Since our downgrade report on 14 Aug (link), we have seen a continuous decline on Innolight’s share price by more than 23%. Our current view on the stock is becoming increasingly favourable, driven by: 1) continuous strong momentum observed in building up AI infrastructure globally; and 2) quick uptake seen in downstream application market (e.g., AI-powered Ads adopted by Meta, Google and Amazon, GitHub copilot by Microsoft). In addition, companies within the AI hardware value chain start to report strong earnings. On Thursday night (19 October), TFC (300394 CH, NA), a leading integrated solution provider for optical sub-assemblies, released impressive 3Q23 earnings, delivering revenue/NP growth of 73.6% and 95.0% YoY, respectively. As we believe Innolight is one of the true AI beneficiaries, we expect AI- related revenue to contribute more in Innolight’s revenue starting from the upcoming 3Q earnings and accelerate in 2024, we upgrade to BUY with adjusted TP of RMB109.30.

Share price is getting attractive again. We downgrade the share price in August　as the stock has gone far ahead its earnings fueled by generative AI frenzy.Valuation was appealing and production ramp-up of 800G transceivers should take time. We believe lots of negative news have been baked into the price, e.g., profit taking, challenging macro, updated US restriction on advanced chip exports.Current share price is getting attractive considering: 1) transceiver is one of the critical components that is widely used in AI datacenters and the global demand on building AI infrastructure remains strong with visibility into 2024; 2) newly announced US restriction should have non-material impacts on the company’s near- to mid-term revenue; and 3) continuous progress on monetization of generative AI should yield stable investments in the field.

True AI beneficiaries apart from Nvidia start riding the tailwind. TFC just　released strong 3Q results. Positioned upstream in Innolight's supply chain and TFC's strong earnings further substantiate the ongoing capacity expansion among the beneficiaries in the AI sector. This also underscores our observation in our recent AI sector report (link) that the players in the AI value chain are gradually experiencing positive outcome in 2023.

Upgrade to BUY with TP of RMB109.30. Considering recent additional orders reported by UDN (link) regarding hyperscalers and better-than-expected ramp-up of TSMC’s CoWoS capacity, we expect Innolight’s revenue to come in better than our previous estimates. We revised up revenue forecasts by 12%, 13% and 4% and slightly lifted GPM for 2023E/24E/25E. We maintain the same multiple of 35x 2025E P/E.

Upside catalysts: 1) faster-than-expected ramp-up of 800G, and 2) slower-than- expected decline of non-AI revenue. Downside risks: 1) continuous rise in interest rates, 2) intensified geopolitical tensions, and 3) lower-than-expected production.