Update: Time to Reduce the AAOI Position

(Published July 13, 2017)

Update: Time to Reduce the AAOI position.

The morning of Friday July 13, Applied Optoelectronics (AAOI) preannounced second-quarter earnings that were far ahead of expectations.

The company anticipates revenue of $117.3 million, well above previous expectations of $106 million to $112 million. Gross margins have strengthened to 45%+ from the 41% to 42.5%, which is likely driven by high demand and the vertical integration setup of the company.

Earnings per share estimates soared. The company now expects to earn between $1.31 to $1.36 per share, up from $1.09 to $1.19 per share.

Previously, we anticipated AAOI to earn between $4.50 to $5 per share in 2017. Now it’s much more likely earnings hit the high end of that range. We’d prefer to see one more quarter of results before adjusting our 6-to-12-month target for a stock price of $100.80 per share and 18-month target of $126. But our confidence in those projects has increased with AAOI’s new guidance.

Despite all the good news, a prudent investor owning this stock below $63 should consider selling one-third of the position here near or above $78. Shares are up some 27% from our newsletter recommendation a week ago and given the volatility associated with the name, we’re likely to get an opportunity to repurchase those shares in the next six months.

The stock started around $76, up about 4%.

Below is our original recommendation published July 5 at 9:15 a.m.

The Uncommon Idea in Brief

Buy fiberoptic networking company Applied Optoelectronics (AAOI) stock for the long term.

-The stock has been pushing higher since an early spring downgrade on concerns of slowing business in China. Begin building a long position under $70 and add aggressively on any pullbacks greater than 10%.

The Industry Opportunity

The need to more data to get from point A to point B faster than ever is pushing current technology to its limits.

Current demand exceeds supply as fiber optic networking companies race to meet the needs of data intensive companies like Amazon (AMZN), Microsoft (MSFT), Apple (AAPL), Alphabet (GOOGL) and Alibaba BABA.

As the cloud grows, there is little sign of this demand abating and data centers for the tech behemoths above will be a major area of growth.

Purchases of optical data center interconnect (DCI) equipment are expected to grow to $4.3 billion in 2021 from $1.69 billion in 2016, according to an April report by ACG Research. Growth is expected in all geographic regions, according to ACG.

What Applied Optoelectronics Does

Applied Optoelectronics produces fiberoptic networking products for internet data centers (IDC), cable television (CATV) and fiber-to-the-home (FTTH) networks.

It also offers optical modules, lasers, transmitters and transceivers and turn-key equipment, as well as headend, node and distribution equipment.

The company’s main market had been the cable television industry as a supplier of optical parts to gear makers like Aurora Networks, Cisco Systems (CSCO), Harmonic (HLIT) and Huawei (SHE). With competitors like Finisar (FNSR), Lumentu Holdings (LITE) and Acacia Communication (ACIA), AAOI has begun transitioning its focus on the faster growing IDC market.

Amazon is the company’s largest client, representing 55% to 60% of its revenue. But Facebook has increased itself to a near-20% customer in terms of revenue. Microsoft dipped below 10% due to an unrelated issue, but that should reverse and head higher as the year moves along. All told, these three companies accounted for 72% of AAOI’s revenue.

Once seen as a weakness, research firm Cowen now believes AAOI’s reliance on its cloud customers is a virtue. Demand from AAOI’s Cloud Titan customers has significantly improved the company’s operational outlook.

Currently, AAOI’s product breakdown is only 30% with 100G (gigabit) products, with 40G products making up the bulk of sales at 62%. This should shift over the next few years. In Q1, 100G revenue soared 76% to $23.9 million.

The Uncommon Market Position

Internet companies upgrading to 100 gigabit-per-second technology in data centers packed with computer servers will be a major boon.

AAOI produces data center interconnect gear that handles server-to-server traffic and provides high speed links between data centers.

Companies can barely build products fast enough to meet end demand. Need for 100G transceivers rise as companies ramp up 100G optics. While the industry is struggling to produce enough transceivers, Applied Optoelectronic benefits because of its vertical integration.

The company can produce its own product without relying on any suppliers.

What Sets Applied Optoelectronics Apart

AAOI’s growth is currently only constrained by its ability to produce products.

As the company scales efficiencies, it will not only be able to continue to growth revenue, but should benefit from margin expansion as well.

AAOI’s chief financial officer said the company sees a major paradigm shift in data centers from copper to fiberoptic components as companies adopt open architecture and expand. Internet firms are upgrading to 100 gigabit-per-second technology in their data centers as quickly as the products can be produced.

Financials – Applied Optoelectronics by the Numbers

In 1Q, after twice boosting guidance, Applied Optoelectronics produced eye-popping year-over-year revenue growth of 91%, delivering revenue of $96.2 million. Quarter-on-quarter growth surged 13%. This translated to non-GAAP earnings of $1 per share, or $21.8 million after reporting a loss in the same period a year earlier. The company’s gross margin remained strong at 43.1%.

Management guided second-quarter revenue and net income higher despite a slight dip in margins. Revenue of $106 million to $112 million on margins of 41% to 42.5% is expected for 2Q, producing non-GAAP net income of $22.2 million to 24.4 million. That would be earnings per share of $1.09 to $1.19.

Given the company’s almost non-existent debt levels along with more than $3 per share in cash, AAOI is poised to deliver 2017 earnings per share of $4.50 to $5 per share.

Why the Stock Is a Buy

The stock gives investors annual earnings of $4.50 to $5 per share and its growing revenue 10% to 15% quarter over quarter at a current projected price-to-earnings ratio of around 15x.

Given the company’s almost non-existent debt along with more than $3 per share in cash, there’s an attractive level of value in a hyper-growth name. But revenue growth is projected to slow to a more “moderate” 20% level in 2018. As the company ramps capacity to meet demand, earnings per share will remain somewhat at the same level in 2018.

