|Shares Out. (in M):||43||P/E||45.0x||13.5x|
|Market Cap (in M):||57||P/FCF||34.0x||12.3x|
|Net Debt (in M):||-41||EBIT||1||4|
We believe Alliance Fiber Optics (AFOP) shares are a timely and attractive investment opportunity. AFOP is a Company with growing sales and profitability with a market value that consists of over 70% cash. We have monitored these shares for many years and now believe that the recent operating results strongly support the thesis that the Company is entering a sustained period of strong operating performance. Through the leadership of Peter Chang, the Company Chairman and CEO, AFOP has succeeded in remaining profitable during the extremely challenging technology operating environment of the last two years and is now exhibiting strong growth.
The popularity of the Internet and the growing number of data-intensive Internet-based applications and services have driven a significant increase in the volume of data traffic. This traffic growth has increased the demands on communication networks which were originally developed primarily to transport voice traffic. To meet this growing demand, many communications service providers have and are designing and installing new networks based on fiber optic technology, which provides greater data capacity, or bandwidth, and increased transmission speeds compared to existing communications networks. Until recently, most of the fiber deployed had been dedicated to long-haul networks which carried data from city to city. However, the demands for high-speed network access and bandwidth are shifting the focus towards more complex metropolitan networks and last mile access networks, which require an increasing number of connections and components.
AFOP was founded in December 1995 to address this increased demand for optical components and integration. AFOP commenced operations to design, manufacture and market fiber optic interconnection products, generally referred to as connectivity products. Over the years the Company has broadened its connectivity product line to include attenuators, planar light wave circuit splitters, and fused fiber products. In early 1999, the company started forming a new product line, optical passive products (devices that direct and manage a large numbers of optical signal channels) and has continued to expand its offerings as market needs have changed. From inception to 2009, the Company has derived the majority of its revenues from the connectivity product line. Optical passive products contributed 37.5% and 36.9% of revenues for the years ended December 31, 2009 and 2008, respectively.
Today, AFOP designs, manufactures and markets a broad range of high-performance fiber optic components, and integrated modules incorporating these components, for leading and emerging communications equipment manufacturers and service providers. The Company offers a broad range of products including interconnect devices that are used to connect optical fibers and components, couplers and splitters that are used to divide and combine optical power, and dense wavelength division multiplexing, or DWDM, devices that separate and combine multiple specific wavelengths. The Company emphasizes design for manufacturing and uses its manufacturing expertise to enable it to produce products efficiently, with high quality, and in volume quantities. The Company's product scope and ability to integrate its components into optical modules enable it to satisfy a wide range of customer requirements throughout the optical networking market. The Company's products are deployed in long-haul networks that connect cities, metropolitan networks that connect areas within cities, last mile access networks that connect to individual businesses and homes, and enterprise networks within businesses.
The Company's main competitors in the components market include Oclaro Inc., JDS Uniphase Corp., Oplink Communications, Inc., and Tyco Electronics Corporation. The Company estimates that it has approximately 20 competitors in the components market. The Company's market is thus highly competitive, but the Company has shown an excellent ability to profitably compete.
As of year-end, AFOP had 870 full-time employees, including 39 located in the United States, 318 in Taiwan and 513 in China. Of these 870 full-time employees, 58 are engaged in product development, 722 are engaged in manufacturing production, 19 are engaged in sales, marketing, application support and customer service, and 71 are engaged in general and administration.
ALLIANCE FIBER OPTIC PRODUCTS, INC.
Consolidated Statements of Operations
(in thousands, except per share data)
Years Ended December 31,
Revenues $ 29,834 $ 38,754
Cost of revenues 20,504 26,589
Gross profit 9,330 12,165
Research and development 2,972 3,322
Sales and marketing 2,276 2,406
General and administrative 3,331 3,487
Total operating expenses 8,579 9,215
Income from operations 751 2,950
Interest and other income, net 766 1,315
Net income before tax 1,517 4,265
Income tax 84 199
Net income 1,433 4,066
Net income per share:
Basic $ 0.03 $ 0.10
Diluted $ 0.03 $ 0.10
Shares used in computing net income per share:
Basic 42,026 41,601
Diluted 42,279 41,657
We find it impressive that the Company was able to maintain profitability, on a quarterly basis, despite extremely difficult market conditions in 2009. Sales dropped 23% from 2008 to 2009, but gross margins remained stable at slightly above 31%. First quarter 2010 results showed a 12% sequential revenue increase with an improved gross margin of 32.1%. Mr. Chang commented that demand remains strong across all businesses and he expected second quarter revenue to grow about 10% sequentially. During the conference call he indicated that there was "up-side" in the 2010 plan.
