Maria Riley - Director, The Blueshirt Group Thompson Lin - Founder, Chairman of the Board, President & CEO Stefan Murry - CFO & Chief Strategy Officer.

Simon Leopold - Raymond James & Associates Mark Kelleher - D.A. Davidson & Co. James Kisner - Loop Capital Markets Fahad Najam - Cowen and Company Richard Shannon - Craig-Hallum Capital Group.

Good afternoon. My name is Jaime, and I will be your conference operator today. At this time, I would like to welcome everyone to Applied Optoelectronics' First Quarter 2018 Earnings Conference Call. [Operator Instructions]. Please also note that today's event is being recorded.

And at this time, I'd like to turn the conference call over to Maria Riley, Investor Relations for AOI. Ms. Riley, you may begin..

Thank you. I'm Maria Riley, Applied Optoelectronics' Investor Relations, and I'm pleased to welcome you to AOI's First Quarter 2018 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its first quarter 2018 results and provided its outlook for the second quarter of 2018.

The release is also available on the company's website at ao-inc.com. This call is being recorded and webcast live. A link to that recording can be found on the Investor Relations page of the AOI website and will be archived for one year. Joining us on today's call is Dr. Thompson Lin, AOI's Founder, Chairman and CEO; and Dr.

Stefan Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give an overview of AOI's Q1 results, and Stefan will provide financial details and the outlook for the second quarter of 2018. A question-and-answer session will follow our prepared remarks.

Before we begin, I would like to remind you to review AOI's Safe Harbor statement. On today's call, management will make forward-looking statements.

These forward-looking statements involve risks and uncertainties as well as assumptions and current expectations, which could cause the company's actual results to differ materially from those anticipated in such forward-looking statements.

You can identify forward-looking statements by terminologies such as may, will, should, expects, plans, anticipates, believes or estimates and by other similar expressions.

Except as required by law, we assume no obligation to update forward-looking statements for any reason after the date of this earnings call to conform these statements to actual results or to changes in the company's expectations.

More information about our risks that may impact the company's business are set forth in the Risk Factors section of the company's reports on file with the SEC. Also, with the exception of revenue, all financial numbers discussed today are on a non-GAAP basis, unless specifically noted otherwise.

Non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation between our GAAP and non-GAAP measures as well as a discussion of why we present non-GAAP financial measures are included in our earnings press release that is available on our website.

Before moving to the financial results, I'd like to announce that AOI management will attend the Cowen Technology, Media and Telecom Conference in New York on May 30. We hope to have the opportunity to see many of you there.

Additionally, I'd like to note the date of our second quarter 2018 earnings call is currently scheduled for Tuesday, August 7, 2018. Now I'd like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO.

Thompson?.

Thank you, Maria. Good afternoon, everyone, and thank you for joining us today. I'm reviewing our first quarter results. AOI delivered revenue of $65.2 million and gross margin of 40%, which led to net income of $5.6 million or $0.28 per diluted share.

Our revenue came in slightly below our guidance as delivery of certain orders late into Q2 due to higher-than-expected employee turnover in our China factory as a result of the Chinese New Year. This order had been shipped in Q2. On a more positive note, market trends were in line with our expectations.

We couldn't believe in the first quarter we represent the pattern of a decline there in the demand we have seen over the past few quarters. There is an inventory condition has begun to normalize with our expectation been that in [indiscernible] will return to more normal level later this year.

We also currently expect 100G volumes to more than double in the second half of the year over the first half as we deliver on the committed orders we announced last quarter. We also met good profit in diversifying our customer base with nine design wins, including five for our 100G products and some of this design wins were with new customers.

In order to meet our customers' needs, AOI has continue to innovate both in new product development as well as in advance automation and the manufacturing process. Our recently announced 200G [indiscernible] prototype array is a great example.

With this new technology, AOI now controls production of both the laser and the [indiscernible], which are the more critical and expensive component required in the production of 200G and 400G transceiver.

We believe our continued innovation, vertical integration and our proprietary manufacturing process together set AOI apart from our competitor as a cost and quality leader in this high competitive industry. With that, I will turn the call over to Stefan to give you the details of our Q1 performance and outlook for Q2.

Stefan?.

Thank you, Thompson. Total revenue for the first quarter was $65.2 million compared with $96.2 million reported in Q1 last year. As Thompson mentioned, our revenue came in below our expectations due to slight delays in the completion of some orders as we work through higher-than-expected employee turnover in our China factory.

As you may know, many of our products are manufactured in our Ningbo, China factory, which experienced a shut down during the Lunar New Year. After the holiday, it is typical for some employees to stay or return to the factory on time or at all.

This can affect our ability to produce sufficient products to meet our demand, which was the case this quarter.

We were able to recruit the additional staff required in Ningbo but because we needed to recruit and train a larger number of employees than usual, the process of bringing these new employees to full productivity took longer than expected and some orders were delayed as a result.

We work closely with our customers to avoid any impact on them from these delays, which were only a few days in duration. Looking ahead, as Thompson mentioned, we believe that unit sales of our 100G products will more than double in the second half of 2018 compared with the first half.

