2017 was a dismal year for optical components maker Oclaro (NASDAQ:OCLR), which lost over 20% of its market value on concerns about its slowing growth. However, that decline reduced Oclaro's P/E to 8, compared to an industry average of 27 for semiconductor makers. Therefore this stock might be a good value play for patient investors who are willing to ride out its cyclical headwinds.
The previous bull case for Oclaro
Oclaro produces optical components, modules, and subsystems for the service provider, enterprise, and data center markets. Over the past few years, the growing use of streaming video, cloud-based apps, app virtualization, and other data-intensive tasks boosted demand for Oclaro's products -- particularly its "100G and beyond" portfolio of high-speed optical products for network upgrades.
This made Oclaro, along with its industry peers Finisar (NASDAQ:FNSR) and Lumentum (NASDAQ:LITE), favorite plays on the so-called "super cycle" of optical upgrades. Research firm Markets and Markets expects the global optical networking and communications market to grow from $15.1 billion this year to nearly $24.1 billion by 2023.
Why Oclaro lost its momentum
The future initially looked rosy for Oclaro. Its revenues respectively rose 55%, 64%, and 61% in the first, second, and third quarters of 2017. But during the third quarter, Oclaro warned that its sales growth would slow down due to soft demand in China, which was exacerbated by a product transition from its older 100G CFP products to its newer QSFP platform.
Those factors caused Oclaro's revenue to grow just 19% annually during the fourth quarter and 15% in the first quarter. CEO Greg Dougherty warned that Oclaro's "near-term visibility includes continued softness in China, compounded by a recent slowdown in data center sales."
For the current quarter, Oclaro expects its revenue to fall 7% to 12%, compared to the 3% growth analysts had expected. Analysts currently expect Oclaro's revenue and non-GAAP earnings to respectively fall 4% and 27% this year.
Oclaro's competitor Finisar is struggling with the same headwinds in China and the data center market, which caused it to miss top-line estimates for two straight quarters. Finisar's stock has fallen more than 30% this year. Meanwhile, Lumentum fared much better with a 56% gain this year thanks to its stronger position in China (as the primary datacom supplier for telecom giant Huawei) and its secondary business of industrial lasers.
Why Oclaro might be a value play
Oclaro and its optical component peers are cyclical plays, and two of its biggest growth engines -- China and data centers -- are arguably closer to a trough than a peak. Its single-digit valuation also suggests that the stock is heavily oversold. Oclaro's gross margin also remains much higher than Finisar and Lumentum's margins:
Oclaro is also keeping its operating expenses under control as it faces cyclical pressures. Its operating expenses rose just 11% annually and stayed nearly flat sequentially last quarter. This enabled the company to continue growing its non-GAAP operating income (up 66% annually last quarter) at a healthy clip.
Looking further ahead, analysts expect Oclaro's revenue and earnings to respectively grow 11% and 9% next year as the cycle turns positive again.
So should you buy Oclaro today?
I was wrong when I suggested that Oclaro could "quietly outperform" the market back in January. I was also wrong to suggest that the market wouldn't peak "anytime soon," and didn't anticipate the steep slowdowns in China and the data center market.
But I now believe that the selling is overdone, and that the stock's low valuation, high gross margins, and disciplined cost controls put it in a good position to rebound as the optical super-cycle finally returns to growth.