2023-11-08 10:14:55 ET
Summary
- AAOI will publish its Q3 results on the 9th of November.
- After a weak group topline performance in Q2, one will likely see a strong bounce back, with the data center segment expected to witness growth of 70% sequentially.
- AAOI's capital position isn't in the best of health and we have concerns over increasing dilution risks.
- The volatility quotient has gone through the roof off late and the risk-reward on the charts isn't very compelling.
Introduction
Applied Optoelectronics ( AAOI ), a micro-cap play on fiber-optic networking products will publish its Q3 results on the 9th of November after market hours. Even though we’re expecting some largely positive developments from the event, we’re not convinced a long position in AAOI would represent the best use of funds.
Q3- Key Discussion Points
Based on the topline performance in Q2-23, some passive observers of AAOI could be excused for feeling a bit morose about the company’s expected performance in Q3, but we would choose to play down those fears.
To refresh your minds, note that on account of excess inventory in the distribution channels of a few CATV customers, demand hasn’t been particularly resilient there, prompting AAOI to only deliver $41.6m of sales, the weakest quarterly number in 11 quarters (this figure had also come in towards the lower end of their guidance of $40.5m to $47.5m, provided during the Q1 earnings event).
However, in Q3, AAOI should more than make up for that slump as guidance provided by the management points to strong sequential momentum of anything between 44-58% growth q-o-q. Currently, the group topline consensus for Q3 stands at $62.6m , which would translate to 10% YoY growth.
On the CATV segment per se (39% of H1 revenue), where AAOI provides products such as lasers, transceivers, turn-key equipment, etc. things should improve sequentially, but on a YoY basis, this segment is still expected to come in rather weak (for context, in Q2 CATV revenue was down by -61%YoY), given the steep base effect from Q3 of last year. Back then, AAOI had received a useful fillip from the outsourcing momentum of CATV equipment vendors for product categories such as head ends, various distribution equipment, etc.
We don’t believe investors should expect this segment to dazzle again, until probably H2-24 or FY25, as that’s around when demand for AAOI’s amplifiers - as part of the DOCIS 4.0 network transition- will pick up steam; A recent industry survey suggested that the adoption of DOCIS 4.0 tech should likely snowball over the next couple of years.
Nonetheless, the flip side of having a lower mix of CATV sales in the overall mix is that there’s less pressure on the AAOI’s non-GAAP gross margin. Besides the favorable mix, AAOI’s gross margins have also benefitted from price increases with certain customers and the discontinuation of some underperforming products. The impact of these actions is reflected in the fact that margins have been trending up sequentially for 4 straight quarters, and it will almost certainly be 5 quarters, as management expects to hit a figure closer to 30% in Q3 (target range of 29.5%-31%). For the uninitiated, note that AAOI’s long-term goal is to get this figure closer to the 40% mark!
Earnings transcripts
Plenty of attention will rightly go to AAOI's data center segment, which has crept up over time, to now become the biggest contributor to the topline (over half of AAOI’s H1 sales).
To support increased bandwidth consumption, we’ve seen internet data center operators pivot away from copper infrastructure to high-end optical fiber, but with the AI penetration, there appears to be an ever-increasing need for even higher data transmission rates. As a result, in recent quarters, AAOI management has flagged the increased interest for its 400 G-related products, which incidentally saw its revenues double in Q2. Nonetheless, currently, most of the data-center revenue (75%) is still coming from 100G products, but that sub-segment is no slouch either, witnessing 30% sequential growth.
Expect another solid quarter for the overall segment, as management's guidance provided during the Q2 earnings would point to a sequential growth of 70% in Q3.
For those wondering about the impact of the recent Microsoft agreement for certain data center goods note that the impact of this will only really flow through from next year onwards (management believes this could be a $300m opportunity spread over an initial term of 5 years).
Closing Thoughts- Limited Incentive To Go Long
We thought it would be prudent to start this section by highlighting that the AAOI stock is probably not meant for the faint-hearted. The variance of its monthly returns has almost always been quite steep by general standards (average annualized standard deviation of 77% over the past 5 years), but recently, things have become even more pronounced with the monthly standard deviation not far from hitting triple-digit-percentage levels! Normally when you’re building a position in a certain counter, you ideally want to do so when volatility is relatively subdued.
Investors should also consider that AAOI is one that typically attracts large hordes of short-sellers; the current level of shares sold short are at 3-year highs, translating to a heightened short-interest share of 23%.
The elevated short float component may perhaps induce some hopes of a strong short squeeze, but we would rather point to the relatively low days-to-cover ratio of only 3 days, which implies that short covering momentum, if any, may not last for too long.
AAOI’s capital position too is a point of concern. Over the last 5 years, its debt levels have grown by 42%, whilst its cash balance has slumped by 61%.
The capital position could have been enhanced by a potential stake sale but this did not quite come to fruition . This also inevitably means that if AAOI is to fulfill its growth ambitions, particularly in the data center space, existing owners will likely have to contend with even greater dilution risks; already over the last 3 years we’ve seen the share count rise by close to a third,
Then, investors looking for suitable rotational opportunities in the telecommunication universe may have eyed AAOI as an attractive bet in the first half of the year, as its relative strength ratio versus a diversified telecommunications portfolio was trading a long way off the mid-point of its range. However, in recent months, we’ve seen the ratio more than mean-revert to its mid-point, dampening the rotational prospects of AAOI.
Finally, based on the price imprints of the larger time frame chart of AAOI here, we feel there isn’t a great deal of incentive for either the bulls, or the bears at this juncture.
After a slump that kickstarted in late Nov 2021, the stock had done well to build a base for a year (May 2022-May 2023) before demonstrating some strength in the form of a rapid uptrend. However, it has now entered a terrain that previously served as a congestion zone (area highlighted in yellow) for over two and a half years, from May 2019 to Oct-2021. Don’t be surprised to see another era of choppy sideway movements within this broad range, as the stock attempts to catch its breath. A HOLD rating feels right.
For further details see:
Applied Optoelectronics: Q3 Results Should Be Fine, But We're Not Enthused About Going Long