Case Study on Finisar Corporation (FNSR)

The Business:

FS 1

FNSR supply optical subsystems and components that allow point-to-point communications on fibre optic cables. These components make their way into their customers’ integrated systems which are used for fibre optics-based data communication and telecommunication networks.

Their product range consists of transmitters, receivers, transceivers, transponders and active optical cables to support a multitude of data transmission protocols. While their functions and applications may vary, they involve the conversion of electrons (electrical signals) to photons (light signals) for transmission over the fibre optic medium which primarily uses glass.

FS 4

Most of these products are also embedded with microprocessors and proprietary software that customers could use to monitor in real-time, various aspects of the data transmission environment, such as transmitted and received power, temperature and other link parameters.

FS 6

Their products address a wide variety of applications in both the IT data centre and telecommunications industries. These include the Fibre Channel storage area network (SAN) standard, as well as telecommunication applications using wavelength division multiplexing (WDM), which is fundamental in building fibre-to-the-home networks, such as Singapore’s OpenNet.

FS 7

FNSR’s customers include a broad base of original equipment manufacturers, or OEMs, distributors and system integrators. Among them, Cisco (CSCO) accounts for more than 10% of FNSR’s total revenues in fiscal year 2013. Prior to that, Huawei and Alcatel-Lucent (ALU) along with CSCO each represented more than 10% of revenues.

They also sell to the so-called “merchant market” where other subsystems manufacturers buy their optical components which FNSR uses to manufacture their optical subsystems. These components includes lasers, couplers, isolators, filters, splitters, amplifiers and so on.

FNSR segregates its business into two segments. The Datacom segment, which contributes about 70% of revenue, are the components that go into enterprise infrastructure network. The Telecom segment supplies components to link fibre optics to telecom antennas and base stations that transmit data back to the Internet Service Provider.

The Risk

FNSR sells to makers of equipment and not direct to the end user. Businesses that have intermediaries like distributors have limited visibility to the demand side. Thus, FNSR uses rolling forecasts based on anticipate product orders to determine component and subassembly requirements. Any miscue here could cause cost overruns.

Likewise, FNSR relies on some key suppliers for their manufacturing. Again, costs might turn against their favour should a calamity break out in any of their suppliers.

Currently, the trend in the optical subsystems market is towards the adoption of “pluggable” modules and subsystems that doesn’t require significant customisation and development of more complex and integrated optical subsystems. There is a risk that their competitors may come up with something new to dilute the value add that FNSR has today.

Personally, I think the greatest risk stems from the aforementioned visibility issues to supply trends. They had a history of great growth in one year only to be offset by charges in the subsequent year when demand did not materialise. Customers also do not pay significant cancellation charges when it happens. Any impact in revenue trends could cause huge fluctuations in FNSR’s stock price. Since its results vary significantly from quarter to quarter, meaning comparisons cannot be made to project future performance, thus FNSR should be viewed as a speculative stock.

The Moat

The fast changing industry of tech sees the introduction of new technologies and even fiercer competition who will try to eke out any sliver of competitive advantage. Barring the failure to release and produce better products and technology which I do not foresee, and as the need for higher and more cost-effective bandwidth increases, the major trump card of FNSR lies in its low cost manufacturing and maintaining it.

Being the largest company in its industry with a 15.5% market share has its advantages. FNSR maintains a vertically integrated operation which they had built through internal development and acquisition, so they can do everything from design and test, to the assembly and testing of their products. The efforts to build this vertically integrated model has resulted in a relatively fixed manufacturing cost structure, which is advantageous when the demand is strong.

If we use the numbers from the bottom of fiscal Q1 2013 (July 2012 ending quarter) through to Q2 2014 (October 2013 ending quarter), FNSR achieved an increase of 273.3% in operating profit ($12 to $44.8) using only 31.8% increase in revenue (from $220.5 to $290.7). This represents an 8.6 times operational leverage. As FNSR continues to grow revenue, it will more favourably be able to absorb fixed costs.

In comparison, Avago (AVGO) outsources its manufacturing while Oclaro (OCLR) is also vertically integrated, OCLR is a loss making venture and is likely maintain losses for some time to come.

What fuels this demand for fibre optics? It is the explosion in data transmission of mobile networks, such as 4G LTE, and the increasing storage and networking demands in the enterprise data centre.

