Cloud Growth, Smartphone Sensors Should Boost Finisar

Alex Zhao: The fiber-optics industry is known for boom and bust cycles that cause large swings of business performance for manufacturers, such as the ramp and subsequent sharp reduction of optics orders from China in 2016 and 2017, respectively. However, in the long term, we believe the advent of the public cloud will inject some secular growth in high-speed fiber optics used to interconnect hyperscale data centers for delivering and hosting cloud services.

As the industry leader, Finisar is well positioned to benefit from this trend in the long run with its high-speed data-comm products. Robust growth in data-comm optics is driven by data center speed upgrades to 100 gigs per second and eventually, 400 gigs per second, over the next few years, in our opinion.

We also expect Finisar to develop a new stream of revenue from selling 3-D sensing lasers in smartphones, starting with supplying Apple's iPhone X in 2017. We expect Finisar to capture its fair share of this fast-growing market vertical.

Also, Telecom network upgrades in the U.S. and China should also support both near-term and longer-term growth drivers in Finisar's telecom products. Although Finisar is facing headwinds from a slowdown in Chinese optical spending, Verizon's ongoing network upgrades provide a near-term boost to revenue, while 5G deployments in the U.S. and optical network upgrades in China should offer longer-term growth opportunities for Finisar.

We concede that Finisar does not have an economic moat due to industry structures that are unlikely to change anytime soon. Yet we still see value in Finisar, as we believe its stock price does not fully account for the firm's long-term growth prospects and our expectations for gross margin expansion over the next few years.

Our fair value estimate is $30, which reflects our view that Finisar is likely to enter a multiyear period of double-digit top-line growth and high-teens operating margins, thanks to a favorable shift in product mix. We believe such growth prospects and margin improvements are underappreciated by the market right now, as the stock is trading at about 25% discount to our fair value estimate.