In my first article on Applied Opto (NASDAQ:AAOI) for Seeking Alpha, published on November 11, 2016, I established 12-month "stand alone" stock price targets of $30 and $38, which represented a 15x P/E multiple applied to my expectations for $2.00 in non-GAAP EPS in 2017 and the same multiple off $2.50 of potential non-GAAP EPS in 2018. At the time Street consensus for 2017 was $1.61 and 2018 had few published estimates. I also set a 12-month "take out" target of $44, as I believe consolidation is likely in the optical industry and Applied Opto is a prime candidate to be acquired by one of the larger players.
Given the strength of Applied Opto's recent operational execution, the ramp of its new lower cost products and solid early stage demand for 100G transceivers for hyperscale/cloud computing applications, the company has just stepped up to a new level of profitability. In my view, this substantially raises the bar on the concept of cross cycle "normalized" earnings power. I also think that the clean operational execution and the higher normalized earnings power suggest AAOI shares should exit the target P/E multiple "penalty box" that was predicated on some historical operational execution missteps.
In previous articles, I laid out multiple potential catalysts for stock-multiple expansion, including improved operational execution, margin expansion, acquisition potential, new customers reducing concentration risk, improving cash flow, and lower capex requirements post the completion of the new factory building leading to a strengthening balance sheet. Also, as the company grows, more investors should pay attention. It is a very under the radar story at present. That should help the future stock multiple as well as more dollars potentially buying the stock.
I now think that Applied Opto has 2017 non-GAAP earnings power of $3.00 and the cycle should continue into 2018, so likely another solid growth year there. Applying an 18x P/E multiple to $3.00 of 2017 earnings power, I am setting a new 12-month stock price target of $54. This replaces my previous targets of $30 and $38.
As mentioned above, in the first article last November, I set a "take-out" target of $44. Given the improved profitability, I now see that as too low. So that is no longer valid. I now see the take-out potential more in line with my new stock price target in the $50+ or higher range. I'll have more to say on that in the near future.
In my initial note on Applied Opto, I suggested that Street consensus, which was $1.61 at the time, would likely trend to $2.00 in 1-3 results periods (February, May, August), and more recently, I suggested within the next two was more likely (February, May). I have also stated several times that rising Street consensus should represent a series of upside stock catalysts. Today, Street consensus - post the upside surprise - is showing as $2.02, up from $1.70. With my new view of 2017 earnings potential of $3.00, I think consensus is still way behind the curve despite the fact that it has exceeded $2.00 a lot faster than I had expected.
The next major catalyst should be the company's formal 4Q2016 results release, which is scheduled for February 23, 2017. 1Q2017 guidance will be the real story. AAOI shares have a tendency to climb a "wall of worry" in anticipation of 1Q guidance. Historically, 1Q is a down sequential quarter for Applied Opto. This has typically been driven by a slowdown in cable buildouts in winter months and Chinese New Year related production holidays. Cable used to be the vast majority business for Applied Opto. However, cable is less than 25% of the business now and shrinking as a percentage of the total and the DOCSIS 3.1 upgrade cycle is starting to percolate, so maybe less downside cable business risk in 1Q this year. More importantly, the 100G hyperscale/cloud computing buildout is poised to accelerate in the first half of 2017 on the back of increased availability of Broadcom (NASDAQ:AVGO) Tomahawk chips for network gear. These devices were a bottleneck for the buildout throughout 2016.
I have suggested several times that better than consensus, and potentially much better first quarter 2017 guidance/results should be a major catalyst for AAOI shares. I still believe this to be the case.
The "new" consensus for 1Q2017 - post the upside 4Q surprise yesterday - is $0.38, up from $0.30, compared to the pre-announced 4Q2016 level of $0.77-0.82. It seems to me that Applied Opto's 1Q2017 non-GAAP EPS could be much larger than the "new" consensus, potentially double. If I am right, it will set a much higher base for the next major revision to 2017 Street consensus from the current $2.02. Again, if I am right, this should be a significant upside stock catalyst.
Here are the pre and post 4Q2017 positive pre-announcement consensus EPS estimate profiles (non-GAAP):
4Q2016 $0.50 $0.75
1Q2017 $0.30 $0.38
2Q2017 $0.40 $0.48
3Q2017 $0.48 $0.56
4Q2017 $0.53 $0.60
2017 $1.70 $2.02
A few observations:
- I don't think every coverage analyst has been adjusted into the new consensus but most appear to be.
- How consensus doesn't think there will be a quarter of earnings in 2017 better than 4Q2016 is beyond my ability to comprehend.
- If you believe this trend, you are selling the stock right now.
- Sell-side analysts sand bagging earnings estimates is fine, as we all know the game. However, sand bagging by excessive amounts seems unnecessary to me.
