CLFD - Clearfield's Compelling Catalyst

• Clearfield recently reported spectacular Q3 results, beating estimates by a hefty margin and raising guidance.
• Industry tailwinds continue to accelerate the demand for fiber.
• Significant government investment in Broadband infrastructure is a huge catalyst for further growth.
• Management’s focus on a disciplined cost structure and expanding capacity has created substantial operating leverage for Clearfield.
• CLFD stock is priced with a slight premium but still looks attractive for long-term investors.

Strengthening Investment Thesis

Clearfield ( CLFD ) recently crushed Q3 estimates and continues to capture surging demand for fiber. This small-cap, fiber-optics company is in prime position to benefit from emerging industries such as Edge Computing, 5G, and the Internet of Things (IoT). Additionally, government investment in broadband deployment represents a significant catalyst for further growth, as evidenced by Clearfield's already accelerating top line. Exceptional management, strong financials, and an attractive valuation are a few more reasons Clearfield is one of my high conviction buys.

Quarter 3 Results

Financial Highlights

Clearfield posted outstanding Q3 results , beating both revenue and EPS estimates. Total revenue grew 84% Year-over-Year (YoY) with Clearfield's largest sales segment, Community Broadband, posting growth of 73%. Other smaller segments grew well in excess of 100% YoY. Management also raised FY 2022 sales guidance to $245 million, representing growth of around 73%.

Quarter-end backlog increased 16% to $157 million, highlighting a sizeable pipeline of demand. Gross margins were only down slightly due to increased overhead costs and inflationary pressures. Operating expenses increased as Clearfield expanded personnel and increased investment in sales, engineering, and product management. But even with higher costs, operating margins actually expanded, showing positive signs of operating leverage. This led to a strong bottom line, with net income climbing 109% YoY to a record net margin of 17.9%.

On their balance sheet, Clearfield increased capital expenditures and inventory to expand capacity and build out new facilities. The firm continues to rely on internally generated funds for growth, with zero long-term debt on its balance sheet.

Business Updates

On the business side, Clearfield completed the acquisition of Nestor Cables, a leading fiber optics company located in Finland. Nestor Cables has worked with Clearfield for over a decade, assisting in the development and manufacturing of several fiber products. With this acquisition, Clearfield will reap a number of strategic benefits :

• Allows Clearfield to vertically integrate the design and supply of the FieldShield product line to meet future customer demand
• Enables Clearfield to leverage Nestor's technical expertise to extend overall supply of FieldShield into North American market
• Expected to reduce the cost and complexity of freight by establishing Mexico-based production of fiber by early 2023
• Allows Clearfield to bring its cassette-based fiber management solutions to European market

Nestor had revenues of €31.7 million and is currently profitable. They were purchased by Clearfield for $23 million using a line of credit and should be accretive to Clearfield financials in FY 2023.

Quarter 3 Takeaways

Clearfield continues to fire on all cylinders. Q3 results highlight their ability to capture significant industry tailwinds through operational excellence.

Robust Industry Tailwinds

As mentioned in my previous coverage of Clearfield, fiber is the lifeblood of several rapidly emerging industries including cloud & edge computing, 5G, and the Internet of Things (IoT). These new markets and the shift to remote work are driving unprecedented levels of demand for fiber optics solutions. The global fiber optics market is expected to reach 11.18 billion by 2030, representing annual growth of 9.3%, according to prnewswire . The opportunity is massive for Clearfield.

Perhaps the biggest growth catalyst for Clearfield is significant government investment in broadband infrastructure. CEO Beranek highlights this undertaking:

…we are in the middle of a historic investment cycle for high-speed broadband, particularly fiber-led broadband.

Nearly $65 billion in funding is available through the Infrastructure Investment and Jobs Act, with $42 billion of that amount being allocated to the Broadband Equity Access and Deployment program known as BEAD. That is expected to be distributed in late 2023 and early 2024.

Furthermore, the elevated demand in this market is not a short-term event. More new fiber is expected in the next five-year period than all prior years combined. Industry research notes that we are in the third year of an investment cycle that may peak 2024 through 2027. It's anticipated that 60 million homes will be passed by fiber by 2030.