A large short interest of 43% hovers above shares, so there are plenty of doubters in the marketplace. But a massive short-squeeze is possible and one has probably already helped push shares higher by 600% over the past year.

With an average estimate of $5.04, we believe a forward P/E of 20x is both reasonable and attractive for a company growing revenues at 20% with the potential to increase those numbers if production capacity increases. This produces a $100.80 price target on the low side with the possibility of increasing to $126 should we experience revenue growth of 23% to 25% in 2018.

If a short-squeeze does take hold, then these targets could simply act as rest stops to much higher prices.

The Technical Analysis — At $80 or lower AAOI is a Long-Term BUY; A close over $67 is a Breakout Buy

If words of warning about AAOI’s volatility weren’t enough, then the chart should spell it out.

Even on the weekly chart, the meteoric rise from the teens at the end of 2016 to nearly $80 by June 201,7 fraught with 20% pullbacks and 100% surges, is clear. The trend for the first six months of the year has been higher. A clean bullish channel, albeit a wide one, guided the stock. Shares haven’t traded below the 20-week simple moving average (SMA) since 2016 and the 13-week SMA has been more important support. Touches of the 13-week SMA have been opportunistic buys during 2017. The question here, or rather the challenge, is whether that will hold here or not.

The challenge in the June pullback is determining whether this is a pause that refreshes or the end of the previous trend and start of a new one.

A rest after more than doubling in price is natural. And the pullback here has been orderly as well as on decreasing volume. These are both signs that favor the current retracement as a bullish flag setting up a continuation to the upside. Unfortunately, with price trending lower rather than sideways, buying support is more difficult as resistance is also declining.

So, a bounce off support could meet resistance a week or two down the road that is the same level as the support just purchased. Additionally, we’d note the bearish crossover (%K line moving below the %D line) in the Full Stochastics occurring in the overbought area (above 80). While not longer-term bearish, this has stalled price in the past for four to six week. We’d expect that drag to dissipate no later than the third week of July.

Our target on a breakout over $67 is $90 in the next 12 months as we anticipate the extension of the breakout would roughly equal the move of the May breakout above the late April resistance. We view $56 as the next level of support should the current level of $60 fail. If AAOI breaks below $56, we anticipate a new trading range developing between $45 and $56.

While this would be concerning, if there are no fundamental changes to the company, we would use support areas to add to our position and take partial opportunistic sales into resistance levels.

AAOI, Applied Optoelectronics, chart, technical analysis
Applied Optoelectronics volatile chart. CLICK CHART FOR LARGER IMAGE.

 Catalysts for the Thoughtful Investor

On the negative side, concerns regarding data center buildout slowing for companies like Amazon, Alphabet, and Apple recently weighed on AAOI. Also, political concerns cast a shadow on AAOI as the market is worried about what President Trump may say about China and the impact it could have on companies doing business overseas.

On the positive, there is lots of sell-side enthusiasm.

Cowen said it believes growth isn’t dependent upon demand, only AAOI’s ability to manufacture. It favors the risk-reward and projects AAOI to earn $5.21 per share on $459 million in revenue in 2017, while 2018 will deliver $5.30 per share on $546 million in revenue.

Raymond James said competition is overexaggerated, especially since AAOI holds the advantage of being vertically integrated while also offering a wide breadth of products. Even still, it says the market can support multiple players and AAOI would be a key player in the group.

Raymond James forecast 2017 earnings per share of $4.63 on $445 million in revenue with a big jump to $5.74 per share on $543 million in revenue in 2018.

Piper Jaffray said the company had robust demand in Q1 driven by the 100G transceivers, due to the ramp to 100G optics and scale efficiencies by internet companies. This is the key driver to the impressive margin expansion for AAOI. Piper estimates earnings per share of $4.52 on $430 million in revenue in 2017 for the company. It’s the most conservative on the 2018 ledger, projecting a small increase in earnings per share to $4.59 and $494.5 million in revenue.

The company’s stock was also added to the S&P 600 Small Cap Index on April 25, 2017.

The Bottom Line

-Applied Optoelectronics is a leader in the high-speed semiconductor sector specializing in 100g technology to connect server-to-server traffic known as Data Center Interconnect.

-The paradigm shift from slower copper to high speed fiberoptical components is still in its early days and growing rapidly. But restrained production capacity has created a situation where demand outstrips supply. The market will support multiple players and AAOI is an early frontrunner to create itself as a cornerstone in the marketplace.

-Applied Optoelectronics holds multiple advantages over competitors. Vertical integration, increased level of automation and breadth of products provide major advantages over competitors. The company’s growth is only restrained by production, not demand. Since AAOI is vertically integrated, it is not dependent upon another company and can bring its own products faster to market than competitors.

-In the range of $65-$75 we think AAOI a long-term buy and hold. The small-cap nature, 600% move higher over the last year, massive short interest, restrained compacity of product and reliance on large customers will make it volatile.

At the time of publication, neither the author nor the company held positions in the stocks mentioned, but positions may change at any time.

Are you a thoughtful investor looking for uncommon investment ideas?

Stirling Strategic Investor is a new source of high-quality investment ideas from seasoned investment professionals Tim Collins and Kim Khan, formerly senior members of TheStreet.com. Tim and Kim share 50 insightful equity trade’s per year for $100. That’s just $2 per trade.

And if you subscribe now, you can get $20 off the the annual price using promo code 20DISCH

Tim and Kim’s first recommendation, Mobileye, was recently acquired at a 34% premium by Intel. We provide the first two ideas at Stirling Strategic Investor for free. We look forward to providing you uncommon ideas of true value.

Learn more at Stirling.