Applied Optoelectronics (AAOI) - LONG

Recommendation
Undervalued and now trading at $37.80, I think it is worth nearly double that at $75,
consensus price is $63 ($75 is my 12-months target) 98.4% gain
o 52-week price range: 21.66 103.41
o Long the stock with first target around $48, second target is the consensus price
at $63, if momentum goes on then last target at $75 (what the price was in July
before the disappointing earnings announcement, changing market sentiment)
o Stop Loss at $30 20.6% loss

Company Background
Briefly what they do
o Applied Optoelectronics designs and makes fiber-optic networking components
that go into communications equipment used by cable-TV providers, broadband
network providers, and Internet data centers to allow for faster network
connections.
o Caters to the fiber optic communication, telecommunication, satellite broadcast
and wireless sectors.
o Applied Optoelectronics sells critical components to a fast-growing industry that
demands more speed and capabilities for data center, cable, and fiber-to-the-
home applications
o Founded in 1997, the company went public in 2013.
o Geographic reach: manufacturing plants in China, Taiwan and the US, about 80%
of sales come from outside the US
o In 2016, 77% of revenue from data centre which represents 118% increase on
2015

Numbers:
o Revenue:
2017 Estimate - 400 m (+53.6% in 2017, 37.4 % in 2016)
o EPS:
2017 Estimate 4.65 (+234 % in 2017, 35% in 2016)
o EBITDA:
37.2 m, 14.3% EBITDA margin (peer group: between -17% to 47%)
o P/B
2.35
Cheap for a growing company
o P/E
P/E is 8.82 cheap relative to the peer group (the multiple was 18.2
when the stock was at its highest at $100)
Median P/E ratio within the Semiconductor Segment is 25.67
o Debt/Equity
Low, 9%
My Investment Thesis
The stock is currently undervalued
o Applied Optoelectronics experienced a large drop back in August (40%) and
October (30%)
o This is due to a production mismatch resulting from a large decrease in 40G
demand, resulting in a preannouncement of a sharp revenue from $107-$117
million to $88-$89 million; drastic drop due to lower sales to Amazon which
represented 10% of total revenues versus this quarter compared to 47% in the
preceding quarter
o Amazon revenue was $55 million in 2017 and crashed to $9 million in Q3 2017
due to accelerated 40G to 100G transition believe $9 is abnormally low and
will bounce back up
o Believe that Applied Optoelectronics experienced a production mismatch during
the quarter and that the growth in revenues will resume from the next quarter
o Company lost some of sales to its largest customer because of new transceiver
modules being built by Fabrinet; At that time, Applied Optoelectronics was still
focused on producing more 40G rather than 100G transceivers
o Believe that market overreacted to the negative news and the stock is now
underpriced
o AAOI has positive sales and earnings growth, reinvestment opportunities and a
strong balance sheet
o Steep increase in non-Amazon revenues

Why market is wrong

The stock now has been oversold, some investors with short positions are not covering
them which means that if the price does go up, the investors with short positions may rush
to buy the stock to stop further losses, driving the price up further
The expectations are too pessimistic given that the optical transceiver market as a whole
is expected to grow at 13.5% between 2017 and 2022
Applied Optoelectronics can further grow continually in a growing market and increase
its revenue and market share
The revenue and earnings fall can be attributed to a short-term issue rather than a long-
term problem which is a result of a temporary production mismatch which came about as
the precise timing of the demand shift was difficult to forecast
Earnings Catalysts
2018 earnings potential of $5.50 (current consensus is $4.64) the street assumes more
downside potential than upside, realistic target as the company has high earnings growth
(20+ %)
Will take some time to rebuild the confidence, the undervaluation is due to market
sentiment and behavioral irrationality
Large increase in data center revenue from 100G sales: 62% increase from the prior
quarter; before mostly sold 40G products
100G-centric hardware such as network switches, routers and servers are now more
readily available now
Sales to other data center customers apart from Amazon are doing fine, and the Amazon
problem should only be temporary; Non-Amazon revenue grew 28% and 100G revenue
grew 59% - and Amazon situation cant get much worse
Potential for a small amount of revenue from new customers smaller data center
operators and enterprises
The company is in a growing industry as many companies are adopting more open
internet data center architectures using a mix of systems and components; There is an
ongoing transition from the use of copper cable to optical fiber since optical fiber
provides speed that is 10 to 100 times faster than copper cable; Expansion of the cloud
services and video streaming increasing need for products manufactured by AAOI
Expect revenue to Applied Optoelectronics from Microsoft and Facebook to increase
sequentially as demand for 100G increase (thats what management said they expect in
Q4 2017); Optimistic on Facebooks fairly robust data center expansion plans and
bringing company data center needs in house

Risk factors and how to mitigate them

Possibility of recession is the main risk
o Can make cheap stocks even cheaper
o AAOI beta is 1.6
New technology making fiber optics obsolete
o But we know fiber optics has been around for a while and copper cable is still
used
Competition mainly Intel and Fabrinet who Applied Optoelectronics lost out to in case
of Amazon, but no reason to believe that it has changed much in the last 3 months. Intel
to be watched most closely
Possible hedging by purchasing put options on the stock