More Downside Than Meets the Eye for Finisar

| About: Finisar Corporation (FNSR)

The worst is not over for Fin­isar Cor­po­ra­tion’s (FNSR) stock. Despite drop­ping over 50% since March, the stock remains on our "most dan­ger­ous stocks" list, where it has been since Octo­ber 2010.

Like all of our “most dan­ger­ous” stocks, FNSR is guilty of both mis­lead­ing earn­ings and an undeservedly-high stock valuation.

Yes, the val­u­a­tion is still mind-bogglingly high despite drop­ping about 50% since March.

The cur­rent stock price of ~$20.44 implies the company’s after-tax oper­at­ing prof­its (NOPAT) will grow by nearly 30% for 10 years in a row. To put this in per­spec­tive, only three non-biotech com­pa­nies with mar­ket caps > $5b have done this in the past 9 years eBay (EBAY), Apple (AAPL), and Ama­zon (AMZN).

I doubt that Finisar’s prod­ucts posi­tion it to achieve any­where near the growth and prof­itabil­ity achieved by the paradigm-shifting busi­nesses led by EBAY, AAPL and AMZN.

On the other hand, I am sure that Finisar’s busi­ness model is worse than what meets the eyes of investors who look only at reported account­ing results. Fig­ure 1 plots the dif­fer­ence between reported GAAP earn­ings and the company’s eco­nomic earn­ings from 2000 to 2010. In 2010, the level of earn­ings over­state­ment made a large turn for the worse as reported earn­ings rose strongly while eco­nomic earn­ings dropped.

click to enlarge image

Fig­ure 1: 2010 Improve­ment in FNSR’s Earn­ings Is Misleading

Sources: New Con­structs, LLC and com­pany filings

The large divergence between reported and economic earnings is made possible by (1) the nearly $150 million in additional financing that bloats FNSR's balance sheet took in 2010 and (2) an accounting loophole that allows the highly-acquisitive Finisar to sweep its capital allocation mistakes under the accounting rug.

Specif­i­cally, I refer to the nearly $950 mil­lion of assets, after-tax, that the com­pany has writ­ten off since 2000.

To put this in per­spec­tive, $950 mil­lion equals 150% and 250% of the total assets of the com­pany in 2010 and 2009. This means that FNSR’s man­age­ment has writ­ten off $1.50 of assets for every dol­lar of assets on its 2010 books. And before the issuance of an addi­tional $130 mil­lion of equity in 2010, FNSR’s man­age­ment was writ­ing assets off at a rate closer to $2.50 for every dol­lar on the bal­ance sheet.

No won­der the com­pany needed more equity capital.

Per our detailed report on asset-write downs, “Given man­agers are paid to cre­ate value, not destroy it, asset write-downs reflect man­age­ment incom­pe­tence and fail­ure to allo­cate cap­i­tal effectively.”

The take­away is obvi­ous: Finisar’s earn­ings have a higher prob­a­bil­ity of con­tin­u­ing to come in lower than expected as management’s inabil­ity to cre­ate value (or pro­cliv­ity for destroy­ing value) is exposed.

Together, FNSR’s earn­ings risk and high val­u­a­tion earn the stock our “very dan­ger­ous” rat­ing, which means the stock’s down­side risk dwarfs its upside potential.

And for a sense of how much down­side risk I see in FNSR: my model shows that with no future profit growth, FNSR is worth about $3.33. Actual results will prob­a­bly come in some­where between no future profit growth and cur­rent expec­ta­tions (30% growth for 10 years com­pounded annually).

My expec­ta­tion is that future profit growth will come in closer to the “no growth” sce­nario, which means the stock has a long way to fall before it hits bottom.

We rec­om­mend investors short or sell FNSR and any ETFs that allo­cate to it. As detailed in in Good, Bad and Ugly Tech Sec­tor ETFs, investors must beware the hold­ings of tech sec­tor ETfs before buy­ing them. Those ETFs have very dif­fer­ent hold­ings and allo­ca­tions, which results in very dif­fer­ent invest­ment poten­tial for each ETF. Below is a list of ETFs we rec­om­mend sell­ing because of their “dan­ger­ous” rat­ings and expo­sure to FNSR.

  1. SPDR S&P Tele­com (XTL) – “dan­ger­ous” rat­ing with 2% allo­cated to FNSR
  2. iShares Morn­ingstar Small Growth Index (JKK) – “dan­ger­ous” rat­ing with 1% allo­cated to FNSR

For a free copy of our report on Fin­isar, click here.

Disclosure: I am short FNSR.