Applied Optoelectronics: How High Can This Stock Go?

Summary

Applied Optoelectronics' shares are blasting off again, up 27% over the past five trading days.

Preliminary Q2 results show revenue and EPS well above estimates.

The concerns over AWS appear unfounded.

This stock still has more room to run.

Applied Optoelectronics (NASDAQ:AAOI) reported preliminary Q2 results well above guidance on both revenue and EPS, fueling further stock gains of 7%+ on Thursday. This caps a five-day run-up of 27%, leading to the question: How much higher can this stock go? Earnings growth is ramping rapidly along with revenue growth, profit margin remains robust, and fears that AWS contracting out to Fabrinet (NYSE:FN) would mean lost revenue for AAOI appears unfounded, indicating we can be in for further upside ahead.

Chart AAOI data by YCharts

I first covered AAOI at the end of June as part of my "Buy On The Drop?" series, where I rated the stock a Buy when it was trading at $59 per share. That article can be read here. The stock price has appreciated more than 30% since then, but I think there is still room to run based on operating results and the broader growth of 100G, especially in the datacenter.

For preliminary Q2 results, AAOI reported revenue of $117 million, above previous guidance of between $106 million and $112 million, and non-GAAP EPS of between $1.31 and $1.36, which is a whopping 17% higher at the midpoint than the previous guidance range of between $1.09 and $1.19. There are still precious few details about why exactly the company exceeded guidance by such significant margins on both the top and bottom lines, but management made reference to expanded capacity and lower manufacturing costs. More details will come on the Q2 conference call, but for now, the numbers on their own are enough to impress.

Another impressive metric here is the profit margin, which increased to 23.1%, up 60 bps QoQ and more than 1,800 bps YoY. The company often talks up how no one can beat it on cost due to vertical integration, and the healthy and expanding profit margins certainly seem to back up that claim.

As I mentioned in my previous article, the datacenter is AAOI's key market for 100G solutions, as 83% of its total sales were derived from the space in Q1. Given that datacenter revenues grew 100% YoY in Q1, Q2 represents a 22% increase in revenue QoQ, and Q2 last year is an easy comp at $55 million in revenue, I'm fairly confident that the company will again report that datacenter revenues grew by triple digits in Q2 YoY.

This growth is being driven by a multi-year cycle in the datacenter (and elsewhere) that is showing no signs of slowing, which bodes well for growth continuing into the next few quarters and years.

100G is the new standard, and demand is currently far outstripping supply as shown by the increases in capacity being undertaken by all major optical communication players and by the revenue growth and margin expansion seen across the industry. Very few, if any, companies in this sector are suffering right now because 100G is in a veritable boom for the foreseeable future.

Speaking of other optical comm companies, there were some concerns a few weeks back when Needham analyst Alex Henderson uncovered that Fabrinet had won a deal with Amazon Web Services ("AWS") to provide 100G products (coarse wavelength division multiplexing solution if you were wondering). AAOI derives about 50% of its revenue from AWS and so there was concern that Fabrinet had replaced some capacity that AAOI would otherwise fill.

However, based on the results from this quarterly report, it appears the bulls have been right of this development: AAOI can't fill all the necessary capacity, so AWS had Fabrinet fill the rest of the necessary supply. A win-win for both Applied Optoelectronics and Fabrinet.

I would still classify the dependence on AWS as a risk to be aware of, but not one that I would be too worried if I were a shareholder. There are other Web 2.0 fish in the sea and AAOI has the product and supply chain to gain market share and diversify its revenue stream.

Lastly, from a valuation standpoint, AAOI looks relatively undervalued despite the run-up:

Chart FN PE Ratio (Forward) data by YCharts

AAOI's forward P/E won't show up on the chart for whatever reason, but according to Yahoo! Finance, it's about 14, which is near the bottom of the pack. When one factors in the robust revenue growth, profit margins close to the best in the industry, and the fact that the forward P/E is including outdated data that doesn't take into account this Q2 EPS beat, AAOI looks to be cheap relative to its peers.

I am maintaining my initial Buy rating on AAOI's shares as I think there is still room to run due to the impressive operating results demonstrated by the company and the expected continued growth of 100G in the datacenter over the next few years. The company is in a great position to capitalize on this demand, and I expect revenue growth to continue on the back of this industry trend.

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Thanks for reading!

Disclosure: I am/we are long FN.

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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