Applied Optoelectronics Shines In Fast-Fiber Internet

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The era of dial-up modems is long gone. Fast fiber optics rule the day, with telecoms, broadband-cable operators, equipment manufacturers and chipmakers racing to provide greater speed and bandwidth to an ever more demanding consumer.

Applied Optoelectronics ( AAOI ), a fiber optic networking products maker based in Sugar Land, Texas, is looking well positioned to help lead the way amid all this activity.

It serves three markets: broadband cable, fiber to the home (FTTH) and data centers. The company went public last September, but it's been in business since 1997.

Applied Optoelectronics stock has risen from an IPO price of 10 to trade near 23. It is up 54% this year and 31% from an early-May dip as the company reported first-quarter earnings per share of 6 cents, just meeting analyst estimates. Revenue in the quarter rose 74% from a year earlier to $24.9 million, ahead of analyst views for $23.9 million.

The company started out making fiber-optic devices such as laser diodes. These elements turn electrical signals into optical signals and then back into electrical signals.

Over the years, the company added more complicated modules and systems based on this technology. It also grew to become a vertically integrated manufacturer, a differentiating factor in the industry.

Cable Industry Capability

The company's legacy traces back to making lasers that are extremely weather-resistant, an ideal quality for the cable TV and FTTH industries, with their significant amount of outdoor infrastructure. Over the years, Applied Optoelectronics has grown to be the largest maker of fiber-optic devices for the cable TV industry.

"Applied Optoelectronics' technological basis is in molecular beam epitaxy (MBE), which is different from virtually all other laser makers that utilize metal-organic chemical vapor deposition," wrote Craig-Hallum Capital Group analyst Richard Shannon in a report. It generally provides better reliability over temperature and humidity changes, he says.

Applied Optoelectronics holds 57 patents related to MBE manufacturing. It has only two direct competitors in the field,Emcore ( EMKR ) and to a lesser extent,Finisar ( FNSR ), he noted.

This segment accounted for about half of Applied Optoelectronics' total revenue last year. Shannon expects this business to grow at about 3% this year and 20% next year, as cable TV companies enter a new upgrade cycle. Customers in this segment includeCisco Systems ( CSCO ) andArris Group ( ARRS ).

The biggest growth is expected to come from Applied Optoelectronics' two other businesses. Shannon forecasts its FTTH and data-center revenue to jump 394% and 203% this year, respectively.

FTTH -- as described by the Fiber to the Home Council -- is a relatively new way of bringing vastly higher bandwidth to consumers and businesses, thereby enabling more robust video, Internet and voice services.

Gigabit Home Internet

Technically, the industry group notes, it means delivering a communications signal by optical fiber from the operator's switching equipment all the way to a home or business, replacing existing copper infrastructure such as telephone wires and coaxial cable.

Two examples of U.S. FTTH services areAT&T 's (T) uVerse offering andVerizon Communications ' (VZ) FIOS service, notes Applied Optoelectronics, which makes both optical transmission and reception equipment for the FTTH industry.

"In particular, we're addressing very high-speed, advanced, gigabit-class fiber-optic home-network deployment," said Stefan Murry, Applied Optoelectronics' chief strategy officer.

"Earlier generations of fiber to the home had given us 50 to 100 megabits per second, but there are customers out there now that are interested in deploying gigabit-per-second type services," he said. "And for that to be done economically, we really need some new technology, and it requires fundamental innovations at the optical-device level."

In this segment, there are two types of customers, he noted. First, companies such as AT&T and Verizon buy their equipment primarily from other suppliers, such asAlcatel-Lucent (ALU) andEricsson (ERIC) . In the FTTH industry, Applied Optoelectronics supplies modules to the latter type of firm.

The second type of customer in the segment is a company innovating at the device level and making specialized equipment to address its particular needs in the FTTH space, Murry says. In this case, there is no "middleman," and Applied Optoelectronics is the direct supplier to this type of company.

A 'Google Fiber' Future?

Google (GOOGL) is an example of the latter type. Applied Optoelectronics hasn't officially said if it is working with the much-ballyhooed Google Fiber fast-broadband buildout, but the analyst and investor communities have speculated that it is.

The most important growth driver on a percentage basis is the FTTH segment, "which is really code for Google Fiber," Shannon said. "That one, the percentage growth rate will be huge, coming from a small base. That may end up to be the largest business in 2015 or 2016, if what we think happens actually does."

The important element in this development is that Applied Optoelectronics continues to own the technology it has developed in partnership with Google, Shannon wrote.

Google Fiber fast-broadband service started around Kansas City, Kansas. The project has now expanded into Provo, Utah, and Austin, Texas. And Google has also been in discussions with dozens of cities in nine more U.S. metro areas about bringing in fast fiber.

Shannon has modeled that the potential annual sales from an Applied Optoelectronics buildout of new infrastructure for Google Fiber could reach between $70 million and $100 million in two to three years.

Big In Data Centers

Applied Optoelectronics' third business segment is data centers. Here, too, strong growth is expected -- especially as cloud computing becomes more prominent. The company is well positioned in this area, with two of the world's four largest data-center operators as customers:Microsoft (MSFT) andAmazon (AMZN).

"You have fiber optics in the data center to transmit data from one network element to another, for example from a server to a switch or from a switch to another switch," said Murry. "Up until a few years ago, data rates in this application were relatively slow, at 1 gigabit per second or lower."

At those data rates, you can transmit using regular copper cable, he says. In the last couple of years, interconnection speed among the switches and servers in data centers has gone up. At the same time, the physical size of the data centers has expanded. So not only is there longer distance, but data rates have sped up from 1 gigabit to as much as 40 gigabits per second.

"As a result, you can no longer transmit a signal over sufficient distance now at those higher speeds to cover one end of the data center to the other using copper cable," said Murry. "So now they have to go to fiber-optic cable."

Being a vertically integrated company helps Applied Optoelectronics work smart and quickly in its varied business segments.

A typical research-and-development process would involve three steps that need to be followed in sequence: making a new laser diode, then subassembling the optical module and finally integrating it within a larger system.

"That's a very lengthy process," said Murry. "By having all of these parts of the business under our own roof, we can do parallel work ... so that by the time the device is ready, everything else is ready as well."

Applied Optoelectronics has manufacturing facilities in Texas, China and Taiwan. It expects to spend $16 million to $18 million across its Taiwan and Houston facilities this year to expand fabrication capacity, mainly to address demand in the data-center and FTTH markets.

Where a complex technological process is involved, there are always risks. If Google Fiber has major slowdowns or can't deploy a nationwide network, it could significantly impact Applied Optoelectronics' stock price, says Shannon. Much of a surge that the stock had in February and March is attributable to Google Fiber expectations, he says.

Updates in data-center industry standards could also affect the business. A lot of data-center customization is required now as standards lag needs, Shannon says. If standards catch up, it could reduce the need for customization.

The timing of the cable operator upgrade cycle is another factor.

But of Applied Optoelectronics, he says, "we think it's not only the highest-growth optical company out there, it's probably one of the highest-growth hardware-technology companies available anywhere in the U.S. market today."



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: AAOI , EMKR , FNSR , CSCO , ARRS

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