Applied Optoelectronics: Top Idea - Solid Fundamental Momentum, Stock Remains Undervalued - Raising Target To $105


AAOI shares are poised to break out to a new high, driven by solid and sustainable fundamental momentum.

A strong technical trend to CWDM from PSM-4 in favor of AOI should help sustain market share and margins.

Raising EPS estimates and target price to $105 from $80.

Following Applied Optoelectronics' (NASDAQ:AAOI) C1Q2017 earnings results on Thursday, May 4th, I am raising my C2017 EPS estimate to $5.00 from $4.00 previously and increasing my C2018 EPS estimate to $6.00 from $5.00 previously.

The post results consensus for Applied Opto for C2017 is now $4.67, up from $3.90 before, while the new C2018 consensus is $5.05, up from $4.17 previously. Of interest, the new C2017 consensus of $4.67 is above the pre-call consensus for C2019 (yes 2019!) at $4.38 and slightly below the prior C2020 consensus estimate of $4.87. Think about that for a minute, in one quarter, the Street consensus for C2019/C2020 just pulled into C2017!!!

AOI's management made some very interesting comments on its C1Q 2017 earnings call.

They stepped out of the quarterly guidance arena and gave full-year guidance for their data center business, which was 83% of total company revenue in C1Q2017. Management said 2017 full-year data center revenue should grow 85% over 2016, and I am sure they plan to beat that. That drives full-year 2017 data center revenue of $372.5 million. 1Q was $79.6 million. Back out 1Q and divide the rest by three and the average for the next three quarters is $98 million.

Despite this very "growthy" guidance, consensus is now modeling the year for non-GAAP EPS as follows: 1QA: $1.10, 2QE: $1.14 (middle of guidance range of $1.09-1.19), 3QE: $1.18, 4QE: $1.18. So obviously the bar remains low and there appears to be plenty of upside to consensus EPS estimates for the remainder of 2017 and well into 2018.

In my last note, I predicted that by the end of 2017, the company would beat the pre C1Q2017 results consensus for C2019. Clearly, AOI is running ahead of that already.

I also stated that 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? Well, believe it or not, one of the sell side analysts that covers Applied Opto is now modeling $1.27 for C3Q and C4Q 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.

My new stock price target is $105, which is 17.5x my new C2018 EPS estimate of $6.00. My previous target was $80, which was 20x my previous C2017 EPS estimate of $4.00. Both target multiples would represent stock-multiple expansion from current levels. I'll look to raise my target multiple off my 2018 EPS estimates assuming the stock continues to rise and as 2018 gets closer or begins to unfold.

At $58, AAOI shares are currently trading at 11.6x my new C2017 EPS estimate of $5.00 and 9.7x my new C2018 EPS estimate of $6.00. Considering that these estimates likely have upside and the company has grown at a 40% CAGR in the five years to 2016, is likely to grow 85-100% in C2017, and is likely to sustain a 25-30%+ CAGR for years to come, these multiples seem quite low.

A core dynamic to my thesis on AOI is the likelihood of stock-multiple expansion driven by many variables, which I have laid out several times. Without regurgitating all of them, I will say the most recent earnings report/guidance did quite a bit to differentiate AOI from the more Telco-centric "comparables" such as Oclaro (NASDAQ:OCLR), Finisar (NASDAQ:FNSR), and Lumentum (NASDAQ:LITE).

Applied Opto's revenue in C1Q2017 was 83% data comm, 14% cable TV, and 3% other. Applied Opto's served markets, data comm, in particular with a focus on hyperscale, offer substantially better secular growth with far less cyclicality than the so-called "comparables," which are Telco-centric with 65%+ exposure. They are much slower secular growers with much more hyper cyclicality, as evidenced by the recent issues in China.

It's been less than a year since Applied Opto has started to become widely recognized by the investment community and I believe the company is still misunderstood by a large number of investors, in particular day traders and "quants" that clearly play the stock.

I have also stated that the key to stock-multiple expansion will be AOI proving the sustainability of its growth potential, its market share, and its margin structure - especially the new and higher target margin model articulated by the company in February. Additionally, stock-multiple expansion should be catalyzed by continued strong operational execution (i.e., better than historical predictability). Also, a broadening out of the customer base (customer concentration de-risking) should aid stock-multiple expansion.

In my view, Applied Opto's C1Q2017 results supported all of these dynamics. The stock has reacted well thus far, but there is a lot of "wood to chop" for this stock to get what I view as a fair multiple.

To reiterate, the concepts of sustainability and predictability, delivered quarter after quarter within the context of solid growth and customer de-risking, should drive stock-multiple expansion for AAOI shares over the next several quarters and years.

The stock-multiple expansion process will likely take a while because investors are used to extreme volatility in traditional Telco-centric optical component stocks.

Applied Opto is a different beast as a virtual small cap "pure play" (83% of revenue and growing) on the emerging hyperscale data center trend. This has not been seen before in optical component companies or optical stocks. It is going to take a while for these concepts to take root in sustainably higher stock multiples for AAOI shares, and much depends on company specific execution.

PSM-4 to CWDM Transition - Important Fundamental Trend

The most important new information on Applied Opto's C1Q2017 results call was technology-based and argues for higher share at 100G than 40G and sustainability of margins - two of the three major bear concerns.

To visualize the commentary below, please refer to the Applied Opto investor slides (link here) specifically pages 10 and 11.

From slide 11 titled "Data Center Transceiver Use Cases," AOI serves the Intra-Data Center market, specifically the "Long Reach" portion of the Intra-Data center market. They sell two main products, PSM-4 for 150m (meters) to 500m, and CWDM for 500m to 2km (kilometers). Management said that because data centers are getting larger, the mix is shifting to more CWDM and less PSM-4.

Management further said CWDM is more difficult technology, AOI is a technology and production leader, and there is less competition there versus PSM-4. AOI had 54% of its C1Q2017 data center revenue from CWDM versus about 26% in C1Q2016, so you can see the shift happening.

The average selling prices are higher for CWDM, the technology is more difficult, AOI is a technology leader in CWDM, there is less competition, and AOI can scale its manufacturing as good or better than anyone in the space as the low cost producer. Management was emphatic that this is a major reason why they expect to gain share at 100G versus 40G and why they think their new target margin model is sustainable or beatable for some significant period of time. So this directly addresses the top two bear arguments against AOI.

Note slide 10 where AOI projects VERY solid growth continuing into 2018 for optical transceiver demand from the data center market.

The third bear argument is fear of a sudden drop off in 40G that 100G can't offset for sufficient growth versus expectations. Management said 40G was record revenues in C1Q2017, essentially flat with C4Q2016. 40G will trend lower, but for the full year 2017 40G revenue should be higher for AOI than 2016 while the industry probably sees it drop off. AOI should see it rise mainly because of a full year at Facebook (NASDAQ:FB) versus a half-year as a "starter supplier" in 2016. Remember, new equipment enters data centers without all the "blades" fitted. They expand over time. So 40G optical transceiver demand remains firm even as 100G is the main new equipment added. Next year AOI will be selling 100G and 200G as 40G tails off faster. Not an issue...

AOI added three new data center customers in C1Q2017 in terms of design wins that will start to ship soon if they haven't already - two small data center operators and one OEM equipment supplier. These were small new customer additions, but very nice to see.

To reiterate, the most important new information - in my mind - from the call today, is the technology transition discussion from PSM-4 to CWDM. This is a true fundamental argument for sustainability of competitive position, share trends and margins. This is a nice fundamental backdrop as the stock is poised to break out to a new high above $60…


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.

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