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Tariff Talk Sinks Applied Optoelectronics Stock Over 20%, but the Worry Is Overdone

By Nicholas Rossolillo – Sep 16, 2018 at 9:21AM

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The roller coaster ride continues, but the company is in good shape.

Shares of fiber optic networking manufacturer Applied Optoelectronics (AAOI -22.25%) fell as much as 25% in late August through early September on tariff worries. Comments from the White House that taxes could be imposed on virtually all goods imported into the U.S. from China sent investors scurrying for the exits, and Wall Street analyst downgrades of some of AOI's peers didn't help either. Since the company has operations in China, it could be argued that the political concerns are valid. However, AOI is in good shape, and after another stock price adjustment, shares look like a value play again.

Why some are concerned

At the beginning of September, President Trump warned he might tax another $267 billion in Chinese goods. After a couple of rounds of tariffs already imposed, that means virtually all goods imported to the U.S. from China would get hit with a tax.

Why is that bad news for Sugarland, Texas-based Applied Optoelectronics? Because AOI has three manufacturing facilities: one in Sugarland; one in Taipei, Taiwan; and a third in Ningbo, China. AOI spreads component manufacturing and different levels of its vertically integrated operations across all of its facilities, but the China factory plays a crucial role. The company explained it this way in its last annual report (emphasis is mine):

In our Sugar Land facility, we manufacture laser chips (utilizing our MBE and MOCVD process), subassemblies and components. The subassemblies are used in the manufacture of components by our other manufacturing facilities or sold to third parties as modules. We manufacture our laser chips only within our Sugar Land facility, where our laser design team is located. In our Taiwan location, we manufacture optical components, such as our butterfly lasers, which incorporate laser chips, subassemblies and components manufactured within our Sugar Land facility. In addition, in our Taiwan location, we manufacture transceivers for the internet data center, telecom, FTTH and other markets. In our China facility, we take advantage of lower labor costs and manufacture certain more labor intensive components and optical equipment systems, such as optical subassemblies and transceivers for the internet data center market, CATV transmitters (at the headend) and CATV outdoor equipment (at the node).

In addition, AOI is spending $90 million this year in capital expenditures, part of which includes a new facility in Ningbo, China, that recently broke ground and is expected to be completed in 2020. AOI doesn't say specifically how much of its manufacturing is done on mainland China, nor does it break down the specifics on the geographies in which its final product is sold. However, there is concern that any product that originates -- or has components that originate -- from China will get an extra tax, and that the extra cost will cause AOI to lose orders from its customers.

An illustration of a cloud representing a data center. Computers are arranged in a circle around the cloud, hooked up to it via the internet.

Image source: Getty Images.

A toxic situation or value play?

AOI's management is aware of the tariff concerns and addressed them during its last conference call. CFO Stefan Murray had this to say:

All three locations are capable of manufacturing transceivers, with Taiwan and China both capable of manufacturing these products in high volume. Because of our vertical integration strategy, we also manufacture many of the components and subassemblies that are used in these modules. The diversity of our manufacturing operations both geographically and in terms of the types of products manufactured gives us significant flexibility and adapting our production location in order to maximize cost efficiency. As political conditions change, we believe that we are well-positioned to adapt and will continue to plan for such contingencies. 

In other words, AOI thinks everything will be OK because it can move manufacturing around to account for taxes and/or the final destination of the product (such as, if a product is sold to Europe instead of the U.S.). Still, the fact that labor-intensive production might have to leave China for either Taiwan or the U.S. to avoid new taxes could mean much lower profit margins. That would be a lose-lose situation. 

The concerns could be premature, however. AOI has been working to diversify its clients and is seeing some early results. In the last quarter, the company reported seven new design wins, including one with a large data center operator in China. That should help further wean the company off of its Amazon dependence. For 2016 and 2017, sales to Amazon made up 54.6% and 35.4% of total revenue, respectively. More design wins could mean more diversification, as well as less dependence on the U.S. market and possible tariffs.

Though the effects of new taxes on the business are still a relative unknown, the bigger worry should be whether AOI can regain its sales momentum that stalled out in late 2017. After this most recent correction, AOI stock has a trailing-12-month price-to-earnings ratio of 19.5 and a forward price to earnings ratio of just 12.5. That implies a big rise in profitability in the next year, which is in the cards if management is correct in its projection that data center orders for 100G ethernet transceivers will double in the second half of this year over the first half, and double again in 2019 over 2018.

Thus, it would seem that the tariff worries tanking AOI's stock are a little overdone -- or at the very least, premature. Play it safe, though; this one is especially volatile and likely will continue to be.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.

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