Shares of Applied Optoelectronics (AAOI) have been declining for almost eight quarters now -- down by about 88% over the period. Unfortunately for longtime investors, it seems like shares could still remain under pressure for the next few months at least. The ethernet transceiver industry is expected to register flat sales this year and the company’s recent debt raise only heightens the uncertainty surrounding its future prospects. Let’s take a closer look.
(Source: Bigstockphoto, Image license purchased by author)
Let me start by saying that things aren’t quite turning out as management would have previously hoped. The top brass had pinned their hopes of turning things around by way of ramping their 100G shipments and diversifying their customer base, but it seems like neither of the two scenarios are playing out as expected.
The chart above provides a revenue breakdown of Applied Opto’s datacenter revenue based on its transceiver speeds. It’s evident that revenue from 100G sales hasn’t ramped up of late, in spite of the bullish forecasts management has made along the way (discussed in more detail here). Rather we have a disappointing news for investors who are long in the company.
LightCounting issued a note a few days ago, stating that the softness in the 100G transceiver market can continue in the first half of 2019. They were previously forecasting ethernet transceiver sales to grow in FY19 but they’re now expecting it to be a flat year. This new market dynamic is bound to make it more difficult for Applied Opto to grow its sales and stage a turnaround over the next few quarters at least.
(Source: LightCounting via Lightwave)
My guess is that as the industry goes through a phase of stagnation this year, transceiver manufacturers would try to undercut each other more fiercely in a bid to maintain their sales figures, and to preserve their market shares at their respective key customers. This is bound to hurt the profitability of most major transceiver manufacturers and Applied Optoelectronics, whose margins have already compressed by a substantial amount over the past few quarters, would be affected as well.
It gets worse for Applied Optoelectronics. Let’s take a look at things from a different angle.
- Facebook is said to be the largest buyer of 100GbE CWDM4 modules;
- Applied Opto listed Facebook as one of its largest customers in its latest 10K filing;
- Applied Opto manufactures 100G CWDM4 modules for 70m, 500m, 2km and 10km distances;
In spite of its close relationship with Facebook, Applied Opto’s revenue continues to languish. One explanation could be that Facebook is sourcing these modules from Applied Opto at extremely discounted prices, which is preventing these sales from making a meaningful impact on the latter’s revenue figures. A more plausible explanation would be that Facebook is sourcing only a part of its requirements from Applied Optoelectronics and the vendor may have actually lost market share at Facebook during Q3.
(Source: BusinessQuant.com, includes estimates)
The chart attached above highlights that Applied Optoelectronics generates a sizable amount of its sales by selling modules to Facebook. Therefore, it’s only natural that losing market share at this particular customer, can materially hurt Applied Opto’s chances of kickstarting its sales growth, over the longer run.
Raising Debt to Repay Debt
Secondly, the company recently raised new debt to retire old debt. Here’s a part of their press release:
[The sale of the Notes] is expected to result in approximately $66.3 million in net proceeds to AOI (or approximately $76.4 million if the initial purchasers fully exercise their option to purchase additional Notes). AOI intends to use approximately $38.3 million of the net proceeds from the offering to fully repay its capital expenditure loan and real estate term loan with Branch Banking and Trust Company and to use the remainder for general corporate purposes.
So, it seems like the company is raising new debt to fund its liabilities and obligations. Note that they did not state that this capital would be used for expansion or funding growth, so it raises a few questions:
- Is the company’s management forecasting their cash flows to substantially decline going forward, that they had to raise debt merely to furnish their existing obligations?
- Is the company’s expansion on hold as of now?
- Management noted during their past earnings call that 400G shipments would commence by 2019-end but does this debt raise mean that it won’t be a revenue driver?
- Has its market share deteriorated so much that it had to resort to raising debt?
- If its cash flows deteriorate further, then would it raise more debt to retire its liabilities?
I had informed readers well in advance in one of my past articles to not pin their hopes on 400G shipments to kickstart the company’s growth engine during 2019, and this round of debt raise only corroborates my line of thinking. (Read – Applied Optoelectronics Disappoints Again).
That said, Applied Opto’s management and board have introduced a new wave of speculation and uncertainty around the company’s prospects with this round of debt raise. This is bound to hurt investors’ sentiment relating to the company, and it also encourages short-selling. So, my guess is that the company stock would remain under pressure until its upcoming earnings call at the very least, because that’s when we’ll get to hear management’s take on how their business is really doing.
Applied Opto’s shares may have declined substantially over the past several quarters but the stock may not have bottomed out yet. I would reiterate that long-side investors should avoid initiating new positions in the scrip, at least until we get more clarity on how their business is doing and when would their sales start to trend upwards. Without any positive news, or indications, the stock could fall further. Good Luck!
Author's Note: I'll be writing another report on Applied Optoelectronics sometime this month.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.