2023-08-04 07:42:52 ET
Summary
- Following new supply agreements with Microsoft Corporation, shares of fiber-optic networking products provider Applied Optoelectronics Inc. have been on a tear in recent months.
- At its peak on July 13, the stock was up by more than 600% from its from its 52-week low but has retreated by more than 40% in recent weeks.
- On Thursday, the company reported mediocre second quarter results but provided a very strong outlook for Q3 based on substantially increased datacenter customer demand.
- On the conference call, management projected initial production ramp-up under the new Microsoft supply agreements to occur in early 2024 with total sales potential over the next three years exceeding $300 million.
- Following many years of losses, substantially increased demand for the company's datacenter solutions in combination with vastly improved margins might have finally positioned Applied Optoelectronics for profitability going forward. Consequently, I am initiating coverage with a "Speculative Buy" rating.
Shares of fiber-optic networking products provider Applied Optoelectronics Inc. ( AAOI ) or "AOI" have been on a tear in recent months.
At its peak on July 13, the stock was up by more than 600% from its 52-week low of $1.60 with much of the gains apparently tied to new supply agreements with core customer Microsoft Corporation ( MSFT ) for next generation lasers and active optical cables disclosed on May 3 and June 21, respectively:
On December 16, 2022, Applied Optoelectronics, Inc. (the “Company”) entered into supply agreement (“the SOW”) with Microsoft Corporation (“Microsoft”), pursuant to which the Company will manufacture certain lasers in accordance with Microsoft’s specifications (“Goods”).
Under the SOW, according to a schedule of milestones expanding from effective date to December 30, 2025, the Company is to start building the supply chain to manufacture the Goods. The term of the SOW started on December 16, 2022 and continues unless earlier terminated.
The SOW includes a termination right in the event of a change of control in the Company. Further, in the event certain offers are made to acquire the Company, Microsoft has a right to notice and of first refusal to acquire the Company.
(...)
On June 21, 2023, Applied Optoelectronics, Inc. (the “Company”) entered into a supply agreement (“the SOW No. 2”) with Microsoft Corporation (“Microsoft”), pursuant to which the Company will provide certain design services and assembly services of goods in accordance with Microsoft’s specifications (“Goods”).
Under the SOW No. 2, according to a time schedule, the Company is to start designing certain Goods and building the supply chain to manufacture, assemble, sell and ship the Goods to Microsoft or an authorized purchasing entity. The initial term of the SOW is five years with automatic renewal unless terminated earlier.
The SOW includes clauses regarding the Company’s commitment to maintain the production line dedicated to the production of Goods and the Company’s three-year warranty for the Goods
That said, shares peaked at $11.48 on July 13 before retreating by more than 40% in recent weeks.
After the close of Thursday's session, the company reported somewhat mixed second quarter results with revenues of $41.6 million coming in at the low end of the range provided by management in the Q1 earnings release while loss per share of $0.21 actually outperformed projections due to better-than-expected gross margins.
Favorable product mix combined with our cost reduction efforts, and the benefit of some of the intentional actions we have taken to improve our cost structure led to a strong improvement in our gross margin, which is a trend we expect will continue. We are thrilled with the increased demand we saw for our 100G and 400G datacenter products.
According to statements made in the quarterly report on form 10-Q, the company has experienced increased orders for its 400G data center products from several large customers with heightened demand expected to persist through the end of this year.
Indeed, datacenter customer demand appears to have picked up substantially as management guided Q3 revenues and earnings per share well above consensus expectations :
On the conference call , management projected initial production ramp-up for the new Microsoft products to occur in early 2024 with total sales potential over the next three years exceeding $300 million.
Despite the company's mediocre second quarter results, AOI generated $14.2 million in free cash flow for the quarter, due to a combination of favorable working capital movements and an $8.7 million customer advance payment.
In addition, AOI raised net proceeds of $9.9 million from selling 2.5 million newly issued shares into the open market under the company's $35 million Equity Distribution Agreement or "ATM Offering" with Raymond James & Associates ( RJF ). As a result, outstanding shares have increased to 32.1 million.
AOI used the funds to reduce outstanding amounts under its various credit facilities and ended the quarter with unrestricted cash of $21.6 million and total debt of $118.8 million of which $80.5 million relate to the company's 5% convertible notes currently scheduled to mature on March 15, 2024.
Admittedly, the company's balance sheet doesn't look great, particularly considering the near-term convertible debt maturity.
That said, AOI is currently awaiting regulatory approval to divest its Chinese manufacturing operations and certain assets related to its transceiver business and multi-channel optical sub-assembly products to Yuhan Optoelectronic Technology (Shanghai) for gross proceeds of $150 million which would be more than sufficient to address the convertible debt overhang.
According to statements made on the conference call, management expects the transaction to close in early 2024, right in time for the convertible notes redemption.
Unfortunately, ongoing tensions between China and the United States might very well result in approval being denied or at least delayed beyond the convertible debt maturity date.
But given the apparent improvement in datacenter customer demand and revenues from the new Microsoft agreements anticipated to kick in early next year, I would expect the company to successfully address the convertible notes even in case the divestiture falls through albeit likely at the price of dilution for common shareholders.
Bottom Line
Following many years of losses, substantially increased demand for the company's datacenter solutions in combination with vastly improved margins might have finally positioned Applied Optoelectronics for profitability going forward.
That said, the company still needs to address the March 2024 convertible debt maturity which might result in additional dilution for common shareholders, particularly in case the proposed divestiture fails to win regulatory approval.
Considering the company's vastly improved outlook, I would expect analysts to remain constructive on the stock and raise price targets across the board.
Following the recent correction, I wouldn't be surprised to see shares developing some renewed momentum over the next couple of sessions.
Consequently, I am initiating coverage on Applied Optoelectronics with a " Speculative Buy " rating.
For further details see:
Applied Optoelectronics: Buy On Vastly Improved Outlook