The need for faster and better fiber connections is a positive long-term trend. As an arms supplier in this speed race, Applied Optoelectronics (AAOI) is at the forefront of this demand.
AAOI is a leading provider of fiber-optic networking products. It doesn’t provide the fiber cable itself, but instead manufactures products such as diode lasers, photodiodes, and related modules and equipment.
The company makes its own analog and digital lasers using a proprietary Molecular Beam Epitaxy (MBE) fabrication process, which it claims is unique in the industry. These laser products are highly tolerant to humidity and temperature, which is often needed for outdoor applications in the cable and FTTH markets.
Although AAOI has great opportunities for growth in its addressable market, I am somewhat neutral on the stock until stabilization of margins occur, and provide some chance of mid-term profitability. (See Insiders’ Hot Stocks on TipRanks)
The company serves four major growth markets; Internet data centers, cable broadband, fiber-to-the-home, and telecommunications.
Demand for AAOI products is driven by end-user bandwidth demand, which is continuously increasing. This is due to the growth in video traffic, cloud computing, social media use, and data center demand as server connection speed must increase to meet consumer and business demand.
Data Center – These are the typical multiple-layered rack servers used by data analytics and search companies. The underlying driver is the need for speed between servers and the ultimate data transfer to the end user. According to a 2021 data optical components market report by Omdia, the market for optical modules sold into this sector was over $4.7 billion in 2020, and is expected to grow to $10 billion in 2026.
Cable Broadband – Continued demand for high-speed cable-based broadband remains strong, as video streaming continues to take market share from traditional cable television. International penetration of cable broadband is still relatively small, with buildout in many countries ongoing.
Telecommunications – AAOI continues to benefit from the global buildout of 5G technologies. In addition, aging coax-fiber infrastructure, some of which was built decades ago, is in continual need of upgrades to the latest technologies.
Fiber-to-the-Home (FTTH) – Telecom companies such AT&T (T) need to compete with cable companies by offering faster Internet speeds to residential households. Existing 2.5gbs infrastructure is being replaced by 10gbs networks.
The markets for fiber-related laser components can provide lumpy results.
Excess inventory, competitive pricing, product obsolescence, and end-market dynamics can all play a role in AAOI’s business results.
For example, Data Center revenues decreased 43.7% in the first six months of 2021, but Cable segment revenues increased over 400% for the same period.
Cable segment revenues in the second quarter represented 51% of total revenues, compared to the year-ago quarter, when it was only 9% of total revenues. Data Center products were 41% of total revenues in Q2, whereas it was 80% of total revenue a year ago.
On top of lumpy end-market results, the national supply chain disruption has also affected expenses, and the company stated this disruption will persist into the third quarter of this year.
Balance Sheet, Inventory Issues
As of June 30, AAOI had $50.5 million in cash on the balance sheet, and $61.2 million in total debt, not counting $78.3 million in convertible debt.
Inventory levels at the end of the quarter stood at $100 million, which may be too high for a company with estimated revenues of just over $200 million for 2021.
The company is aware of this low inventory-turnover ratio, and management stated in the recent Q2 conference call that it hopes to reduce the inventory to a more appropriate level of approximately $80 million.
Wall Street’s Take
Turning to Wall Street, AAOI has a Moderate Buy consensus rating, based on two Buy ratings and three Holds assigned in the past three months.
At $9.50, the average AAOI price target implies 26.7% upside potential.
AAOI is not currently profitable, and is not expected be in 2022 unless gross margins materially increase beyond expectations.
The stock trades at a 0.9x price-to-sales ratio based on 2021 estimates. A leading competitor, NeoPhotonics (NPTN), trades at 1.6x sales.
Disclosure: At the time of publication, Tom Kerr did not own shares of any stocks mentioned above.
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