Oclaro Inc. (OCLR, Financial) is a technology company that provides optical components and modules for network equipment in the long haul, metro and data center markets. Despite a slowdown in China, the company has growth potential in the optical networking and data center spaces.
Revenue insights
Oclaro generates most of its revenue from selling transmission modules for100 gigabits per second network devices. Legacy devices, including 40 gigabit and 10 gigabit, also contribute to the company's revenue, but the product mix is shifting toward faster, smaller and low-power products. The company's revenue from 100 gigabit products increased more than 100% during fiscal 2017. In contrast, revenue from legacy products declined approximately 36% over the same period.
Its customers include Cisco Systems Inc. (CSCO, Financial), Huawei, Alcatel-Lucent (ALU, Financial) and Amazon.com Inc. (AMZN, Financial). Applied Optoelectronics Inc. (AAOI, Financial) and Finisar Corp. (FNSR, Financial) are two of its main competitors.Â
Revenue Classification, OCLR 10-K, 2017
From a geographic perspective, the company generates most of its revenue from China, Thailand and the U.S. The company doubled its Chinese revenue during fiscal 2017. However, the growth is not sustainable amid recent slowdown in China. The company noted the following in its annual filing with the Securities and Exchange Commission.
“We do not expect to sustain revenue growth of that magnitude, primarily due to a lower anticipated growth rate in China as well as lower anticipated sales of our CFPx family of 100 Gb/s client side transceivers as customers transition to newer package form factors.”
The slowdown in Chinese revenue growth is reflected in the company's guidance for the second quarter.
“We expect revenues for the three months ended December 30, 2017 to decrease by 8 percent to 13 percent as compared to the three months ended September 30, 2017 as a result of reduced customer demand and market uncertainty in China.”
Revenue Classification, OCLR 10-Q, Oct 2017
Although Oclaro witnessed revenue growth during the first fiscal quarter of 2018, negative guidance is putting pressure on the stock price. The stock is down almost 16% amid the China concerns noted in the recent filing.
In fiscal 2017, Cisco, ZTE, Huawei and Alcatel-Lucent were Oclaro's biggest customers. Together these companies were responsible for 63% of its total revenue.
The company witnessed solid growth in the 100 gigabit optical network components market over the last several quarters. However, the stock is suffering due to the short-term headwinds from China. Once the recovery kicks in, Oclaro is poised to reward investors handsomely.
Why is Oclaro a good pick right now?
Due to the slowdown in China, Oclaro may not be a good pick right now, but it is already beaten down amid the recent sell-off. Industry growth prospects are intact. Deployment of 5G networks and the need for increasing data center capacity and fast connectivity will benefit Oclaro over the medium term. Moreover, due to the sell-off, the stock is in value territory. Therefore, buying the dip can reward investors going forward.
Industry prospects
According to Oclaro’s internal estimates, digital coherent optical (DCO) ports are expected to double by 2020 in China. In the data center space, the market for 100G 2km and 100G 10km optical tranceivers is expected to reach $1.1 billion by 2019, a compound annual growth rate of 36% from 2017 to 2019. The 400G single mod market is expected to grow at a CAGR of 258% between 2018 and 2020 to reach $720 million. Growth in the space is illustrated in the graphs below. Â
Overall, there are several growth opportunities for Oclaro going forward.
Value prospects
The stock is trading around a price-earnings (P/E) ratio of 10.7 based on 2018 earnings. Analysts are expecting earnings to grow 14% over the next five years. This results in a P/E to growth ratio below 1, which suggests the stock is cheaply priced.
Absolute valuation measures like enterprise value also reveal upside. Despite the inclusion of declining growth in the valuation model, the stock is cheaply priced.
Assumptions
- Earnings are expected to grow 5% annually from 2020 to 2023.
- No growth is assumed in perpetuity.
- Cost of equity is assumed to grow in line with earnings growth.
- The capital asset pricing model is used to calculate cost of equity.
| Projections | Â | Â | 2018 | 2019 | 2020 | 2021 | 2022 | Perpetuity |
| Â | Â | Notes | Â | Â | Â | Â | Â | Dollars in millions |
| Net Income | Â | Â | 96.20 | 106.33 | 111.65 | 117.23 | 123.09 | 129.25 |
| Â | Cost of capital | r*capital invested | 39.81 | 44.18 | 49.00 | 53.85 | 58.77 | 63.75 |
| Dividends | Â | Â | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
| Economic value added | Â | Â | 56.39 | 62.15 | 62.65 | 63.38 | 64.33 | 65.50 |
| Discount factor | Â | Â | 1.00 | 0.93 | 0.86 | 0.80 | 0.74 | 10.99 |
| Discounted EVA | Â | Â | 56.39 | 57.68 | 53.96 | 50.66 | 47.72 | 719.84 |
| Period | Â | Â | 0 | 1 | 2 | 3 | 4 | 5 |
| Â | Â | Â | Â | Â | Â | Â | Â | Â |
| Â | Â | Â | Â | Market value added | 986 | Â | ||
| Â | Â | Â | Â | Invested capital | 514 | Â | ||
| Â | Â | Â | Â | Value of the equity | 1500 | Â | ||
| Perpetual growth in residual earnings | 1.4% | Price target | 8.9 | Â | ||||
Focus equity estimates
The valuation reveals a price target of $8.9, an upside of approximately 33% to the price at the time of writing.
Bottom line
Oclaro is exposed to the potential increase in spending by network equipment providers amid the need for increasing capacity or shifting toward new technologies like 5G. Recent weakness is China is a short-term headwind, which is expected to diminish by the end of next year. The stock is trading on the low side following a recent recent sell-off and has a cheap valuation. Overall, Oclaro offers long-term value in the small-cap arena.
Disclosure: I have no positions in any stocks mentioned and do not plan to initiate any positions within the next 72 hours.
