Applied Optoelectronics (NASDAQ: AAOI) reported during the last earnings call an inventory increase, however the increase was lower than expected. The company invests heavily in customer diversification, which will help to stabilize revenues and reduces the dependency on a single client. The guidance for the next quarter is considered weak, but we believe that from the first quarter of 2018 the revenues will begin to rise. The next important dates to watch is the possible pre-announcement date and the next earnings call. We still believe that the stock is undervalued and that a target valuation of 80$-100$ can be achieved during the next fiscal year.
Inventory and Pricing
As we expected, the inventory level increased; however, if we compare it with Q2, the inventory level in finished goods increased with just 15m (21m-6m). This inventory is estimated to be consumed until the first half of next year, so assuming a linear sales of inventory, this would mean 5m of excess inventory sales/ quarter.
(Source: Q3 AAOI SEC filing)
(Source: Q2 AAOI SEC filing)
We know that AAOI had ~89m revenues and 49m COGS in Q3.
(Source: Q3 AAOI SEC filing)
If we calculate the potential revenue from the excess inventory, we can estimate that these can generate a revenue of ~27m (89m/49m*15m). So overall they had 89m+27m=116m in potential revenue (and the 6m, but we leave that out since we would like to compare the situation to Q2, where the finished goods inventory level was 6m), which is almost the same as last quarter. From this we know that the value of produced goods stayed the same.
In our last article we estimated that they will be able to increase their production with 30% in Q3 assuming a linear production growth; however we now think that this did not happen, otherwise they would have an extremely competitive pricing environment.
Moreover, they also noted during the call that:
We have brought the capacity down a little bit. And it did impact our gross margins a little bit. There’s 2 impacts. I mean, as you could see our gross margin, we guided down slightly from Q3 in Q4 and part of that is due to capacity utilization and part of it is due to price reduction.
We also know that in the next quarter they expect to reduce the capital expenditures planned this year with 10m (from 85m to 75m), which also suggests that the production growth this year will be less.
Overall, we can conclude that the pricing environment is competitive and that AAOI was able keep up with the dynamics of the competitive landscape and that they will not experience capacity shortcuts what we saw in Q2. Moreover, it is not expected that the inventory will be impaired.
Client and product diversification
The company has still receives 71% (37%, 24% and 10%) of its revenues from its top three data center customers (Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN)), which makes it the company vulnerable to core customer specific changes. As we experienced from the previous quarter, this dependency can be painful. However, in this quarter they announced that they have acquired 9 new clients and from those 3 are 100G clients.
We secured 9 design wins in the quarter, including 3 for 100G products. These include 3 new customers of varying scale as well as wins with existing customers. As a reminder, we only record a design win when the customer has fully tested and qualified our product and we have begun to receive orders from the customer for the product.
This is great news, since the diversification of clients is going to increase the stability of revenues and decreases the dependency on some core clients.
Moreover, they also noted that:
Looking ahead, we have approximately 40 100G and 200G qualification efforts underway with various customers, many of whom are outside of our core hyperscale customer base.
Having 40 new product qualifications is a real effort in diversification for a company which receives 71% of its revenues from 3 clients and this will reduce the possibility of Amazon quarters in the future.
Moreover, when Alexander Henderson from Needham & Company asked whether
customers move radically to a PSM architecture where PSM is pushing past 500 meters into the 2-kilometer distances or changing the architecture in the environment in any meaningful way that would alter your competitive position relative to your bias towards CWDM4?
CEO Dr. Thompson Lin replied that:
So actually, more customer are moving into CWDM, not PSM4 and the price is more attractive, so some customers are talking about to use CWDM to even up to 10 kilometer.
This is also great for AAOI, since the competitive position of the company is better in CWDM. This is bullish for them and we can expect that they can remain competitive in the future.
We think that the customer and product diversification efforts will stabilize revenue estimations and reduce the volatility of the stock.
Q4 and next year
The guidelines for Q4 also lower than what the market expected:
We expect Q4 revenue to be between $81 million and $90 million. We expect Q4 gross margin to be in the range of 41% to 43%. Net income is expected to be in the range of $16.6 million to $19.5 million and EPS between $0.82 per share and $0.96 per share using a weighted average fully diluted share count of approximately 20.3 million shares.
However, part of this low guideline is due to the seasonal decline in cable spending and still due to the transition of Amazon from 40G to 100G. We also believe that they did not lose Amazon as a customer and that Amazon will ramp up purchases from 17Q4 or 18Q1.
Regarding next year, we believe that the company will materially increase its sales. 17Q4 will still not be great, but during 18Q1 and 18Q2 the revenues should ramp up. Until then the customer and product differentiation efforts can materialize, the seasonality of cable sales is going to be behind the door and Amazon can also come back to purchase 100G.
Important stock price moving dates
Around 11-13 days after the reporting period end date, the company will pre-announce the earnings result, if it is going to be materially different from the guidelines provided. Please note that the pre-announcement should only happen, if there is a material change to the guidance provided earlier, which the 17Q3 earnings call is currently. In the table below we can see the previous pre-announcement dates and the days after reporting period end date.
From that table we can assume that the company will pre-announce the next earnings at around 11.01.2018-13.01.2018, if the quarterly results are materially different from the guidance provided earlier.
The next important date will be Q4 earnings call (estimated at around 22.02.2018-27.02.2018), since then the company will provide the 18Q1 guidance.
Valuation and takeaway
We are delighted to see that since the last earnings call the stock price increased ~20%. We still believe that the company is undervalued and that our target valuation of 20x 25x P/E translating to a stock price of 80$-100$ can be reached in the next fiscal year.
Although the market environment is competitive, it is not expected that the excess inventory will be impaired. The customer diversification will help to stabilize revenues, the seasonal decline in datacenter sales will fade away and Amazon can increase its purchases after the transition from 40G to 100G.
Disclosure: I am/we are long AAOI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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