Alliance Fiber Optic Products (AFOP) is a tiny maker of optical networking components. They make beam splitters, WDM, attenuators, couplers, and connectors. I like this type of product, but the technical condition was so good, I couldn't resist and bought the stock about a year ago and sold it after about 3 months with some 26% of gain. Then I watched in dismay as their revenue continued what is now a three year climb of 57% alongside cash flow climbing 167% and earnings doing over a 3 bagger. The stock has now done over a double from where I cleverly took my measly profit, leaving me wondering just what in the blue blazes is going on with this company.
Technology in general has been doing well, and the telecom optical equipment stocks have been breaking out of years of slumber here in 2013, and have been doing even better than tech in general. Lightwave Online has a broad optical index of stocks large and small and it has been nicely outperforming their broad market technology index: (click on images to enlarge)
But their Lightwave Index has actually been in a lull for almost six months, while a certain type of lightwave stock (including AFOP) has been vastly outperforming about everything recently. In fact, another such type of stock, Clearfield (CLFD) about which I've written in the past, is included in their index and is the #1 gainer in the 30 stock index over the last one year period. What is this superior type of stock?
The Great Divide In Optical
A great deal of AFOP's appeal (at least to me) is their strong location on the passive side of the passive/active divide in optical networking. I know this sounds like some kind of civil war and I don't want to create a lot of strife, but there are two trains of thought on how to best do the optical web. The active designers seek to enhance a basic optical pipe with the interjection of electronics and software to rout, switch, amplify or do whatever is needed to put more bit flow through any given cable. The passive designers let light flow uninterrupted from source to building and manipulate light with passive devices such as splitters and wavelength division gratings within the fiber instead of mangling the light with conversion to electrical signals, software controlled routing, and what have you. By my use of the word "mangling" I suppose you can guess which side of the fence I'm on. You can disagree, that's fine. It's a free country, you have your right to be wrong.
Actually, there is some right in each camp, and about any optical network today is some combination of active and passive devices. The packet switched networks, which seem to permeate the minds of all but a few public networking companies, take the information stream, chop it up into a little bitty pieces, cleverly label them (all at the speed of electricity) and feed (switch) them into the hopper - the infinite bandwidth of a fiber optic cable. Then at the destination, the pieces are cleverly reassembled again (at the speed and cost of electricity and software). This allows more information to flow in any given fiber optic strand (any given innate bandwidth) but at the expense of electricity and software. Passive devices, on the other hand, just open up huge new vistas of bandwidth by simply shining the beam through "prisms" separating, bending, and manipulating light (all at the speed of light).
I know I sound like George Gilder saying that. He is the eccentric (I won't call him crazy) seer of tech trends through boom and bust. Wired did a fascinating piece on him in 2004 - The Madness of King George - where they talked about his GTR newsletter way outperforming the Nasdaq in the late '90s. Unfortunately, we all view that as a despicable fool's market and tune out anything about it. But he also vastly outperformed the post bubble market with a 345% gain from October, 2002 onward (vs 125% for the Nasdaq) and a 155% gain over the fairly normal market three year period from 2004-2007, at which time he ended the newsletter and started a fund.
Gilder has been rightly criticized as being a poor stock analyst, but then analyzing a stock isn't what he does. He sees major science based trends in tech before others do and attaches companies to those trends, good, bad, and ugly. He usually gets the trend right, so he looks like a stock genius.
On the issue of active vs passive optical, I agree with Gilder's view when he said "Needless to say, big bandwidth is not a perfect substitute for big software, but it will do...it is advancing its cost effectiveness at least 40 times faster than big software". He wrote this in 2000 and today, according to a Stanford study, "A useful rule of thumb is that an optical circuit [passive] switch consumes about 1/10th of the volume, 1/10th of the power, and costs about 1/10th the price as an electronic packet switch with the same capacity". In Telecosm, Gilder wrote:
...the ascendant technology is optics and the canonical abundance is bandwidth. Companies focused on jamming more and more information packets down a single-lane bit stream - as if there were no bandwidth to spare - will lose to companies that waste bandwidth in order to build capacious multi-lane highways with each lane running well below capacity. This mandate is difficult for most experts in the industry to grasp because it seems to reverse every important advance in networking over the past three decades" Telecosm, p206
Gilder Was Right
This was a bold statement for George to make. He is saying passive component makers are going to be beating active component makers. I can't help but suspect that Broadband Magazine also feels this way.
They put out a ranking each year for the FTTH Top 100 where they rate the contribution a company or group is making to last mile local optical networking (Fiber To The Home). If you look at this year's results, you see that they have 11 categories of their top selections, and a whole such category is "Passive Components For FTTH Networks" (no such category for active components).
