could reach optical scale by specializing in a specific component.

Finisar and Lumentum are rumored to be supplying laser diodes into Apple’s upcoming iPhone 8 in order to enable 3-D sensing. However, we want to see sales prove to be sticky before turning more positive on our moat rating, given expansion by other potential laser suppliers into the space.

Following the spin-off of its optical components business as Lumentum in 2015, Viavi Solutions now mainly focuses on selling network testing tools to telecom carriers. Viavi also has a smaller service enablement business that sells network monitoring tools to cloud vendors and content providers; we think management is properly scaling back on this segment.

Viavi sells testing tools under its network enablement segment, which contributes to over half of total sales. Network enablement tools are handheld devices used by carrier technicians to evaluate the performance of routers, network switches, and firewalls during the initial buildout stage of a network. Existing carrier clients do face some switching costs, given the time and knowledge their technicians need to spend to learn about Viavi’s tools. However, we do not think this translates into long-lasting premium pricing power for Viavi, because competing network testing tools handle many of the same functions. Almost all network enablement sales are order-based with a short lead time (in days), and demand for such tools is highly discretionary in nature, tied to carriers’ capital spending budgets and driven by waves of network upgrade projects. These traits weaken Viavi’s negotiating power, in our view.

A growth catalyst for Viavi is to sell optical filters used in consumer electronics for 3-D sensing, such as mobile phones. We believe Viavi has some intangible assets--mostly name recognition and technology leadership--in this market niche, as it supplied into the Xbox Kinect in 2010, arguably the first retail adoption of 3-D sensing. Viavi recently received a sizable prepayment from a consumer electronics manufacturer, which we believe to be Apple. The addition of such a high-volume customer could be a windfall for Viavi, but it is too early to ascribe a moat based on the existing preorder. Outside network enablement and 3-D sensing, the firm plans to trim its service enablement segment to less than 10% of sales from 17% now, while keeping its legacy optical-related business intact.

Alex Zhao does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.