Dear Subscriber,

After a 34% drubbing on Friday (8/4), AAOI stock is popping 10% higher on today (8/7).

The stock still has another 35%-plus upside to its pre-earnings price..and I think 50% higher from here.

Valuation is cheap and the current growth narrative may actually be more promising than the one before the Q2 report.That move could happen quickly.

Action to Take: BUY Applied Optoelectronics < $75 with $105 Target

Buy AAOI January 2018 $80 Call Option Under $4.50 with $22 Target

On Friday, 8/4, our Applied Optoelectronics (AAOI) stock got killed as investors freaked out that the secular growth narrative was coming to an end. We thought the sell-off was a gross overreaction to a mere pause in the growth story.

The stock is up more than 10% on Monday, 8/7 and the big move higher begs a natural question. Now what? We say stick with the rally. AAOI dropped 34% on Friday. It's up 10% on Monday. That means there is a whole 35%-plus upside gap between Monday's intra-day price (~$71) and the pre-earnings price (~$98). Meanwhile, the valuation remains cheap and the growth trajectory remains promising. The sentiment, which appeared depressingly dour on Friday, has turned a corner as bulls now seem to be in control. Overall, we continue to like AAOI stock both in the near and long term.

As you can see the stock was WAY overbought going into the earnings based on pre-accounement. That overhang was momemtum traders obviously who cut and run on the first talk of slower Q3.. Like all momentum buyers they are just buying a symbol with a hot 20-day chart...they don't know and don't care for the real story.

Our thesis is that AAOI will return to its pre-earnings price sometime quite soon. Given the stock's tendency to post big daily moves you buy on the DOWN days.

As we have stated before, AAOI is a multi-year growth story and the current concerns around AAOI stock feel unnecessarily short-sighted. The growth narrative is pausing in Q3 due to 40G laser fall-off outpacing 100G ramp. But that pause is temporary and somewhat expected considering the transition away from 40G and towards higher data rates. In Q4, 100G demand ramp will outpace 40G fall-off, and the growth narrative will resume.

Moving past the near term noise, AAOI is really a growth story at the 100G and up data rates. It really sounds like the 200G and 400G growth stories will be just exciting as the 100G growth story has been, and that means robust demand for AAOI product will continue over the next several years.

As companies shift towards higher and higher data rates over the next several years, that will: 1) highlight AAOI's low-cost leadership position in the market and allow the company to grab more market share, and 2) grow gross margins as higher data rate product usually carries with it higher margins than lower data rate product.

Meanwhile, the company continues to broaden its customer base and diversify its revenue streams. That puts the company less at-risk to sometimes erratic one-customer spending habits (read Amazon).

All in all, the growth narrative now actually looks more promising than the one before the Q2 report. One-customer reliance is a problem, but that's being fixed. Meanwhile, the long-term revenue and gross margin narratives are better than they have ever been due to demand ramp at higher data rates.

So now let's talk valuation. AAOI stock trades around 12.4x FY18 EPS estimates. That is a low multiple for a growth stock with a projected earnings CAGR of 15% over the next 5 years. There really isn't much reason that a stock with this robust of growth potential should trade at such a discounted valuation. That is especially true considering there aren't any problems on the balance sheet.

Consequently, we think AAOI stock can and will head materially higher, even after today's big move. We like AAOI stock both in the near and long term.

- Tobin

Weekly Update 8.7.17