Applied Optoelectronics: Identifying Near-Term Upside Stock And Multiple Expansion Catalysts

Summary

Maintaining 12-month stock targets of $38 as a standalone company and $44 as a takeout candidate, but see target multiples as very conservative with upside potential.

I see several near-term upside stock and multiple expansion catalysts, including the likelihood of a seasonally strong 1Q 2017 that is not in Street forecasts.

AAOI appears undervalued against primary comparables on current Street consensus and very undervalued on upside potential revenue and earnings growth in 2017 and 2018 plus multiple expansion.

For more details on the fundamental story please see my recent Top Idea and a follow-up article on Applied Optoelectronics (NASDAQ:AAOI) in Seeking Alpha.

AAOI shares are currently consolidating a recent and solid move from $19 to $27. With that said, I firmly believe the company is in the very early stages of the strongest wave of demand in its history, driven by the emerging "Optical Super Cycle" as recently named by Needham & Co. Specifically, Applied Optoelectronics is poised to benefit from a large 100G optical transceiver demand "surge" driven by high-growth cloud computing/hyper-scale data center operators such as its largest customers Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT), and its newest customer Facebook (NASDAQ:FB). Over 75% of Applied Opto's sales - and growing - are dedicated to the high-growth cloud computing/hyper-scale data center sector. Upside revenue growth and margin expansion for Applied Opto are also likely to be enhanced over the next several years by the DOCSIS 3.1 conversion by cable TV operators. Given the solid demand drivers that are likely to be prevalent over the next several years, I firmly believe AAOI shares are very likely to make several more upside moves or "waves" throughout 2017 and potentially into 2018.

Near-Term Upside Stock Catalysts:

