Our last pick, Ocwen Financial Corporation (OCN) met our expectations. On April 26 we recommended a buy on OCN, expecting it to hit over $3 from the low $2's which it did a few days later. On May 3 we sold our position after a negative reaction the the company's conference call and it has settled back down to around $2.50. If you like our picks make sure to follow our blog by clicking the follow button on the top of the left hand panel. We are up to 185 followers despite the relatively few articles that we publish. We think this good growth in followers is indicative of people liking our picks and research. If you wish to share this post, use the suffix blogspot.mx as blogspot.com doesn't pass some sites' spam filters.
After another successful play in the small cap world with OCN, we have decided to move on to a tech unicorn which has just recently passed a billion dollars in market cap after an excellent Q1 report - Applied Optoelectronics (AAOI). The term unicorn is usually applied to software and app startups that have turned into billion dollar companies, but we think that it should also apply to this young hardware company uniquely positioned in an explosive industry. AAOI is an optical communication equipment manufacturer that sells specifically to four end markets - internet data centers, telecom, cable TV and fiber-to-home (FTTH). However, by far the biggest driver of its growth and bullish sentiment is its data center business. Its primary customers are Amazon (Web Services), Microsoft and Facebook.
It is always better to be late to a good party than to have missed it entirely. AAOI has moved from $8 to $56 over the past 52 weeks but we think this rise will continue. We believe that $60 is possible as early as next week, $80 by mid-summer and $100 or more by the end of the year, providing a near double for the people who have showed up late to this party in early May 2017. Here are eight reasons why:
1. Record Q1 financial performance beats analyst expectations
A link to AAOI's financial results is here. AAOI's analyst expectations according to Yahoo Finance is here, with the chart provided below as we expect this data to be updated shortly. Highlights:
This growth was largely driven by the data center business where revenue grew from $39 million to $79.6 million for Q1, a growth rate of 104%. Gross profit nearly tripled from $14.3 million to $41.5 million as demand transitions towards higher-margin 100G products.
2. Q2 guidance
Updated Q2 guidance can be seen at this link to the Q1 conference call:
"Moving now to our Q2 outlook, we expect Q2 revenue to be between $106 million and $112 million, representing 92% to 103% year-over-year growth. We expect Q2 non-GAAP gross margin to be in the range of 41% to 42.5%. Non-GAAP net income is expected to be in the range of $22.2 million to $24.3 million, and non-GAAP EPS between $1.09 per share and $1.19 using a weighted average fully diluted share count of approximately 20.4 million shares. We expect our income tax rate for the quarter to be approximately 20.5%."
The mid-point of $109 million in an expected range of $106 to $112 million in revenue beats previous analyst consensus of Q2 revenue of $98 million by 11%. The mid-point EPS of $1.14 in the expected range of $1.09 to $1.19 beats previous analyst consensus of $0.96 by 19%.
This beat is so large, particularly on the bottom line number that analyst expectations of a $3.90 EPS for 2017 no longer makes any sense. Analyst consensus was $1.94 for the first half of 2017. Non-GAAP EPS is on pace to be $2.24 for the first half of the year. Extrapolating this 15% improvement over full-year 2017 and that would lead to a consensus 2017 EPS of $4.50. At $56, AAOI is trading at only a 12.4 P/E multiple. A $100 stock price leads to a reasonable 22.2 P/E multiple. This is why we think the stock can make it to $100 by the end of the year.
3. Excellent balance sheet management
AAOI is in a very cyclical and competitive industry. Balance sheet management is paramount in the good times as well as the bad times, because things can turn on a time. AAOI has done an excellent job in this aspect. Here is a snapshot of the balance sheet:
Key points to highlight:
4. Analyst upgrades
Analysts had a very positive reception after the call. Review analyst upgrades at this link. Raymond James increased its target on AAOI from $74 to $100. Cowen raised its target from $75 to $94. So we aren't the only ones who think AAOI can hit $100 in short order. We think that as more analyst upgrades come early next week, the stock will be pushed over $60 and into a new 52-week high. After that, the sky is the limit.
