It's official: The short-lived Applied Optoelectronics (NASDAQ:AAOI) rally is over. Tariffs on products coming out of China got the snowball started, but internal product quality issues were ultimately what caused the avalanche. As of this writing, shares of the optical networking manufacturer are half the value they were during the summer of 2018.
The last time the stock was at these levels, it set up a great buying opportunity. While this could be the case once again, investors not interested in babysitting might want to steer clear.
What happened this time?
After bottoming out in the spring of 2018, AOI shares started to rebound as its sales slide started to subside. Management has also been talking up its deals with new customers and development of next-gen products for the data center market. That led to optimism that sales would return to growth in 2019.
The feel-good started to wane, though, with the recent round of tariffs announced between the U.S. and China in September. AOI has one of its three manufacturing facilities in China, which meant some of its product would be assessed an extra tax when entering the states. With data center build-out in North America still the primary moneymaker for AOI, there was concern that higher pricing due to tariffs or the relocation of AAOI's China facility to Taiwan or Texas would lead customers to look elsewhere for product.
As it turns out, tariffs weren't what led to a halt in AOI sales. The company recently updated its guidance for third quarter 2018 revenue to $55 million to $58 million. During its second-quarter report, management told investors to look for sales of $82 million to $92 million in the third quarter. CEO Dr. Thompson Lin said the one-third reduction in sales was due to a temporary issue with some of its lasers:
During the third quarter, we identified an issue with a small percentage of 25G lasers within a specific customer environment. Consistent with AOI's commitment to supreme product quality and customer support, we mutually agreed with the customer to temporarily suspend shipments of certain transceivers utilizing these lasers while we worked to gain a deeper understanding of the scope of the issue and implement a solution. We have since determined that less than one percent of these lasers were subject to this issue, we have enacted a solution and with the agreement of the customer, resumed shipments.
Progress masked by a circus stock
This setback appears to be temporary and AOI won't suffer any long-term repercussions from the freeze in shipments during the third quarter. However, investors won't know for sure -- and whether the lost sales will be made up for -- until AOI gives its official report on Nov. 7.
Thus, it's possible that this is just another speed bump for the manufacturer -- albeit a pretty big one. There is a lesson to be learned here. AOI is making progress diversifying its clients; during the second quarter, the company said it picked up seven new customers, including a deal with an undisclosed data center operator in China. Facebook became a big patron in 2017, further reducing AOI's dependence on Amazon.
The third-quarter update proves the optics maker has a long way to go, though. At the end of 2017, Amazon and Facebook accounted for 35.4% and 28.6% of total revenue, respectively, making them by far AAOI's biggest customers. With sales guidance suddenly taking a similar haircut, it would seem that Amazon or Facebook were the culprit and that they still wield a great deal of power over AOI's results.
After the tumble, AOI shares have a one-year trailing and forward price-to-earnings ratio of 13.3 and 9.3, respectively. That's cheap, but it doesn't include the third quarter, which is certain to be ugly. Nevertheless, depending on management's comments in November, now could be a good buying opportunity to catch a rebound if all is well. I'm waiting until then to make a decision. Either way, with AOI still struggling to manage and diversify its sales, remember to keep those positions small. For investors who can't stomach the big swings in stock price, it would be best to ignore this one altogether.