2023-10-26 11:06:42 ET
Summary
- Applied Optoelectronics has been experiencing negative margins since 2019, with the worst figure in a decade in 2023.
- The company has a new commercial agreement with Microsoft worth $300 million in turnover over 3 years.
- The data center market is expected to grow rapidly, but Applied Optoelectronics' financial performance and debt-to-asset ratio raise concerns.
Applied Optoelectronics, Inc. ( AAOI ) has certainly experienced many market cycles having been around for more than a quarter of a century. What the company probably hadn't foreseen is such a negative period (in terms of margins) that has now continued since 2019. The EBIT trend has been decreasing for 6 years, and 2023 marks the worst figure of the last decade. Small improvements can be seen in the last quarter in terms of gross margin but the real recovery is entrusted to the new commercial agreement with Microsoft for an estimated $300M in revenue over 3 years. Other initiatives are underway to improve the margin mix. However, the road seems very long and the risk for a recovery in profitability not before three years is very high in my opinion. Ultimately, even Capex does not seem to be suitable for guaranteeing the correct maintenance of company assets. I prefer to stay out of the market at this time.
General Overview
Applied Optoelectronics, Inc. is a US company that designs, develops, and manufactures optoelectronic components for a wide range of applications, including optical communications, imaging, defense, and medicine. The company was founded at the University of Houston in 1997 and is headquartered in Sugar Land, Texas.
Applied Optoelectronics is a world leader in the manufacturing of laser modules, photodiodes, optical amplifiers, and other optoelectronic components. The main application fields are optical communications (both terrestrial and satellite to transmit data over long distances with superior speed and reliability), imaging (for photography, medicine, and defense), defense (surveillance, weapons guidance, and electronic warfare), medicine (diagnosis, treatment, and surgery - the products are used to provide high-quality images and to perform medical procedures with precision and safety).
Applied Optoelectronics is a company that is investing in research and development to develop new products and technologies. The company is headquartered in the US but has offices around the world.
Highlights
Facilities acquisition
On September 15, 2022, Yuhan Optoelectronic Technology (Shanghai) Co., Ltd. entered into a definitive agreement to acquire the Chinese manufacturing facilities and certain assets related to the transceiver business of Applied Optoelectronics, Inc. for $150 million.
Yuhan Optoelectronic Technology is a Chinese company that designs and manufactures optical components and modules.
The acquisition would have given Yuhan Optoelectronic Technology access to Applied Optoelectronics' manufacturing facilities and expertise in optical transceiver manufacturing. This would have allowed Yuhan Optoelectronic Technology to expand its own business and compete more effectively in the global optical transceiver market. On the other side, the transition would have allowed Applied Optoelectronics to disinvest in assets no longer considered core for the business and to improve its financial health.
However, on September 11, 2023, Yuhan Optoelectronic Technology Co., Ltd. canceled the acquisition.
New trade agreements
In the latest earnings call the company confirmed the presence of new commercial agreements due to the development of 400G or a new supply agreement with Microsoft ( MSFT ) which could be worth $300M over 3 years.
The supply that AAOI will make to Microsoft will be of active optical cables [AOC] and should bring a positive contribution in terms of Gross Margin starting from 2024.
Datacenter Market trend
The data center market is expected to grow rapidly and significantly with an expectation of up to 33% [CAGR] for 400G. The optical cables produced by the company should follow this strong growth trend in terms of sales
Financial
Large margin problems [EBIT] have now persisted for 6 years (EBIT has been negative since 2018). The trend is also negative, having reached the lowest figure of the last decade in 2023 (29.1%). The Gross Margin has the same trend as the EBIT with a small trend reversal in 2023 where the figure improves by 0.4% compared to 2022.
Revenue seems to have remained fairly stable for 4 years now and this could be seen in contrast with the forecast of significantly growing demand for data centers for the period from 2020 to 2026. Special attention should also be given to inventory management. We note how the trend has been decreasing since 2020 (even if the levels are high) and this underlines a virtuous action by the management that has been underway for 4 years.
Regarding the improvement in the Gross Margin, we can listen to the latest earnings call:
These actions included the exit of several low-profit legacy products, shifting R&D resources away from some low-margin projects to focus our resources on areas where we can maximize margin, and some success in executing price increases with some customers.
We are pleased with the execution we made on increasing our gross margin and expect this trend to continue. We remain committed to the long-term goal of returning the gross margin to around 40% and believe that this goal is achieved.