- The coverage analysts have not yet begun to articulate why AAOI should have a higher stock multiple or target multiple. With a historical CAGR of 40% and a forward CAGR of 20%-25%+, improving operational execution, the likelihood of customer de-concentration, a strengthening balance sheet, and historically high early cycle profitability, a forward target P/E multiple of 15x seems way too low to me. Why should it be lower than the market multiple? This company is growing like a weed and delivering substantial margin expansion.
- Multiple and substantial upside Street earnings revisions are likely over the coming months and quarters, so understanding the likely trend and reaction by sell side coverage analysts allows investors to get ahead of the curve.
AAOI shares hit $30+ today following the positive 4Q2016 earnings surprise news. In my view, the stock is well behind the curve and $30 was justified before the recent news.
There are three primary drivers to the so-called "Optical Super Cycle" - China, US Metro and Data Center, especially Web 2.0 hyperscale/cloud. Hyperscale/cloud is the fastest growth part of the three-legged stool and likely the least cyclical. Optical stocks have sold off over the last month after Finisar reported record margins on fear of peak margins, overcapacity (i.e., pricing pressure) and slowing China.
AOI was 75% exposed to Data Center in 3Q2016 and it is almost all Web 2.0 hyperscale/cloud. Soon it will be over 85% of the business. The stock has - incorrectly in my view - been trading as a small cap proxy for FNSR and LITE, both of which have massive exposure to the other segments like Telco that experiences an annual 1Q price concession. LITE is barely exposed to Web 2.0 hyperscale/cloud, which is why I think LITE should buy AOI.
As 2017 unfolds, I think AOI has the largest upside EPS revision potential in the group given its dedicated exposure to Web 2.0 hyperscale/cloud. Supposedly the 100G data center cycle doesn't really start until 1Q2017 given the now rapidly expanding availability of the Tomahawk network chip from BCOM. That chip is necessary for the network boxes to handle the 100G speeds. AOI has been benefiting in 3Q and 4Q2016 from early availability of 100G parts and the right customer base. I don't think they would say the strong 3Q and 4Q2016 have been a material "pull in" of early 2017 demand. In fact, a larger part of the 4Q upside surprise was margins. Revenue was only 10% above guidance. If I am right and AOI has more EPS upside "beta" than the group as 2017 unfolds, then maybe the company and the stock will begin to stand out. Maybe yesterday was the start of the process. As a rapidly growing pure play on the fastest growth segment in the industry I think AAOI shares should get a premium multiple not a discount. So I still see significant upside to consensus and many reasons for stock multiple expansion.
With all that said, this stock has a super high beta and can drop 5% on any given day if there is a "buyer's strike" and a few sellers around. I also think the market may be in for a rough ride for a while as the Trump legislation "sausage making process" is potentially a lot uglier than the promise of business-friendly legislation.
So, AAOI will likely consolidate the pop yesterday, but I believe it is destined to go higher. I was encouraged that the stock did not "pop and fade" intraday yesterday. It stayed strong with VERY high volume. This suggests to me that there was real buying all day long. As opposed to a short covering rally followed by a wave of profit-taking. Good sign.
When Applied Opto reports in February, I expect another round of upside consensus estimate revisions. The stock always fears 1Q guidance. The fundamental set up for a historically strong 1Q this year is as good as ever. If the analysts have to raise 1Q, potentially by 50% or more from current estimates, possibly 100%, then they will model a creep up from there, which will likely be wrong, and then they will likely increase estimates again in May and August.
I think the cyclical sweet spot for this stock was the 3Q2016 positive pre-announcement to the early August 2Q2017 results call, purely on fundamentals not acquisition potential. But I hope for a $3.00 consensus for 2017 by May and a $45+ stock. AAOI deserves a 20x multiple in my view, but that will likely take longer to matriculate.
The optical group stock backdrop is important, and a lot will depend on optical stocks coming back into favor or at least going neutral. I am amazed that Lumentum (NASDAQ:LITE) was down yesterday. But it has relatively small Web 2.0 hyperscale/cloud exposure.
Finisar (NASDAQ:FNSR) and LITE are the big "bellwether" players in optical. They clearly set the tone for the stocks in the optical space. It would be really good if LITE can hold $34/$35. I think it will be tougher for AAOI to rise if it breaks down. FNSR needs to hold $27 in my view. If these stocks build a base at those support levels and start to creep up again, that would be a really good backdrop for AAOI to excel. If they break down it will be tougher, like a salmon swimming against the tide.
Lastly, when AAOI crosses $40, the company is likely to entertain serious offers to be bought out. This may creep into the stock multiple after August 2017 to keep the party going, assuming 100G pricing is holding up.
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.