2023-09-14 12:02:40 ET
Summary
- Applied Optoelectronics, Inc.'s latest quarterly results show promise, particularly in the data center segment, with strong revenue growth rates and improving gross margins.
- The failed asset sale, which was expected to bring in $150 million in proceeds, has put additional pressure on the Applied Optoelectronics balance sheet.
- Applied Optoelectronics faces a significant challenge in its balance sheet, with limited cash and impending debt obligations, which raises concerns about its ability to sustain its recovery.
Investment Thesis
Applied Optoelectronics, Inc. ( AAOI ) has been on an absolute tear in 2023.
Can you imagine that this stock is the same stock that was down 95% over the past 5 years? And that it would suddenly turn around and is now on a path to be up more than 300% this year? Shareholders are undoubtedly cheering. And so they should be. The business puts together yet another set of quarterly results that show the business continues to survive.
And incidentally, it's worthwhile noticing that this was the exact same sentence I ended my previous analysis on this name. Survive, but not thrive.
Therefore, I'm revising my rating from a hold to a tepid buy.
Rapid Recap
In my previous analysis, I said,
Applied Optoelectronics manufactures advanced optical communications products. The business is in the process of selling a portion of its business to Yuhan Optoelectronic Technology (Shanghai) Co., Ltd. This asset sale will bring $150 million in proceeds.
Now the sale has fallen through . I don't know why it has fallen through. Some have opined that AAOI actively chose to terminate the deal. I don't think it matters too much why it fell through , only that AAOI needed cash, and now it hasn't got that immediate cash coming.
So that's clearly weighing on the stock. Or more specifically, it's weighing down AAOI's balance sheet .
Admittedly, I was skeptical about AAOI already, as I argued that its underlying business wasn't stable enough. But frankly speaking, its latest set of results are a solid step in the right direction.
Not only are its datacenter revenues making up 66% of its underlying business, but that segment is also growing at a very rapid clip, led by its 400G datacenter products.
Revenue Growth Rates Point Towards Massive Improvement
The graphic above shows AAOI's outlook for Q3 2023. I had to double-check its guidance several times. This company was on the way out. But with this strong guidance ahead, investors have much to be pleased about.
Not only is the business going to report its highest absolute revenues in more than 10 quarters, but its gross margins are expected to dramatically improve too.
More specifically, AAOI's gross margins are pointing towards up to 31% non-GAAP gross margins, compared with approximately 25% non-GAAP gross margins reported in Q2. This means that since the start of 2023, AAOI's gross margins will have expanded by about 800 basis points. These are not small numbers by any stretch.
Next, we'll discuss the main overhang on the stock.
Balance Sheet Update
In my previous analysis, I said,
Management is upfront with the fact that it's selling its business, and a substantial portion of the proceeds is going to clean off its balance sheet. Meaning that there's little excess capital to reinvest back into the business to improve its profit margins over time.
Here's the problem facing AAOI. It has close to $29 million of cash. And it's barely profitable. In fact, if we subtract the advancement customer payment of approximately $9 million, AAOI's free cash flow this quarter would have been less than $10 million.
Furthermore, if we include the capital expenditure that AAOI needs to grow its revenues, the business is going to need more cash. To be clear, it's not hemorrhaging cash. However, it does need the cash on its balance sheet to continue its growth strategy of manufacturing its 400G products.
Then, on top of that, it has around $80 million of convertible debt coming due soon.
So, it's a business that certainly has what it takes to turn around. But at the same time, it must also raise capital by diluting shareholders to shore up its balance sheet. And do so quickly.
The Bottom Line
Applied Optoelectronics has experienced a remarkable turnaround in 2023, with its stock up over 300% after years of decline.
The recent quarterly results demonstrate that the company is surviving, but the question remains whether it can thrive. The failed asset sale, which was expected to bring in $150 million, has left AAOI without much-needed cash. This financial struggle is weighing down the stock and the company's balance sheet.
While I was initially skeptical about AAOI's stability, its latest results, particularly in the datacenter segment, show promise. The revenue growth rates and improved gross margins indicate positive momentum. However, the overhang on the stock remains its precarious balance sheet, with limited cash and looming debt obligations. I find myself cautiously optimistic about AAOI's prospects, but the financial challenges are a significant concern.
For further details see:
Applied Optoelectronics: Far From Thriving, But Optimistic (Rating Upgrade)