Is Applied Optoelectronics’ Stock Too Cheap to Pass Up?

Data by YCharts.

If there is one way to sum up the fortunes of Applied Optoelectronics (NASDAQ: AAOI) in the last year, it would be this: Amazon (NASDAQ: AMZN) giveth and Amazon taketh away. Shares of the fiber-optic supply manufacturer plunged after full-year 2017 results showed year-over-year contraction in sales, attributable primarily to lower demand from its largest customer, Amazon. That furthers a trend that started last summer when revenue began to slow down.

But with a P/E sitting at only 7.5 as of this writing, at some point Applied Optoelectronics (AOI) will be too cheap to ignore. Right?

First, a recap

The big takeaway from the numbers is that 2017 was a landmark year for AOI. Fueled by strong sales, the company surged to a nearly $2 billion valuation in July. But the stock has sold off over 70% since then, as sales growth went from seemingly unstoppable to negative in the fourth quarter.

Let’s not take too much away from the company, though. While sales slid in the last quarter of the year, revenue is still hovering near all-time highs. Plus, in spite of pricing pressure from competition, profitability is still strong. Management also announced its largest ever purchase commitment was signed. The customer is apparently Facebook (NASDAQ: FB) and is expected to begin contributing to revenue in the second half of the year.

Still, the drop in revenue and the accompanying steeper drop in profitability is concerning. It is proof that AOI hasn’t reached efficient scale in its operations yet, and the outlook is that sales will remain soft for a while longer.

Did something go wrong?

No, nothing is wrong with AOI, it’s simply that this type of business is highly cyclical. AOI is especially so, as large portions of its business rely on just a small handful of customers. The biggest, which AOI categorizes in its “data center” segment, is Amazon. Buildout of new data centers for cloud and e-commerce has slowed as of late, so without good diversification of sales, that trend is having a big negative impact on the company’s results.

An artists rendition of data and computing getting connected all over the world.

There are several more reasons for the sudden slowdown. Company management thinks the trend will continue in the current quarter because of regulatory headwinds in China surrounding internet censorship. That censorship has slowed down the develop of data centers crucial to things like video streaming and social networks. Chinese New Year, which landed on February 16 this year, also impacts production at AOI’s factories in China and makes for a usually slow first quarter.

More broadly, the company is also facing the current migration from slower optical technology to newer, faster standards. It takes time for data center design teams to integrate new tech into plans, and it also takes time for a company like AOI to upgrade its operations to account for demand.

The point is, this cyclicity is normal and to be expected. Up until this last report, AOI owners had little information to work with regarding when the current down cycle would end. The good news is that management sees it ending by mid-2018. The bad news: That point is two quarterly reports away.

Considering the stock traded at 30 times trailing earnings in April of 2017, its P/E of just 7.5 makes the stock look pretty cheap. But I can speak from experience when saying that “value” stocks like AOI can, and often will, fall much further than investors expect. That’s the nature of cyclical businesses, and it can be painful.

For those already in it for the long haul, now could be a decent opportunity to buy more. Don’t be surprised if the pain isn’t over yet, though.

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