  • Completion of the Current Stock Offering. On November 14th, Applied Opto entered into an agreement with Raymond James to sell upwards of $50 million of stock "at the market" from time to time. The company entered into a similar agreement with Raymond James in mid-2015 and it took about a month to complete. On November 23rd, Applied Opto filed an 8-K and stated that it had completed the sale of 1.1 million shares, netting $26.8 million. As such, the current deal process is over 50% complete. This is likely an overhang on the stock at the same time it was due for some technical consolidation. Once this deal is completed, likely in the next few weeks, I think it will be an upside stock catalyst as a fairly large overhang will be cleared out.
  • Raymond James Moving Off Restriction. I'm not totally sure, but I believe Raymond James is restricted from publishing reports on Applied Opto while the current stock offering is being executed. Raymond James appears to be the most widely followed research provider/market maker on AAOI - the so-called "Axe" in the name on Wall Street. Raymond James is currently sitting with a Strong Buy on AAOI but has a $24 stock price target, which doesn't make sense. As such, I expect a meaningful upside adjustment in the Raymond James stock price target once the offering is done, probably into the high $20 range or possibly more. This should have an impact on Raymond James's institutional clients. With that said, it is my perspective that Raymond James's coverage of AAOI tends to be very incremental, meaning very small forecast and target adjustments, despite a Strong Buy rating. Conversely, I am taking what I believe to be a more realistic approach on the upside fundamental potential as the current demand trends play out over 2017 and 2018, as I don't have institutional money managers to placate that tend to like sandbagged analyst estimates, but I get that. I'm not criticizing, I'm just pointing out the difference as a potential money-making phenomenon.
  • Upside Consensus Estimate Revisions. Specifically, Raymond James is currently forecasting 22% revenue growth for 2017 and $1.60 of non-GAAP EPS before including the current deal shares of approximately 2 million and the consensus is about $1.66. Raymond James has not yet published a 2018 estimate. Similar to 2015, when Applied Opto delivered 46% growth on the initial ramp of the 40G optical cycle, I believe consensus is likely to trend towards 35-40%+ revenue growth for 2017 and $2.00+ in non-GAAP earnings potential over the next three earnings seasons (late February - FY end results, early May, and early August). I do not see the roughly 2 million new deal shares as an impediment to this process. I believe the upside revisions will likely and initially be driven by a stronger than seasonally usual first calendar quarter as the 100G cycle accelerates with a further mix shift to higher average selling price and higher-margin 100G products. Assuming the company doesn't positively pre-announce 4Q 2016, which is possible. 100G products were only 13% of sales in 3Q 2016 and the new, lower-cost/higher-margin versions appeared late in the quarter. So the 100G "wave" is in its infancy and is poised to accelerate. Thus, it could buck normal seasonal weakness in 1Q. I also think demand from cable TV providers is likely to be better than seasonally normal in 1Q 2017 as the DOCSIS 3.1 upgrade cycle gains momentum. The cable business is often slower in winter months and is typically a larger source of 1Q seasonal weakness for Applied Opto than its data center business, but the cable business is a lot smaller than it has been historically, given the robust growth in the company's data center business over the past few years. Further margin expansion above current Street forecasts is also likely as high-priced 100G and DOCSIS 3.1 products increase as a percentage of sales and revenue grows faster than operating expenses while gross margin expands a bit further. In other words, a solid operating leverage story. The Street consensus is currently forecasting $0.50 for Applied Opto's 4Q 2016 and $0.29 for 1Q 2017, while Raymond James is at $0.51 and $0.24, respectively. In my view, a seasonally strong 1Q could drive a substantial upside C2017 and 2018 forecasting exercise for Street consensus off a higher 1Q base to start 2017. The setup certainly seems to be there. The offset is the fact that there will be about eight vacation days associated with Chinese New Year at Applied Opto's Asian factories (Taiwan and China). We will see how much production they can squeeze in with some new equipment and a mix shift to higher ASP 100G products to help revenue on fewer units on fewer days of production.
  • Finisar Earnings. Finisar (NASDAQ:FNSR) will report its FY 2Q 2017 quarter (October ending) on Thursday, December 8th after the market close. Finisar is the largest company serving the optical market. As such, it is a bellwether of sorts and has the ability to sway investor sentiment on the optical space and optical stocks in general. There have been a few upgrades of FNSR shares in the past week and fairly broad expectations that it can deliver a "beat and raise" quarter. Given the recent surge in FNSR shares, it wouldn't be surprising to see the stock experience a "buy the rumor, sell the news" scenario. However, commentary positive to Applied Opto's fundamentals as a comparable could very well be a positive catalyst for AAOI shares. Especially as Applied Opto's secondary stock offering may be completed around that time and AAOI shares will likely be poised to emerge from its current technical consolidation. Specifically, I am looking for commentary from Finisar on the cloud computing/hyper-scale data center market that suggests potentially accelerating demand that is likely to drive unusual seasonal demand strength in the first calendar quarter of 2017 for optical transceivers, 100G in particular, perhaps on a loosening up of supply for Broadcom (NASDAQ:AVGO) Tomahawk chipsets for network gear. Despite the fact that Applied Opto is seeing strong and steady growth in 100G in 3Q and 4Q 2016, as it was early to market with decent capacity, there has been a theme in the industry that the initial critical mass ramp of 100G in data centers has been delayed from C2H 2016 to C1H 2017. Confirmation from Finisar of accelerating 100G demand in data centers in C1H 2017 with abnormally strong first quarter demand would clearly signal the likelihood of a meaningful upside 1Q 2017 and full year 2017 Street consensus revenue and earnings forecast revision for Applied Opto. This could happen proactively by coverage analysts or after the company reports 4Q and FY 2016 in late February. As a side note, be sure to focus on Finisar's comments on cloud computing/hyper-scale data centers, not blended data comm. Finisar has a substantial presence in the enterprise market, which is in a state of decline as much of that business shifts to cloud computing. At the present time, Applied Opto does not serve the enterprise market, at least in any meaningful way. It is focused on cloud computing/hyper-scale.
  • New Customer Announcements. It is likely that Applied Opto will announce new customers sometime in the first half of 2017, and that would likely generate an upside demand forecast/guidance scenario and catalyze upside stock price appreciation.

