Buy Applied Optoelectronics (AAOI) Stock at These Discounted Prices
Applied Optoelectronics Inc (NASDAQ:AAOI) used to be one of the best growth stories on Wall Street. But in early August, AAOI stock went from growth darling to ugly duckling overnight after an ugly earnings report showed weakness in the underlying growth story.
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AAOI stock lost about a third of its value in a day. Since then, every rally in AAOI stock has been faded and the stock appears to be in a solid downtrend.
But does that mean you should give up on this hyper-growth name?
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I don’t think so. Although the stock may be due for some turbulence in the near-term, AAOI is a materially undervalued stock with significant long-term upside from these depressed levels.
Why AAOI Dropped Big
AAOI makes parts for hyperscale data center operators like Amazon.com, Inc. (NASDAQ:AMZN), Microsoft Corporation (NASDAQ:MSFT), Alibaba Group Holding Ltd (NASDAQ:BABA), and Baidu Inc (ADR) (NASDAQ:BIDU).
In this sense, investors looked at AAOI as a play purely on the hyperscale data center growth trend. As more data migrated to the cloud, the more companies like Amazon and Microsoft would be forced to enhance and build-out their hyperscale data centers. The more those tech giants are forced to do that, the more business AAOI generates.
This is why AAOI stock was up 300% year-to-date ahead of its second quarter earnings report.
But that report had a number of red flags, the biggest being that the company had hit pause on the secular growth story. For multiple quarters, AAOI had demonstrated positive sequential revenue growth. Simply put, each quarter’s revenues were bigger than the prior quarter’s revenues. This trend illustrated that the business had tremendous ramp, regardless of seasonality.
The third quarter guide called for that trend to end. Revenues are supposed to be down about 5% next quarter.
So, what’s going on the under hood? Two things. One, the 40G market is slowing down more than initially anticipated. Two, AAOI is a victim of heavy single-customer reliance.
On the first point, the optical market is experiencing a massive shift from lower data rate (40G) to higher data rate (100G) equipment. This shift has been underway for some time, but AAOI has continued to post positive revenue growth because 100G ramp has consistently offset 40G churn. The guide implies that this will reverse in the third quarter and that 40G slowdown will more than offset 100G ramp.
On the second point, the acceleration in 40G slowdown is a result of AAOI losing sales from one major customer (although not mentioned specifically, all signs point to Amazon). This underscored that AAOI is heavily dependent on a few major customers. Therefore, any slack in demand from those major customers will have huge negative repercussions on operating results.
For those two reasons, AAOI stock dropped big.
Why AAOI Stock Will Rebound
Both of those headwinds are near-term in nature.
The higher the date rate, the more differentiated AAOI is from competitors. From this vantage point, less 40G demand and more 100G demand is a favorable long-term dynamic for the company. Granted, right now, the 40G slowdown is weighing on operations, but, longer term, 100G demand ramp implies more market share gains for AAOI. Plus, 100G carries higher gross margins than 40G, so the shift from 40G to 100G implies a boost to AAOI margins.
Its also worth talking about the forthcoming demand ramp at even higher data rates like 200G and 400G.
Because hyperscale data centers are growing so quickly and harvesting so much data, demand for higher and higher data rates will almost assuredly grow. This is why, last quarter, AAOI announced 14 new active qualification efforts for their 100G and 200G technologies with customers outside of the core hyperscale customer base.
In the long-term, then, AAOI is looking at significantly higher margins on a significantly larger revenue base.
Bottom Line on AAOI Stock
Near-term pain is weighing on the stock. The latest wave of data (the second quarter earnings report) wasn’t great. Until we get new, positive data, this stock is likely stuck in neutral.
But 100G and 200G demand ramp is so strong that this positive data will likely come soon. I’m looking at the third quarter earnings report. That report has the potential to hit “play” on the secular growth story, resume the sequential revenue growth trend and send the stock significantly higher.
In the meantime, I think its worth accumulating AAOI stock before that report hits the tape.
As of this writing, Luke Lango was long AAOI, AMZN, BABA, and BIDU.
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