Should You Buy Applied Optoelectronics Inc (AAOI) Stock Before Earnings?

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Applied Optoelectronics Inc (NASDAQ:AAOI) isn’t a household name, yet. But the Sugar Land, Texas-based semiconductor firm certainly has delivered sweet returns for its loyal shareholders. Over the past year, shares have run up more than 700%, moving from around $10 to $100 today.

Should You Buy Applied Optoelectronics Inc (AAOI) Stock Before Earnings?

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That’s an incredible result. However, with earnings coming up shortly, should shareholders be nervous? Or are further new highs on the way? Let’s dive into the pros and cons for this high-flying stock.

AAOI Stock Cons

Key Customer Risk: It’s important to understand that Applied Opto has a concentrated revenue base. Hugely concentrated, in fact. According to its latest annual filing, the company’s top 10 customers account for an incredible 95.5% of its sales.

It gets even more amazing. Amazon.com, Inc. (NASDAQ:AMZN) alone made up 55% of AAOI’s revenues in 2016. Microsoft Corporation (NASDAQ:MSFT) delivered another 18% of the company’s sales. Thus, just these two firms makes up 73% of Applied Opto’s business. Needless to say, if either defects to a competitor or demands price concessions, it could be devastating for the price of AAOI stock. It’s worth considering that the company generally doesn’t have long-term contracts with its key customers, thus exposing it to further risk.

Sizzling Stock: As mentioned, AAOI stock is up from the low teens to $100 in a short period of time. Some sort of profit-taking would be far from unusual, given the tremendous gains. Going into earnings, there is real risk to the downside if the earnings number or forward guidance isn’t all that strong.

In particular, investors should use caution, since key customer Amazon delivered mediocre earnings last week. And the Amazon Web Services results — what matters most to Applied Opto — didn’t look that strong either. Microsoft, AAOI’s other key customer, put in a mixed earnings result. However to its credit, its Azure division is still performing strongly. Regardless, given the run in AAOI stock, investors will likely lock in profits unless this quarter delivers sensational results. Just since the beginning of July, investors have bid AAOI up from $60 to $100. There is a lot of positive sentiment baked into the price.

China Risk: Applied Opto generates 22% of its revenues, a number that has been rising in recent years, from products that are manufactured in China. This comes with several risks.

For one thing, the market for optical equipment has weakened recently in China. So far, AAOI stock hasn’t been hit, since it has its key U.S. clients that generate the vast majority of revenues. However, a prolonged slowdown in China would likely hit the whole sector. Additionally, numerous U.S. firms have had issues over the years protecting their intellectual property in China when manufacturing a substantial portion of their products there.

AAOI Stock Pros

Incredible Growth: Applied Opto has enjoyed jaw-dropping growth rates over the past year. Over the past 12 months, revenues have increased 33%, EBITDA is up 155%, operating income has more than tripled, and EPS is up more than 300%. EPS in particular went from just 65 cents in 2015 to 1.76 per share last year, and is already up to 2.81 per share over the trailing 12 months.

This hyper-growth comes as a result of the surge in demand for hyperscale data centers. This category of cutting-edge network facility barely existed last year, but is projected to grow into a tens of billions of dollars market over the next few years. Forget AAOI’s past as a CATV player, the company’s hyperscale data ambitions could have a long time left to play out.

Increasing Growth Rate: Not only is AAOI blowing away analyst’s estimates, things appear to be accelerating to the upside. Both Amazon and Microsoft are investing heavily in the area, and the company has suggested that there will be a third 10%-plus portion of revenues customer this year. That rising customer could well be Facebook Inc (NASDAQ:FB).

AAOI has marquee customers because its products are central to the current digital push. Everyone’s data is going increasingly into the cloud, and AAOI has the networking equipment necessary to fuel this inexorable growth. Sure, competition will arrive, and margins will fall. But there are few signs this is happening yet; analysts keep raising their estimates for AAOI as it ramps up production further and further.

Not That Expensive: For a high-flying stock, you’d normally expect a nosebleed price-to-earnings ratio. However, this isn’t the case with AAOI stock. Applied Opto trades at 35x trailing earnings and 18x forward earnings. For a company that set to literally double its EPS over the next 12 months, 17x forward earnings seems very cheap.

Some of this discount reflects investors’ skepticism toward the hyperscale data center story. We’ve seen past fiber optic cycles turn out badly. These are, admittedly, very cyclical stocks. Traditionally, the sector runs up when telco companies roll out next-generation networks, and then sell off once the bulk of the upgrade cycle has ended. With these data centers, however, demand is likely to be more consistent; the growth at companies such as Amazon and Microsoft is likely to be much more sequential. While the gold rush for Applied Opto will eventually end, analysts’ forecasts for 2018 and 2019 might be quite a bit too low; this run appears to have sustained momentum.

Verdict

There is undeniably a great deal of risk in AAOI stock heading into earnings. Any stock that is up more than 50% in a month can plummet if earnings miss analyst estimates. It might be wise to lighten up heading into the report.

That said, all signs point to the business continuing to ramp up. Guidance, production levels and key customers all seem to be giving off positive signs. With short sellers betting against a gigantic 59% of AAOI stock’s float, the potential is there for a huge squeeze should earnings continue their stellar run. Sure, AAOI stock is up huge over the past year, but the rally could carry on even farther over the next quarter.

At the time of this writing, Ian Bezek held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2017/08/applied-optoelectronics-inc-aaoi-stock-earnings/.

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