Most of the entities on their list are not public companies and those that are typically do purely optical networking as just part of their business. Mind you they are not trying to do stock picking with their work. They merely look at the significance an entity is exerting on effectively bringing optical 'net to our doors. When you go through this passive list of theirs and find just the publicly traded companies and further narrow it down to just those that focus entirely on optical, you are left with only three names: Alliance Fiber Optic , Zhone Technologies (ZHNE), and Clearfield. If you've read my previous articles, or were paying attention to Jim Cramer in his Mad Money show back in September, you are aware that the optical stocks are doing a massive breakout here in 2013. Cramer pontificated "One word: Optical."
(click to enlarge)
May I elaborate with "Three words: Passive Optical Components". There is a massive divide in performance so far in this optical breakout. AFOP is the only one of the passive three here in anything resembling a pullback right now. George seems to be very right in what he said back in 2000.
The Great Divide Back Then
Back in the 2000 passive/optical divide, we really have just two contenders for passive - JDS Uniphase and Ciena. The WDMs (Wavelength Division Multiplexers) of Ciena were truly a star of the optical show back then quickly developing the ability in gratings to deliver 16, then 40, and then 120 wavelengths on a single fiber. They held a whopping 40% market share in WDM at one point. And "Uniphase", became JDS Uniphase by the merger with JDS-Fitel which was "the leading manufacturer of passives" by Gilder's account and "a stock market star as meteoric as Uniphase". So we had two passive optical stars stealing the show in the '90s, Ciena and Uniphase (three counting JDS). But Ciena was actually a customer of Uniphase, who made the critical passive parts to make the WDMs out of. Ciena was and is more a network supplier of all types of networking schemes like, say Nortel and Tellabs were back then. Ciena is made up of four divisions, three of which are mostly active networking (counting their software division as active). They focus on packet and switching technologies.
Gilder draws a comparison in the science of passive optics and its microscopic gratings and wavelength manipulation in the internet era to that of building microprocessors in the computer era. In fact, he devoted a whole chapter of Telecosm to this idea, "Searching for a New Intel". Both sciences leap ahead by going down in scale, where there is much more efficiency and things can run cooler and cheaper. "The less the space, the more the room" produced Intel as the mega star of the computer.
In the new era, rather than using transistor switches and power to compensate for inadequate bandwidth, successful companies will race down the learning curve with ever more cost-effective broadband optical components. Uniphase is a prime candidate to lead this race...JDS Uniphase is the current leader in the pursuit of the Intel dream. Telecosm, George Gilder, 2000, p.212, 231
So considering all the above, I will nominate only JDS Uniphase as the passive representative in the previous networking bonanza. And this is how the market responded:
Where AFOP Is In The New Network Build
Then or now, bubble or not, it is passive far outperforming the rest. This is the networking landscape AFOP finds itself in today. But before crying "crazy dot.bomb" and fleeing the current climb in AFOP, let's compare the two situations, then and now. First, in the '90s networking boom, there was real money being made off a real build-out, the internet backbone. The networkers' unbelievable climb (check out the gain percentages in the graph above) was not pure speculation about future cash. Sales and earnings were growing by a steady 35% a year or more. But by the last few years of it, valuations finally left reality. JDSU was trading at a PE of around 300 with price/sales of 40! Ciena was considered cheap (by '99 analysis methods) at price/sales of around 18. And after nearly 10 years of frantic building, the backbone gradually moved ahead of the growing 'net traffic and was overbuilt. Today the build-out that is just beginning is the last mile. With about 90% of it still ahead, they are estimating it to be a 10 to 20 year build. AFOP's valuation is anything but unreasonable:
With the vigorous climb in results, the PE has actually cheapened to a near market average 17. Price/cash-flow is also 17. They have marvelous high tech products with very strong demand, but they have zero debt and are not spending a fortune in R and D for this. To see how AFOP stacks up against the other opticals, see the research and development margin graph comparison in my Finisar article . AFOP is at the very extreme profitability end of that curve. The cash-flow chart looks exactly like the EPS chart. Everything about their numbers just reaches off the page and slaps me in the face with management intelligence. They currently rank #30 in the Forbes America's Best 100 Small Companies list. GARP lovers should note the 0.58 given by Yahoo Finance as the PEG. This is not a dot.bomb.
