2 Risks Investors Might Be Ignoring About Applied Optoelectronics

The stock of broadband fiber network parts supplier Applied Optoelectronics Inc (NASDAQ: AAOI) is down some 30% since its latest quarterly report after hitting record levels in July. The stock is up roughly 175% so far this year. Based on forward expectations, the stock looks pretty cheap, but the drop may not be over if the company can't maintain its revenue and profit momentum.

The cyclical nature of sales

A couple of months ago -- right before AOI's big slump started -- I warned investors of the biggest risks facing tech supply companies: sales cycles. My piece was by no means prophetic, nor do I possess any special insight here. Rather, it's simply about understanding the fact that following a big boom in sales, companies that supply parts used in a more complex final product tend to experience a slowdown.

Such has been the case with AOI. When the company reported on its second quarter last month, it notched another big year-over-year gain in sales, especially in its bread-and-butter internet data center division. However, management warned that the previous momentum was unsustainable as a slowdown is expected in sales to a key data center customer (read Amazon.com). Let's take a look at some of Applied Optoelectronics numbers.

Adding to the problem is that a majority of AOI's sales are concentrated with just a handful of customers. For example, 74% of data center sales came from just two customers during the second quarter. Talk about putting all your eggs in one basket.

The company has been working to establish new customer relationships, but it will take some time for those to account for a meaningful share of sales.

Profits follow sales

A big tailwind for AOI in the last year has been increasing profit margins. In the last quarter, revenue was up 112%, and gross margin increased to 45% compared with 31% last year. As a result, earnings per share were $1.43 compared to $0.03 in the second quarter of 2016.

Why the big boost to profits? AOI still hasn't realized a big enough scale of operations that consistently covers fixed expenses and maximizes profit. With the higher sales in the last year, those costs got covered, and an increasing amount of the income went to the bottom line -- thus, the big percentage gains from a smaller top-line percent increase.

If sales continue to grind higher, AOI could see more big bumps to that bottom figure that matters most. However, that also implies that a drop in sales could see profit margins drop just as dramatically as they rose. What has been a massive tailwind in the last year could turn into a headwind.

Food for thought

After the big pullback, AOI stock may well be a bargain. Its trailing-12-month price-to-earnings ratio is at 19.7, but that number drops to 9.7 using profit expectations in the year to come.

However, with management's new outlook that quarter-over-quarter sequential growth is stalling out from its data center business, there is still risk that this downturn isn't over. The long and the short: Don't chase this stock. If you believe data center build-outs will continue well into the future, buy for the long term, not over speculation of a quick bounce-back to all-time highs.

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Nicholas Rossolillo has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.