Value Play: Alliance Fiber Optic Products (Nasdaq: AFOP)

 Back in September, I was hesitant to sell off Fabrinet despite its accounting irregularities because the business of high-speed Internet and fiber optics needed to construct the information superhighway is such an exciting megatrend of future wealth that virtually all investors should participate.  I recommend re-reading the introduction to my Fabrinet recommendation from January 2014 because all of the comments relating to the fiber-optic industry in general remain valid. The one difference is that Cisco Systems’ updated 2013-18 forecast of global mobile data traffic growth is even more optimistic than its forecast from last year.

Given the tremendous opportunity in fiber optics, I’ve been chomping at the bit to recommend a replacement stock for Fabrinet and now is the time to jump into Alliance Fiber Optics Products (AFOP). Fiber-optic components are used for both slow-growing telecommunications voice services and fast-growing Internet data traffic. Whereas Fabrinet’s business was only 70-percent fiber optics, of which two-thirds was telco voice and one-third was data traffic, Alliance Fiber Optics Products operates in “a single industry segment” (page 10)  that is 100-percent fiber optics, of which two-thirds is fast-growing data traffic and one-third is slow-growing telco. In other words, AFOP not only is a worthy replacement for Fabrinet in the fiber-optics space, it is more of a pure play in the fastest-growing data segment.

The first boom in fiber optics occurred back in the late 1990s with the advent of the Internet and after the passage of the Telecommunications Act of 1996 opened up the local telephone loop to competition from competitive local exchange carriers (CLECs). Virtually all of the fiber laid back then was for long-distance backhaul and interconnection between telco networks and a glut developed. Today, by contrast, the new boom in fiber optics involves video streaming from data centers of non-telco companies like Google, Netflix, and Amazon.com, as well as installing “fiber to the home” — the last section of the network closest to the end customer that previously had been the bottleneck preventing full consumer reception of high-speed data and video.  Back in 2012, a Wall Street Journal article entitled Optical Delusion? Fiber Booms Again, Despite Bust described the new fiber boom this way:

It is early days in what some in the fiber-optic business are calling a new boom for their long-beaten-down industry. Demand is being driven by skyrocketing Internet video traffic, requests from the financial sector for ever-faster trading connections, and soaring mobile phone use—which has to be tied into landline networks.

Telecom builders say it is the location of the fiber-optic networks—rather than their capacity—that is driving new demand. Networks don’t exist where they are needed—at cellphone towers, suburban office parks, and remote data centers, for instance. Carriers that prize reliability want alternative routes. And new uses, such as high-frequency trading, are also emerging that call for new routes.

In fact, demand for fiber could explode if online video streaming continues to take off, some companies and analysts say. Companies like Netflix Inc., Apple Inc., Hulu and Amazon.com Inc. deliver movies and TV shows to consumers over the Web. But media executives note that widespread adoption of such services would stress the existing Internet infrastructure.

More recently, in June 2014, a Reuters article entitled Business Bandwidth Demand Lights up Once Dark Fiber Sector made similar observations:

The fastest growing area of the market is in local fiber routes that connect directly to buildings, in stark contrast to the long haul routes that were built out during the telecom boom more than a decade ago. Constructing fiber routes to the “last mile” to local buildings and offices is very expensive because in densely populated areas, companies have to get permits and often have to be built underground around electricity and gas lines. The companies that drove the boom about 15 years ago ran out of money before they could build out these local routes. Now, fiber networks in cities are in demand and their services sell for a premium.

One of the biggest boosters of high-speed video is Google, which is rolling out local fiber-optic networks in 34 cities through its Google Fiber division that are capable of Internet speeds of 1 gigabit per second, which is 47 times faster than the current broadband standard of 21.2 megabits per second.  Simply put, speed matters. AT&T is getting into the act also, announcing plans to compete against Google Fiber with a nationwide GigaPower service in 100 cities. Municipal governments such as San Leandro in Northern California are showing great interest in these super-speed local networks, believing that such networks are a competitive advantage that attracts businesses, jobs, and urban development. Both the Google and AT&T fiber-network high-speed build outs are great news for fiber-optic component vendors like AFOP. In fact, rumor has it that AFOP’s largest customer, which accounted for 35.5 percent of the company’s total revenue in the third quarter (page 5), is either Google or AT&T.

