Acacia Communications – Getting More Appealing, Not Pulling The Trigger Yet

Acacia Communications (ACIA) has seen a disastrous year in 2017 despite solid operating conditions. In the first days of 2017 I noted that Acacia looked more appealing after a 50% retreat to levels around $60, as that move did not make me a buyer yet. Shares lost another 40% following a very difficult year as I think that shares are almost de-risked enough to start initiating a speculative long position, with the focus on speculative.

Long term potential and strong cash holdings are a real pro, but stiff competition, reliance on a few large accounts and quality issues make that I am not jumping aboard just yet.

The Business, Great Post-IPO Momentum, Struggles Ever Since

Acacia produces high-speed optical interconnect products which are used by cloud infrastructure players, as well as communication companies and content providers. The company has certainly enjoyed boom times, but for an investor it is very hard to figure out how sustainable growth is, as many of these overnight successes have turned out to become a disappointment for investors.

The timing of the IPO was good as shares were sold to the public at $23 in May of 2016. Accelerating topline sales growth pushed shares to a high of $120 in September of that year. That momentum run was driven by accelerating growth and margins being on the increase as well, but this momentum which was too strong in hindsight.

Boom Times Following IPO

The timing of the IPO of Acacia has been very good as the company grew sales by 63% in 2015 to $239 million, as strong operating leverage resulted in operating margins expanding from 12% to 17.5% of sales.

Shares got a big boost following the IPO as the company was showing no signs of slowing down, in fact the contrary was the case. First quarter sales growth for 2016 accelerated to 79% as growth came in at 101% in the second quarter of that year. This growth acceleration and profit explosion pushed shares up to levels in excess of $100 per share by the summer of 2016, as the company and some selling shareholders were ignited to sell some shares at these elevated levels. While growth was very strong at 106% in the third quarter, and 108% in the final quarter of the year, margins were already starting to weaken towards the end of the year.

The company reported revenues of $478 million for the record year, accompanied by operating margins equal to 24.6% of sales. Despite these very strong results, as Acacia reported net earnings of $3.22 per share in 2016, accompanied by dazzling growth, shares had fallen from $120 to $55 at the time of the release of the full year earnings report in February of 2017.

This marked a rather dramatic sell-off from highs around $120 per share, taking into account that included in the $55 valuation were net cash holdings in excess of $7 per share.

More Troubles Ever Since

By the time the first quarter results had been released in early May, shares had fallen back to the high-forties. Revenue growth slowed down rather dramatically, although a 36% growth rate remains impressive nonetheless as operating margins of 26.0% were quite solid. The issue is that the quarter marked a rapid slowdown in sales and was accompanied by a soft guidance for the second quarter.

By the time those second quarter results were released in August, shares had fallen back to the mid-forties after briefly touching upon the $40 mark following a profit warning and after the company warned on product quality issues. Second quarter revenues fell 32% year-on-year to $79 million and the company reported an operating loss of nearly $7 million. While the company guided for a sequential recovery in the third quarter, shares have continued to lose ground. By the time the third quarter results were released in November, shares traded at $36 per share, levels at which shares are still trading today.

Third quarter revenues came in at $105 million, marking a solid improvement on a sequential basis although revenues were still down 22% year-on-year. Operating margins fell to 8.5% of sales as the company has seen a huge decline in profitability. Even worse, the company guided for fourth quarter revenues to fall to just $83-$93 million, as adjusted earnings are seen at just $0.19-$0.36 per share. As stock-based compensation runs at roughly $6 million per quarter, or at roughly $0.15 per share on a pre-tax basis, realistic GAAP earnings are expected to be very limited in the final quarter of the year.

The good thing is that the the past boom in earnings and secondary offerings have resulted in a net cash position of $348 million, more than $8 per share. Trading at $36, operating assets are hereby valued at just $28 per share, or $1.17 billion in absolute terms.

With revenues seen at $386 million this year, sales multiples have compressed to 3.0 times (on an enterprise valuation basis) as the earnings number is an entirely different picture. Peak operating margins in the mid-twenties are set to fall to the high single digits this year, having dramatic consequences on realistic earnings. Pegging operating margins at 8% on sales of $386 million this year, and applying a 20% tax rate, realistic earnings trend at just $0.60 per share. The company reports a much higher earnings number, inflated by huge tax returns, which makes reported earnings not indicative of earnings power going forward.

The Current Thesis

While shares looked reasonably priced at $60 in early 2017, trading at 17-20 times earnings, I was cautioned by the rapid decline in profitability on a sequential basis, which turned out to be right. Shares have fallen another 40% ever since, despite the solid net cash position, as earnings have taken a huge beating this year, greater than I could have imagined at the start of the year. I furthermore noted that momentum was very strong leading up to the highs of $120, as the IPO price in May of 2016 was set at just $23, levels which we still have not seen despite the current challenges.

Part of my caution last year was driven by the high customer concentration, as the top 5 customers make up 80% of sales, and over 40% of sales were derived in China, with the two largest customers making up nearly two thirds of sales. This reliance, product quality issues and fierce competition from names like Oclora, Lumentum, Finisar and others makes that the business is inherently volatile, despite generally rosy conditions. While sales multiples have compressed to 3 times, many of these competing firms are actually still trading at lower (sales) multiples, and most of its peers with exposure to China have seen a very difficult year as well.

Buying A Further Dip

Appeal for Acacia is driven by the lagging share price, substantial net cash position and the generally good prospects for the industry. If we peg realistic revenue numbers around $400 million per annum, and assume that operating margins of around 10% could be sustainable, profits could hit $32 million with a 20% tax rate, equivalent to $0.75 per share. If we apply a market multiple to these sustainable earnings and add back the net cash position, fair value is seen just above the $20 mark.

If a $500 million revenue number is more realistic (incorporating a return to growth) and 15% margins are more sustainable, earnings could come in around $1.50. The similar valuation exercise shows that fair value in that case is seen around $35 per share, more or less in line with the current valuation.

The good thing is that the company remains upbeat on the long term prospects in China, improved customer diversification and the company continues to invest heavily into R&D, as it is actually increasing dollar spent in absolute terms. This gives confidence that perhaps another boom time to come in the future. If another Chinese-led boom could make that sales could perhaps boom to $600 million per a year, with margins of 20-25%, net earnings potential could be seen at $96-120 million, or $2.30-$2.90 per share. If such earnings potential could be valued at a market multiple, while adding back growing cash holdings, shares could easily double from here.

While the situation is highly uncertain, I have to recognise that Acacia has been de-risked a great deal, although the operating performance has been absolutely terrible this year. Based on continued R&D investments and long term growth potential in China, there are reasons to be upbeat as well in the long run, although the near term outlook remains dismal. So while Acacia remains a highly risky stock, the potential rewards are large as well as the current share price is in part supported by substantial net cash holdings.

To get a little bit better protection in case a recovery does not materialise in 2018, I will only start buying if shares hit the $30-$33 range.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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