This estimate is based largely on the committed orders we announced last quarter. While there will be some price reduction as volume increases this year, we believe that the percentage reduction in price over this time period will be less than we saw last year.

In Q1, our datacenter revenue came in at $50.6 million compared with $79.6 million in Q1 of last year. In the quarter, 41% of our datacenter revenue was derived from our 100G transceiver products compared with 35% last quarter, and 53% was from our 40G products.

We continue to maintain focus on diversifying our customer base and in the quarter had nine design wins, including five for our 100G products. We believe our cost leadership, scalable production capacity, in-house component supply and track record of innovation will allow us to be successful in this customer engagements.

As Thompson mentioned, AOI continues to innovate and expand our product portfolio. We recently announced the development of a 200G TAM4 tin photodiode rate that can be leveraged to produce 200G and 400G transceivers based on 50G technology.

With the development of this new technology, AOI now manufactures the two most expensive component required to produce 200G and 400G transceivers in-house, enabling us to maintain low cost and reduce our time to market for these products.

Regarding cost reduction on our current 100G products, during the first quarter, AOI successfully transitioned a majority of the optical multiplexer used in our CWDM datacenter transceivers to in-house produced parts. By the end of Q3, we expect the majority of the demultiplexers to be sourced internally as well.

Together, demultiplexer and demultiplexer pair represents the second-highest cost material in our CWDM modules just behind the active optical performance. By transitioning these to in-house produced parts, we are realizing significant cost reduction on these high-value components.

This continues our strategy of vertical integration as we have now brought the lasers, the photodiodes and the MUX in-house with DeMUX to follow in Q3.

The cost advantage, time-to-market and flexibility afforded us by bringing this components in-house is a significant factor in our success and one that is a source of competitive advantage with our customers.

At OFC, we showcased our full suite of next-generation technology, including our 200G and 400G transceiver products and 100G EML and DML lasers, and we are very encouraged by the customer response. We also discussed that during our OFC investor session, our new 400G high density light engine assembly, which extends our 40G and 100G platform to 400G.

We expect to leverage this mature, high quality and low-cost platform for years to come. Turning to our Cable Television market. We generated revenue of $10.6 million compared with the unusually strong $13.1 million that we generated in Q1 of last year.

Looking ahead, we continue to anticipate growth in this market, especially as demand for Remote-PHY picks up later this year. Our telecom products delivered revenue of $3.6 million compared with $3.2 million in Q1 of last year.

For the quarter, 78% of our revenue was from datacenter products, 16% from CATV products with the remaining 6% from FTTH, telecom and other. In the first quarter, we had 3, 10% or greater customers in the datacenter business that contributed 36%, 26% and 14% of total revenue, respectively. Moving beyond revenue.

We generated a gross margin of 40%, which represents a decrease of 100 basis points compared with the 41% reported last quarter. Our gross margin came in slightly below our expectations due to capacity on the utilization during the Chinese New Year, and higher-than-anticipated costs for training employees in Ningbo.

Total operating expenses in the quarter were $20.1 million, or 30.8% of revenue compared with $18.9 million or 23.7% of revenue in the prior quarter.

The sequential increase was mostly due to higher R&D expense as we invested in new production technologies that will enable further cost reduction on our transceiver products as well as 200G, 400G and Remote-PHY products. As a reminder, we expect R&D to remain at this level over the next few quarters, while we focus our efforts on these initiatives.

Operating income in Q1 was $6 million compared with operating income of $13.8 million in Q4 of 2017. Our operating margin in the quarter was 9.2% compared with the 17.3% reported in Q4 of 2017. During the quarter, we had a larger-than-expected foreign exchange loss associated with the settlement of intercompany accounts receivable balances.

This negatively impacted our non-GAAP income by approximately $1.2 million. Non-GAAP net income after-tax for the first quarter was $5.6 million or $0.28 per diluted share compared with $21.8 million or $1.10 per diluted share in Q1 of 2017.

GAAP net income for Q1 was $2.1 million, or $0.11 per diluted share compared with GAAP net income of $19.8 million or $1 per diluted share in Q1 of last year. The Q1 weighted average fully diluted share count was approximately 20 million shares.

We recognized approximately $0.3 million in tax benefit from employee options that were exercised during the quarter. Turning now to the balance sheet. We ended Q1 with $83.3 million in total cash, cash equivalents, short-term investments and restricted cash compared with $84 million at the end of the previous quarter.

As of March 31, we had $92.6 million in inventory, an increase of $16.9 million from Q4. The increase in inventory is primarily attributed to higher working process as we prepare for expected demand in Q2 in the second half of the year.

We made a total of $9.7 million in capital investments in the quarter, including $7.5 million in production equipment and machinery and $2.1 million on construction and building improvements.

We continue to expect our capital expenditures in 2018 to approach $109 million with the construction of our new factory in China, accounting for most of the increased spend compared to last year. Moving now to our Q2 outlook. We expect Q2 revenue to be between $75 million and $81 million, and non-GAAP gross margin to be in the range of 39.5% to 41%.

