Here's Why the Worst Is Yet to Come for Finisar Corporation

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It's been a rough year for Finisar (NASDAQ: FNSR), which lost about 40% of its market value on softer demand for its fiber-optics components. Finisar's performance was particularly disappointing since it was once considered a top play on the "super cycle" in the fiber market, as service providers upgraded their infrastructure to address the growing bandwidth needs of media streaming, cloud storage, and other data-intensive tasks.

But with the stock now trading at just 10 times earnings, bottom-fishing investors might be wondering if this unloved stock is primed for a rebound. However, I think things could get worse for Finisar before they get better.

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Ongoing problems in China

The biggest headwind for Finisar is China, where major OEMs like Huawei have been reducing their orders. Finisar already faced problems with Huawei earlier this year, when the latter disqualified Finisar for its 100G CFP2 production due to firmware issues. Those orders went to Finisar's rivals Oclaro (NASDAQ: OCLR) and Lumentum (NASDAQ: LITE) instead.

Finisar's products were requalified by Huawei this summer, but rivals like Lumentum responded by slashing their prices. As a result, the average CFP2 prices at Huawei fell about 20%. Rosenblatt analyst Jun Zhang believes that drop will cause Finisar's market share at Huawei (about 35%) to drop as Lumentum gains ground as the OEM's top datacom supplier.

Revenue fell 3% sequentially (10% annually) to $332.2 million last quarter, "primarily due to lower revenues from our Chinese OEM customers." During the conference call, CEO Jerry Rawls admitted that Chinese OEMs weren't optimistic about 2018 either, but "there would be a lot of optics procured in 2019."

That glum outlook for 2018 is troubling, since Finisar is currently increasing its capex in China with the construction of a new plant in Wuxi amid soft demand. That's why analysts expect its revenue and earnings to fall 6% and 43%, respectively, in fiscal 2018.

Slumping margins

These problems caused Finisar's non-GAAP gross margin to fall 460 basis points sequentially to 30.3% and for its operating margin to plunge 570 basis points to 7.8%. On the bright side, the company expects those figures to stay roughly the same this quarter, with a gross margin of 30%-31% and an operating margin of 7.5%-8.5%.

But here's the bad news: Lumentum is still willing to operate at much lower margins than Finisar, and that strategy could hurt both companies next year.

Lumentum also benefits from running a secondary business of industrial lasers, which makes it a more diversified play than fiber "pure plays" like Finisar and Oclaro. That's why Lumentum's stock is up nearly 30% for the year, while Finisar and Oclaro investors are both sitting on ugly losses.

But look on the bright side...

Things look bleak for Finisar now, but they should improve over the long term. In China, Finisar expects sales of new ROADM (Reconfigurable Optical Add/Drop Multiplexing) devices to complement its market-leading position in wavelength selective switches. This could generate a fresh stream of revenue as sales of its other fiber components rebound.

Finisar also recently started shipping VCSEL arrays for 3D sensing in mobile devices and cars, which is partly offsetting its margin declines in the telecom market. Apple (NASDAQ: AAPL) is a big buyer of these arrays, which power the iPhone X's TrueDepth camera and the proximity-sensing capabilities of AirPods.

The cost of producing these arrays should decline in the second half of calendar 2018, as Finisar's newly acquired facility in Sherman, Texas, enables it to produce more VCSEL arrays using 6" wafers. More importantly, Apple recently awarded Finisar $390 million from its Advanced Manufacturing Fund, to massively expand the Sherman facility to become the "VSCEL capital of the US."

The bottom line

Finisar isn't down for the count. After all, analysts still expect its revenue and earnings to rise 11% and 27%, respectively, in fiscal 2019. But I think it's premature to buy the stock, which still faces a few more quarters of weak growth and tough price competition.

Finisar is a cyclical stock, which should be bought at a trough and sold at a peak. It clearly hit that peak earlier this year after a strong 2016, but it still hasn't dropped to the trough yet.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.