To put this into perspective, $65 billion spread over 5 years would be $13 billion annually. Now let's say, hypothetically, that Clearfield is able to capture just 1% of this annual government investment. That would equate to an extra $130 million of annual revenue, which by itself would be nearly double Clearfield's 2021 total revenue (annual growth of 92.3%). This is just a thought experiment, but it nevertheless illustrates the tremendous opportunity ahead for Clearfield. Especially when combined with the other drivers of demand as discussed earlier. The below ten-year chart is evidence enough that Clearfield is beginning to capture these fiber tailwinds.

Operational Excellence

Clearfield has been able to turn increasing demand for fiber into meaningful topline growth, and they've carried this growth all the way down the income statement every quarter since September of 2008. The company has focused on organic growth without sacrificing a positive bottom line. Though operating expenses tend to climb as a business scales, it has remained near 20% of sales for Clearfield. This disciplined cost structure, coupled with strong revenue growth, results in massive operating leverage as evidenced by the below chart.

One area I had to dig into further was negative cash flow from operations last quarter. The reason for this was largely due to Clearfield heavily increasing inventory and expanding capacity for foreseen demand. This is turns out to be a positive sign for shareholders as it aligns with management's 'Now of Age' initiative, which includes "augmenting capacity for ongoing growth" as a pillar. Management sees the once-in-a-decade opportunity ahead of them, and they're moving strategically to capitalize on it. In addition to increased inventories, Clearfield continues to expand its manufacturing footprint within Minnesota and Mexico. Two new facilities were opened in Q2, effectively tripling their manufacturing square footage. The company also increased its headcount by 50%. The Nestor Cables acquisition further strengthens Clearfield's supply chain, which remains a problem area for many like-industries.

As a shareholder, I have the utmost confidence in Clearfield's management given their impressive track record and strategic execution. Insiders also hold 16.52% of outstanding shares showing an alignment of incentives. With such strong returns on capital, it's an easy investment decision for management.

Valuation

CLFD stock has exploded almost 70% in the last month alone, in large part due to such an impressive Q3 report. It's no question Clearfield checks the boxes for high-quality and strong growth, but how about valuation?

Relatively, Clearfield's recent multiple expansion has driven its valuation grade down within Seeking Alpha's quant ratings.

But given Clearfield's strong growth and profitability, I have no problem paying a slight premium for shares.

I also ran CLFD stock through an inverted DCF model I built based on the Expectations Investing approach to judge the market's implied expectations for Clearfield. This model allows us to forego the many assumptions baked into a traditional DCF, instead starting with the stock price and finding the amount of FCF needed to justify the current price.

We start by using the market's consensus forecast for CLFD's sales growth, operating profit margin, and incremental investment rate. Then we assess their reasonableness using CLFDs' historical figures. In addition, we calculate the cost of capital ((WACC)). Here are the consensus figures and other inputs.

These are then used to calculate the present value ((PV)) of expected free cash flows, PV of residual value, and shareholder value per share. Lastly, the model finds the market-implied forecast period (MIFP): how long the market expects a company to generate returns on investments above the cost of capital. This is found by lengthening the forecast period as many years as it takes to arrive at today's stock price.

For CLFD, this results in a MIFP of only 2 years. Next, we test a high and low scenario for sales growth on the output of the model, then estimate the probabilities of each scenario occurring. This gives us an expected value and margin of safety estimate.

I believe Clearfield will outperform the market's expectations based on the accelerating demand for fiber, the company's ability to capture this growth, and the shareholder value Clearfield creates through strong returns on capital. CLFD's expected value of $117.47 is right around the current price but the market is only expecting Clearfield to generate returns above the cost of capital for 2 years. In my view, Clearfield has a much longer growth runway than is priced in. With this, I rate CLFD a strong buy.

Risks & Uncertainties

A few risks investors should be aware of are persistent supply chain issues, price increases, and customer concentration. CEO Beranek touches on how CLFD is dealing with supply chains in the Q3 earnings call, stating:

…we cannot overlook the fact that fiber availability continues to be challenged and supply chain issues persist across all industries. We are continuously working on ways to strengthen our relationship with our suppliers going forward.

Along with supply chain problems are increased input costs as shown in Clearfield's operating expenses year-over-year change. Lastly, Clearfield does carry some customer concentration risk with two customers comprising 18% and 11% of the Company's net sales, respectively. Investors should monitor each of these risks going forward, but they don't materially affect the company's long-term thesis in my view.

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