Over the past two months, Applied Optoelectronics (NASDAQ:AAOI) shares appreciated approximately 155% from a low of $22 to a high of $56, and subsequently corrected about 16% over the past few weeks to a low of $47 a few days ago, then popped to $51 on solid volume on Friday, March 17th. I believe $46 was likely the low for the current technical consolidation in AAOI shares or may set the low for a potential short-term trading range. I liked the trading trend intra-day on Friday, March 17th, with a steady rise throughout the day on high volume versus the previous few weeks, where there seemed to be relatively steady selling pressure that overwhelmed attempts by the stock to rise.
The recent technical consolidation was/is warranted in my view given the sharp move over the past two months and the fact that the stock got a bit overbought. So it was due for a short breather. What is somewhat interesting, though, is the fact that the recent consolidation in AAOI shares appears to have been catalyzed fundamentally by weakness in its Telco-centric "comparables." In particular, an earnings and forecast miss by Finisar (NASDAQ:FNSR).
I did not see anything in the Finisar miss that had anything to do with Applied Opto's fundamentals. Finisar's demand problem was from China in Telco where Applied Opto does not participate, the annual pricing drop was Telco-centric - again where Applied Opto does not play, and the company-specific execution issues primarily related to a Chinese Telco customer. The fact that AAOI shares sold off in tandem with Telco-centric comparables fundamental issues just reinforces my view that the Applied Opto story is not yet fully understood.
As management stated in its recent 4Q2016 results call, Applied Opto is in a "fundamentally different business" than its Telco-centric "comparables," specifically FNSR, LITE and OCLR to name a few. Applied Opto has a previous five-year CAGR of 40% versus the average of the other three at 3%. Going forward, Applied Opto should deliver secular revenue growth in the 25-30% range versus the other three averaged at 10-15%. Applied Opto revenue exposure is 80%+ hyperscale/cloud data center that is expected to grow 20-25% for the foreseeable future and about 15% of revenue is from 4Cable TV (OTCPK:CATV), which is in the early stages of a multi-year DOCSIS 3.1 bandwidth expansion wave. As such, Applied Opto's business exposure is much more sustained and higher growth and less cyclical than its Telco-centric "comparables" which are 60%+ exposed to the more cyclical and lower secular growth Telco space.
As the company gets more sizeable - its market cap recently exceeded $1 billion - I believe Applied Opto is beginning to be recognized for being different and of higher sustained growth potential than its Telco-centric "comparables," but there is a long way to go. In my last Seeking Alpha article on Applied Opto, I spent a lot of time identifying several different fundamental catalysts for stock multiple-expansion potential for AAOI shares. I believe the process is in the early stages of materializing, but has a long way to go.
Below are some comments from a sell-side analyst that were published last week after visiting several optical companies. The comments aggregate his recent research combined with his general knowledge of the sector. I have added my own Applied Opto-centric comments below each of his statements.
Every year in CY1Q, there is an annual price reduction, which amplifies the seasonal softness….
- For Telco, not Data Comm or CATV where Applied Opto lives
We strongly believe the Data Comm upgrade to 25G/100G architectures is just about to shift into high gear and should ramp sharply in CY2Q and CY2H17….
- This is Applied Opto's sweet spot
Data Comm is shifting into high gear, but the mix is shifting to shorter reach lower ASPs….
- This is totally Applied Opto's sweet spot - sub 2K intra data center lowest cost devices.
Consensus Still too Low
Street consensus is currently modeling virtually zero sequential growth from 1Q to 4Q2017 for Applied Opto and that makes no sense at all to me. How does that "jive" with "shifting into high gear"? The current consensus for C2017 is 1QE $0.83 (below the midpoint of guidance), 2QE $0.84, 3QE $0.86, 4QE $0.87 for a full year consensus of $3.39. Amazingly, not one quarter in the C2017 consensus is above the high end of the range for 1Q2017 company guidance of $0.80-0.88.
The full year C2017 Street consensus of $3.39 for Applied Opto is mind-numbingly conservative in light of the surge that is about to happen in 100G demand starting in 2Q2017, assuming the analyst highlighted above and conventional wisdom on the space is correct. But hey, that is opportunity for observers who believe it is low and invest.
Company guidance for C1Q2017 is $0.80 to $0.88. Let's say they deliver $0.90 and guide $0.95 (midpoint) for C2Q2017. I could see consensus going to something like this: 1QA $0.90, 2QE $0.95, 3QE $0.96, 4QE $0.98, for a full year C2017 Street consensus of $3.79, up from $3.39 currently. That would be $0.40 of upside to consensus and a major move towards my C2017 EPS estimate of $4.00, which I view as beatable. If 2Q-4Q2017 and beyond is a serious 100G-centric surge, the question in my mind is, can Applied Opto do $1.25 by 4Q 2017? Bottom line: earnings momentum is strong and is likely to continue, consensus will likely rise several more times as 2017 unfolds and stock-multiple expansion is likely as well.
Street consensus on Applied Opto for C2018 EPS is currently $3.70 and C2019 is $4.17. After Applied Opto reports 1Q2017 results and guides 2Q2017, I believe the new C2017 consensus will likely be higher than the current C2018 consensus. Further, by the time 2017 plays out, I think it will look more like the current C2019 consensus of $4.17. I remain at $4.00 for C2017 and $5.00 for C2018 and expect consensus to continue to move my way.
A measly 15x multiple - for a company with 25-30% secular growth and a rising normalized margin structure - off $4.00 of earnings power in 2017 drives a $60 target. I'm using a 20x multiple for an $80 target and have written extensively why I think the stock multiple should be higher and what can catalyze it to be higher. In short, though, the real issue for the multiple is "sustainability." Is this demand surge a "flash in the pan" or is it sustainable? If it does pause, can Applied Opto maintain its newly guided target margin structure? I think the answer to both questions is yes and there are other upside multiple catalysts such as adding more customers, which is an issue for many investors and is likely to happen this year. Also, at some point in the next six months, AAOI shares should fully discount C2017 earnings potential and begin to discount material growth in C2018.
I think AAOI shares deserve to be purchased on the current pullback and reiterate my $80 stock price target.
In terms of catalysts, Applied Opto will deliver an investor session on the side of the Optical Fiber Communications Conference in Los Angeles on Wednesday, March 22nd, at 10:00 am PST/1:00 pm EST and it will be webcast. See Applied Opto's website for details to connect. In its last earnings call, as I mentioned above, Applied Opto stated that it is in a "fundamentally different" business than its Telco-centric "comparables" and I think this is a theme that will be repeated until coverage analysts and investors reflect a full understanding of the concept in AAOI's stock price target multiples and valuation.
I also see 1Q2017 results in early May as a likely catalyst as I think it should be a "beat and raise" exercise with a subsequent and material uptick in forward consensus estimates.
Despite substantial improvement in recent quarters as the company has executed a sharp ramp and commercialized new products, operational execution is probably still the primary company-specific risk for Applied Opto, in particular to near- and medium-term earnings momentum and margin strength. But I think the new factory, learning curve improvements and increased use of automation are reducing the risk in general.
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. Exactly when that could happen is currently an unknown to investors in general and probably to industry suppliers. I think it is unlikely to occur before the summer or fall of 2017 and likely later is my best guesstimate at the current time, but these things have a habit of sneaking up unexpectedly.
In my view, I believe pricing is the main fundamental dynamic to watch that could signal or catalyze an end to the "Optical Super Cycle" trade/investment, however temporary before the 200G and 400G waves materialize.
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.