2023-05-10 19:54:35 ET
Summary
- Applied Optoelectronics' latest earnings report shows that the company is making progress in improving its margins.
- However, the company is still burning cash at a high rate, has high debt and does not look likely to become profitable any time soon.
- AOI's bull thesis hinges on the sale of its transceiver which might allow it to invest in its more promising businesses and maybe even pay down debt.
Back in March, I published a bullish piece on Applied Optoelectronics Inc. (AAOI) whereby I touted the company's business transition. Last week, the company returned its quarterly scorecard, prompting me to revisit my thesis. Back then, AOI was one of the top performers in the semiconductor industry, having gained nearly 50% in the space of a little over two months.
Unfortunately, AOI has given up all its early-year gains and then some. As I pointed out in the March article, AOI is an extremely volatile stock, capable of making double-digit moves in a day's trading session. For instance, last year, the shares jumped nearly 50% in a single day after the company announced that it had entered into a definitive agreement to sell its transceiver business to a Chinese company. AOI has pulled back 36% since the beginning of March on no particular company specific news other than the deteriorating macroeconomic outlook including growing risk of a recession and weak global chip sales .
AOI is vertically integrated to provide a wide range of products for cable television broadband, internet data centers and fiber-to-home. The company's products are the backbone of the lightning-fast Gigabit internet and the ongoing 5G buildout. Its largest business segments are CATV (52% of company revenue last quarter) while its data center products including transceivers contribute 38% of company revenue and the remaining 9% from FTTH.
AOI delivered yet another mixed report, with the pivotal CATV segment continuing to expand but the company missed both top-and bottom-line expectations. Overall Q1 2023 revenue clocked in at $53.03M (+1.5% Y/Y), $0.74M below the consensus while Q1 Non-GAAP EPS of -$0.25 missed by $0.07. Total revenue for the CATV segment was $27.8 million, down 27% sequentially of the record Q4 but up 11% year-over-year, something the company attributed to the ''…negative impact by the loss of production days that occurred during the Lunar New Year holidays in China.'' A big reason why AOI's CATV business is recording fast growth is due to the ongoing DOCSIS 4.0 network upgrades. A good case in point is Charter Communications (CHTR) which, back in December, announced plans to spend ~$5.5 billion over the next several years on network upgrades. Demand is set to improve even further when MSOs start to install amplifiers and other network elements for DOCSIS 4.0, something AOI estimates could happen as early as H2 2023 or early 2024. Demand for these products continues to grow, as companies like AT&T (T), Verizon (VZ), and Comcast ( CMCSA ) aim to provide high-speed connectivity to the masses.
AOI's data center segment delivered mixed results, with revenue coming in at $20.4 million, an increase of 23% sequentially but a decrease of 5% year-over-year which the company said was largely due to the increased demand for its 100G products. In the first quarter, 78% of the company's data center revenue was from its 100G products up from 71% in the previous quarter; 6% was from its 40G transceiver products down from 11% in the December quarter while 8% was from its 200G and 400G transceiver products, equal to the previous quarter's share.
AOI shares first came under serious pressure in 2017 when 40G sales began dropping at a faster-than-expected clip. But with the planned sale of the company's business and newer products gaining traction, the segment's woes might soon be over. For instance, AOI signed a contract to develop next-generation lasers for data centers with long-term customer Microsoft Inc. (MSFT), a validation of the strength and the quality of its core laser fabrication ability. Microsoft has agreed to provide $4 million in R&D funding for the first phase of this project. AOI manufactures its devices in its own semiconductor fabrication facility.
Here's a dichotomy of how I view this company.
The Good:
#1. Sale Of Transceiver Business
Last year, AOI announced that it had entered into a definitive agreement for the sale of its manufacturing facilities in China and certain assets related to its underperforming transceiver business to Yuhan Optoelectronic Technology for $150M. Prior to the deal closing, AOI will also invest 4-10% of the estimated proceeds in exchange for a 10% stake in Yuhan Optoelectronic while the rest of the proceeds for general working capital purposes. AOI will continue using the manufacturing facilities in China on a contract basis to make certain CATV products.
According to AOI's management, the majority of proceeds from the sale will be invested in the company's other segments, particularly in the CATV business and some newer laser-related products.
... it is in the best interest of our shareholders for AAOI to exit the transceiver market and focus resources on our CATV business and manufacturing lasers and laser components for the datacenter, CATV, telecom, and FTTH markets," said AAOI CEO Thompson Lin.
Thankfully, AOI reaffirmed that the deal is still very much on, and the two companies have been making progress in preparing the information required to file for the various regulatory approvals in order to finalize the divestiture. AOI sees the deal closing later this year or in early 2024.
Sale of the transceiver business appears like a sensible move because not only does it have the potential to unlock considerable shareholder value for a business in terminal decline but will also provide much-needed cash that the company can invest in its growth businesses and, hopefully, pay down its mountain of debt.
#2. Margin Expansion
AOI's margins have eroded at an alarming clip ever since the company's transceiver business started contracting. The company's gross margin has also come under serious pressure due to inventory headwinds.
Luckily, last quarter, AOI's margins showed a considerable improvement. Non-GAAP gross margin clocked in at 23.2%, a 180 bps sequential improvement and 570 bps Y/Y increase. Q1 GAAP gross margin was 17.4%, a modest 10 bps Y/Y improvement but a much better 730 bps from the fourth quarter of 2022.
These are very positive trends and I hope the company can maintain that trajectory in the coming quarters--which appears quite likely. After all, AOI guided for Q2 2023 Non-GAAP gross margin in the range of 20.5% to 23.5%, much better even at the lower end of that range than 16.7% for last year's comparable quarter. The company posted Non-GAAP gross margin of 25.0% in the second quarter of 2021 though, meaning there's still room for improvement.
The Bad:
#1. Inventory Headwinds, Again
AOI has been struggling with inventory issues for about a year now, and its woes are not over yet. The company revealed that it has been ''…notified of some inventory build-up with certain CATV customers which we expect will negatively impact our Q2 revenue.'' According to the company, excess inventory has built up among various distribution channels for three key customers.
Thankfully, AOI says overall demand for CATV products from MSOs remains robust, and any inventory buildup is likely to be transitory.
# 2 . High Debt And High Cash Burn
AOI is a company with a market cap of just $53M, high cash burn, high debt and still in the red.
Over the last 12 months, AAOI had revenue of $223.61 million and -$66.63 million in losses. The company ended Q1 2023 with $28.03 million in cash and $156.23 million in debt, giving a net cash position of -$128.20 million or -$4.41 per share (current share price is $1.83). These are not very encouraging metrics and reek of a pretty risky stock.
More concerning, AOI has failed to turn a profit for 18 straight quarters, which suggests that its ailing transceiver business could be a big reason why this is the case.
Overall, I think the company's latest report proves that AOI remains very much a work in progress and might take several quarters for its businesses to stabilize. The bull thesis still hinges on the sale of the transceiver business, meaning it might take up to a year for me to be able to fully evaluate the new-look AOI. I think AAOI stock is more of a Hold than a Buy at this juncture.
For further details see:
Applied Optoelectronics: Still Very Much A Work In Progress