Emcore: Q1 Update

| About: EMCORE Corporation (EMKR)

Summary

Broad market sentiment has amplified the selling after earnings.

The underlying Fiber business is being valued near nothing.

I will continue to buy shares as Emcore trades near cash value.

Emcore's (NASDAQ: EMKR) Q1 2016 report has caused shareholders to run for the exits, but can be explained by a few factors. One factor being the changing economic conditions have caused shareholders to develop a high uncertainty avoidance. The market sentiment has caused shareholders to hold cash instead of a micro-cap stock. The risks the market perceives toward Emcore are irrational. These risks include:

  • Cable TV spending will decelerate in 2016
  • Gross margins will remain weak
  • Broad market conditions will hold the stock down

Shareholders continue to focus on the short-term market narrative and are missing the longer term prospects of DOCSIS 3.1 and the Wafer Chip spending patterns.

DOCSIS 3.1 is still expected to accelerate in 2016.

Mark Weinswig Q1 2016 earnings call,

"In the Broadband Cable TV segment, over the past six quarters, we have seen significant strength in the results and outlook. In general, after tough times in 2012 and 2013, the Cable TV Optical Network Infrastructure business has seen improving market trends. Looking forward, EMCORE is excited about opportunities with the migration to DOCSIS 3.1 and the further investment by the MSOs to increase the capacity of their networks."

They are seeing record growth from their chip business

Jeff Rittichier Q1 2016 earnings call,

"The past quarter, we recognized revenues up $4 million with the majority being from GPON applications. Going forward we do expect non-GPON chips to comprise a greater fraction of our chip business than they did over the past year with our goal for non-GPON to be one-third of our chip revenues over the year.

As a matter of fact, non-GPON chip shipments in 2016 could be larger than our entire chip business was in 2015. EMCORE's long history as one of the industry's premier optical semiconductor companies has given us a substantial portfolio of chips to sell and the divestiture of our telecom module business eliminated any channel conflict concerns in the minds of our customers."

Business Trends

Remember the first quarter is cyclically slow for optical and semiconductor companies. The New Year is always a slow time of the year for Emcore because of the budgeting of customers. Once these budgets are established for 2016 we should see revenue acceleration into the fall. Looking at their Q1 2016 report gross profit margins were soft due to sales volumes being lower. The key point is why their margins declined - they need more sales to absorb fixed costs and drive margins higher. The most overlooked portion of the Q1 2016 report was their GPON chip business doubled YOY from $2 million to $4 million. Looking forward, they anticipate growth from non GPON chips to overtake GPON chip sales in 2016. In Q2 2016, sales guidance was in the range of $21 to $24 million and margins are expected to be in low to mid 30% range. Also, SGA is expected to decline from the settlement of the Sumitomo lawsuit, thus increasing their operating income by roughly $900,000. The decreased legal costs should lead to additional 2-3 cents of GAAP profitability setting up Q2 for an earnings beat.

Where is the Value?

With the stock trading near $5 per share, Emcore is one of the best bargains in the optics industry because they are cash flow positive, generate positive GAAP income, and are positioned for growth in their chip and DOCSIS 3.1 product lines. Emcore's underlying business is being valued at next to nothing and the current share price is based on the assets of the balance sheet. They hold $4.50 in cash and an additional $1.35 per share in current assets. Not taking into account the Fiber business or plant assets, If Emcore satisfied their liabilities they would have $4.93 per share to return to shareholders. The Fiber business is receiving effectively no value from Wall Street and shareholders have thrown the going concern principle out the door. The lack of respect Emcore is receiving from Wall Street leaves me feeling bullish because they will receive credit for their underlying fiber business once broad market sentiment reverses and we get out the slow part of the year.

Buy More Shares?

One thing I have learned from four years investing in optical companies is the stocks go through periods of depressed pricing due to two factors, one being cyclical trends in telecom/datacom spending and the second being broad market sentiment. Being in the early parts of the year we can't determine if spending has softened and we can determine the market has substantial negative sentiment. To put things into perspective, the emotional selling in this market has caused a number biotech companies to trade below their cash value. As long as Emcore trades near its cash value the risk to reward ratio is heavily in favor of the reward. If you don't mind holding stock during downtrends in optics the investment works in the longer term more than it doesn't. I remain confident that once the headwinds subside in the market, shareholders will begin to receive some sort of value to the underlying business and approach my $10 price target. Until then, I will continue adding to my stock position.

Disclosure: I am/we are long EMKR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I acquired additional shares within 24 hours of publishing this article.