The recent revised guidance revealed that Mr. Chang was accurate when he expected "up-side" in the 2010 plan:
"For the 2nd quarter of 2010, the Company expects to report net sales above $10 million, exceeding previously stated revenue guidance provided in the first quarter conference call. This revenue level represents approximately 30% growth compared with the year ago quarter.
"The Company's higher than anticipated net sales in the second quarter of 2010 primarily reflects stronger than expected demand from customers across several lines and market segments. In addition to managing current increased customer delivery requirements, we continue our capacity expansion efforts to support our customer needs going forward," commented Peter Chang, President and Chief Executive Officer."
Is this simply a cyclical recovery? Perhaps, but for a Company that maintained it's profitability through the "Great Recession" and is selling only marginally above its huge cash balance, the higher profitability supports the assertion that these shares are undervalued.
Balance Sheet/Cash Balance/Dividend
How would one describe AFOP's balance sheet? Bullet-proof, pristine, and immaculate are a few adjectives that would be appropriate. The Company holds over $41 million in cash and equivalents, which equates to $.97 per share. In fact, the company has about $33 million ($.78 per share) in net-net cash or cash net of all its liabilities. Book value, which is obviously essentially cash, is $1.17 per share.
What is the Company going to do with all this cash? Does it need the cash to run the business? No, it clearly does not need the cash to run its business. We, along with many other shareholders, have attempted to address this issue with Mr. Chang in conference calls and private discussions over the past seven years, but he has always been non-committal. He has repeatedly affirmed, when asked, that he is open to a dividend policy, a share buy-back or possibly an acquisition. The cash has provided, in our opinion, a security blanket for the Company; this is obviously not an optimal use of cash from the perspective of outside shareholders.
The Company's policy and Mr. Chang's approach appeared to have, at a minimum, marginally changed in October, 2009 as the Company declared a special $.02 dividend. Was this a one-time event? It could be, but we doubt it. Mr. Chang has always been hesitant over the years to reduce the Company's cash position and has maintained it as an insurance policy. The fact that he paid any dividend at all, demonstrates, we believe, a high level of confidence in the future profitability of the Company. Perhaps, it is just an appeasement to outside shareholders, but it's encouraging, even if this is the case as the Company is for the first time showing sensitivity to the interest of external shareholders.
Peter Chang is the founder of the Company and has been Chairman and CEO from inception. Including options, Mr. Chang holds 6.6 million shares of AFOP which represents 15% of shares outstanding. Management in the aggregate holds 21% of the Company's shares. Mr. Chang's total compensation was $259,000 in 2009 and $275,000 in 2008. His compensation is thus modest and reasonable. His reward for managing the Company to growth and profitability will come from the valuation of his shares and not from his compensation. Thus, his incentives are complete alignmed with the interest of outside shareholders.
First, is the current share valuation reasonable? The shares trade for about $1.35 per share which gives the Company a market value of about $57 million. If we subtract the $41 million for the cash position, we get a net market value (or enterprise value) of $16 million. Let's consider the Company's valuation net of cash.
In 2009, a horrible recessionary year in the Company's markets, AFOP generated $0.8 million in operating earnings. In 2008, a more normal year and a conservative proxy for 2010, the Company generated almost $3.0 million of operating earnings. Thus, if we conservatively assume that operating earnings for 2010 earnings approximate 2008 results the Company is selling for about 5.3 times operating earnings. It's important to note that this number is equal to the after tax multiple as the Company has over $35 million in federal tax loss carry forwards and is not expected to pay taxes for many years.
Would 10 times, after tax operating earnings be a reasonable multiple for a company with good growth prospects? This would value the operating portion of the Company at $30 million and give the company a total value of $71 million or $1.67 per share, a 24% premium above the current share price.
We believe a more reasonable expectation for operating earnings in 2010 is $4 million. If we are correct with this estimate, the total value of the company at ten times after tax operating earnings would be $81 million or $1.91 per share, a 42% premium to the current share price.
In any case, the Company is worth substantially more the its current share price and its cash balance provides a significant margin of safety. Finally, the above valuation gives no credit to the Company's current expansion to its facilities in China and its impact on the Company's future earnings.
Summary: Why buy AFOP shares?