Description

Description

Opnext (OPXT, $4.86) provides investors with a rare opportunity to buy a profitable growth business generating free cash flow at very close to tangible asset value.  The stock is a broken IPO that has seen its stock thrown in the garbage by its initial investors because of recent execution missteps.  Barring a disastrous downturn in its business that seems unlikely to happen even in the current economic environment, an investor is not likely to lose money but can reasonably hope to achieve an 80% return in less than one year and potentially a 200%+ return in 2 to 3 years under a not-too-heroic set of assumptions.

OPXT designs, manufactures and sells optical components that are critical parts of modern high speed data and telecommunications networks.  OPXT was spun off by Hitachi’s fiber optics business in 2000 and received financial backing from Clarity Partners.  Hitachi still owns over 40% of OPXT.  OPXT has leading market share of 25-30% in 10G and 40G transceivers, which convert signals between the electrical and optical domains for transmitting and receiving data over fiber optics networks.  OPXT’s direct customers are leading systems vendors such as Cisco (37.6% of MRQ revenue), Alcatel-Lucent (19.9%), Nortel, Hitachi, Huawei, Ericsson, Nokia Siemens Networks and Fujitsu.  10G is currently the mainstream data rate for new enterprise and service provider high speed optical networks, while 40G deployments are in their early stages.  Approximately 80% of OPXT’s business is in 10G and faster data rate transceivers, so it has little exposure to the slower growing legacy parts of the fiber optics components business.  While macroeconomic uncertainty has reduced growth expectations somewhat, the market for 10G and 40G optical transceivers is estimated at over $1B and still expected to grow by about 25% in 2008. 

The optical components industry is currently out of favor with investors for several reasons.  It has never really recovered from the technology bubble of 2000, when too much investment capital was thrown at the business and too much capacity was built both in the networks themselves and in the manufacturing assets of the optical suppliers.  Components suppliers have further had their negotiating power eroded by the consolidation among network carriers and systems OEMs.  As a result, since 2000 the optical components industry has struggled to meet growth expectations and continued to operate at low gross margins and frequently negative operating margins.  Opnext’s competitors like Bookham, Avanex, JDS-Uniphase and Finisar have generally been unrewarding basket cases for investors and several have balance sheet problems. 

It has taken a while for all the excess network capacity built during the bubble to be absorbed, but there are signs that with the continued growth of Internet traffic and especially the growth of Internet video, service providers are being forced to increase their core metro and long haul fiber optic network capacity investments.  Recent comments from Cisco and AT&T indicate there is a real need for more bandwidth around the world, and at the same time optical communications are being pushed farther into enterprise networks as 10G Ethernet becomes pervasive.  While the industry is still in need of consolidation the optical components companies are experiencing the best demand environment they’ve had since the bubble.  Attendees at the recent Optical Fiber Conference in San Diego were generally upbeat about demand, although visibility is limited.  Most importantly, Opnext has emerged as a leading supplier in the industry for its focus product areas.  In fact Cisco recently underwent a comprehensive vendor evaluation process to winnow its list of core optical components suppliers to four, which ended up as Finisar, Sumitomo, Avago and Opnext.  Notably some of the traditionally biggest names in optical components such as Bookham, JDS and Emcore/Intel did not make the list, and should see their Cisco business reduced over time as a result. 

Recent Results and Situation

OPXT went public in February of 2007 at $15.00 per share in an offering led by Goldman Sachs and JP Morgan.  The offering was oversubscribed and priced aggressively but the research coverage by the bulge bracket banks was generally neutral upon initiation.  The stock drifted between $10.00 and $15.00 until the company reported its September quarter results on November 1.  EPS was $0.01 penny short of analyst expectations and the market for small cap tech stocks was falling sharply, so the shares drifted even lower, to the $7-$8 range, near where they closed out the year.  Several analysts had upgraded the company and gotten more positive along the way, but the company gave investors a double whammy in January.  First, the company pre-announced it would miss revenue estimates by about 15% for the December quarter on January 11, it then announced it would need to restate results due to a raw materials inventory accounting issue on February 13.  Due to these events investors abandoned the stock en masse, sending the shares down to its current range of $4-$5.

While OPXT’s stock is clearly down for a reason, most of the issues behind the decline are outside of the company’s control and not indicative of a fundamental downturn or problem in its business, while the stock is now priced like a company that will be burning capital or going out of business.  The revenue shortfall is clearly the biggest issue, but the underlying reasons do not seem to indicate a change in OPXT’s attractive position.  The shortfall was caused by 3 unrelated temporary issues that do not seem likely to affect business going forward, and upon reporting the December quarter results guided March results to be sequentially up.  The company’s restatement was relatively minor in amount and scope, as a result net income was reduced by an aggregate of around $3M for the last two completed fiscal years.  Importantly, the most recent periods were not affected, and the entire timeline from announcement to completed restatement was less than two weeks. 

At the same time competitors JDS Uniphase, Finisar and Bookham all reported good sales results and guidance.  The outlooks of large communications OEMs like Cisco, Nortel and Alcatel-Lucent have been perceived as disappointing by investors, but the optical parts of their businesses have been described as relative strengths. 