Stock Multiple Expansion Catalysts

  • Take Out Potential. In my first report on Applied Opto, I focused quite a bit on the potential for the company to be acquired. Many sell-side analysts have suggested industry consolidation makes sense. As we have seen in the semiconductor industry, once it starts, it has the potential to catch fire, meaning a pickup in M&A cadence. I think the second half of 2017 could be a very interesting time when both potential sellers and buyers can see value - upside from here for the potential sellers, but not too expensive to make sense for the buyers. Applied Opto management did not in any way, shape, or form, suggest it was not willing to consider reasonable offers when asked about industry consolidation at a recent investor conference that was webcast. In my view, it would be logical for Applied Opto management to give itself a healthy dose of annual inventive stock compensation in the middle of the first half of 2017, and then be open to offers in the mid-$40 dollar or higher range, potentially meaningfully higher thereafter. Any hints that industry consolidation is beginning to happen or that Applied Opto is "in play" would likely to be very impactful upside stock multiple catalysts, and I see it as a probable concept in 2017, especially in the second half.
  • Customer Diversification. Applied Opto began shipping to Facebook in 3Q 2016 and should ramp its business with FB to a higher level in the coming quarters. Applied Opto's other principal data center customers are Amazon and Microsoft and the company is the primary provider of optical transceivers to both. The company is actively pursuing more new customers, and each material new one should be a positive stock-multiple driver as customer concentration decreases and upside estimates ensue.
  • More Consistent Operational Execution. Applied Opto had a few operational miscues over the past few years, driven by several factors such as poor supplier yields on component parts, Asian employees going home for Chinese New Year and not returning, a mix shift in demand/poor forecasting, and a surge in R&D to develop new lower-cost versions of its 40G and 100G optical transceiver products. Throughout the first half of 2016 and into the fall, several sell-side firms, including Raymond James, began to couch their target multiples by stating that Applied Opto was in the "penalty box" until it could demonstrate consistent and clean operational execution. As such, forward targets are mainly based on low ball estimates and a low 15x forward P/E. I say low because a company that has a past five-year CAGR of 40% and a likely forward five-year CAGR of 25%+ would typically derive a much higher multiple. With the new factory in Texas in place, dependence upon outside component suppliers is substantially reduced. Further, the new lower-cost versions of the company's 40G and 100G transceiver products are now in the market as of late 3Q 2016. We will see how the company manages the Chinese New Year in early 2017. More automation is now in place and the company is likely planning better this year after getting blindsided last year. In my view, Applied Opto is working its way out of the operational inconsistency-centric stock target multiple "penalty box" and each successive clean quarter should enhance the upside stock multiple expansion potential. Coverage analysts should also get more comfortable using higher target multiples, more in tune with the company's historical and future growth potential, especially now that it is more profitable.
  • Balance Sheet Clean-up and Improving Positive Cash Flow. Over the past few years, Applied Opto spent a lot of money and utilized debt to expand its PP&E infrastructure in anticipation of the 100G-centric growth wave. In particular, the company built a brand-new laser diode factory in Texas and implemented increased automation in its Asian facilities. As such, the company is in a position now where it can add capacity in increments shortly before demand ramps with a large amount of upside expansion potential, meaning unused "slab" capacity. It can also entice new customers with the ability to expand capacity for them rapidly. With the $50 million from the current deal, Applied Opto is likely to reduce debt, add to working capital, and have plenty of cash for incremental capex, which will be equipment-centric versus buildings. Further, despite the likelihood of some quarters of heavy capex for incremental capacity adds, the company is increasingly profitable and yearly capex requirements are trending down. Therefore, management is increasingly focused on transitioning to cash generation. Cleaning up the balance sheet and trending cash generation up should be slow and steady multiple expansion drivers for the foreseeable future.
  • Momentum in the Optical Space, and More Eyes on Applied Opto. Optical stocks, in general, should experience stock multiple expansion as the space delivers potentially material upside to consensus revenue and EPS growth forecasts as 2017 unfolds, as it is likely to be a high-octane, "risk on" tech stock area. This should draw in more momentum investors and institutional PMs that are underperforming by not being fully exposed to the space. With that said, Applied Opto is not exposed in any meaningful manner to the Telco portion of optical, which is substantially slower growth and more cyclical than cloud computing/hyper-scale data center, but is also expected to experience strong demand patterns in 2017 and into 2018. Thus the moniker "Optical Super Cycle" as all cylinders fire simultaneously. As such, Applied Opto is a more sustained, higher secular growth story, perhaps in the 25%+ range versus roughly 10-15% for the Telco heavy diversified suppliers. Also, Applied Opto is an under-followed, under-the-radar company. Many sell-side brokers that cover the optical industry, especially the larger firms, do not cover the company nor do they even include AAOI in comparable valuation tables. Further, there is little to no exposure to retail investors. This is actually where I am trying to help. Anyway, as the company grows rapidly over the next few years, more eyes should be following and investing in the story. That should help the stock multiple expand.

