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Bull of the Day: Applied Optoelectronics (AAOI)

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Applied Optoelectronics (AAOI - Free Report) is now a $1.5 billion fiber optics component and system supplier, after a 25% rally in shares last week.

That rocket launch came from an explosive combination of ingredients:

1) a company that has become a "serial pre-announcer" of positive sales and earnings surprises

2) a stock that was beaten down from its May highs near $75 after a growing bear thesis crept into the shares

3) a short interest of 10.37 million shares -- well over 50% of the float! -- that was like kindling in a bonfire when the company delivered this little message in a July 13 press release...

"I'm pleased to announce that we expect to deliver another record quarter with our top and bottom-line results expected to exceed our guidance," said Dr. Thompson Lin, Applied Optoelectronics, Inc. founder, president and CEO.

And here were the details...

Second Quarter 2017 Preliminary Unaudited Financial Results

  • Revenue of approximately $117.3 million, above the prior outlook of $106.0 million to $112.0 million.
  • GAAP and non-GAAP gross margin in the range of 45.0% to 45.4%, above the prior non-GAAP outlook of 41.0% to 42.5%.
  • GAAP fully diluted earnings per share in the range of $1.37 to $1.42 and non-GAAP fully diluted earnings per share in the range of $1.31 to $1.36, using a weighted-average fully diluted share count of approximately 20.4 million shares. This is above the prior non-GAAP outlook of $1.09 to $1.19 per share, using approximately 20.4 million shares.

And that is why AAOI popped from $72.64 (last Wednesday's close) to record highs over $86 on Friday, driving those holding the 10.377 million shares short to get out, or get burned.

Why the Massive Short Position?

This scramble begs the obvious question: why are so many so busy being short this "serial surpriser?"

I explained all this in my June report on the company. I'll share some key excerpts...

First, you have to understand that AAOI shares saw a terrific 200% rally in the first half of 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 often follow 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 (June 26) 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.

(end of excerpt from June 26 Bull of the Day on AAOI)

The Bulls Charge After the July 13 Preannounce

Here's what I shared with my TAZR Trader group on Thursday as I collected investment bank analyst notes...

Piper Jaffray, Raymond James and Cowen & Co. analysts all chimed in this morning on the good news.

Piper Jaffray raised its price target on Applied Optoelectronics to $90 from $85 while maintaining their Overweight rating.

Analyst Troy Jensen said he believes top line strength will continue through 2017 and well into 2018 in light of the imbalance due to quantities of 100G transceivers that Web 2.0 clients are demanding. He also noted the company can sustain industry leading gross/operating margin levels thanks to the company's competitive advantage being vertically integrated and sees significant room for further expansion.

Jensen raised his 2017 EPS estimate from $4.82 to $5.14 and 2018 profit projection from $5.22 to $5.53. He kept his 2019 estimate at $5.80.

Cowen analyst Paul Silverstein raised his price target on Applied Optoelectronics to $100 from $94 and maintained his Outperform rating following today's positive preannouncement.

Silverstein said he continues to see meaningful upside to both AAOI's operating model and shares driven by positive leverage to Web 2.0, still early ramp in 100G, and potential penetration of China Web 2.0 customers.

The firm raised their Street-high revenue and EPS estimates by $13 million and $0.33, respectively, to $472 million and $5.55 for 2017. And for 2018, they bumped their sales and profit projections by $25 million and $0.49 to $570 million and $5.79. Silverstein even nudged 2019 estimates up by $16 million and $0.26 to $618 million and $5.80.

Raymond James analysts reiterated their Strong Buy rating on Applied Optoelectronics and increased their estimates, while also raising their price target to $107 from $100 following the company’s  positive pre-announce. Here's what they had to say...

Management commentary lacked details on the source of the strength, but we associate the positive results to a combination of AAOI’s success expanding product output along with a favorable mix driven by increasing demand for its 100G solutions. We do not anticipate strong contributions from Microsoft (as a customer) in F2Q17, and this remains a 2H17 story and a source of upside to our estimates.

Bottom line: Keep AAOI on your buy list this quarter and watch for a good pullback under $80.

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

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