2023-09-16 03:41:42 ET
Summary
- Shares sold off after the company terminated the $150 million sale of its Chinese manufacturing facilities and increased the amount available under its Equity Distribution Agreement.
- Last week's disclosures have resulted in renewed concerns regarding the company's weak financial condition and a $80.5 million convertible debt maturity in March.
- However, investors would be well-served to focus on the company's very strong near-term business prospects as demand for high-speed data center components continues to accelerate across the board.
- Considering my expectations for 2024 earnings per share to potentially reach $1.50, I am raising my rating on the shares to "Strong Buy" with a near-term price target of $22.50.
- Consequently, I would advise investors to take advantage of last week's sell-off to initiate or add to existing positions.
Note:
I have covered Applied Optoelectronics Inc. ( AAOI ) previously, so investors should view this as an update to my earlier article on the company.
After providing stellar third quarter guidance in early August, shares of fiber-optic networking products provider Applied Optoelectronics Inc. or "AOI" rallied to new multi-year highs.
The stock peaked at $16.26 on August 24 before pulling back somewhat on investor scrutiny regarding the sustainability of elevated AI-driven investments in the data center space as also evidenced by the heated discussion of the prospects of AI poster child Nvidia Corporation or "Nvidia" ( NVDA ) on the platform.
Adding insult to injury, AOI's stock has been hit by a host of perceived bad news last week.
On Tuesday, the company disclosed the termination of the $150 million sale of its Chinese manufacturing facilities to Yuhan Optoelectronic Technology (Shanghai) Co. or "Yuhan" which was announced 12 months ago (emphasis added by author):
Applied Optoelectronics, Inc. (the “Company” or “AOI”) previously reported in its Current Report on Form 8-K dated September 15, 2022 that the Company and Prime World International Holdings Ltd. (the “Seller”), which is a company incorporated in the British Virgin Islands and a wholly owned subsidiary of AOI, entered into a definitive agreement (the “Purchase Agreement”) with Yuhan Optoelectronic Technology (Shanghai) Co., Ltd. (the “Purchaser”). Pursuant to the Purchase Agreement, AOI agreed to sell its manufacturing facilities located in the People’s Republic of China and certain assets related to its transceiver business and multi-channel optical sub-assembly products for the internet datacenter, fiber-to-the-home and telecom markets.
On September 12, 2023, AOI and the Seller delivered a notice of termination (the “Termination Notice”) to the Purchaser to terminate the Purchase Agreement as a result of the Purchaser’s breach of or omission to observe certain of the Purchaser’s obligations under the Purchase Agreement. As a result of the Company’s delivery of the Termination Notice, the Purchase Agreement has been terminated.
Please note that according to the purchase agreement , AOI might have to pay an up to $3 million breakup fee.
On Wednesday, the company doubled the amount available under its Equity Distribution Agreement with Raymond James & Associates, Inc. to $70 million (emphasis added by author):
On September 12, 2023, Applied Optoelectronics, Inc. (the “Company”) entered into Amendment No. 1 to the Equity Distribution Agreement (the “Amendment”) with Raymond James & Associates, Inc. (the “Sales Agent”), amending the Equity Distribution Agreement dated as of March 24, 2023 between the Company and the Sales Agent (the “Original Agreement” and, together with the Amendment, the “Equity Distribution Agreement”). Pursuant to the Equity Distribution Agreement, the Company may issue and sell shares of the Company’s common stock, par value $0.001 per share (the “Shares”) having an aggregate offering price of up to $70 million from time to time through the Sales Agent.
As of September 12, 2023, the Company has sold 3,690,599 shares of Company’s common stock with an aggregate offering price of approximately $24 million.
At least on first glance, market participants' renewed concerns appear to be well-founded.
AOI ended the second quarter with unrestricted cash of just $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.
Moreover, with Q3 revenues projected to increase by more than 50% on a sequential basis, the company will likely be required to invest in working capital.