5. Optical supercycle: buzzwords that create volatility
If you do a search on the words "optical supercycle" you will get a lot of divergent opinions. These buzzwords seem to have been invented by sell-side analysts as AAOI and other companies in the industry had an extremely hot 2016. But some naysayers have doubted the virility of this "supercycle" as larger players in the optical industry haven't seen such intense growth and stock price performances have greatly diverged by the various mid-cap players. A great example is Acacia Communications (ACIA) which started out extremely hot after its IPO in the spring of 2016. The stock price jumped to over $100 by the summer but has since pulled back by more than 50% to the high $40's.
The naysayers in the industry and the lack of recognition that AAOI may be doing something special that is driving customer loyalty for its data center equipment has led to a lot of people blindly shorting this high-flying stock, leading into the next point.
6. Short squeeze potential on a thin float stock
AAOI has a fully diluted share count of 20.4 million. AAOI's short interest can be accessed at this link, as well as this snapshot:
AAOI's short interest has been increasing over the past several weeks, and is likely a contributing factor when the stock price pulled back substantially after the first time it hit $60 in late March. It's a good idea for investors to keep an eye on this short data for when it is made available as of April 30th, but if it has remained steady at 4.7 million shares, that means short interest is 23% of the fully diluted share count. Yahoo Finance does not have float details. However it shows insider holdings of 7% and institutional holdings of 67%, and AAOI hasn't given institutions any reason to rush out of the door. So the short interest outstanding as a percentage of the float will be substantially higher than 23%.
7. Data center builds are ongoing
Lending further support that the optical supercycle is more than just an empty phrase meant to pump up the industry, the big internet companies continue to build data centers. Last month there was a report that Amazon Web Services is building data center facilities in Sweden. This would be AWS' fifth data center in Europe. But the most important point may be the second last paragraph in the article:
"Another reason for this data center proliferation across many countries is that many nations have data sovereignty laws requiring citizen data to be kept in the country of origin. The old days when AWS Dublin data center could serve all of Europe are over."
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After another successful play in the small cap world with OCN, we have decided to move on to a tech unicorn which has just recently passed a billion dollars in market cap after an excellent Q1 report - Applied Optoelectronics (AAOI). The term unicorn is usually applied to software and app startups that have turned into billion dollar companies, but we think that it should also apply to this young hardware company uniquely positioned in an explosive industry. AAOI is an optical communication equipment manufacturer that sells specifically to four end markets - internet data centers, telecom, cable TV and fiber-to-home (FTTH). However, by far the biggest driver of its growth and bullish sentiment is its data center business. Its primary customers are Amazon (Web Services), Microsoft and Facebook.
It is always better to be late to a good party than to have missed it entirely. AAOI has moved from $8 to $56 over the past 52 weeks but we think this rise will continue. We believe that $60 is possible as early as next week, $80 by mid-summer and $100 or more by the end of the year, providing a near double for the people who have showed up late to this party in early May 2017. Here are eight reasons why:
1. Record Q1 financial performance beats analyst expectations
A link to AAOI's financial results is here. AAOI's analyst expectations according to Yahoo Finance is here, with the chart provided below as we expect this data to be updated shortly. Highlights:
- total revenue increased to $96.2 million, up 91% compared with $50.4 million in the first quarter 2016 and up 13% compared with $84.9 million in the fourth quarter of 2016.
- This beats consensus of $95 million and comes in line with the highest analyst estimate of $96.2 million.
- GAAP net-income was $1.00 per share and non-GAAP net income was $1.10 per share. 8 cents of this 10 cent difference is attributed to share compensation expense. As the stock price has risen greatly over the last year, any employee stock and options are worth a lot more as a result, requiring this expense.
- Analyst consensus was $0.98 in EPS. Even considering the GAAP EPS, this is a beat by 2%. When considering the non-GAAP result, which is what most analyst expectations are compared against, this beats by 12% and beats the highest estimate of $1.02 by 8%.
This growth was largely driven by the data center business where revenue grew from $39 million to $79.6 million for Q1, a growth rate of 104%. Gross profit nearly tripled from $14.3 million to $41.5 million as demand transitions towards higher-margin 100G products.
