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This Tech Stock Is Getting a Massive Augmented Reality Boost

Harsh Chauhan, The Motley Fool

Augmented reality (AR) in smartphones is already here. Apple (NASDAQ: AAPL) showed us last year that AR can be deployed in smartphones on a mass scale when it launched the iPhone X with ARKit, which lets the iPhone X unlock itself using facial recognition and use Animoji to create animated characters that mimic you.

But such features wouldn't have been possible without Lumentum Holdings (NASDAQ: LITE) and its vertical-cavity surface-emitting laser (VCSEL) arrays. The iPhone X's TrueDepth camera uses Lumentum's VCSEL component to project 30,000 invisible dots on a user's face to map it in 3D, forming a critical component of the device's 3D sensing module.

In fact, Lumentum is the primary supplier of VCSEL arrays to Apple, with a 75% market share in the iPhone X, and the chipmaker looks well-placed to build upon this terrific start. Here's how.

Person holding a smartphone and using AR applications.

Image Source: Getty Images

Apple is the immediate catalyst

Lumentum was struggling with weak demand for its optical fiber components in China before Apple came into the picture, with its top line moving in the wrong direction.

LITE Revenue (TTM) Chart

LITE Revenue (TTM) data by YCharts

Lumentum's revenue shot up 35% year over year in the latest quarter, while non-GAAP gross margin increased 4.3 percentage points and non-GAAP operating margin jumped 8.6 percentage points. This momentum won't be dying out anytime soon as Apple has equipped all of its iPhones with Face ID this year, boosting demand for VCSEL arrays.

This is why Lumentum had started shipping VCSEL products for the new iPhones early on in the June quarter, as Apple had started the production ramp earlier than usual. 

According to CEO Alan Lowe:

Early in the fourth quarter, we started shipping VCSEL products, we believe will be used in next-generation product cycles. We expect this volume ramp to continue through the first quarter and into the fiscal second quarter of 2019.

Not surprisingly, its $350 million revenue guidance for the current quarter will translate into an annual top line jump of 44%. The momentum could continue into the next quarter because, as we saw above, management expects the volume ramp to continue.

Additionally, CEO Alan Lowe had noted in February this year that the company was adding new VCSEL manufacturing capacity, and it would be in a position to begin deliveries in the first half of fiscal year 2019. This could be one of the reasons why Lumentum is now in a position to diversify beyond Apple.   

Moving beyond Apple

Lumentum has a head-start in augmented reality, but the chipmaker has already started exploring other options to secure long-term growth.

The company has already started receiving orders from multiple Android smartphone OEMs (original equipment manufacturers) for 3D sensing solutions, so it won't be surprising to see this side of the business take off as well. Google is reportedly working with OEMs to provide AR functionality across multiple price points through the ARCore development platform. There are currently just a few high-end Android smartphones, such as Samsung's Galaxy flagship and the Google Pixel series, that support AR features.

But Google is pushing the envelope by partnering with the likes of Huawei, Xiaomi, and Vivo so that it can tap the popularity of these Chinese players, which have set the smartphone sales chart on fire. As such, Lumentum's addressable market is set to expand in a big way.

Sales of VCSEL chips are expected to jump from 652 million units last year to more than 3.3 billion units in 2023. Consumer devices such as smartphones currently account for half of VCSEL sales, but by 2023 they will account for almost 90% of the VCSEL market and generate $3.1 billion in annual revenue. For comparison, VCSEL sales into consumer devices generated just $165 million in revenue last year. 

A smart bet

Lumentum is sitting on a gold mine as an early mover in this space. The company has already struck partnerships with Android smartphone makers and is the leading supplier of VCSEL arrays to Apple, which makes it a solid bet at its current valuation.

Lumentum's trailing price-to-earnings (P/E) ratio is just 15.7, and its forward P/E is just over 11. At this valuation, getting into Lumentum for the long run looks like a smart move given its rapid earnings growth.  The company doubled its adjusted net income last year, and it should be able to sustain its high bottom line growth rate on the back of the massive AR opportunity in smartphones.

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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 the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.