Is Applied Optoelectronics a Buy? | The Motley Fool

2022-07-09 11:26:57 By : Ms. Ivy Li

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Poor Applied Optoelectronics (AAOI 0.62% ) . The small supplier of fiber-optic components has been a rags-to-riches-to-rags story in a relatively short period of time, hit by a slowdown in demand for its products, global trade disputes, resulting tariffs, and increased competition all at the same time.

The big run-up through the summer of 2018 was on the back of booming demand for AOI's fiber-optic components for use in data centers, with the likes of Amazon and its cloud business making up the bulk of the sales surge. Supply manufacturing is a volatile and cyclical business, and the moderation in data center construction in the last year hasn't been mitigated by a replacement growth driver. That could be changing, but the fact remains that this optics maker will continue to give investors a wild ride.

To illustrate the cyclical nature of AOI's business, look no further than the earnings reports through the first half of 2019. The company does sell products to other end-users outside the data center market, but those segments are small and in a similar cyclical slump as of late. The result? Sales that haven't yet found a bottom.

Fiber to the home and other

Adding to the problem is that Applied Optoelectronics derives most of its sales from just a handful of customers. Its fortunes will thus be tied to the construction activities of these customers, and with the global economy slowing down, AOI has been left out to dry. Plus, since the manufacturer has to deal with profitable scale, falling sales mean margins on product sold will cause even wilder swings in the bottom line.

Pp = percentage point. Data source: Applied Optoelectronics.

This is all to say that AOI will, at least for the foreseeable future, be a gut-wrenching ride -- with surges to the upside matched with swings back down again. CEO Thompson Lin reported on the second-quarter 2019 earnings call that there are early signs of a recovery in data center demand, but consistent with other tech industry forecasts, a recovery has yet to take shape. The good news? Revenue forecasts for Q3 2019 of $46 million to $49 million imply at least a sequential quarter-over-quarter increase. A bottom may have been found for the time being.

AOI top brass says that diversifying the company's customer base remains its top priority. While that will help mitigate some of the severe ebb and flow experienced in the last couple of years, it won't completely solve the cyclical supplier problem.

Other growth drivers on the horizon could help, too, like edge computing (computing power moving away from the cloud and closer to the source) and 5G mobile networks (which will make use of fiber on the back end to handle larger data streams). These are all emerging growth trends, though, that may or may not pan out. Plus, it isn't as if AOI is without competition in these areas.

That competition turns up in the recent acquisition activity in the optical networking industry. Cisco Systems recently announced it was purchasing larger AOI peer Acacia Communications, giving optical outfits like AOI and friends a boost on optimism that other takeovers might be near at hand. I wouldn't buy AOI stock betting on it as an acquisition, though. While a rebound story isn't a terrible hope, bear in mind the company is currently bleeding cash, and bigger competitors might look more attractive as takeover candidates.

Nevertheless, as is the case with supply-side businesses, a recovery should eventually take place, and this could be the bottom for AOI on route to a cyclical upturn. However, this is a tiny stock, so diversify accordingly and keep the position small -- if you buy in at all. For most long-term investors not interested in babysitting, though, this stock looks like a pass.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.

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