The market opportunity is huge, but it’s huge for every fiber-optic component company and not all will compete successfully. The reason AFOP is one of the winners is because it integrates commodity components into much more useful and value-added assemblies. As one analyst recently explained it:

What impresses me the most about AFOP is its ability to grow and generate very strong margins in a category that’s not known for having consistent growth and strong operating margins. Some industry observers view companies that supply fiber-optic parts as operating in a commodity business. But when it comes to AFOP, it is not discrete components. It’s the integration that has allowed them to be dominant and produce more value. They’re going from piece parts to full modules.”

Connectors (e.g., amplifiers and repeaters) was AFOP’s original business and still represents 75 percent of sales. These fiber-optic products are used in large-scale “active” optical networks.  The big growth area now, however, is in small-scale “passive” optical networks that are used in fiber-to-the-home.  This high-growth passive segment currently represents 25 percent of AFOP’s sales, but the passive segment’s share of total AFOP revenues continues to increase. In the most recent 10-Q filing (page 17), the company states:

We believe that our future growth and a significant portion of our future revenues will depend on the commercial success of our optical passive products.

AFOP was founded in 1995 by  Peter Chang, a mechanical engineer who had previously worked in the fiber optics divisions of Lucent Technology and Taiwan’s Hon Hai Foxconn — which assembles Apple’s iPhone. In fact, Hon Hai Foxconn helped Chang found AFOP and remains the company’s largest shareholder with a 17.4% ownership stake (page 11).  Forbes Magazine recently named AFOP one of “America’s Best 100 Small Companies” for the third consecutive year. AFOP also made Forbes list of “most trustworthy companies” in 2010.

AFOP exhibits the rare combination of high profitability and low valuation. Take a look first at profitability: 

Source: Morningstar

Revenue and income growth have both very strong over the past 1, 3, and 5-year periods:

Source: Morningstar

All of this growth has been achieved without leverage – the balance sheet is strong with zero debt. What’s so striking is that this tremendous growth and profitability has not yet translated into a premium valuation. The company is currently trading at a bargain-basement EV-to-EBITDA ratio of 7.65 and a PE ratio-to-Growth (PEG) ratio of 0.47. The last time I saw a PEG ratio that low was United Therapeutics, which has been one of Roadrunner’s best all-time performers.

There are three reasons why the stock is trading so cheaply given its stellar balance sheet, high profitability, and strong growth rates. First, AFOP’s customer base is highly concentrated, with the Company’s 10 largest customers comprising 76% of total revenues and the top-two customers accounting for 40% and 10% of the Company’s revenues, respectively. If one of these top customers were to stop buying from AFOP, the impact could be devastating. Given the megatrend of fiber-to-the-home and the commitment of both Google and AT&T to a nationwide rollout of 100 gigabit-per-second local networks, I don’t view the likelihood of AFOP losing its top customer as material. AFOP’s products are the best, as evidenced by AFOP’s winning of the Huawei Supplier Award.

Second, CEO Chang sold about 600,000 shares ($12 million value) in May 2014 at an average price of about $20.75, reducing his ownership stake from 10% to 8%. In the second-quarter conference call, an analyst asked him about the insider sales and he was evasive, stating that the long-term growth trend of the company is intact so investors shouldn’t be concerned. As it turned out, Chang’s sales were well-timed as the stock has fallen from his average May sales price of 20.75 down to 13.60, a 34% decline. But the fact remains that he continues to own an 8% stake in the company, which is substantial, and 200,000 of the sold shares was from his charitable foundation, which periodically needs cash for its philanthropic purposes.

Third, the company’s third-quarter financial report was weak, missing analyst estimates. However, CEO Chang noted that the problem was macro in nature and not indicative of any company-specific problems. Indeed, AFOP’s market share during the quarter did not worsen and the company continues to forecast record earnings and revenues for the full fiscal year.  In the Q3 conference call, management indicated that consumer demand would rebound in the fourth quarter and that new projects in 2015 could be “needle movers” for AFOP. The company took advantage of the share-price decline to initiate a $15 million share buyback program. According to a Needham analyst, the Q3 earnings miss “reflects lumpiness in demand and we think it is likely to snap back in the first half of 2015.” Similarly, Standpoint Research initiated AFOP as a “buy” after the earnings miss with a $18 price target.

