Has The Optics Sector Become A Stock Picker's Market?

The optics sector may be overlooked by many investors, but a handful of stock picks in the space could yield attractive returns, according to Loop Capital Markets.

The Analyst

Loop Capital Markets' James Kisner initiated coverage on the following stocks:

Oclaro Inc OCLR: Buy rating and $10 price target.
Lumentum Holdings Inc LITE: Buy rating and $65 price target.
II-VI, Inc. IIVI: Buy rating and $70 price target.
Acacia Communications, Inc. ACIA: Buy rating and $50 price target.

Oclaro: Unique Player

Oclaro is a "unique" player in the optical component sector, as it focuses mostly on high-performance and differentiated products, Kisner said. More than 80 percent of the company's sales in the September quarter came from products that generate signals of 100 gigabits per second or faster, and these products boast higher margins and can be made only from companies with "significant expertise, he said.

Oclaro is expected to continue posting gross margins that are above its optical peers given its focus on complex products, the analyst said. The stock's 8x calendar 2019 consensus earnings per share valuation "reflects a lack of confidence" from investors in the sustainability of the company's margins, which in turn creates a "compelling" entry point for investors, Kisner said.

Lumentum: 3-D Sensing Leader

Lumentum is the top provider of light sources that power Apple Inc. AAPL's facial recognition technologies in the iPhone X, Kisner said. Perhaps more important, this represents "only the tip of the iceberg," as other phone manufacturers are likely to follow Apple's lead and institute not only facial recognition technology, but augmented reality features, he said.

A "limited number" of companies can match Lumentum's 3-D-sensing-based light source technologies, the analyst said.

Companies like Finisar Corporation FNSR are facing difficulties in ramping their technologies, which implies Lumentum can benefit over the next two years amid strong secular trends, Kisner said.

II-VI: Diversified Portfolio

II-VI is an integrated materials specialist that focus on multiple markets, which gives it many sources of "significant growth" ahead, Kisner said. The company has exposure to fiber optics, wireless infrastructure, industrial materials processing, 3-D sensing, EUV lithography and silicon carbide. More than 40 percent of the entire company's business is exposed to the communications sector, which should benefit from "very positive" secular trends, Kisner said.

II-VI's heavily diversified business shouldn't be of concern to investors, as the company's 23-percent compounded annual growth rate return on capital over the past three decades is "arguably a validation" of the company's strategy, the analyst said.

Acacia Communications: Advantaged Position

Acacia develops silicon-based photonic integrated circuits and coherent digital signal processors, which gives it at an advantageous position, Kisner said. Since the company has exposure to these two segments, a fact that's unlikely to be claimed by a competitor, it's in a strong position to innovate and take share in the high-growth metro and data center interconnect markets, he said.

Acacia also has a large exposure to China and sells DCO modules to one of its largest clients, ZTE, the analyst also said. After a slowdown in business from ZTE over the past two quarters, sales will likely rebound to support a 5G wireless network build-out in China, Kisner said.