Valuation

As detailed in the table below, OPXT is currently in the strange situation of having the best business metrics of its industry but the lowest valuation: 

Business Metrics Comparison- Trailing Twelve Months Basis, as of 4/14/08

		Market	Ent	Rev	Gross	EBITDA
Symbol	Price	Cap	Value	Growth	Margin	Margin
AVNX	$      0.65	149	103	11%	18%	1.9%
BKHM	$      1.39	139	76	-8%	14%	-16.1%
FNSR	$      1.21	373	516	11%	35%	7.2%
JDSU	$    13.37	2,935	2,535	11%	32%	7.8%
OPTM	$      6.43	164	112	53%	26%	4.6%
Average				16%	25%	1.1%
OPXT	$      4.86	314	133	36%	35%	7.3%

Valuation Metrics Comparison

	Price/	EV/	EV/	CY 08	% of
Symbol	TBV	Rev	EBITDA	P/E	52 Wk Hi
AVNX	2.2	0.5	N/A	21.7	31%
BKHM	1.0	0.4	N/A	N/A	41%
FNSR	16.1	1.3	17.4	11.0	29%
JDSU	4.3	1.7	22.1	18.1	78%
OPTM	1.6	0.9	18.4	19.5	29%
Average	5.0	0.9	19.3	17.6	42%
OPXT	1.0	0.5	6.6	16.2	24%

You would expect Opnext to have one of the highest if not the highest valuation in the industry, as its growth and gross margins are far above average while its EBITDA margin is the best in the list.  However, because of the temporary issues detailed above, OPXT has the lowest or nearly the lowest valuation in terms of price/TBV, EV/Rev, and EV/EBITDA.  Its valuation is also attractive on an absolute basis for a business with its growth and market position.  Note that the entire industry is at recent historical valuation lows, with plenty of headroom for multiple expansion should speculative investors get excited about optical components again as they tend to do from time to time.  The vast majority of OPXT’s TBV is in cash at over $3.00 per share.  The company also has over $266M in net operating loss carryforwards that are not reflected as deferred tax assets on its balance sheet.

Also note that as a result of the recent shortfall OPXT’s Y on Y growth has slowed to the single digits as of the last two quarters.  OPXT’s revenue growth has been lumpy in the past, for example the company grew revenue 74% in FY 2005 but only 10% in FY 2006 before jumping back to 45% in FY 2007.  I expect revenue growth to re-accelerate by the end of the current fiscal year especially as the company laps easier comps. 

Return Potential

I view the return potential for an investment in Opnext as two pronged- I believe that OPXT could increase 80% in value by just getting credit in the market for its current business and position, while in the longer term the stock could more than triple from its current value if management continues to grow the business and can achieve modest operating margin expansion.

It will likely take 3-4 quarters of execution to get there, but given its superior operating statistics OPXT could and should trade near the valuation of the two largest and most successful players in optical components- JDSU and FNSR.  A stock price of $8.50 would give OPXT a valuation just below those two comps on an EV/Sales and EV/EBITDA basis. 

Longer term, if OPXT can consistently return to the business execution and growth that it demonstrated in the two years prior to the most recent quarter, it could easily achieve or surpass its original IPO price of $15.00 per share.  The company should do around $280M of sales for its March 2008 fiscal year, compounding 20% growth on top of this (lower than expected for its market) results in $400M of revenue for the March 2010 fiscal year.  The company should be able to expand its operating margin as it gets bigger, and a 10% operating margin for the whole year yields $40M in operating profits.  Note that the company has achieved a 7% operating margin in the past and has a target goal of 10-15%.  $40M operating profits multiplied by 18 (a discount to the growth rate) gives us $720M in enterprise value or about $11.00 per share.  Adding the over $3.00 per share in cash today and the value is over $14.00, not counting the free cash flow the company should generate over this time.

Investment Risks

I view OPXT as a fairly low risk investment because it trades at tangible asset value, the vast majority of this tangible asset value is in cash and it generates free cash flow.  However the company is clearly exposed to execution risk, significant competition, customer concentration risk and is dependent on the health of the optical communications industry.  The company also has significant fixed costs denominated in Japanese Yen.

Two of these risks bear close attention today.  First, the biggest customer risk is obviously Cisco and it has been widely reported that Cisco’s business has experienced some weakness.  The weakness seems to mainly relate to the U.S. enterprise business and the optical business has been a relative strength, but a broad reduction of supplier orders by Cisco could be negative for OPXT.  Note that some of the recent revenue miss was due to a vendor managed inventory program by Cisco, which also forced OPXT to build up some inventory. 

Second, a significant part of the company’s COGS and operating expenses are denominated in Japanese Yen.  The Yen has appreciated roughly 10% against the U.S. dollar YTD, which is a significant headwind for OPXT’s gross and operating margins.  The company does hedge a portion of its balance sheet and operating costs according to recent disclosures.

The recent missteps have also created a couple of new risks- first, several class action law firms have launched lawsuits against OPXT.  The re-statement has also shown that OPXT has a material weakness in financial controls, which may not be addressed before it files its 10-K for the March 2008 fiscal year.

As a spinoff from Hitachi the company also has a complicated relationship with its parent company.  The companies share R&D resources and Opnext still has some operations in Hitachi’s corporate campus.  The companies have cross-licensed IP and have some small product overlaps.  Hitachi owns over 40% of OPXT.  I view the relationship with Hitachi and the work with their R&D labs as a source of a technology competitive advantage especially for lasers, but the relationship obviously has risks and may reduce OPXT’s attractiveness as an M&A target.

Disclosure: Long OPXT

Catalyst

There is no significant near term catalyst, but in my opinion the valuation is so far below the rest of its already depressed industry that any slight change in investment sentiment could send the shares up sharply. I view the next potential catalyst to be the earnings announcement for the March 2008 quarter and fiscal year end. Note that the pre-announcement season has passed as I write this so (fingers crossed) it seems unlikely that OPXT has another negative revenue surprise in store for investors in the near term.