nasdaq: aaoi | charlie h., ben e., alina s., amy r. | dec. ‘17 · pdf fileml + deep...
TRANSCRIPT
NASDAQ: AAOI | Charlie H., Ben E., Alina S., Amy R. | Dec. ‘17
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q/A
Agenda1. Business Overview
a. Summaryb. Product Overview
2. Industry Overviewa. Industry Growthb. Industry Analysis
3. Competitorsa. Fabrinetb. Macom
4. Variant Perceptiona. Summaryb. Amazon Contractc. Technology
5. Valuation + Risksa. Comparablesb. Valuationc. Risks
6. Appendix
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Business Overview
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Applied Optoelectronics Inc.
Business Overview● AAOI is a vertically integrated manufacturer and distributor of fiber optic products:
○ Cable TV (CATV)○ Datacenter○ Essentially, all the parts needed for a network
● In 2013, AAOI’s end market was primarily CATV (60% of revenue), today almost 80% of the company’s revenue comes from data-centers
Stock Performance Other Info● The company’s revenue is highly concentrated with 10
companies making up over 90% of revenue○ Ex: Cisco, Amazon, Microsoft
● When Amazon announced they were going to withdraw from a purchase agreement, the stock plummeted
○ The stock is down over 60% from YTD highs, despite posting solid revenue growth and beating on both revenue and EPS every quarter this year
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Applied Optoelectronics Inc.
Supply Chain● Designs and fabs all core components● Non-core components are outsourced in China (not trade secrets related to non-core components)● Proprietary, heavy R&D components are made in self-owned fabs● Newly-finished Sugarland, TX fab handles the bottleneck of the important components (super secretive fab)
Product Comparison● Extremely reliable, very heat resistant (important in data centers!), relatively easy to put together compared to
combining parts from a bunch of manufacturers● Macom’s products suck, especially for data centers● Fabrinet technically have better designs but have much worse execution of the products (since they contract
everything out), leading to significant problems with product reliability
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Industry Overview
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Industry Growth
Ovum Optical Component Study
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Industry Analysis
Barriers to Entry
● Fiber optics: backbone of the internet, networks, and basically everything relating to those○ Television○ Internet○ Mobile Communication
● Large scale distributed computing (AWS, Azure, Spark, Scala, Hadoop) + ML + Deep Learning + Uber/Palantir growth = explosive demand for fiber
● Requires mastery of at least 4 disciplines:○ Optics○ Material Science○ Signal processing○ Networking
● Buyers: massive internet companies, ISPs, occasional massive investment bank○ Usually large, long-term contracts
between companies
Fiber Optics
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Competitors
Competitive Analysis - Fabrinet
Fabrinet
● FN specializes in complex prototype and new product introduction services, with resources to meet customers’ quick-turn printed circuit board assembly and early stage manufacturing requirements;
● In many cases, FN is the sole outsourced manufacturing partner used by customers for the products
● As part of the testing process, for over a month FN engineers work closely with the customer’s design and procurement teams.
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Competitive Analysis - Macom
Macom
● Potentially working with Amazon and Fabrinet to produce CWDM optical transceivers○ Has not been confirmed, but is rumored amongst analysts and industry insiders
● Macom has recently been having a lot of production struggles○ Lasers have low power at high temperature○ Incompatibility between manufacturing process and certain materials required to
achieve better performance.○ Extremely low yield○ No one knows when this issue will be fixed
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Variant Perception
Variant Perception
Street’s Perception
Amazon’s possible termination of AAOI’s exclusive contract and slowdown in fiber optic purchases shows weakness in their business
AAOI is behind competitors in producing 100G modules and their will be unable to compete in 2018 and beyond.
AAOI is highly reliant on a few large customers for their revenue; losing Amazon indicates that AAOI has a key driver of growth.
Variant PerceptionThe Amazon contract termination is an extremely overstated risk and doesn’t impact the core business or justify a 60% drop in the stock price. AAOI is still technologically ahead of their competitors and maintains the same competitive advantages they held 6 months ago. The street fails to see other opportunities to grow revenue outside of Amazon.
