Applied Optoelectronics Inc (NASDAQ:AAOI) was one of 2017’s brightest stars. AAOI stock shot up from $20 at the start of the year, to more than $100 a share. Now it’s halved that gain.
I last wrote about AAOI prior to last quarter’s earnings. Unfortunately, the bearish points I noted have since played out; Since that earnings report in early August, AAOI stock has lost a stunning 43% of its value. Shares are sliding again this week, with a strong selling wave pounding AAOI back to the mid $50s now. Is this huge decline a buying opportunity, or is it time to throw in the towel here?
AAOI Stock Cons
China Market Still Slow: The optical equipment sector trades heavily based on Chinese demand. While AAOI is far from the most-exposed player to China specifically, investors tend to dump the whole sector on weakness.
The slump in Chinese optical demand, alas, shows no sign of letting up. Thursday brought the latest blow, with NeoPhotonics Corp (NYSE:NPTN) firing workers, presumably due to weak Chinese demand. NPTN stock got crushed on the day, slumping more than 15%. AAOI, along with other rivals including Lumentum Holdings Inc (NASDAQ:LITE) and Acacia Communications, Inc. (NASDAQ:ACIA) declined in sympathy.
Bad Guidance: Applied Optoelectronics’ Q2 results weren’t bad at all on the surface. Revenue showed more than 100% year-over-year growth. Both EPS and revenues beat analyst estimates by comfortable amounts.
However, the company admitted that the growth picture is going to be a bit rocky. They guided Q3 revenue to between $107 million to $115 million, way short of analysts’ $123 million consensus estimate. The company is transitioning from 40G demand to 100G, but it won’t be able to reposition itself in time to keep its torrid revenue growth streak intact. The company expects a better Q4, however the market will demand results now, given the uncertainty since the Q3 guidance cut came out of the blue.
Sector Is Prone To Boom/Bust Cycle: Optical equipment sector stocks are incredibly volatile. There have been countless times over the years where a company or two have a hot product. They ride it for a few quarters, and earnings appear to have limitless potential.
But then competitors emerge, or technology moves on to some newer faster design. It’s difficult for AAOI, or any of its peers, to carve out a sustainable technological advantage. AAOI stock bulls can rightfully say that the company is printing money now. But how long will the good times last? Already, that messy transition to 100G technology has shown weakness in Applied Optoelectronics’ competitive position.
AAOI Stock Pros
Sentiment Can Swing Quickly: As the earnings beatdown showed, investors in AAOI stock will make huge changes in their positioning based on small differences in outlook. It wasn’t a good earnings report, sure, but usually, you won’t see the market take a stock down more than 40% in a quarter following a stinker either.
The positive side of this is that AAOI stock could shoot right back up to $100 if they hit next quarter and re-establish credibility in their growth story. And unlike many high-fliers, this stock looks quite cheap. AAOI sells at just 14x trailing and 11x forward earnings. Obviously, bears have their reasons for doubting AAOI earnings. But if management can successfully get the growth rolling again, the stock could nearly double off current levels and still sell under 20x forward earnings.
Big Short Position: Now, it’s worth stating at the outset that big short positions are often a warning sign for a stock. Many times, short sellers have good insight into a situation. However, when they gravitate to a stock in excessive numbers, it often leads to powerful short squeezes.
The fuse is lit for AAOI stock. Short interest in AAOI stock swelled to more than 10 million shares (at its peak, a $1 billion bet against AAOI) earlier this summer. Keep in mind that AAOI has fewer than 20 million shares outstanding; 10 million of them selling short is an amazing amount. And it’s getting even more extreme now. In the wake of the earnings report, short interest dipped slightly, however the bears are back. The latest report now shows more than 13 million shares sold short — that’s more than two-thirds of the float. A strong earnings report would catch the AAOI bears in a very bad place.
Finisar Positive Sign: AAOI rival Finisar Corporation (NASDAQ:FNSR) reported spotty results last month. However, they indicated that in AAOI’s key 40-gigs market, things are going alright.
Finisar’s CFO Kurt Adzema said on their conference call that: “40 Gig was relatively stable last quarter and I would say the expectation is that it will be relatively stable this coming quarter as well.” If that stability holds and carries over to AAOI’s demand in that space, it’d be great news.
That’d also be a big difference from analyst’s expectations. Needham & Company, for example, was modeling a 10% decline in 40G pricing. If you’re looking for a catalyst that would cause AAOI stock to beat expectations this quarter, this is a good one.
Verdict on AAOI Stock
AAOI stock has gotten smashed since its last earnings report. There’s good reason to think the market has punished it excessively in fact. With a huge short position, it wouldn’t take much for the stock to shoot back up.
That said, exercise caution, and certainly don’t bet big on the earnings report. The company has lost credibility with its growth story. If they miss again, for whatever reason, the downside could be significant. And in the longer-run, it’s far from certain that AAOI has a lasting technological edge to support more record-breaking profits beyond the next few quarters.
At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.