Back to top

Bull of the Day: Applied Optoelectronics (AAOI)

Read MoreHide Full Article

Applied Optoelectronics (AAOI - Free Report) is a $1.25 billion fiber optics component and system supplier that saw a terrific 200% rally in its shares this year after big sales growth and a broader awareness of who their big customers were.

Alphabet (GOOGL - Free Report) , Amazon (AMZN - Free Report) , Facebook (FB - Free Report) , and Microsoft (MSFT - Free Report) are the top builders of cloud-based data centers in what is sometimes called Web 2.0, as massive amounts of dynamic, high-bandwidth content -- especially the kind involving user-generated video and parallel processing for virtual reality and AI functions -- will require lots of advanced, high-speed optical equipment.

And three of these top four architects of Web 2.0 (all but Alphabet) are reportedly "AOI" customers. (The company uses the initials AOI to represent Applied Optoelectronics Inc. and I will frequently use that convention in this article.)

Based on sales projections to these web giants, analysts quickly raised their estimates for the top and bottom lines of AOI this year, keeping shares a Zacks #1 Strong Buy.

The Math of AOI Optimism

In late April and early May, analysts from Raymond James reviewed Q1 reports from AOI and its mega customers and found the spending trends to be very positive, despite AOI's over-dependence on AMZN alone for nearly 50% of sales.

The analysts estimated that cloud capex is expected to grow 14% year over year in 2017 to $39.1 billion. The big 4 were estimated to have spent a combined $7.4 billion on capex in the March quarter, a 20% year-over-year increase.

And Amazon was the leader, with a capex of $1.86 billion, vs consensus for $1.5 billion, while the other 3 were weaker than expectations.

Since Amazon Web Systems (AWS) growth is considered a good proxy for gauging optical equipment demand, the Raymond James analysts saw clear runway for over 70% top line growth this year for AOI to $445 million, and over 20% growth next year to $543 million.

They consequently raised their price target on AAOI shares to a Street high $100.

And they were joined by other investment bank analysts raising earnings estimates. In the past 60 days, the full-year 2017 Zacks EPS consensus moved 15% higher from $3.76 to $4.34.

But 2018 profit projections surged nearly 24% to $5.01 from $4.05.

A Fly in the Champagne?

Since that spring optimism, the month of June has been much more humbling to AOI, as concerns about demand from China hit optical stocks.

And more importantly, there is a notable "bear" case on AOI as short-interest on the stock rose to nearly 50% at the end of May.

Granted, much of the short interest could be from aggressive traders who want to fade the company's 200% moonshot this year.

But some hedge funds are focused on the fact that AOI may be getting temporarily luck filling orders in one passing generation of optical gear at the expense of the next generation market opportunity.

Here was how I summed up the situation for my TAZR Trader members recently, where we own the stock...

AAOI is recording stunning sales growth in a segment of the market that other players have left behind, namely 40 Gigabit Ethernet fiber optic switching equipment. The competition is preparing for the 100G era. The bears claim that management is misrepresenting the current good times with superstar customers AMZN, MSFT, and FB, because in a quarter or two, (1) commodity pricing will resume in this area and (2) big data center customers will be transitioning more toward 100G, where AAOI cannot compete with other fiber players, including possible moves by Intel. There is also skepticism about terrific margins in such a competitive space.

But since the emergence of this bear case, no major investment bank analysts have given us any reason to pay attention to it.

Cowen & Co. analysts put out a note last week and reiterated their Outperform rating and $94 price target after AOI issued a press release about production goals being exceeded.

After the company's June 19 announcement that it expects to achieve its goal of manufacturing 1 million lasers by end of 2017, analyst Paul Silverstein believes this reinforces his AAOI investment thesis and he continues to see meaningful upside to both AAOI's operating model and shares driven by positive leverage to Web 2.0 data center buildouts.

New Competition Surfaces

AAOI shares were down 6.5% on Monday after research hit the street that Fabrinet (FN) was ramping a 100G product for Amazon using MACOM (MTSI) design and components.

Needham & Company analyst, Alex Henderson, reiterated his Strong Buy rating on shares of Applied Optoelectronics acknowledging the increasing competition but still expecting quarterly beats and raises from AOI.

Henderson noted that he had expected and modeled for competition when he started coverage of AOI in May with an $85 price target. Here's what he said then, courtesy of StreetInsider...

"We see substantial upside to AOI’s revenue forecasts, gross margin estimates, and valuation. We think AOI will materially exceed Street estimates in CY17 as the industry rolls through the steep ramp phase of the Data Comm upgrade to 25G/100G. We think the timidity of the Street estimates provides significant upside to the stock. Moreover, we de-risked our CY18 forecast by modeling in pricing pressure as demand and supply come into balance and price declines squeeze out marginal players. AOI looks like the market share leader and lower cost supplier. We expect very strong demand growth over the next several years as the Web 2.0 Big Data, Social Media and IaaS companies drive efficiencies through their current and new scaled-out Data Center footprints."

The outlook for AOI is still strong, but investors are nervous about competition. A couple of weeks from now we should have more visibility on the second half. AOI doesn't report Q2 earnings until early August, but if the quarter was strong, we can expect the company to preannounce in July like they did in April.

Disclosure: I own AAOI shares for the Zacks TAZR Trader.

The Best & Worst of Zacks

Today you are invited to download the full, up-to-the-minute list of 220 Zacks Rank #1 "Strong Buys" free of charge. From 1988 through 2015 this list has averaged a stellar gain of +25% per year. Plus, you may download 220 Zacks Rank #5 "Strong Sells." Even though this list holds many stocks that seem to be solid, it has historically performed 6X worse than the market.

See these critical buys and sells free >>

More from Zacks Bull of the Day

You May Like