As Joel Greenblatt reminds us, when we buy high quality companies cheaply with patience and discipline, the investments work out favorably over time. And if Alliance Fiber Optic Products (NASDAQ:AFOP) is not a Greenblatt stock, I don't know what is.
But before I get to the uncertainties regarding this company, I thought I would spend a little time on its financials. The best way to find out if a company is a good company relative to its industry is to compare it with its industry: "Elementary, my dear Watson!" Elementary as it may be, it's an often forgotten tool for investors. When I buy apples at a supermarket, I compare what apples are on offer (I generally like them cheap and of good to high quality). And I do the same when looking for businesses.
I will not spend a long time on the company's financials because I believe there is little doubt among the investor community that AFOP has excellent financials. Therefore, to avoid sounding repetitive I will not cover this here (if you have any questions regarding the risk with the financials, please post a comment below and I will try to answer as objectively as possible). However, just before I delve into some of the uncertainty regarding this business, I will deviate slightly with a brief remark.
I love uncertainty in the stock market because this is where returns are made; when there is uncertainty, investors become inactive like a deer in the headlights. When clarity finally prevails, it's already too late and value investors are vindicated and headed for the exit. However, a problem with this style of value/contrarian investing is that you must go against what the market is telling you. At the moment, the market is saying that AFOP is cheap and getting cheaper and its growth is stagnating. That AFOP is a stock for traders. That the business is too reliant and uncertain, regarding that No. 1 customer, as well as a lot of insider selling. Therefore, allow me to explain why I believe AFOP is a worthwhile investment.
Reliance on That No. 1 Customer
There are plenty of businesses that flourish by having a very close partnership with one main customer. (For example, Samsung and Android). Therefore, I do not see a huge problem with AFOP and its No. 1 customer having such a large share of its business (~35%). It's not the best strategy, but its not that bad either (there is a saying that goes: "To be in business you only need one customer"). While having a concentrated number of customers has its problems, on the plus side it allows for a streamlined operation, with recurrent orders leading to good operating margins. Every company stumbles from time to time and seeing through this mist of uncertainty allows intelligent investors to profits. This has already been more than accounted for at the current share price.
When reading through AFOP's annual reports, one gets a true sense of how much Chang has a hold of this tightly run business -- from salaries and bonuses to the running his organized business in a highly competitive industry. I wonder if he picked this up while working for Foxconn in the 1990s. AFOP has been successful for around 22 consecutive quarters, every business takes a breather from time to time; take a look at Apple (NASDAQ:AAPL) last year. Even Kang (AFOP's main long-term analyst) was surprised that the No. 2 customer was not Chinese and that AFOP has increased revenues from other sources (Europe). That reinforces the fact that Chang is active in diversifying its customer base.
There is a stock market adage that says: "There are 100 reasons for insiders to sell, only one to buy." Chang is ~56, Hubbard ~54 and Ms. Ho ~67. Now, unlike our "Dear Leader" (Buffett), not everyone wants to work for the rest of their life; some people want to cash in some of their gains and live a happy life. Over the last 10 years there has not been a better time to bank some gains. In an extremely competitive and cyclical industry, last year was a really good year to make some sales. I know I would have. However, even after all the recent insiders selling they still own ~10% of the company (Chang owns ~8%). Therefore, any loss that could be made on a relative base, insiders would lose a lot more on a absolute base. So our interests appear to be aligned.
As for Chang being dismissive of insider selling on the conference call: I don't want a Frank Underwood CEO who will say one thing to my face and do another -- well, in my face! I want a CEO to run his business professionally and fanatically; I don't want a manipulative CEO who sugarcoats all questions. If you want an eloquent CEO, invest in JDS Uniphase (JDSU).
When buying a property, only three things matter: "location, location, location." But when buying a business three different things matter: "cash flow, cash flow, cash flow." A business with consistent free cash flow north of 10% has to be doing something right. If this same business has a ROE>15% with little debt, then this is a type of business I like. Or, in the words of Munger, "we prefer those [businesses] that can write us a check at the end of the year" vs. those with heavy reinvestment needs. I do not want a business that might work out tomorrow, I want a business that is drowning in cash today. On this note I am also happy.
Discounted Cash Flow Analysis/Valuation
I know I am going to alienate the majority of readers with the following comment, that is why I have left to the bottom of my article. I find discount cash flow analysis a pointless activity. Why would I want to predict a company's growth five years out and a slightly slower growth for another five years, etc.? Too many assumptions for me. I might not even be holding onto to AFOP after three years (I could be, but might not also). I am looking to make 50%-100% return over two to three years in AFOP. Nothing glamorous -- I will leave that to Buffett. I know I cannot make intelligent assumptions about the future, so why try?
I know that relative to the industry it has the lowest P/E, excellent growth, growing margins with no debt (with cash and short-term investments at around ~16% of market cap, so it's very well funded). I can easily see this with a P/E of 18 (S&P's P/E ratio) within the next year. AFOP is in an industry with a notoriously high P/E ratios, so I think you will agree that I have been very conservative in this assumption.
How do you spell quality? F-O-R-B-E-S. Few companies get Forbes' attention and fewer still get listed on Forbes' "America's Best Small Companies." But as of October 2013, AFOP was listed at No. 30 (it also got Forbes' attention in 2011 and 2010).
With its employee count having risen to around 1,500 recently, I think I can conclude with Chang's and Hubbard's comment: "We remain bullish."
Disclosure: The author is long AFOP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.