AFOP has a good insider/institutional ownership ratio, actually less than 1 with institutional just 26% and insiders owning a large 35% of the company. This shows a lot of insider confidence with plenty of room for needle moving institutional money to flood the ultra-tiny float of just 12 million shares. A turbo booster could be a large short squeeze with 34% of the float held short. Far from being the overpriced darling, skepticism abounds with this stock. High tech is high risk, of course. But a risk mitigating feature of AFOP is it's product mix. They sell the risky high tech passive modules, but about 70% of sales is from what they categorize as "Interconnect Systems". Plugging into an optic beam of bits isn't like plugging in your lamp, and it's high tech enough. But it's relatively mundane compared to WDMs and such. So most of sales could be considered pick-and-shovel fare in the build of the last mile, immune to what comes in and out of favor in the devices themselves.
The building of the optical internet backbone occurred for the most part with relatively few of us on the web. In 1994, there were only 13 million people in the whole world online - out of over 300 million in the US alone! Now as we enter another networking build in the finely branched local portion, where 90% of all networking is actually done (just a measly 10% was made optic before) we are all so much more dependent on the internet and the demand for enough capacity will be enormously more urgent than in the previous builders' windfall.
Does the recent breakout of the component stocks like AFOP have legs, or is it just a head fake? Well, not long after Cramer uttered his One Word in September, AT&T (T) announced in November a massive $14 billion spending package for their wireless gear and according to a Motley Fool article, "Network Equipment Makers: You've Been Cleared For Takeoff":
The clarity you seek lies with fiber-optic and fiber-optic component suppliers By now you're probably wondering, "How do we know this increase in spending is trickling down to equipment makers?" The answer to this question is written entirely in fiber-optic and fiber-optic component suppliers, which have seen a revival of sorts this year. When telecom service companies announce a big boost in spending, it often takes a few quarters for that money to trickle down to fiber-optic providers.
That's at least "a few quarters" of clarity. The $14 billion is to be for wireless to try to catch up with Verizon, which has surged well ahead of AT and T in 4G served cities. If the telecoms are beginning to play catch up with Verizon, you must consider that Verizon is the unchallenged leader in FTTH providing about 80% of this service in the US. The rest have got a lot of catching up to do.
The Problem With Alternatives
In my articles on IPG Photonics, Fabrinet, and Finisar, I looked at the alternatives to running a direct glass line to each of us uninterrupted by anything. There was Free Space Optics (just beaming a harmless laser light through the air to our door) and G.fast (the next generation of DSL) and wireless (through the air without optics) but these all run into physical limits that leave us with no internet growth in the years ahead. Here I want to consider another problem with wireless other than the radio spectrum resource I discussed in the Finisar article. That is simply the vastly lower ultimate capacity when compared to optical.
The advances in DSL in getting more speed through our ancient copper wires and the billions spent on going from 2G to 3G to 4G will probably be viewed decades from now as money foolishly wasted. I don't know if anyone has done a tally on this, but I bet if you would add up all that's been spent doing these upgrades in speed, it would have given us most if not all of a future proof all optical network by now. Instead, we are mired in this:
(click to enlarge)
This basic speed versus distance chart from NBN Myths shows what a pathetic substitute the alternatives are for a simple optical cable. Note how the costly advances in DSL only make any big difference within about a football field of the nearest fiber optic line. How many people live that close? I have added for perspective the experimental results obtained in Alcatel-Lucent's lab for G.fast, the next generation of DSL that will begin to be implemented in 2015. As I've mentioned before, this is over pristine special purpose copper that has little resemblance to what runs through our neighborhoods, and the actual speed for it will likely be a fraction of what is shown.
A recent cnet.com article covering the Broadband World Forum 2013 acknowledged that advancing wireless capacity is now finding a wall in basic physics:
More limits crop up in traditional ways to expand data capacity. Spectrum is severely constrained, so opening up new tracts of radio-frequency transmissions is tough. Physics also means that spectrum can be pushed only so far: Wireless transmission is reaching the maximum data transfer possible. The next solution, then, is to get the network closer to the customer who needs it.
The industry seems to be coming around to Gilder's "glass cathedral" where we must all plug into the light somewhere to peek into the web's full function.
It's not all about wireless for Alcatel-Lucent. The company also is pushing for better wired networks. The company also announced new micronode technology to make high-speed networks affordable when a network links only to a small number of customers - 48, 16, or even a single one that's tied into the node. On the other side, the micronode can link to the network with high-speed, passive fiber-optic lines.
Getting the light speed network closer to the customer is what AFOP does. That is their devoted specialty and there are only a tiny handful of such public companies. The mid and large size companies do it as a sideline. There are, however, a lot of private companies specializing in passive - many more private than public. This poses a risk factor for tiny AFOP. They must continue to do a good job relative to an army of good private companies, not to mention the big ones, wanting to take their market share. But there may be enough pie to make pigs out of a large host of passive optical players.
Disclosure: I am long AFOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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