Description

Oclaro (OCLR) has lost money – lots of it – pretty consistently from the 1990’s – 2015. All that is changing and the company is finally ready to have its day in the sun.

OCLR is a provider of optical components that are key pieces of telecom and data-center (DC) infrastructure. These components help drive fiber optic connections and help power the ever-increasing amounts of data and video-consumption (landline and mobile), as well as cloud computing. The company / industry’s not-so-glorious past along with its volatile end-markets make the company easy to hate (see high short interest) but long-term investors willing to take a firm view on the industry’s future will benefit from a unique time in the history of optics – which is witnessing the combination of three cycles kicking into gear at the same time. This week’s Barron’s “Tech Trader” feature highlights the industry and that may be a nice introduction along with this write-up.

Industry Overview

Telecom, cable, and DC operators all need fiber. In order for fiber to carry data, it is required to be “lit” using optical equipment. The key piece of equipment (for telcos) is a “linecard” and is provided by network equipment manufacturers (NEMs) such as Ciena, Huawei, Infinera, ZTE, etc. However, these NEMs require components for those linecards from component suppliers. There are a bunch of components – transmitters, receivers, modulators, ROADMs, amplifiers, and more. This is where Oclaro steps in – OCLR is a leading provider of these components that act as the building blocks for today’s high speed data transmission. Other companies such as NPTN, LITE, FNSR, etc. also provide components and compete directly with OCLR depending on component. Some of these same companies also act as customers. While LITE and FNSR are larger companies, the industry in general consists of subscale operators (see lead comment about profitability) and while the industry has consolidated to some limited degree, it still largely consists of small cap companies.  

Now, I mentioned this being a unique time in optics history due to the convergence of three simultaneous cycle upturns. These correspond to the three parts of a transport network – long-haul (get data between cities), metro (intracity or regional), and data center (connections between data centers).

Digressing into history for a moment… this industry has always been cyclical. As telcos upgrade equipment, optical components become in high demand. Once those upgrades are complete, the industry may fall into overcapacity with all the related pitfalls. Over time, network speeds have gone from 1G to 10G to 40G to 100G. 10G carried us from the 1990’s through 2011 at which time the 100G long-haul cycle kicked off. If you look at the OCLR stock chart, you’ll see 2010 – 2011 reflects this. While much of this long-haul cycle has been completed, we’re now in the early days of three powerful cycles: (a) the U.S. / Euro metro cycle (b) China metro / long-haul cycle, and (c) DCI 100G upgrade cycles.  

The three cycles

As mentioned long haul networks have largely been upgraded, but now metro networks in the U.S. and Europe need to catch up. Optical component spend in this area is likely to double over the next five years to $2 bn. Verizon and AT&T are leading the upgrade cycle in the U.S. while Tier 2/3 suppliers will likely follow.  

Second, China continues to prioritize communications in its central planning (see “Broadband 2020” and its five year plans) and the entire nation is upgrading to 100G. The country has allocated $200 bn for vast wireline / broadband upgrades which will include optical components. All the major national carriers in China are participating. Now, admittedly, China’s near-term appetite / order-flow for optics is hard to predict and when China sneezes (i.e., pauses purchases for a quarter or two), optical component company share prices catch a cold (i.e., plummet). For this reason, I think it helps to purchase optical names when sentiment around China is low. That is currently the case as numerous sell-siders have soured as recent channel-checks and 4Q results point to a 1H slowdown in China orders. However, given the broader backdrop in China and the focus on creating a world-class communications infrastructure there, I think the long-term outlook remains very healthy.

Third, data centers are currently in the process of building out and upgrading their infrastructure with 100G upgrades, having begun this process in 2016. To highlight one product here; next-gen transceivers (QSFP28) are expected to grow from $100 mm to $1.5 bn by 2020. Catching a company with a leading, first-to-market product can be very attractive and OCLR has demonstrated such leadership. The drivers underlying this data center cycle are the web 2.0 companies who are ramping their data center / cloud computing efforts, a megatrend that most readers are familiar with.