Given this issue, I wasn't exactly surprised by AOI raising an additional $13.9 million in gross proceeds from selling approximately $1.2 million newly issued shares into the open market since publishing its Q2 report in early August.
With the average selling price for the new shares calculating to $11.66, it seems that the company raised the majority of the funds directly before terminating the asset sale to Yuhan as the stock price never closed below $12 between August 7 and September 7.
To be perfectly honest, AOI should have upsized and agressively utilized the Equity Distribution Agreement already last month to take advantage of the elevated stock price and very high trading volume.
However, assuming the company delivers on its near-term financial projections and with revenues from the recently-announced supply agreements with core customer Microsoft Corporation ( MSFT ) for next generation lasers and active optical cables anticipated to kick in early next year, I do not expect the $80.5 million convertible debt maturity in March to be a major issue.
Quite frankly, I wouldn't be surprised at all to see the convertible notes being converted to equity as shares might very well trade above the $17.55 conversion price by March.
Three weeks ago, shares of much larger optical component contract manufacturer Fabrinet ( FN ) soared by more than 30% after the company reported very strong AI-driven demand for its high speed data center transceivers thus confirming the trend stated by AOI management on the Q2 conference call .
With analysts currently not anticipating meaningful sequential growth for Q4 despite ongoing, strong datacenter component demand, I firmly expect AOI to report a beat-and-raise quarter in November with additional growth from the new Microsoft products further adding to the top line next year.
Moreover, considering how much market conditions have shifted in favor of AOI, the company might actually benefit from keeping its Chinese assets. While production in China is mostly focused on CATV components, the Ningbo facility also manufactures transceivers for the internet data center market.
Also keep in mind that the Yuhan transaction was negotiated at a time when the company was burning substantial amounts of cash and non-GAAP gross margins hovering well below 20% as compared to approximately 30% projected for Q3.
Should the business indeed run ahead of market expectations, I would expect the company to make limited near-term use of the Equity Distribution Agreement and become more aggressive following the beat-and-raise report anticipated by me in November to cover increased working capital investments related to the upcoming launch of the Microsoft product lines.
At least in my opinion, investors would be well-served to focus on AOI's very strong near-term business prospects rather than being concerned about the convertible debt maturity in March and potential dilution from additional sales of newly issued shares into the open market.
For my part, I wouldn't be surprised to see quarterly revenues exceeding $100 million starting in Q2/2024 which even when factoring in some additional dilution could result in annual earnings per share closer to $1.50 rather than the $0.40 currently projected by analysts.
That said, even a somewhat weaker growth trajectory would still leave plenty of upside potential for the shares.
Apparently, AOI's president and CEO, Thompson Lin remains positive on the company's near-term outlook, too as he used last week's weakness to add another 15,000 shares at an average price of $9.79.
Bottom Line
While AOI's business has been messy for the last couple of years, the company has emerged as a prime beneficiary of strong AI-driven demand for high-speed data center equipment.
Last week's disclosures have resulted in market participants being afraid of additional near-term dilution in order to address the March 2024 convertible debt maturity.
However, investors would be well-served to focus on AOI's very strong near-term business prospects which are likely to result in the convertible notes becoming a non-issue well ahead of their March 15, 2024 maturity.
Considering my expectations for 2024 earnings per share to potentially reach $1.50, I am raising my rating on the shares to " Strong Buy " with a near-term price target of $22.50 or approximately 15x my 2024 estimate.
Consequently, I would advise investors to take advantage of last week's sell-off to initiate or add to existing positions.
Risks
Any sign of weakening demand in the AI data center space would almost certainly result in a massive sell-off for all stocks associated with this latest megatrend.
In addition, the company underperforming its own projections in Q3 coupled with weaker-than-expected guidance for Q4 would impact the shares in a very similar way, particularly with the convertible notes coming into play in March.
For further details see:
Applied Optoelectronics: Buy With Both Hands After Unwarranted Selloff