Why Oclaro Inc. Could Quietly Outperform the Market in 2017

By Leo Sun Markets Fool.com

Shares of Oclaro (NASDAQ: OCLR) recently surged after the optical components manufacturer released its preliminary second quarter results. Revenue is expected to rise 63%-64% annually, compared to its prior forecast for 55%-64% growth. It expects its non-GAAP gross margin to hit 40%, boosting its non-GAAP operating income from $5.3 million a year ago to $36 million -- which tops its prior guidance of $22-$26 million. On a GAAP basis, Oclaro expects gross margin of 39.5% and operating income of $33 million.

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Oclaro CEO Greg Dougherty attributed that growth to the company's "strong execution, a richer product mix, and favorable exchange rates." Analysts expect Oclaro's revenue and non-GAAP earnings to respectively rise 62% and 500% for the quarter when it reports its full results on Jan. 31. For the full year, Oclaro's revenue and earnings are expected to respectively grow 45% and 253%.

Those impressive growth figures explain why Oclaro rallied 160% over the past 12 months. But some analysts believe that rally hasn't ended -- Needham analyst Alex Henderson sees the stock rising more than 50% to $14 asthe company remains "an optical super cycle darling," while Stifel Nicolaus analyst Patrick Newton sees about 30% upside potential for similar reasons. Let's take a closer look at Oclaro's business to see why those estimates might be right.

Oclaro's business and the "optical super cycle"

Oclaro makes optical components, modules, and subsystems for the service provider, enterprise, and data center markets. These customers are now facing bandwidth bottlenecks due to the increased usage of streaming video, cloud-based apps, application virtualization, and other data-intensive tasks. That growing demand has boosted demand for Oclaro's "100G and beyond" portfolio of high-speed optical products.

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That demand has also lifted sales at bigger rivals like Finisar (NASDAQ: FNSR) and Lumentum (NASDAQ: LITE). Analysts expect both companies' revenues to rise about 18% this year, and are calling this industrywide growth a "super cycle" that won't peak anytime soon.

Research firm Markets and Markets estimates that the optical networking and communications market will morethan double from $12.6 billion in 2013 to nearly $26 billion by 2020. Last year, IDC predicted that spending on IT infrastructure for cloud environments will grow at a 5-year compound annual growth rateof 12.5% to $57.8 billion in 2020 -- which is great news for optical hardware suppliers.

Why Oclaro could outperform its peers this year

Oclaro is expected to grow much faster than Finisar and Lumentum because it's much smaller. That's why Oclaro outperformed Finisar and Lumentum's respective rallies of 130% and 75% over the past 12 months. But Oclaro also has a lofty trailing P/E of 119, which is much higher than its industry average of 26. Finisar trades at 56 times earnings, and Lumentum has a negative P/E due to its losses last year.

But looking ahead, Oclaro's valuations look more reasonable. It trades at just 13 times next year's earnings, compared to Finisar's forward P/E of 11 and Lumentum's forward P/E of 15. Analysts expect Oclaro's earnings to grow at an average rate of 15% per year over the next five years, giving it a 5-year PEG ratio of 1.03. Since a PEG ratio under 1 is considered "cheap", Oclaro looks attractively priced relative to its earnings growth potential.

Oclaro and Lumentum could also benefit from Finisar's recent misstep in China. Finisar's 100G CFP2 product was recently found to beincompatible with Huawei's systems due to a firmware issue, and Rosenblatt analyst Jun Zhang estimates the blunder could turn Oclaro and Lumentum's comparable products into attractive alternatives.

The key takeaway

The bullish thesis for Oclaro is simple and straightforward. The rising use of mobile devices, Internet of Things gadgets, cloud apps, and streaming media will boost workloads tremendously across multiple industries over the next few years.IT infrastructure providers must upgrade their optical hardware to meet those demands, benefiting top players in the market like Oclaro.

Oclaro's rising margins indicate that it has solid pricing power in the market, and that its earnings will continue improving. The stock might initially seem pricey, but it's cheap relative to its future earnings. Therefore, I believe that Oclaro could quietly outperform the market this year, although the stock doesn't enjoy as much coverage as some better-known tech plays.

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Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.