Positioning

As one can tell, I’m bullish on the optics sector and this, in many ways, is a sector / thematic bet. However, I do think there is wisdom to positioning oneself in certain parts of the sector value-chain. The NEMs generally compete regionally which means that they don’t benefit from all geographies (e.g., Ciena doesn’t sell into China). NEMs also face a growing threat of whiteboxing. On the other hand, the component players don’t face geography or whitebox limitations.

Additionally, while I think a full-blown product discussion is beyond the scope of this write-up, I naturally prefer exposure to new products, which often garner extremely high demand and profit margins especially when first to market. This is the case with Oclaro and its CFP2-ACO product.

Oclaro Specifically

OCLR is somewhat unique in that its levered to all the trends I’ve discussed. OCLR is particularly levered to the 100G upgrade cycle with 3/4ths of products falling into that category. Additionally, Oclaro has a fairly diversified product suite (some industry players live and die by one product / one end market) including components (modulators, lasers, transceivers) and pluggable modules (CFP, CFP2/4, QSFP28). OCLR has been operating with supply constraints the past several quarters, even as earnings have dramatically ramped. Additionally, the “ACO” is an important new product that could generate $250 mm of revenue for OCLR, who is the first-mover here (OCLR’s TTM revenue is just ~$515 mm and so this highlights the potential for a “re-sizing” of the income statement based on just one or two new products). And while I earlier cautioned about the industry’s history of losses as a result of competition and overcapacity, that should not be confused with thinking that product development in this industry is easy. Developing quality products that meet the stringent testing standards of large telcos, along with the ability ramp production of these products seamlessly, is a challenging task. There have been numerous companies (NPTN comes to mind) that have missed out on revenue ramp-ups due to manufacturing hiccups. OCLR, for the most part, seems to operate a tight ship. As an interesting anecdote, the Barron’s article I referenced earlier discusses the average engineer in the optics industry is over 50 years old. While competition / cycle-driven overcapacity happens, real barriers to entry do exist.

OCLR’s coming revenue ramp will also trigger material margin expansion. Gross margins have already ramped from the 20’s in CY ’16 to ~40% in the most recent quarter. I believe they’ll continue to increase into the mid-40’s as volumes continue to ramp. Operating expenses need not grow much from here as incremental demand comes from a well-defined set of existing customers. Bears will inevitably latch onto margin reversion and point to historical industry profitability. Such thinking has undoubtedly created many successful shorts. However, I simply think the concurrent upgrade cycles and the magnitude / durability of the underlying trends will make this a painful trade for shorts in the long run. Street analysts are generally bullish on OCLR (and the optical names at large) but understandably lack the imagination / resoluteness to call for material upside over the long term, particularly given a strong 1 year historical trading performance, share price declines during previous cycle “hang-overs,” and the current China spending slowdown concerns. I think this setup helps the long case.

OCLR grew revenue nearly 50% last year and I believe the trends / product successes I’ve discussed will ultimately allow the company to reset its revenue much higher. After a recent China-driven share price dip, OCLR now trades for ~11x earnings which I believe is far too cheap. OCLR can earn $1 per share in FY ’18 and could easily fetch a 12-13x or higher multiple as confidence returns. Additionally, OCLR is still of small enough size that a larger player such as LITE or FNSR (both of whom have recently raised capital, have strong cash balances, and have historically discussed participating in industry consolidation) would likely find the company to be of significant interest.

Summary

While a cyclical hardware component manufacturer with a long history of losing money isn’t every VIC member's yearning desire (it’s not mine either), I also imagine many investors may be interested in another way to play the increased importance of data transport while realizing that significant money is often made when an industry’s historical pattern no longer applies. I hope this write-up has served to introduce the industry, the company, identified the bear case, and discussed the underlying trends that I believe support material revenue and earnings growth from this point.

**NOTE: Earnings are tomorrow - 5/2/17 - post-close (a China slowdown is expected but the severity is unknown, and the stock may be volatile).**

Catalyst

A resurgence in China demand.

Further U.S. / Euro buildout announcements.

Earnings are on 5/2.