Shares of Acacia Communications (NASDAQ:ACIA) plunged 36% with the rest of the optical sector on April 16 after the U.S. Department of Commerce banned all American companies from selling components to Chinese tech giant ZTE (OTC:ZTCO.Y). The seven-year ban is aimed at punishing ZTE for violating trade sanctions against Iran.
ZTE pleaded guilty to the charges in late March, and agreed to pay up to $1.2 billion in fines. That's the largest fine ever levied by U.S. regulators against a Chinese company.
The Commerce Department's ruling dealt a devastating blow to American fiber companies, which supply 25% to 30% of the components used in ZTE's hardware. ZTE produces a wide range of communications devices, including telecommunications gear and smartphones. Acacia was hit the hardest, since 30% of its sales came from ZTE last year.
What happened to Acacia?
Acacia was one of the hottest IPOs of 2016. The bulls considered it a hot growth play on the "super cycle" in fiber upgrades worldwide, particularly in China. That's why the stock surged from its IPO price of $23 to almost $120 in the first four months.
However, a secondary offering near that peak popped the bubble, and an unexpected slowdown in network upgrades in China caused its growth to grind to a halt. The stock gave up nearly all of its gains and currently trades in the mid-$20s.
Acacia's revenue doubled to $478 million in fiscal 2016, but fell 20% in 2017. Prior to the ZTE ban, analysts had expected its revenue to dip another 4% this year. But with ZTE's orders now blocked, it's reasonable to assume that Acacia's annual sales could drop by at least 20% to 30%.
Acacia previously expected its first quarter sales to fall 35% to 42% year-over-year on soft demand in China. The ZTE ban comes after the end of Acacia's first quarter (March 31), so its first quarter numbers shouldn't be affected. Acacia is expected to reveal those numbers on May 3. Investors should pay close attention to guidance to see if Acacia can survive the loss of its top customer.
Rising expenses and dismal profit growth
Acacia's bottom line growth has also been weak. Its non-GAAP operating expenses accounted for 34% of its revenues during the fourth quarter, compared to 16% a year earlier.
Acacia attributes those higher expenses to foundry and development milestone payments and strategic investments, but they caused its non-GAAP earnings to plunge 71% annually last quarter. Acacia also posted a GAAP loss during the quarter.
Acacia expects non-GAAP earnings of just $0.01 to $0.10 per share for the first quarter, which represents a steep drop from its earnings of $0.77 a year earlier. Prior to the news about ZTE, analysts expected Acacia's non-GAAP earnings to drop 43% to $0.99 per share. With ZTE out of the picture, the decline will be much uglier.
Even after its recent drop, Acacia still can't be considered cheap at 26 times this year's earnings -- which itself is based on analyst estimates which still need to be revised.
Finding the silver lining
It's tough to find reasons to buy Acacia at these prices. However, investors should remember that its coherent interconnect products, which boost the capacity of existing networks, are generally better suited for newer software-defined networking solutions than older equipment.
Specifically, its 400G chipset is smaller, denser, and more power-efficient than many rival products, and the company relies more on the high-growth metro and DCI (data center interconnect) markets instead of the slower-growth long-haul market.
Therefore Acacia could be a lucrative takeover target in its weakened state. Lumentum, for example, recently agreed to buy Oclaro (NASDAQ:OCLR) -- which also relies heavily on China -- for $1.7 billion.
That buyout was considered a major blow to Finisar (NASDAQ:FNSR), which was also reportedly mulling a bid for Oclaro. I'm not saying Finisar will buy Acacia, but the latter's enterprise value of $740 million makes it a feasible takeover target for bigger fiber players.
The bottom line
Most investors should avoid Acacia for now. The company just lost its top customer, the rest of the Chinese market looks soft, and the stock isn't fundamentally cheap. However, investors with an appetite for risk should see if the stock eventually bottoms out and attracts buyout interest from industry peers like Finisar.