POET Technologies Inc.

Published: Sept 30, 2016 8:58 p.m. ET

Optical-networking components, such as fiber optic cable, is suddenly in great demand again.

If “The Graduate” had been set in the late 1990s, Dustin Hoffman’s young protagonist might have heard these two words of advice: fiber optics.

Major leaps forward in the development of fiber optics was a core underpinning of the growth of the internet and helped fuel the optical-networking sector to explode—and then implode—at the turn of the 21st century. Like most component and semiconductor markets, this sector is extremely cyclical—as soon as the first big internet build-out pushed optical-networking companies to outlandish valuations, the cycle ended and they came crashing down amid the massive telecommunications bust.

The timing of the current cycle is the big question for investors who are now benefiting from another boom in optical networking, thanks to internet growth in China, new cloud-focused data center infrastructure and big trans-ocean fiber optic cable projects like the one announced in May in development under the Atlantic Ocean by Microsoft Corp. MSFT, +0.35% and Facebook Inc. FB, +0.14% as well as Alphabet Inc.’s GOOG, +0.29% GOOGL, +0.18% ongoing Google Fiber installation project.

The boom in optical-networking stocks last quarter is unlike anything they’ve experienced since the dot-com bust. In the last three months, shares of these optical-networking companies have gained at least 70%, with one more than doubling: Oclaro Corp. OCLR, -0.81% OCLR, -0.81% NeoPhotonics Corp. NPTN, +0.25% Applied Optoelectronics Inc. AAOI, +5.96% Finisar Corp. FNSR, +1.09% and Lumentum Holdings Inc. LITE, +0.99% Even amid a drought for initial public offerings for tech companies, Acacia Communications Inc. ACIA, +0.29% managed to debut in the sector in mid-May, and that stock is up 233% since.

In a note this week, Cowen & Co. analyst Paul Silverstein was fully aware that investors are leery of a sector that saw an estimated $1 trillion loss in market value during the dot-com bust. But he still touted the current demand cycle for companies like Oclaro and Applied Optoelectronics and gave many convincing data points in a 58-page initiation report on Oclaro.

“At the risk of uttering the four most dangerous words in the investment lexicon, regarding the critical issue of the duration of the current optical upgrade cycle, we think the nature of this cycle is different this time,” Silverstein wrote.

He added that, while the nature of the business of these companies is cyclical, the current cycle is too strong to ignore.

“To be clear, current end demand and the near-term outlook for optical systems and components is not uniform across all product, customer or regional markets; by extension, nor is it uniform across all vendors,” Silverstein wrote. “That said, virtually all optical industry participants that we met with or heard from cited strong demand and/or underlying demand drivers with no letup in sight.”

Indeed, many of these new companies have roots in the first telecom/internet boom and bust, and investors appear to be hoping that their education during one of the most memorable busts will help them proceed more cautiously during another boom time.

Oclaro, the big focus of Silverstein’s note, has been led since 2013 by Greg Dougherty, who served briefly as chief operating officer of JDS Uniphase, a company that was the poster child for the incredible rise and disastrous fall of the optical-networking sector. Dougherty joined JDS after one of the biggest mergers of the era, when JDS bought rival SDL, where he was COO, for about $41 billion in stock.

Silverstein noted that Dougherty and Chief Financial Officer Pete Mangan “have led a breathtaking turnaround” of a company that is now an “early market leader in the highest growth component of the optical component sector.”

JDS Uniphase survived the lean years since the bust, but not entirely intact. Lumentum is the old JDS laser and optical networking components business that was separated from JDS along with Viavi Solutions Inc. VIAV, +1.79% In its most recent earnings call last month, Lumentum CEO Alan Lowe noted that revenue in its 100 gigabit datacom business had surged 241%, while its business selling reconfigurable multiplexers for optical networks was up nearly 100%. Overall, revenue growth in the most recent quarter was 15.7%.

“Increasingly, network and data center operators around the world are critically dependent upon our products,” Lowe told analysts in early August. He said demand from China continued to be strong, and full-scale deployments in North American metropolitan areas were ramping up.

NeoPhotonics has an even longer history. Initially founded in 1996 to develop nanomaterials, the company became NeoPhotonics in 2002 and spun out its non-telecom businesses. Since 2003, it has been buying companies to expand its technologies, starting with its purchase of Lightwave Microwave Systems.

In the past few months, NeoPhontonics has received serious attention on Wall Street, including from Michael Burry, the hedge-fund investor known for his early prediction of the housing market collapse, as chronicled in Michael Lewis’s book “The Big Short.” According to a regulatory filing in August, Burry’s Scion Asset Management bought 300,000 shares of NeoPhotonics as he dumped his Apple stake and loaded up on Alphabet.

Last month, at an analyst meeting, the company forecast revenue growth of 25%-plus from 2017 to 2019, as revenue from China and other metro markets surges.

“Welcome to the second inning of the Optical Super Cycle,” Alex Henderson, an analyst at Needham & Co., wrote in upgrading NeoPhotonics to a strong buy over the summer.

Investors looking for deals in this group may have a hard time after the booming quarter they just experienced. Most of these stocks are now trading at higher growth multiples than other tech holdovers from the dot-com era. Finisar and Lumentum, for example, are trading at 22 times and 26 times 2016 earnings estimates, respectively, while Oclaro trades at about 31 times 2016 estimates. Newly public Acacia trades around 38 times its 2016 estimates, while Applied Optoelectronics is trading at 30 times 2016 estimates and NeoPhotonics is trading at 24.5 times its annual earnings estimates.

In addition, investors are likely to remain jittery about this sector after the carnage of 2000-2001. Cowen’s Silverstein, well aware of the potential for skepticism, noted several factors for his call on Oclaro. He said that a few markets for 100 gigabit optical networking components are in the early stages of a multiyear upgrade cycle, and cited Infonetics/IHS market research data that predicts compound annual growth rates of 30% to 60% for certain equipment.

Optical networking is a complex sector that is hard to understand for non-techies, and the current prices of many of these stocks may be a deterrent. But if we are still early in a “super cycle,” they could still be worth a look, and investors with a long timeline may want to jump in if these stocks bust yet again.

http://www.marketwatch.com/story/a-dormant-tech-sector-is-suddenly-surging-like-its-1999-2016-09-30?siteid=rss&utm_source=twitterfeed&utm_medium=twitter