Finisar - Dramatic Margin Pressure Triggers A Sell-Off

| About: Finisar Corporation (FNSR)


Finisar reports soft fourth quarter earnings, as gross margins are under severe pressure.

Management's explanations for gross margin pressure are not very convincing.

The very poor guidance for the first quarter warrants the sell-off.

Finisar (NASDAQ:FNSR) saw its shares witnessing a brutal sell-off on Thursday after the company issued a soft fourth quarter earnings report. This was accompanied by a very disappointing outlook for the current first quarter of its fiscal 2015.

Despite the significant drop, shares don't offer appeal as the business appears to have run into big operational headwinds.

Fourth Quarter Highlights

Finisar reported fourth quarter revenues of $306.0 million which is up by 25.7% on the year before, and came in just ahead of consensus estimate of $303.2 million.

Reported GAAP earnings came in at $28.4 million versus earnings of just $3.9 million reported last year. GAAP earnings came in at $0.27 per share compared to just $0.04 per share last year. On a non-GAAP basis, earnings came in at $0.36 per share which was two cents lower than anticipated.

Looking Into The Results

While these headline results appear to be not that bad investors are not pleased at all. Revenues were up by 4.1% compared on a sequential basis as well, yet the real concern was in the gross margin developments.

Gross margins rose by 400 basis points to 31.7% of sales on an annual basis, but contracted by 420 basis points compared to the third quarter. The strong growth on an annual basis allowed Finisar to reduce operating expenses by 290 basis points to 24.6% of sales, boosting operating margins.

Compared to the third quarter, operating costs fell by just 10 basis points. Combined with severe gross margin compression on a sequential basis, this pressured operating earnings.

Gross margins were down on price reductions for telecom products as well as the acquisition of Photonics AG, which carries lower than average margins. This does not sound as a very convincing argument to me given that Finisar only bought the company for $27 million which included $7 million in debt. In comparison, Finisar's market valuation stood at $2.4 billion before the results were announced.

While reported GAAP earnings of $28.3 million rose modestly compared to earnings of $27.1 million in the third quarter, acknowledge that fourth quarter revenues were "inflated" by a $8.1 million benefit from "other income". The company also reported a $1.1 million tax benefit, instead of a provision.

First Quarter Outlook

For the current first quarter of its fiscal 2015, Finisar sees revenues of $320 to $335 million on a non-GAAP margins.

Operating margins are seen between 10.3 and 11.3% on a non-GAAP metric, which compares to 12.7% in the already challenged fourth quarter. Non-GAAP earnings are seen between $0.30 and $0.34 per share, down from $0.36 in the fourth quarter.

The guidance for non-GAAP earnings falls dramatically short versus consensus estimates which stand at $0.41 per share.

Valuing Finisar

The company ended the quarter with $513 million in cash, equivalents and short to medium term investments. Total debt, which predominantly consists out of convertible notes, came in at nearly $253 million. This still results in a solid net cash position of roughly $260 million.

Factoring in a decline of over 20% in after-hours trading with shares trading at $19.50 per share, Finisar is valued at $2.05 billion on a diluted basis. This values operating assets at roughly $1.8 billion.

As such operating assets are valued at 1.5 times annual revenues of $1.16 billion over the past year. Shares trade at 16 times GAAP earnings of $111 million. Note that provision for income taxes came in at just $3.7 million for the year, which is very low and could pressure GAAP earnings in the long run if rates normalize.

Finisar does not pay a dividend at the moment.

Takeaway For Investors

Investors are clearly very disappointed with the soft fourth quarter results and ugly margin and earnings outlook for the first quarter.

The fiber optics components producer saw margin pressure but the reasons for it can not really convince me. Poor pricing for telecom might be a real problem, yet the unit only made up 27% of its total sales in the fourth quarter. The impact of the acquisition of Photonics has already been discussed above.

Worse, the company sees continued margin pressure which might actually intensify in the current first quarter as investments in China are draining cash resources as well.

I must say that I am quite surprised after the company sounded upbeat when releasing its third quarter results at the start of March. Following the report, shares rose from levels around $24 per share to highs of $28, after which they have lost some 30% by now.

I must say that this sell-off does not automatically create a buying opportunity. Shares trade at 16 times GAAP earnings for 2014, while earnings might very well fall in 2015 if these trends continue. Furthermore the very low effective tax rate, being in the low single digits, marks a poor "quality" of earnings if the company is seeing tax rates increase towards statutory levels.

I continue to shun shares.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.