Applied Optoelectronics (AAOI) reports its Q3 results on November 7. The company has been going through a bit of a turmoil lately and investors should closely track its operational performance to get insights about where its shares could be headed next. Speaking specifically, key items such as its 100G shipment trends, resolution to its yield issues and tariffs impact are likely to dominate its share price over the coming month at least as they will indicate if Applied is coming out of its rough phase or not. Let’s take a closer look.
(Source: Bigstockphoto, Image license purchased by author, Image is not related to Applied Optoelectronics or its personnel)
Yield Issues
Applied Optoelectronics shocked investors by abruptly lowering its guidance last month. Its Q3 mid-point guidance was lowered from $87 million to $56.5 million, marking a downward revision of 35% or a year-on-year sales decline of over 36%. The company blamed yield issues in its 25G production lines and noted that it has come up with a solution to fix the problem. Naturally so, its shares went on a downward spiral ever since the announcement was made and are still down by about 40% at the time of writing this report.
Here’s an excerpt from its press release:
During the third quarter, we identified an issue with a small percentage of 25G lasers within a specific customer environment. Consistent with AOI’s commitment to supreme product quality and customer support, we mutually agreed with the customer to temporarily suspend shipments of certain transceivers utilizing these lasers while we worked to gain a deeper understanding of the scope of the issue and implement a solution. We have since determined that less than one percent of these lasers were subject to this issue, we have enacted a solution and with the agreement of the customer, resumed shipments
Now, Applied Optoelectronics hasn’t revealed the specifications of its affected transceivers, but my guess is that these are 100G modules running a 4x25G configuration. Also, I’m guessing it’s Facebook (NASDAQ:FB) that temporarily suspended its orders. I say this primarily because it was the largest customer for Applied Opto in the last quarter and any disruption in its purchase trends had the potential to meaningfully hurt the former’s sales. But then again, these are just my guesstimates and investors should look for confirmations around these vital pieces of information when Applied hosts its earnings call in November.
(Source: BQ’s Fundamental Tracker)
If the management doesn’t spell out specs for investors, then looking at its bandwidth-wise sales mix might actually reveal the impacted spec. A material fluctuation in 100G sales would indicate that the company’s ramp isn’t going as smoothly as previously expected and its bold guidance of doubling down its 100G sales in H2 FY18 may not be realized.
(BusinessQuant.com)
Next, pay close attention to the last sentence in the excerpt attached above. What is the solution exactly? There are broadly two ways that the company could have fixed the issue:
- Addressing glitches in its production lines and/or improving its manufacturing design/process to get rid of the issue in-house; or
- Source 25G lasers from third parties at least until the above solution is implemented.
It’s in the best interest of the company, its management and its long-side shareholders that solution #1 is implemented. It might take time but it’s a long-lasting solution that perfectly aligns with the company’s roadmap of having functioning in-house production lines. However, fixing issues immediately isn’t always practically possible and so it’s likely that Applied Optoelectronics sourced its 25G lasers from a third party.
Its PR states that less than 1% of its 25G lasers were impacted. But sourcing 25G lasers from third parties is bound to hurt Applied Opto’s margin profile, depending on the magnitude of procurement. So, investors should pay particularly close attention to how it addressed the yield issue. A material decline in its gross margin over the coming quarter can potentially hurt investors’ sentiment and further drag down its shares. Hence, this is another key area that investors should be closely tracking during Applied’s earnings call.
100G Dynamics
In light of this yield issue, investors should also be particularly curious about how Applied’s guidance for FY18 would evolve going forward. To put things in perspective, Thompson Lin of Applied Opto had noted during its Q2 conference call that the company is on track to meaningfully grow its 100G volume in H2 FY18.
We continue to expect 100G volume will more than double in the second half of this year over the first half, which is based largely on the committed orders we announced in Q1 of this year… Additionally, we expect 100G volume to double again next year over this year, as data traffic continues to grow, requiring datacenter operators to expand their datacenters and upgrade their infrastructure to keep up with bandwidth demand.
A disruption in 100G shipments during Q3 would naturally make it difficult for the company to meet its shipment-related guidance. But I’d be particularly interested in hearing the management’s take on the same and if it still stands by its prior guidance. If it has lowered 100G shipment guidance for H2, then is this specific to its yield issue, or did any of its key customers decide to cut down on their purchases over the long run?
More importantly, management last issued its shipment-related guidance back in August, based on the then-existing customer and industry-specific demand trends. Any acknowledgement from it about whether 100G demand remains strong, or if it’s starting to fizzle out, can potentially dictate where Applied Opto’s shares can be headed over the next couple of quarters. This is particularly important because 100G parts tend to carry higher ASPs than their 40G counterparts (pricing differential varies from spec to spec).
Tariffs Situation
The escalating trade-related tensions between the U.S and China could be another cause of concern for Applied Opto. The chart attached below would indicate that the company has sizable operations in China.
(BusinessQuant.com)
Besides that, Applied Opto’s 10K suggests that it ships parts from its manufacturing facility in the U.S to China for packaging, addition of a few more components and final assembly. Here’s an excerpt from the document:
We currently manufacture our lasers using a proprietary process and customized equipment located only in our Sugar Land, Texas facility, and it will be costly to duplicate that facility, to scale our laser manufacturing capacity or to mitigate the risks associated with operating a single facility… In our China facility, we take advantage of lower labor costs and manufacture certain more labor-intensive components and optical equipment systems, such as optical subassemblies and transceivers for the internet data center market, CATV transmitters (at the headend) and CATV outdoor equipment (at the node).
Why is this important? Well, Applied Opto last hosted its earnings call in the first week of August wherein its management noted that the impact of the then imposed tariffs was minimal. But China imposed tariffs on $60 billion worth of U.S-based goods and items only last month and the U.S is threatening tariffs on approximately $267 billion worth of additional imports from China. Hence, Applied Opto’s upcoming earnings call is an opportune time for its management to clearly state if it’s impacted by these tariffs or not.
Final Takeaway
The takeaway is that Applied Opto’s Q3 earnings call could be a pivotal moment for the company’s stock and its shareholders. We’ll get to hear the management’s take on what really caused the yield issues, how it addressed the situation, how its 100G shipments are trending and if it’s a casualty of the escalating trade tensions between the U.S and China. Hence, I would recommend readers and investors to keep a close eye on the aforementioned key items as these are likely going to determine where its shares are headed next. Good Luck!
Author’s Note: I’ll be reviewing Applied Optoelectronics in a follow-up article. You can click the “Follow” button at the top of this page to get a notification as soon as the report goes live. Thanks!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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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