We can understand that the actual target of 40% has a gap of around 25 percentage points to fill. Regarding the forecast:
Moving now to our Q3 outlook. We expect Q3 revenue to be between $60 million and $66 million and non-GAAP gross margin to be in the range of 29.5% to 31%. Non-GAAP net income was expected to be in the range of a loss of $1.9 million to income of $0.2 million and non-GAAP income between a loss of $0.06 per basic share, and income of $0.01 per basic share using a weighted average basic share count of approximately 33.1 million shares.
It seems that the company believes it can recover as many as 15 percentage points already in the second half of the year and that this will even lead to positive EPS.
Free Cash Flow, Earnings per Share, and Capex
EPS has now stabilized in an almost flat (negative) trend from 2021 while small signs of improvement can be seen in the FCF mainly due to interventions on inventories (discussed in the previous paragraph).
Note the also negative trend of the Capex to depreciation ratio which reached the minimum level of the decade in the last two years. The company is not investing in growth and this is a negative connotation that could lead to serious asset sustainability problems in the coming years.
In Q2 the company has $21.6M in cash which is not enough to guarantee operations for 12 months and, again from the last earnings call:
As we disclosed in March, we initiated a new at-the-market offering. To date, we have raised $9.9 million net of commissions and fees under this new program, all of which were raised in Q2.
We can note that actions (not yet sufficient) to search for liquidity are underway to guarantee the sustainability of the business.
The debt-to-asset ratio stands at 37%, also increasing compared to previous years. The data is starting to become worrying in light of the negative EPS and Cash Flow data.
Peers and Valuation
Applied Optoelectronics' main publicly traded competitors could identified as:
• IPG Photonics (IPGP): designs, develops, and manufactures laser sources and optical components for a wide range of applications, including optical communications, imaging, defense, and medicine.
• Lumentum Holdings (LITE): designs, develops, and manufactures optoelectronic components.
• Corning Optical Communications: is a division of Corning Incorporated (GLW) involved in optoelectronic components.
• AudioCodes (AUDC): Provides voice and media communications solutions for businesses and telecommunications operators. Its products enable businesses to build and manage IP voice networks for unified communications, contact centers, and hosted services.
These companies compete with Applied Optoelectronics for market share in all the core business areas.
Using Seeking Alpha's comparative ratings we can see that AAOI has excellent ratings when compared to its competitors. By the Quant Ratings alone, AAOI seems to be the only company worth investing in.
The explanation for this high rate lies in the favorable moment in which the share price recorded +177% in a year and also in the revision of the EPS which suggests a positive trend. Profitability and Valuation are at the lowest level in the comparison while growth, although very low, is among the best.
The favorable moment, as anticipated in the previous paragraph, is reflected very well in the performance of the share price which outperforms all peers.
Price share valuation
Using the main parameters of price to sales and price to book in comparison with peers and also with the reference industry we can see that AAOI has a P/S of 1.1 which is lower than the average of peers equal to 1.8 and is slightly higher than the industry average of 0.9. In terms of price-to-sales ratio, AAOI appears to be valued conveniently. Moving on to the price-to-book ratio AAOI has a value of 1.5 which also in this case is better than the average of peers of 1.7 while concerning the comparison with the reference industry (the ratio is 1.1) the company seems expensive.
To summarize, the share price appears to be convenient when compared with peers and quite in line with the reference market if the comparison is extended to the entire industry.
Risks
Company profitability has been at a minus for 6 years and despite a timid recovery at Gross Margin level in the last year, the gap to bring the company into profit is around 25 percentage points . At the moment this challenge is entrusted to the new commercial agreement stipulated with Microsoft but before seeing the results, in my opinion, it will take several years. A very complex and very difficult challenge that AAOI has in its belly which in my opinion represents a very high risk for a possible (almost certain) negative return on the investment in AAOI to date.
Conclusion
Applied Optoelectronics, active in the optoelectronic components market for more than 25 years, is going through a particularly unfavorable period with profitability that has been missing for 6 years. 2023 saw a timid recovery only at the gross margin level but a possible disinvestment of assets was canceled and commercial agreements with a giant like Microsoft will not bring benefits before 2024. The coffers are languishing and the efforts made to date are not enough to see growth in the short to medium term. I think it is best to stay away from this investment at this time.
For further details see:
Applied Optoelectronics: Returning To Profit May Take Too Long