2. Q2 guidance
Updated Q2 guidance can be seen at this link to the Q1 conference call:
"Moving now to our Q2 outlook, we expect Q2 revenue to be between $106 million and $112 million, representing 92% to 103% year-over-year growth. We expect Q2 non-GAAP gross margin to be in the range of 41% to 42.5%. Non-GAAP net income is expected to be in the range of $22.2 million to $24.3 million, and non-GAAP EPS between $1.09 per share and $1.19 using a weighted average fully diluted share count of approximately 20.4 million shares. We expect our income tax rate for the quarter to be approximately 20.5%."
The mid-point of $109 million in an expected range of $106 to $112 million in revenue beats previous analyst consensus of Q2 revenue of $98 million by 11%. The mid-point EPS of $1.14 in the expected range of $1.09 to $1.19 beats previous analyst consensus of $0.96 by 19%.
This beat is so large, particularly on the bottom line number that analyst expectations of a $3.90 EPS for 2017 no longer makes any sense. Analyst consensus was $1.94 for the first half of 2017. Non-GAAP EPS is on pace to be $2.24 for the first half of the year. Extrapolating this 15% improvement over full-year 2017 and that would lead to a consensus 2017 EPS of $4.50. At $56, AAOI is trading at only a 12.4 P/E multiple. A $100 stock price leads to a reasonable 22.2 P/E multiple. This is why we think the stock can make it to $100 by the end of the year.
3. Excellent balance sheet management
AAOI is in a very cyclical and competitive industry. Balance sheet management is paramount in the good times as well as the bad times, because things can turn on a time. AAOI has done an excellent job in this aspect. Here is a snapshot of the balance sheet:
Key points to highlight:
- Cash has risen from $52 million to $60.6 million over the three month period from December 2016 to March 2017.
- AAOI's long-term debt has been paid down from $42.8 million to $28.6 million during the quarter and is now less than half of cash.
- Accounts receivable are up 34% from Q4 2016 and up 72% from $38.8 million at the end of 2015. This increase is still at a much slower pace than revenue growth. Days Sales Outstanding are decreasing. This is a positive sign as it shows that AAOI's customers are quick to pay their bills and that AAOI's revenue recognition policy is sufficiently conservative.
- Inventory is up $57.5 million from $51.8 million from the end of 2016, but is down from $66.2 million at the end of 2015. This is a mixed result. Inventory is turning over very quickly which is generally a good sign. But the decline from 2015 to 2016 when revenue nearly doubled may be indicative of the company struggling to meet high demand. The good news it that inventory increased slightly in Q1 and AAOI made $7.2 million in capital investments during Q1 for production equipment and building improvements.
4. Analyst upgrades
Analysts had a very positive reception after the call. Review analyst upgrades at this link. Raymond James increased its target on AAOI from $74 to $100. Cowen raised its target from $75 to $94. So we aren't the only ones who think AAOI can hit $100 in short order. We think that as more analyst upgrades come early next week, the stock will be pushed over $60 and into a new 52-week high. After that, the sky is the limit.
5. Optical supercycle: buzzwords that create volatility
If you do a search on the words "optical supercycle" you will get a lot of divergent opinions. These buzzwords seem to have been invented by sell-side analysts as AAOI and other companies in the industry had an extremely hot 2016. But some naysayers have doubted the virility of this "supercycle" as larger players in the optical industry haven't seen such intense growth and stock price performances have greatly diverged by the various mid-cap players. A great example is Acacia Communications (ACIA) which started out extremely hot after its IPO in the spring of 2016. The stock price jumped to over $100 by the summer but has since pulled back by more than 50% to the high $40's.
The naysayers in the industry and the lack of recognition that AAOI may be doing something special that is driving customer loyalty for its data center equipment has led to a lot of people blindly shorting this high-flying stock, leading into the next point.
6. Short squeeze potential on a thin float stock
AAOI has a fully diluted share count of 20.4 million. AAOI's short interest can be accessed at this link, as well as this snapshot:
AAOI's short interest has been increasing over the past several weeks, and is likely a contributing factor when the stock price pulled back substantially after the first time it hit $60 in late March. It's a good idea for investors to keep an eye on this short data for when it is made available as of April 30th, but if it has remained steady at 4.7 million shares, that means short interest is 23% of the fully diluted share count. Yahoo Finance does not have float details. However it shows insider holdings of 7% and institutional holdings of 67%, and AAOI hasn't given institutions any reason to rush out of the door. So the short interest outstanding as a percentage of the float will be substantially higher than 23%.
