Acacia Communications (NASDAQ:ACIA) lost over a third of its value on April 16 after the U.S. Commerce Department blocked all American companies from selling products to Chinese tech giant ZTE (OTC:ZTCOY). Acacia, which sells fiber optic components for network upgrades, generated 30% of its sales from ZTE last year.
The seven-year ban punishes ZTE for violating trade sanctions by incorporating American components into the products it shipped to Iran. ZTE, which makes a wide range of telco hardware and smartphones, pleaded guilty to the charges in late March and was fined nearly $900 million.
Acacia's plunge to the mid-$20s kept it above its IPO price of $23, but it still marked a massive decline from its post-IPO peak of nearly $120 in Sept. 2016. I discussed Acacia's chances of survival in a recent article, but today I'll highlight five lessons investors should learn from its sudden downfall.
1. Read the SEC filings
Investors who were blindsided by the ZTE ruling probably didn't read Acacia's SEC filings. In its latest 10-K filing, Acacia stated that its "five largest customers" generated 70% of its revenues in 2017, and that ZTE is its top customer.
Acacia also notes that in March 2016, the Commerce Department added ZTE to flagged companies on the "Entity List" for "actions contrary to the national security and foreign policy interests of the United States." Acacia stated that the rule "had the practical effect of preventing us from making any sales to ZTE."
Acacia obtained a temporary sales license to keep selling products to ZTE, and the Commerce Department eventually reached a settlement with ZTE and removed it from the Entity List last March. However, Acacia warned that "there can be no guarantee" that the Commerce Department "will not take future regulatory action" against ZTE.
2. Avoid companies that have high customer concentration
Acacia's customer concentration risk was already apparent last year when it reported slower-than-expected orders from a major customer. That customer was likely ADVA Optical Networking, which accounted for 26% of Acacia's sales in 2016.
That percentage dropped to just 15% in 2017. That decline caused Acacia's revenue to drop 20% for the year, compared to a 100% jump in 2016.
Many supply chain companies have customer concentration issues. For example, Cirrus Logic (NASDAQ:CRUS) -- which supplies audio chips to Apple (NASDAQ:AAPL) -- relied on the iPhone maker for 79% of its revenues last year. If Apple ever developed its own in-house audio chips, Cirrus' business would be wiped out.
3. Be wary of "industry super cycles"
When Acacia went public in 2016, the bulls claimed that it would be a great way to play the "super cycle" in fiber optic upgrades worldwide, particularly in China. The thesis was simple -- the rising use of cloud services and streaming media would push service providers to upgrade their networks.
However, the term "super cycle" also indicates that there might be too much industry hype. That was certainly the case with the fiber industry, which ran into an unexpected slowdown in China last year. Therefore, whenever the bulls claim that a stock is a great play on a "super cycle," consider what would happen if that cycle ground to a halt.
4. Be wary of post-IPO secondary offerings
Acacia raised over $100 million during its IPO in May 2016. But just four months later, it filed for a secondary offering of $450 million, with the company selling $125 million in shares and the rest coming from other shareholders.
That secondary offering, which was priced at $100, seemed greedy. Many investors saw it as a cue to take profits, which turned out to be the right move.
Companies that try to capitalize on soaring post-IPO prices with a secondary offering often deflate their own stocks. Another example is action camera maker GoPro (NASDAQ:GPRO), which went public at $24 per share in June 2014, surged to the mid-$90s in September, and launched a secondary in November at $75. The stock never saw the $70s again, and currently trades at about $5.
5. Valuations matter
Acacia and GoPro are in different industries, but early investors in both companies ignored the stocks' valuations. During their peaks, shares of Acacia and GoPro both traded at nearly ten times trailing sales.
The bulls justified those lofty P/S ratios by pointing to their past growth, but past gains never guarantee future ones. Acacia's sales growth decelerated due to the problems with ADVA and the slowdown in China, while GoPro ran into a wall of cheaper competitors. Here's how much Acacia's P/S ratio contracted since its IPO.
Some bears will argue that its current P/S ratio of 3 is still too high, since Acacia's revenues could easily tumble more than 30% this year due to the ZTE ban.
The key takeaway
Acacia is in serious trouble, and it probably won't recover anytime soon. However, these five lessons might help investors avoid other painful losses in the future.