On June 24, Finisar Corporation (FNSR) reported results which showed that revenues were up, but margins were down. Future guidance was conservative. As of July 18, the stock is down more than 30% from its recent high.
In my opinion, any small-cap company that reports disappointing news has a tendency to be sold off quickly. This may be because traders can now continue to short stock until the price finds a bottom. Before a loosening of the old short trading rules by the Securities and Exchange Commission in 2010, a stock could only be shorted on an uptick in most cases.
For the fourth quarter of 2014, FNSR reported its seventh consecutive quarter of revenue growth and annual revenue growth of 23.8%. Fourth-quarter revenue increased by 4.1% over the third quarter and by 25.7% over the fourth quarter of the prior year.
Margins were another story, according to the financial results. The so-called GAAP operating income decreased 7% ($11.5 million) to $21.6 million. Non-GAAP operating income decreased 12.7% ($7.4 million) to $38.9 million.
Finisar Chief Financial Officer Kurt Adzema cited the impact of a recent acquisition and seasonal telecom price reductions, among other reasons, for the decline in margins in a conference call.
Jerry Rawls, Executive Chairman of FNSR, noted that wireless products lowered the corporate margins but are increasing revenues. The business is profitable and it opens the door for FNSR to create new opportunities with those customers.
The company’s wireless products are older and off-the-shelf, so they don’t require much research and development costs. As Rawls explained in the call:
“This wireless opportunity is large for us and its growing and we expect it to grow even more in Q1, which is why consequently we’re guiding gross margins down in Q1… even though the company is guiding for high growth in revenues. The fourth generation wireless expansion in China …. is hundreds of thousands of …… new LTE towers.”
In January, 2014, Finisar purchased a German company, u2t Photonics, that fills out the company’s offerings of 100 gigabit products. U2t now has low profit margins, but when their production is transferred to the new China plants within the next year, that may improve things. The 100 gigabyte products are in high demand, have large profit margins and the business is expected to have grow significantly, according to Adzema.
Adzema also pointed out that Finisar is spending heavily on capital expenditures for investments in China, including two new buildings. “Depreciation is going up approximately $2 million a quarter and so obviously that has some impact on gross margins. The first building will be fully occupied by the end of the Q2 and the second building completed in the fall and occupied by the end of Q4,” Adzema said.
I read the details on results and a transcript of the conference call. In my opinion, the company’s explanation of margin pressure is credible. The cost of revenue went up about $21 million to $208 million. The details are not defined, but this could certainly be mostly attributable to product mix in my view.
The operating expenses, including R&D, sales and marketing and other items, went up about $2.8 million. In my opinion, the acquisition of u2t could have contributed to this increase.
FNSR added about $8.3 million of GAAP net income from the sale of a majority owned subsidiary Finisar Korea Ltd. There was a $3,384 charge for “change in excess and obsolete inventory reserve.”
On the positive side, FNSR is scheduled to complete two new plants in China that will significantly increase capacity and lower costs. Finisar is also developing new, higher-margin products in the “Web 2.0 market,” according to Adzema said.
“We expect it to grow for years to come. The size will depend on the aspirations of each Web 2.0 operators… but they…have plans and dreams for networks that crisscross this country. So it’s pretty amazing in terms of optics.”
In my opinion, the market reaction to the company’s results may be overblown. I believe it is possible that the demand for FNSR products will continue to grow and the stock may trade higher from its recent sell off.\
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DISCLAIMER: The investments discussed are held in client accounts as of June 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.