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Don't Chase Acacia Communications' Latest Rally

By Leo Sun - May 15, 2018 at 3:30PM

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It’s unlikely that the Commerce Department will completely reverse the ZTE ban.

Shares of Acacia Communications (ACIA) rallied 9% on May 14 after President Trump announced that he was "working together" with President Xi to give ZTE (ZTCOY) -- the second largest telecom equipment maker in China -- "a way to get back into business."

In April, the US Commerce Department banned American companies from selling components to ZTE for seven years after ZTE violated trade sanctions by shipping products with US components to Iran and North Korea. The ban crippled Acacia, which generated 30% of its sales from ZTE in 2017, and its stock plunged from $40 to the mid-$20s in a single day.

A visualization of internet connections across the globe.

Image source: Getty Images.

The stock has since rebounded to the low $30s, and Trump's announcement indicates that rosier days could be ahead for Acacia. However, I think this temporary rally could be a better selling opportunity than a buying one, for four simple reasons.

1. It's not a done deal

President Trump claims to have "instructed" the Commerce Department to resolve the ZTE issue, but there's no guarantee that the regulators will abruptly allow American companies to sell components to ZTE again.

The Chinese government reportedly demanded the resolution of the ZTE issue before broader trade talks could begin. ZTE's ability to purchase components from Acacia and other American companies is crucial to the expansion of China's 5G network. If these talks collapse or tensions escalate, Acacia will remain cut off from ZTE's orders.

2. The Chinese telecom market remains weak

Acacia's stock nearly hit $120 in Sept. 2016 due to the erroneous belief that a "super cycle" in telecom infrastructure upgrades -- fueled by rising demand for cloud services and streaming media -- would let it keep generating massive sales growth.

Unfortunately, that growth hit a brick wall last year when demand from China abruptly cooled off. That slowdown was exacerbated by declining orders from another top Acacia customer: European telecom equipment vendor ADVA Optical Networking.

As a result, Acacia posted five straight quarters of double-digit sales declines. Analysts originally expected Acacia's revenue to drop 4% for the full year, but newer forecasts -- which were updated for the ZTE ban -- call for a 26% decline.

A close-up of a fiber optic cable.

Image source: Getty Images.

Therefore, even if the ZTE ban was completely reversed, Acacia's top line growth would still be weighed down by the weakness of the Chinese market. During last quarter's conference call, CEO Murugesan Shanmugaraj stated that Acacia faces "greater uncertainty in the China market for the second quarter and the remainder of the year."

3. The stock is still too expensive

Analysts expect Acacia's non-GAAP earnings to plunge 86% to $0.25 per share this year, but possibly rebound to $0.85 next year.

This means that at $34, this stock trades at 136 times this year's earnings and 40 times next year's earnings. Those are lofty high multiples for a company that faces tough regulatory and macro issues.

4. Customer concentration is still a problem

Lastly, the ZTE disaster highlighted Acacia's customer concentration issues. 26% of its sales came from ADVA in 2016, which cut its orders to just 15% of its sales in 2017. In its latest 10-K filing, Acacia stated that 70% of its revenues still came from its five largest customers.

If another major customer cuts orders, which could certainly be possible due to volatile demand for infrastructure upgrades, Acacia's stock would tumble again.

The bottom line

A reversal of the ZTE ban would certainly be good news for Acacia. However, the best case scenario merely resets expectations for the company -- which still faces sluggish demand in China and customer concentration issues.

Meanwhile, the worst case scenario will result in the ban being upheld, and investors who chased this news-driven rally will be left holding the bag. Therefore, the best idea is to avoid this stock or cut your losses.

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