I agree with Needham and Standpoint’s bullish view, and believe that now is a good time to invest in AFOP while it is trading at a bargain price of $13.60. In both 2013 and 2014, the stock has traded as high as $22.60 and AFOP can get back up to that price level again in 2015, which would be a gain of more than 65 percent. Given the company’s continued high growth, a very conservative valuation for AFOP would be a 20 P/E ratio (its five-year average). At the consensus 2015 estimate of $1.03, this would equal a price of $20.60 – a 51 percent gain from its current price level.  

Value Sell Alert

To make room for Vishay Product Group, Roadrunner is selling:

• Buckle (BKE)

I’ve always been a big fan of this Midwest teen jeans retailer, thanks to its high insider ownership, prudent store expansion, and reasonable valuation. But the fact remains that its same-store-sales growth has been negative recently and U.S. retail sales generally have been sluggish. Growth prospects are muted, as evidenced by the company’s sky-high PEG ratio of 7.22. The stock hasn’t been one of the best Roadrunner performers over the past two years, lagging significantly behind its VBR small-cap value benchmark. Lastly, the stock price is near the top of its trading range this year and I’d like to sell before it trades back down. Granted, the company usually pays a special dividend in December, so arguably it may make sense to hold on for that, but I believe the recent stock run-up already anticipates the special dividend. I’ve never understood why Buckle’s short-interest ratio is so high — routinely exceeding 20-percent of the stock float — but short sellers are pretty smart and I prefer not to get in their way if possible. Lastly, the Roadrunner Value Portfolio was overweight the consumer discretionary sector and unloading Buckle helps bring the portfolio back towards market-weight.

Despite these shortcomings, if I wasn’t burdened by the 20-stock limit on portfolio size, I would be perfectly comfortable holding on to the Buckle. But the holding constraint exists, so I have to continually decide which stock — including good stocks — need to be jettisoned in order to make room for even better stocks. This month, Buckle’s number came up and it’s time to go.

Buckle is (reluctantly) being sold from the Value Portfolio.

Momentum Buys:

1. Autohome (Nasdaq: ATHM)

Autohome is a competitor of BitAuto in the business of providing automobile information to Chinese consumers via the Internet. BitAuto has done well in the Roadrunner Momentum Portfolio, so why not add a similar company promising similar gains?

• Price gain between 12 months ago and 3 months ago = 176.0% (100th percentile)
• Price gain over the past 2 months = -3.6%
• Price gain over the past month = 10.7%
• Roadrunner Momentum Rating: 176.0 – (-3.6) – (3*10.7) = 147.5

Autohome is a buy up to $54; I’m also adding the stock to my Momentum Portfolio.

2. Platform Specialty Products (NYSE: PAH)

Platform Specialty Products is a former special purpose acquisition company (SPAC) that on October 31, 2013 acquired specialty chemicals company MacDermid. Private-equity investors Martin Franklin, Nicolas Berggruen, and Bill Ackman are big shareholders in the company. Hedge-fund-like compensation system where for seven years the private-equity founders receive 20 percent of the stock’s annual price appreciation in the form of a stock dividend.

• Price gain between 12 months ago and 3 months ago = 129.5% (100th percentile)
• Price gain over the past 2 months = -5.6%
• Price gain over the past month = -4.9%
• Roadrunner Momentum Rating: 129.5 – (-5.6) – (3*-4.9) = 149.8

Platform Specialty Products is a buy up to $30 I’m also adding the stock to my Momentum Portfolio.

3. OmniVision Technologies (Nasdaq: OVTI)

OmniVision Technologies is a semiconductor company that supplies the image sensors used in Apple’s iPhone and tablet products, as well as the rearview cameras used in Tesla Motors’ electric cars.  

• Price gain between 12 months ago and 3 months ago = 85.8% (98th percentile)
• Price gain over the past 2 months = -1.5%
• Price gain over the past month = 3.0%
• Roadrunner Momentum Rating: 85.8 – (-1.5) – (3*3.0) = 78.3

OmniVision Technologies is a buy up to $32.50; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alerts

To make room for these three new momentum stocks, Roadrunner will be selling three price laggards: 

• International Speedway (ISCA)
  
  
• Emerge Energy Services (EMES)
  
  
• Synaptics (SYNA)