RecommendationWe recommend an 8% long position at a price per share of $38.69
Target Price Upside
$46.41 19.9%
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
I. Amazon Contract Termination
Street View● Fabrinet and Macom have announced a partnership to take away AAOI’s exclusive contract with Amazon in 100 Ghz● Amazon has slowed down orders on 100Ghz, stopped orders of 40Ghz, which has had an impact on AAOI’s revenue in
Q3 and will continue to be a major headwind● Amazon’s contract termination shows a weakness in AAOI’s business
Our View - Amazon Our View - Other Tailwinds● Amazon has been limiting their CapEx on their
data-centers in the last few quarters● Amazon has also only terminated their orders for
40Ghz modules, which are on the outs anyways● Amazon’s termination of the 100Ghz contract will
take multiple years and by that point AAOI will have found other places to sell their product
● Amazon has also done this to AAOI before and they recovered and restructured the deal within 6 months
● Datacenter growth is extremely rapid and the world demand for fiber is far outpacing manufacturing growth
● Facebook and Microsoft (two other major customers) are aggressively expanding their data-centers and will need more 100Ghz modules
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
II. AAOI is behind technologically
Street View● Amazon’s termination of the contract is indicative of AAOI’s technological and manufacturing weakness● AAOI will continue to struggle to meet the needs of their customers and will slowly die out as stronger competitors gain
market share
Our View Our View - Technology● Amazon terminated their contract because AAOI
couldn’t produce enough fiber exclusively to meet their demand
● AAOI was only late by a few weeks with their rollout of 100Ghz and already is ahead technologically with their rollout of 200Ghz
● The rise of distributed computing and the resulting expanding data-centers will drive even more demand for 100Ghz and 200Ghz modules in the coming years
● AAOI has very high R+D spending and a very large amount of patents
○ They are one of the only companies to have rolled out 200Ghz and provide all the parts needed to create a network
○ Fabricom and Macom can’t do this, they just make modules
● AAOI also has extremely high stock based compensation, attracting the best researchers and motivating them to succeed
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Valuation
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Comparable Companies
Ticker Mkt. Cap(Bil. $) ROA P/S EV/Rev P/E P/FCF
AAOI .75 21.5% 1.92 1.87 9.09 N/A
FN 1.11 1.34% .77 .69 11.97 N/A
MTSI 2.03 -11.3% 2.90 3.64 12.36 33.21
FNSR 2.03 10.6% 1.40 1.10 8.58 10.6
VIAV 2.01 4.2% 2.53 2.02 25.06 44.41
Average(Excl. AAOI
1.80 1.21% 1.9 1.86 14.49 29.4
Comps Table
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Valuation
Base Case$46.4119.9%
Bull Case$54.6041.1%
Bear Case$35.02-9.4%
Current Price: $38.69
Valuation
Key Assumptions● We took on extremely bearish assumptions
○ No growth in any of the three smaller segments○ 15% datacenter CAGR
■ A segment which has seen 80% growth over the last 9 months and 25% growth in the last quarter despite Amazon deal termination of 40 Ghz
○ We assumed 400bps lower gross margins over the next 4 years and a weakening tax shield, despite margins significantly decreasing this year and the company’s NOL allowing them to pay little to no taxes over the next 5 years
● We also used bearish multiples of 1.9 P/S, 2 EV/Rev, 14 P/E, each weighted equally at 33.3%
● Our model also includes a DCF, as the company became FCF positive this year however we believe this isn’t a good way to value the company
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Risks
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Risk #1: Lawsuit
Response
● Amazon’s 100ghz slowdown and 40ghz shutdown drove the stock price down 60%
● A bunch of law firms jumped on and sued the company for failing to disclose the risk
● AAOI’s management didn’t explicitly talk about this risk○ However, 40ghz production was
going up○ Management may have been
unaware?● It is disclosed in their 10-k though...
Other Considerations
Should be settled out of court because corporate lawyers are just parasites on industry anyways
Risk
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Risk #2: Reliance on Amazon
Response
● AAOI relies on Amazon as a customer● When Amazon slowed down their
orders, AAOI’s top-line guidance for the next quarter fell 10%
● Other current and highly likely customers:○ Microsoft (Azure)○ Facebook’s data centers○ Google
● New Sugarland fab should help bolster production
Other Considerations
Amazon also tried to buy up ALL of AAOI’s fiber, which limited their ability to sell to others, but they refused. AAOI has been trying to diversify their revenue sources anyway to curtail this risk.
Risk
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Risk #3: Capex Spending
Response
● AAOI has been ramping up their capex and spending in recent years
● This has hurt the company’s ability to generate positive FCF
● Hyper-research intensive business● The technological edge + performance
per cost is the most important in this industry
● Remember: this is a pure tech-oriented business (NOT consumer facing)
Other Considerations
Looking only at capex does not reveal AAOI’s true value
Risk
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Risk #4: China
Response
● China wants to build fiber optics to compete with the large players in the industry
● The Chinese could potentially gain access to AAOI’s technology and outproduce them
● Would require at least a few years to catch up on R&D … by then industry demand might be different
● Does not have enough bandwidth to execute even if they steal designs
● High security, super secret fab in TX does the intensive R&D; hard to steal
Other Considerations
● Laser chip manufacturing is unique to AAOI
Risk
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Q&A
AppendixBusiness Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Bull Case Revenue Build
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Base Case Revenue Build
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Base Case Income Statement
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Base Case Balance Sheet
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Base Case CF Statement
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Base Case DCF
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Valuation Flowchart
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Base Case$46.4119.9%
Bull Case$54.6041.1%
Bear Case$35.02-9.4%
P/S30.20
EV/Rev34.68
P/E40.17
P/S38.26
EV/Rev44.75
P/E56.24
P/S45.33
EV/Rev52.08
P/E66.39
New
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
New Data Center Design
Old
Pros: reliable, scalable, parallel
Cons: incredibly bandwidth-hungry
Pros: cheap
Cons: unreliable, less scalable
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Decline of 40Ghz
Corollary of Moore’s Law: network bandwidth doubles every few years for the same cost
● Implies both the technology and industry itself is cyclical○ Heavy R&D pressure to be ahead of the cyclical change○ Sudden drop-off in demand for previous generation’s technology when the next generation
comes out● Tech Companies want to be ahead of this shift
○ Huge opportunity costs in using older tech, especially in large-scale, distributed computing● Amazon wanted to fully upgrade ASAP to 100Ghz when it came out
○ Wants to maintain technical edge over competitors such as Azure○ Pivoted much more quickly than analysts and management expected
Business Overview
Industry Overview
Competitors Variant Perception
Valuation & Risks
Q&A
Importance of Fiber in Data Centers
● Almost all industry computing is now done on large distributed systems○ Thousands to millions of machines processing massive data sets, performing analysis, and
storing results, … etc.○ Minimize time spent: For Amazon, a 1 sec delay on each page would cost $1.6 BILLION
dollars a year● Bottleneck has always been the cost of communication between machines
○ A single 100GB dataset still takes at least 8 seconds to transmit on a 100Ghz fiber optic link○ Machines process data MUCH faster than they can send and receive
● Companies want to build data centers as close as possible to high-demand regions○ Minimize physical delay to each customer○ Data center itself must be able to send data fast enough to make the physical delay the major
cost or the data center is useless, so fiber is necessary