Why Finisar Corporation Stock Fumbled 30% in 2014

Fiber optics components maker Finisar (FNSR) had a dismal 2014.

Its stock has plunged 30% since the beginning of the year due to ongoing concerns about declining margins. But after that big drop, the stock is only trading at 11 times forward earnings, which makes it a tempting investment for value investors. Let's take a closer look Finisar to see if it's a bargain or bull trap at current prices.

Source: Ycharts

Why Finisar crashed
Finisar's big plunge started in June following its fourth quarter earnings. Quarterly revenue rose 4.1% sequentially, marking the company's seventh consecutive quarter of top line growth. However, GAAP-adjusted operating income fell 35% sequentially to $21.6 million.

CFO Kurt Adzema noted during the conference call that the margin contraction was mostly due to "annual price reductions for telecom products" and higher sales of lower margin products. Some of these lower margin products came from Finisar's acquisition of Berlin-based u2t Photonics in January, which expanded Finisar's portfolio of 100 gigabit products. u2t has lower margins than Finisar, but an upcoming transfer of production from Europe to China is expected to improve its bottom line. Other investments in China, including the construction of two new plants, also weighed down Finisar's margins.

Although Finisar's explanations were rational, and new plants in China should eventually increase production capacity while lowering costs, the margin contraction spooked investors and the stock has been volatile as a result.

Some of Finisar's fiber optic components. Source: Finisar

A mixed first quarter
In September, Finisar's first quarter earnings revealed that although margins were still falling, they showed signs of bottoming out. GAAP operating income fell 3.5% sequentially to $20.4 million, but revenue grew at a slower rate of 7% to $327.6 million.

Finisar benefited from the expansion of 4G LTE networks worldwide, which boosted sales of its transceivers for wireless applications. Those devices are included in Finisar's datacom products category, which posted 31% year-over-year growth to $241.2 million during the quarter. However, Finisar expects this demand to decline in the second quarter before bouncing back in the third quarter. Finisar also reported lower sales of its lower margin telecom products, which only climbed 6% year over year to $86.4 million. As a result of those mixed earnings, Finisar expects second quarter revenues to come in between $305 million to $320 million, which remains in line with the average analyst estimate of $312 million.

Finisar is clearly in the middle of a transition, and when it completes construction of its plants in China next year, margins should substantially improve. However, it could also be sacrificing margins to gain market share against a key industry rival, JDS Uniphase (VIAV -0.25%), which recently posted a net loss of $9.7 million on revenue of $433.6 million. If that's the case, Finisar's margins could remain under pressure even after it increases its investments in China.

Why Finisar could rise again
Despite the murky near-term outlook, investors should remember that Finisar's top customers include networking giants Cisco (CSCO 0.06%) and Ciena (CIEN 0.72%), and that the fiber optic upgrade cycle can result in seasonal slowdowns in revenue and earnings growth. As 4G LTE networks expand and wireless providers order more networking equipment from companies like Cisco and Ciena, demand will trickle down and boost sales of Finisar's fiber optic components. For now, the stock is trading at bargain basement prices based on its sales and earnings multiples:

Source: Yahoo Finance, Nov. 4

Finisar's current P/E of 17 sits at a three year low, while its PEG ratio of 0.82 suggests that it is undervalued based on forward earnings estimates. Of course, value stocks like Finisar will remain on sale until its current problems can be cleared up.

The road ahead
Although the fiber optics components market can be a bumpy one, it is expected to keep growing. According to research firm Ovum, the global optical components market grew 3% year over year in 2013 to $6.8 billion. While 3% growth isn't that impressive, Ovum expects demand in the WAN (wide area network) segment, which includes 100G components, to grow at a compound annual growth rate of 11% to $7 billion by 2019.

Finisar clearly made the right move by acquiring u2t Photonics and expanding into China, although both moves are currently weighing down its margins and scaring away investors. But long-term investors looking for a value play for today's wired world should keep a close eye on this stock.