Alliance Fiber Optic Products (NASDAQ:AFOP) is an optical arms merchant to the rapid data center build-out that is happening today at large Web 2.0 companies. AFOP's largest customer is Google, whose data center ramp has driven AFOP's revenue growth of 63% in 2013 and 104% in Q1 2014. Some of AFOP's low valuation can be explained by investor unease with its customer concentration. Google, however, has long-term plans to build more data centers, and there are plenty of other targets for AFOP to pursue, such as Facebook, Amazon, Microsoft, etc. We think that the company's growth will continue and as such, its current multiple is way too low. Using a 20x P/E multiple and adding back its $3 in net cash, we arrive at a $27 price target.
Taking a step back, what is it that AFOP makes, and why do we think that it has a differentiated place in its industry? AFOP makes two product lines. First are fiber optic connectors that make up 75% of the company's revenue. These connectors are used to link two (or more) fiber optics strands together. The goal is to minimize signal loss at that junction, something AFOP does extremely well. Also, AFOP is usually the preferred supplier because it is the one-stop shop carrying the widest variety of connectors in the industry. These connectors are becoming increasingly important in data centers, as connectivity to servers and switches there are moving from copper to fiber connectors. Copper connections were fine at slower data speeds, such as 1G/s, but as speeds have increased to 10G/s and 40G/s, fiber is needed, as it provides less data loss in transit from one switch to another. This is a boon for AFOP, because its fiber connectors are needed at each data connection. This trend is behind AFOP's heady growth over the last years.
AFOP's other business is providing passive optical components in telecom networks. These components split and combine light waves moving from point to point in these networks. This business has grown slowly for the company over time, but is poised to accelerate its growth over the next few years as smaller optical modules at the 100G speed incorporate AFOP's proprietary Nanomux switches within them.
Management has done a great job with the business, both in lean times and now in more prosperous times. During the optical lean years between 2002 and 2009, CEO Peter Chang managed expenses and maintained profitability, while many of his competitors went bankrupt from their continual losses. Recently, as business has improved, Peter has scaled the business on both a gross margin basis, as well as an operating margin basis, and now has some of the highest margins in the industry.
I believe that revenue growth at AFOP will continue and the concerns about customer concentration will ease as the company picks up other large customers besides Google. I think that a 20x P/E multiple is very conservative given the 63% growth last year and the 104% growth this quarter.
Disclosure: I am long AFOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.