Valuation

Using current consensus estimates for Applied Opto, and its three primary comparables Finisar, Lumentum (NASDAQ:LITE), and Oclaro (NASDAQ:OCLR), AAOI shares are generally trading at a 10%+ discount to the average of the other three on several valuation metrics including P/E, EV/S, and P/S on 2016, 2017, and 2018 time frames.

I view this as unwarranted given the substantially higher prior five-year growth CAGR for AAOI of 40% versus an average of about 10% for the other three, and the likely superior forward five-year growth CAGR potential of 25% for Applied Opto versus a 10-15% average for the other three combined.

AAOI is a smaller, high-growth story with a high percentage of revenue focused on the rapidly growing cloud computing/hyper-scale data center business whereas Finisar and Lumentum have slower growth, more cyclical Telco exposure. This is why Applied Opto is a potentially attractive takeout by Finisar or Lumentum. Oclaro is more like Applied Opto but as a turnaround story. It has an emerging 100G story but does have more Telco exposure than Applied Opto, thus perhaps a slightly lower secular forward CAGR growth potential, but probably higher than the larger diversified players.

I personally feel the pure-play substantially higher secular growth company with takeout potential should trade at a premium valuation to the average of the others. I would expect several of the dynamics highlighted above to drive a valuation transformation for AAOI shares as the next year unfolds, perhaps to a premium valuation to the comparables' averages.

Also, there is substantial upside potential to 2017 and 2018 Street consensus estimates for all four companies. However, if Applied Opto can deliver higher magnitude upside revisions as a pure-play on cloud/hyper-scale data center with new customers scaling in, it may begin to experience better stock multiple expansion than the others for a period of time, especially if takeout potential seeps into the valuation.

Risks

I continue to see operational execution as the primary company-specific risk for Applied Opto, especially with Chinese New Year coming up in 1Q 2017. From an industry perspective, I think it is inevitable that 100G optical transceivers will eventually enter a state of supply equal to demand or potentially supply greater than demand. Any hints of increasing pricing pressure would signal a margin peak and subsequent decline. So pricing is the main fundamental dynamic to watch out for in my view that could signal or catalyze an end to the "Optical Super Cycle" trade/investment, however temporary before the 200G and 400G waves materialize. My current feel is this is not likely an issue for the next 6-9 months and potentially a bit longer, but these things have a habit of sneaking up unexpectedly.

By most accounts, 100G optical transceivers are sold out deep into 2017 as demand is expected to be quite huge and the wave is just starting. In fact, ecosystem chips such as the Tomahawk from Broadcom for network gear are only now becoming more widely available. But that is always the case until it suddenly isn't.

Disclosure: I am/we are long AAOI.

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.