Applied Optoelectronics Inc (NASDAQ:AAOI) took another dive when the company issued preliminary results on October 12 that shook investor confidence. The company blamed a single customer for the miss but reaffirmed its profitability for the quarter. With the stock trading at a P/E below 10 and with solid 40% sales growth in the past five years, will AAOI stock recover?
Applied Optoelectronics lowered its revenue target to $88 million to $89 million, down from $107 million to $115 million. Non-GAAP EPS will fall as low as $1.04 a share, down from the $1.30 – $1.43 per share range. The revenue and earnings miss is not a small one.
Preliminary Outlook for AAOI Stock
The company clearly failed to anticipate a contract cancellation or delay from a major customer. That customer is likely Amazon.com, Inc. (NASDAQ:AMZN), which is balancing its 100G and 40G orders. Amazon may have cut its orders for the slower 40G in favor of 100G. Even though demand for both networks is strong in the industry, Applied Optoelectronics relied too much on a single customer for all its revenue in the quarter.
Shareholders are unfortunately suffering from the company depending on Amazon for most of its revenue. Now that Amazon is around 10 percent of sales, the revised guidance does not look bad. So long as Amazon’s order cut for 40G is due to the 100G transition and not a canceled order, AAOI stock looks oversold. The upside is even higher if Amazon is only delaying its orders for 100G, instead of pushing out its orders for Q4.
Bearishness Rises Sharply in AAOI
As AAOI stock rose, so did short selling. On August 31, 2017, short interest topped 12.96M shares as AAOI peaked at $103.41 a share. But bears are not done yet, as short interest rose further despite the stock closing lower at $60 a share at the end of September.
| Settlement Date | Short Interest | Avg Daily Share Volume |
| 9/29/2017 | 13,079,825 | 2,922,808 |
| 9/15/2017 | 13,247,898 | 1,925,617 |
| 8/31/2017 | 12,956,196 | 2,359,059 |
| 8/15/2017 | 10,675,524 | 5,996,263 |
| 7/31/2017 | 8,713,039 | 4,595,603 |
| 7/14/2017 | 10,750,517 | 3,477,173 |
Source: Nasdaq.com
A value investor may think that AAOI’s steep stock discount (with a P/E of 9.9 and forward P/E of 9) would dissuade more bearish bets. This group of investors may have held a big enough position to hurt the stock price. But the company’s short-term fundamentals are deteriorating because of the concentrated reliance on a few customers and a specific niche in the networking market.
Per finbox.io, AAOI’s historical view of its income statement shows that the company did not raise its R&D spending enough at an absolute level as revenue grew more than five-fold between fiscal 2011 and 2016. Though R&D rose at the same pace (five-fold), the company only spent $32 million in fiscal 2016 when revenue topped $261 million. This leaves the company vulnerable to competitors entering the market.
Source: finbox.io (click link to enter your own assumptions)
Takeaway for AAOI Stock
Markets are fretting over Applied Optoelectronics’ lost or delayed business with Amazon. Management still did not clear up what happened and what led to its significantly lowered forecast. In the upcoming Q3 report, the company must reassure shareholders that Amazon is still a key customer and that the e-commerce giant is buying 100G equipment from AAOI. If not, then management needs to build its customer base or risk lowering its outlook yet again. In the meantime, shareholders must decide if the stock is worth its current price. If the customer transition from 40G to 100G is only slowing orders in the short term, the business in the longer term is still healthy. But if AAOI is permanently losing customers, then the stock will have more downside ahead.
The author does not have a position in any of the stocks mentioned. AAOI is a top idea on the DIY Value Investing Newsletter.