As the trend shifts towards higher data usage over wireless, our legacy communications network would be replaced by fibre optics backhaul links. Field tests conducted in Melbourne, Australia, had boosted 4G using TD-LTE technology to 160 Megabits per second, or 20 megabytes per second. I am pretty certain that each cell tower is supporting at least a thousand devices within a 1km radius, which means we are talking gigabytes per second required to bring data to and fro the ISP.

The mobile trend upshift is also supported by statistics from the ITU (International Telecommunications Union), which you can download here. Notable is the 500% increase in active mobile-broadband subscriptions in developing Africa from 2009 to 2013, with a corresponding 61.4% increase in individuals using the Internet. I also believe this accelerated trend extends across many other developing countries and territories such as Myanmar and China.

I believe that given the backdrop discussed above, we have enough drivers for FNSR’s growth in its sales of wavelength selective switches (WSS) and optical add-drop multiplexer (ROADM) products, which make their way into optical switch products from the likes of Ciena (CIEN).

The trend on the Datacom side looks good too, in fact, it is even much better than the Telecom side of the story. Data centres have been increasing bandwidth in the switching cabinet, and it is more likely that server cabinets will use more fibre as they need to crunch ever increasing amounts of data. The exponential growth of data consumption bodes well for storage array growth that utilises the Fibre Channel protocol, in turn driving up the demand for Brocade (BRCD) and CSCO SAN switches, which in turn would usually supply FNSR or AVGO transceivers.

Personally, I see the increase in adoption of fibre optics for intra-device connectivity, such as SAS (serial attached SCSI) cables between disk storage shelves as storage array configurations could stretch multiple server racks. FCP requires a lossless medium to ensure data integrity and low latency transmission. Then again, more upside for FNSR since customers have moved on to 8 Gb, and 16 Gb FC storage arrays are going mainstream to corporate customers.

Changes at the network architecture side are also making things favourable for FNSR. Where the predominant network topology in large data centres follow the tree topology with core, aggregation and access layers, the leaf-spine topology is gaining mind share with network planners who wants to massively scale their data centres. For the technically inclined or for those who are curious, Cisco’s primer here could serve up either a visual or mind blowing feast.

The Numbers

FNSR reported with Q1 2014 non-GAAP earnings of $0.31 on revenue of $266.1m. This represents a sequential increase of 9.3%, a year-over-year (y/y) increase of 20.7%, and set an all-time quarterly revenue record. This was followed by its Q2 2014 non-GAAP earnings of $0.43 on revenue of $290.7m. Both quarters easily beat the consensus.
For the upcoming Q3 2014 quarter, FNSR’s Chairman, Jerry Rawls, provided guidance in the range of $0.43 to $0.47 on the back projected revenues from $290m – $305m. Given the trend over the past quarters of reporting above estimates, I believe Jerry Rawls was being conservative.

FNSR is also a company with very low debt. Its long term debt is only 4% of its cash and cash equivalents, so I am pretty certain there is safety concerning its liabilities.

The forward EPS consensus of the covering analysts is $1.42, but I think FNSR could handily beat that and achieve EPS of at least $1.60. With a forward PE range from 13 to 18, and using an estimated balance sheet value of around $4, the fair value of FNSR would be as follows:

$1.42 x 13 + $4 = $22.46
$1.42 x 18 + $4 = $29.56
$1.60 x 13 + $4 = $24.80
$1.60 x 18 + $4 = $32.80

I also performed a valuation using Warren Buffett’s “owner earnings”.

Free cash flow
Cash from operations $149,230
Capital expenditures $113,176
Free cash flow $36,054
FCF per share $0.38
Owner earnings FCF $262,406
Owner earnings FCF per share (shares outstanding 96,128,666) $2.73

Note that I wasn’t able to put a finger on the maintenance capex of the equation, so I used the trailing 12 months as a gauge. If I use the same PE multiples, it would yield values of $35.49 to $49.14. While I am optimistic about FNSR’s prospects, I would play safe to use the PE+balance sheet valuation approach. The fair derived to the covering analysts consensus price target of $29.05, ranging from a low of $24 to $32.75.
Disclosure: At the time of this publication, out of the companies discussed herein, I have long positions in FNSR.

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Yong Mann Wai

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Disclaimer :  The above-mentioned Case Study is the view of author of the article  and not that of Mind Kinesis Value Investing Academy.


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