7. Data center builds are ongoing
Lending further support that the optical supercycle is more than just an empty phrase meant to pump up the industry, the big internet companies continue to build data centers. Last month there was a report that Amazon Web Services is building data center facilities in Sweden. This would be AWS' fifth data center in Europe. But the most important point may be the second last paragraph in the article:
"Another reason for this data center proliferation across many countries is that many nations have data sovereignty laws requiring citizen data to be kept in the country of origin. The old days when AWS Dublin data center could serve all of Europe are over."
Data sovereignty will remain an issue going forward in Europe and other places across the globe. This would necessitate the building of data centers in the country of origin if one does not yet exist for those countries that have such laws. Here is a link to an excellent article introducing the issue from a customer perspective.
Facebook is building a massive data center in Nebraska that plans to be up and running by 2020. This center would be the company's sixth in the United States but only ninth worldwide. With Facebook being a global company and actively trying to improve its global ARPU ex-North America, its only choice will be to build data centers outside of the United States in order to reduce latency to its global user base and comply with aforementioned data sovereignty laws where applicable. The company has determined that six centers are needed to cover North America and surrounding regions which may cover up to 10% of the world's population, if that. So how many data centers is Facebook planning to have to span the rest of the globe? Certainly more than three. Germany, France and Russia each require their own centers to comply with their to data sovereignty laws.
The data center builds are ongoing with no end in sight. We believe that the optical supercycle will remain robust for years and when the investment community finally wakes up to this fact, AAOI and other optical component manufacturers will be at much higher valuations. At least until the supply can catch up to the demand. Looking at AAOI's income statement, as well as auxiliary line items such as inventory, it looks like we will have a while to go before that balance is achieved.
8. AAOI makes a good buyout target
Anyone can say this of the company that they own. But we believe that this industry is ripe for consolidation with how many players there are out there that provide various inputs into the data centers and other areas where optical equipment is required. Consolidation into larger players should improve manufacturing capacity to get to the supply-demand balance quicker and purchasers will be looking to eat up as much market share as possible of this growing pie. Given the robust state of the optical communications equipment industry, AAOI's unique position in the industry and its reasonable valuation, we think AAOI will be in the middle of this M&A frenzy if it so chooses to be purchased. Investors can make their own decisions but we think we have presented a good enough investment case with the previous seven reasons whether one wants to believe in a buyout scenario or thinks it's just a fantasy.
Disclosure: We are long AAOI
Facebook is building a massive data center in Nebraska that plans to be up and running by 2020. This center would be the company's sixth in the United States but only ninth worldwide. With Facebook being a global company and actively trying to improve its global ARPU ex-North America, its only choice will be to build data centers outside of the United States in order to reduce latency to its global user base and comply with aforementioned data sovereignty laws where applicable. The company has determined that six centers are needed to cover North America and surrounding regions which may cover up to 10% of the world's population, if that. So how many data centers is Facebook planning to have to span the rest of the globe? Certainly more than three. Germany, France and Russia each require their own centers to comply with their to data sovereignty laws.
The data center builds are ongoing with no end in sight. We believe that the optical supercycle will remain robust for years and when the investment community finally wakes up to this fact, AAOI and other optical component manufacturers will be at much higher valuations. At least until the supply can catch up to the demand. Looking at AAOI's income statement, as well as auxiliary line items such as inventory, it looks like we will have a while to go before that balance is achieved.
8. AAOI makes a good buyout target
Anyone can say this of the company that they own. But we believe that this industry is ripe for consolidation with how many players there are out there that provide various inputs into the data centers and other areas where optical equipment is required. Consolidation into larger players should improve manufacturing capacity to get to the supply-demand balance quicker and purchasers will be looking to eat up as much market share as possible of this growing pie. Given the robust state of the optical communications equipment industry, AAOI's unique position in the industry and its reasonable valuation, we think AAOI will be in the middle of this M&A frenzy if it so chooses to be purchased. Investors can make their own decisions but we think we have presented a good enough investment case with the previous seven reasons whether one wants to believe in a buyout scenario or thinks it's just a fantasy.
Disclosure: We are long AAOI
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