Applied Optoelectronics Inc (NASDAQ:AAOI) stock has lost over half of its value in two and a half months. AAOI stock cleared $100 in late July; it now trades below $45.
The good news for AAOI stock, at least from a long-term perspective, is that at those late July levels, the stock had more than quadrupled since the beginning of the year. AAOI’s roller-coaster is such that the stock is down 60% from its 52-week high and still has almost doubled so far in 2017.
The huge amount of volatility here opens the door to contrasting opinions about fair value. On this site, Luke Lango argued on Friday that AAOI was a steal under $50. The day before, James Brumley wrote that the sell-off wasn’t justified by the fundamentals.
Both authors make good points and combined a good contrarian case for AAOI stock. But, respectfully, I disagree. I’m not sure I’m willing to join the parade of shorts betting against AAOI stock after the recent decline. Still, I see more than enough reason to stay far, far away from Applied Opto at the moment.
Not Just an Amazon Problem
The bullish thesis for buying AAOI after the plunge revolves around key customer Amazon.com, Inc. (NASDAQ:AMZN). AAOI stock fell after Q2, based on disappointing Q3 guidance and fell again on Friday when Q3 preliminary results missed that guidance badly.
But per AAOI management, most of the pressure came from a single customer, widely believed to be Amazon. As that company is moving to 100G transceivers in the data centers that back Amazon Web Services, it’s moving away to other suppliers, at least for the time being. But CEO Dr. Thompson Lin insisted in the Q3 preliminary results release that the company “continued to experience solid demand with other top datacenter customers.”
The result was a big hit to revenue. Guidance of $107-$115 million was cut to $88-$89 million. But I can see the argument that sellers of AAOI stock are throwing out the baby with the bathwater. Gross profit margins held up in Q3. Non-GAAP EPS still is guided to $1.04-$1.09, a $4+ run rate on an annual basis. Against a share price a few dollars above $40, that seems to imply an attractive 10-11x P/E multiple off the back of what even management admits was an ugly quarter.
In other words, even if Q3 is what AAOI looks like going forward, the stock might still be a buy. Bear in mind that the midpoint of Q3 preliminary results suggests 26% revenue growth and a 180% increase in non-GAAP EPS. That’s in a a disappointing quarter. If AAOI can recapture lost Amazon business and/or drive growth else, a 10-12x P/E multiple is an absolute steal.
Why AAOI Stock Still Is Dangerous
I’m sympathetic to that case. But there are two key reasons why I remain skeptical toward AAOI stock.
The first is that it strikes me as far too optimistic to suggest that Amazon’s transition to other suppliers is manageable. Amazon isn’t just a key customer; it’s the key customer. Amazon drove over half (54.6%) of Applied Opto’s 2017 revenue, according to the AAOI 10-K. Microsoft Corporation (NASDAQ:MSFT) drove another 18%.
The Amazon revenue is in the same datacenter space that has driven so much of the optimism toward AAOI stock over the past few quarters. It’s not something that can be easily replaced, particularly with AWS and Microsoft Azure driving so much of the overall growth in that segment. The idea that the Amazon concerns are somehow limited to the transition from 40G to 100G misses the point. If AAOI loses more of Amazon’s business, its numbers are going to get worse, not better.
The second concern is that the optical networking sector traditionally is a cyclical business and is priced as such. A 10-12x EPS multiple for AAOI ‘sounds’ cheap. But look at the other players in the space. Fabrinet (NYSE:FN), who reportedly has taken some of AAOI’s Amazon business, trades at barely 9x forward earnings. Oclaro Inc (NASDAQ:OCLR) trades at 10.2x. Finisar Corporation (NASDAQ:FNSR) is at 11.3x and under 10x backing out its net cash.
Obviously, Applied Opto is outgrowing most of those peers for now. But even a ‘cheap’ headline multiple suggests that growth will continue. And it’s there that I diverge from the AAOI bulls.
Too Much Uncertainty
There’s simply a major risk that further weakness at Amazon will arise. There’s almost certainly something close to peak demand for 100G. AAOI isn’t a long-term growth stock. Rather, it’s benefiting mostly from a cyclical swing. And the obvious question here is that if the company can’t take advantage of that swing, what happens when the industry tailwind fades, particularly if Amazon no longer is a key customer?
That question isn’t answered yet and I’m not convinced the answer will be what AAOI bulls are expecting. Until it is, I’m staying on the sidelines.
As of this writing, Vince Martin has no positions in any securities mentioned.