Morgan Stanley's Guide On How To Play The Optical Space

The optical space boasts multiple demand drivers from facial recognition, telecom companies looking to expand bandwidth, and the industrial/semicap sectors requiring optical products, Morgan Stanley says. But at the same time the optical space has been challenged by fragmentation, a highly competitive market and limited visibility into long-term growth and margins.

The Analysts

Morgan Stanley's Meta Marshall, James Faucette and Yuuji Anderson made the following recommendations.

IIVI: 'Looks Good'

II-VI stands out within the optical space, as its exposure to the industrial, semicap, and military markets accounts for around 50 percent of its entire business, the analysts said. This level of exposure is "attractive" due to the less concentrated nature of the end customers and translates to better margins and pricing stability, according to Morgan Stanley. 

II-VI's exposure mostly focuses on product lines where materials and technologies can be used across multiple customer types, which also translates to better yields and margin leverage, the analysts said. Investors sould expect the company to report less volatile earnings growth versus other names in the optical sector, according to Morgan Stanley. 

Oclaro: 'Poor Theme Exposure'

The most notable argument against a bullish stance on Oclaro's stock is the company's 60-to-70-percent exposure to the datacomm market and China, the analysts said. The datacomm market remains extremely competitive, and buyers always seek out cheaper solutions, according to Morgan Stanley. 

Demand from the Chinese market appears to be rebounding, and manufacturers are looking to assemble more devices as the 100G/200G cycle continues, the analyst said. Oclaro is seeing some weakness in its CFP and QSFP28 LR4 products in China, and to counter the revenue headwind, the company must grow its market share, according to Morgan Stanley. 

Related Link: Has The Optics Sector Become A Stock Picker's Market?

Finisar: Dampened Earnings Power

Finisar's 60-percent exposure to the datacomm market will likely prove to be a challenge in the near-term, as hyperscalers are able to exert pricing pressure while other suppliers are entering the market at the same time, the analysts said. "Plenty" of datacomm demand exists, but Finisar faces earnings pressure for the next year, as gross margins are likely to fall on a maturing 100G cycle and its declining <100G business, according to Morgan Stanley. 

Finisar is countering the pressures by fixing some of its "early missteps" in 3-D sensing and ROADAMs, but any upside is likely to be "minimal" throughout most of 2018, the analysts said. A bearish case for Finisar's stock is unwarranted, as the company has an opportunity for balance sheet utilization — and at the same time, industry consolidation represents a "meaningful long-term positive" for the company, according to Morgan Stanley. 

Acacia Communications: Earnings Pressure

Acacia has introduced new products for 2018, such as the AC1200, but Street estimates are still too high for 2019, the analysts said in the downgrade note.

Street estimates call for 9-percent annual revenue growth and over 250 basis points of gross margin expansion. The only way for Acacia to achieve the estimates is in the event the company benefits from a rebound in its two biggest markets, China and datacomm systems, according to Morgan Stanley. 

Realistically, Acacia's growth will likely be "much more metered," the analysts said. In China, ZTE is looking to self-assemble many of the modules it buys from Acacia, which could add some top-line pressure.

Acacia could regain market share in the datacomm systems market with its AC1200, but the competitive environment will be more fierce compared to a few years ago when it released the AC400, according to Morgan Stanley. 

Acacia's 400ZR could prove to be a "game changer," but is unlikely to be a meaningful revenue driver until 2020, the analysts said. 

Related Link:

UBS Highlights Two Buys, One Sell In The Optics Sector