The Best Optical Equipment Stock, But Still Selling

The fiber optic equipment market was the poster child for bubble-era excesses, with share prices of companies like JDS Uniphase (JDSU) exploding upwards, only to implode later. For all the wailing and gnashing of teeth, it was Econ 101: Too many customers and then too few.

Today, the demand for optical networking equipment has recovered to the point where it is theoretically possible to make a living as a manufacturer for the big telecoms, yet only one company is consistently doing so. No, not JDS, Avanex (AVNX) (aren’t they bankrupt already? -- and I’ll support this salvo in a future column), Bookham (BKHM), Sycamore (SYCM) or even Ciena (CIEN). In fact, it’s a company that until very recently no one wrote about, not even The Wall Street Journal’s James Stewart, who foresaw the optical networking recovery but never mentioned the one company not burning cash.

Value-based speculation at Oplink

Value investors found Oplink Communications (OPLK), if they were willing to try a little value-based “informed speculation,” to borrow from Benjamin Graham. With a share price just over net cash, no debt, and neutral structural free cash flow (net income plus D&A minus cap ex, Warren Buffett’s “owner’s earnings, or “SFCF”) after steadily cutting the burn to zero, and a management team that beat the rest of the industry to low-cost Chinese manufacturing, Oplink was an informed speculation on a possible recovery. We took the risk in August 2004 at a split-adjusted $10.74.

The recovery began with new orders in 2005 for Oplink’s major customers Tellabs (TLAB), Huawei, and Nortel (NT), and a few others. With contracts in the billions for network extension known for so-called “Fiber-to-the-X” [FTTX], or fiber to the home or everywhere, these folks would only need to drop a few crumbs to make a difference for a company whose revenues had fallen from 2001’s $132 million to $38, $23, $34, and again $34 million in 2005. And drop they have. Today Oplink’s TTM revenues are $55 million, growing YOY quarterly at the accelerating rates of 20%, 55% and most recently 74%.

Strong stuff, so why sell now? Certainly not for some artificial limitation to return. Anyone who invested when we did has seen more than a double within five years on a compound annual growth rate basis, where at $19 and change today, the 72% total return and 32% CAGR over two years easily trounces the 14.9% CAGR you need for 100% in five years. No, this sale illustrates the extreme importance of valuation as a reality check when venturing into the informed speculation realm.

Growth without free cash flow

Simply, Oplink’s revenue growth did not bring rising GAAP EPS or structural FCF. Including interest income, shares sell for 30 times EV/SFCF (structural free cash flow), which would be fine if SFCF were growing anywhere near that rate. But it’s not. Without interest income, we find a stratospheric 150 times EV/SFCF. That makes the high growth come today at an unreasonable price. The EV/SFCF multiples are simply unsustainable.

Plus, the current valuation is a middle-range estimate of intrinsic value (IV, calculated using discounted SFCF) only if you assume double-digit growth in SFCF going forwards a number of years -- and that's only if you include interest income. If you exclude it, you get IV merely over half the current valuation.

Interest income only goes so far

The truth about interest income is somewhere between all and nothing, and a Solomon approach gives us a likely IV in the mid-teens. Here's my thinking: The interest income is real because it represents income from cash that the company can invest in acquisitions or in buybacks. While most acquisitions fail to add shareholder value, this management team in my opinion can be trusted to make smart decisions, given its care to date rejecting bad opportunities (Avanex) and accepting very small but targeted others (Red Clover). I don't think buybacks at this valuation would be a smart allocation of capital (you only want buybacks at enough of a discount to IV to represent enough potential return top beat all other investments), which is certainly why this capable management team has no buyback plan right now.

No margin of safety

But let's take that possible IV in the mid-teens: the current $19 and change a share still presents too high a risk for potential rewards for a company that has no real moat and is constantly subject to pricing pressures, no matter how much its industry is rebounding.

One wild card: Could Oplink be bought? Perhaps, though one of the most likely buyers, JDS Uniphase, appears more preoccupied with staunching its red ink than buying. Even if a buyer were found and Oplink would sell, its negative EBITDA suggests a limited premium over today's valuation.

Oplink’s price may rise or it may fall, but its risk-reward potential at its current fantasy valuation and with no margin of safety makes it a smart sell. We’ve just sold, but all else equal, should Oplink shares fall towards the low teens, we would become more interested again.

OPLK 1-yr chart:

Disclosure: Tom Jacobs owns no shares of companies mentioned here. He owns all selections he makes for Complete Growth Investor and sold his Oplink holding after issuing this edited Sell Report to CGI Members.