What happened
Fiber-optic networking stocks had a wild year in 2017. According to data from S&P Global Market Intelligence, shares of Applied Optoelectronics (AAOI -8.17%) raced to a 325% gain at the end of July only to complete the year with a far smaller 61.35% gain. Meanwhile, Oclaro (OCLR) investors took a 24.7% haircut last year, and Finisar (FNSR) suffered a 32.8% loss.
So what
In the first half, Applied Optoelectronics ran far ahead of the pack as its largest customer, Amazon.com (AMZN 1.49%), ordered up tons of additional fiber modules for use in the e-commerce and cloud computing giant's data centers.
Zooming in on the last five months of the year, all of these tickers traded as a fairly coherent group. The chart lines are uniformly punctuated by drastic drops around their earnings reports in October, for much the same reasons.
There are two issues at play here.
First, the optical networking industry as a whole is moving on from transceiver modules that can handle 40 gigabits of data per second and into the newer, faster 100-gigabit generation. This changeover is putting a lot of stress on the manufacturing lines of Oclaro, Finisar, and Applied Optoelectronics alike, and their clients would really love to complete the shift faster than the production lines can be modified and upgraded. So their growth isn't quite what investors had expected or hoped for.
Second, the world's largest networking market is facing timid infrastructure upgrade budgets amid regulatory pressure. Chinese regulators are debating the requirements of next-generation network standards, causing both equipment builders and telecom operators to tap their brakes on hardware investments. This is the specific issue behind those drastic drops in October, and also Applied Optoelectronics' 39% plunge in August.
Image source: Getty Images.
Now what
The Chinese order slowdown is obviously a temporary issue, and the changeover between technology generations isn't permanent either. That's why I'm convinced that we're looking at a trough period in the history of fiber-optic networking investments, and that most of these trodden-down tickers should come roaring back to life when market conditions improve.
All of the tickers discussed seem likely to make it through these difficult quarters relatively unblemished. Oclaro and Applied Optoelectronics boast net profit margins north of the 20% mark, while Finisar lags a bit behind at 14%. On the other hand, Finisar's cash-rich balance sheet and more substantial economies of scale should keep this company afloat anyhow.
With double-digit earnings growth and price to earnings ratios below 13, all three are tempting buys right now. And if you expect the rough market conditions to trigger consolidation in the optical networking industry, Applied Optoelectronics looks like the most likely buyout target thanks to a low enterprise value, bargain-bin valuation ratios, and skyrocketing revenue growth.