Non-GAAP net income is expected to be in the range of $7.8 million to $10.4 million, and non-GAAP EPS between $0.39 per share and $0.52 per share using a weighted average fully diluted share count of approximately 20 million shares. We expect our Q2 effective tax rate on our non-GAAP net income to be between 7% and 12%.

With that, I will turn it back over to the operator for the Q&A session.

Operator?.

[Operator Instructions]. And our first question comes from Simon Leopold from Raymond James..

A couple things I wanted to check on. One was from a longer-term perspective, I think you've given guidance for gross margin in a range of 41% to 45%. You're guiding a little bit below that for the June quarter, and I know this is one of the questions we get a lot given the Facebook commitment, worry about gross margin.

Can you talk about the longer-term gross margin trend?.

Yes, Simon. I think we still believe that we can, in the longer term, maintain that 41%-plus gross margin. Part of what's affecting us right that is of some inventory that we had to buy towards the end of the year and into the first quarter that was at a little bit higher cost than we what expect that inventory to be at in the longer term.

So that's pulling down the gross margin a little bit in this quarter and in Q2. The other thing as we mentioned in the call is we have a number of components that we're going to be bringing in-house. For example, we talked about the multiplexer and demultiplexer as well as the photodiode, and those components will also help us reduce costs.

So we do think we can get back up to that 41% range, but we have a little bit of work to do to get there..

And could you quantify how much, or can you quantify how much revenue has slid from the March quarter into June? I'm just wondering why given the timing issues with what happened in March, why the June outlook wasn't a little bit better?.

Well, as we noted in the remarks, it's just a couple of days' worth of production. So basically you could take our sort of average daily production and tuck on 2 or 3 days to that and that was the size of the slip. It was not that much.

We had significant orders in the quarter but we just couldn't ship all of them due to the personnel issues that we talked around Chinese New Year..

Okay. And one last one, Arista on its earnings call last week and yesterday at its analyst meeting indicated that it viewed the 100 gig optical transceiver market as having adequate supply now, and it wasn't clear what exactly they were alluding to given your 100G shipments, it doesn't seem as if you've open up the floodgates.

I'm just wondering what you're seeing in terms of in the marketplace of new capacity, competitive landscape?.

Yes, I mean, we continue to adjust our capacity as needed to make sure that we can meet the growing demand and the demand that we expect to see in the future. I think you mentioned earlier that we expect the second half to be a pretty strong second half to the year. So we're certainly preparing to meet that demand.

I don't if that answer your entire question there, Simon..

Well, any commentary on competitive landscapes because listening to the supply chains, for example, Fabrinet, it's not clear to us a significant volume of new supply could be coming from. And so I'm not seeing it, I'm just wondering what you're seeing in terms of supply from your competitors..

I mean, I think there's pretty good evidence that a couple of our competitors has either exited the market or are changing their focus in terms of the way that they attack the market.

So from that perspective, I think the biggest strength that we've seen is those competitors you know mostly big producers in the first place, basically changing the strategy or getting out altogether.

Whereas AOI has been the cost leader in this market, I think we continue to believe that we are the cost leader and I think in the long term, that's what it takes for us to continue to win these customer engagements as we mentioned in our remarks..

And our next question comes from Mark Kelleher from D. A. Davidson..

Just a follow-up on that last thought there. Let me ask it in a different way. Are you seeing any change, a couple have exited but there are a couple that's still in the market, very aggressively pricing.

Have you seen any change in that pricing dynamic?.

No, I don't think so. Look, our prices are generally negotiated well in advance so we think we have a pretty good handle on what prices are going to be in the future and we haven't seen anything in the pricing dynamic that's meaningfully changed from what it was before..

Okay.

And on those personnel issues that you encountered on the Chinese New Year, is that something that caught you by surprise? Is that something unusual? Is that something we should anticipate each March quarter? How odd was that, that you had that problem?.

Well, I think anybody that produces product in China has issues surrounding the Chinese New Year. That is there is typically factory shutdowns and there's personnel turnover around that time, that's definitely not unique to us, and it's something that the experience every first quarter.

What we have to do is take sort of an estimate on how many employees are going to come back and which employees, how many do we need to hire and that sort of thing. And obviously, this year, we were off by a little more than we expected.

But I think it's worth mentioning that we made so much progress over the last couple of years in terms of adding automation and thing. If you go back a few years, we had a much larger problem in the first quarter again, related to Chinese New Year.

This year, while there was some slip, it was relatively minor compared to what we've seen in years past and the way that we're doing that is by improving the automation so that we can retrain and rehire more workers and get them up to full productivity faster.

It's also worth noting that this year, the Chinese New Year was a little later in the year that it sometimes is and that also makes it a little bit harder for us that the employees in the door and sort of get them up to full speed and that still be able to ship by the end of the quarter..

Our next question comes from James Kisner from Loop Capital..

So really appreciate the comments about the second half and then return to a normal level and much more growth, doubling 100 gig. But can you help us just the overall revenue level for the year.

At this point, is it clear to you the visibility that you could actually grow your top line year-over-year versus 2017?.

Yes, so we don't really give that far out. It's still relatively early in the year. As we've mentioned, we've seen - we're looking at a pretty good second half. A lot of that is based on orders that we have committed, which is unusual for us to have that many committed orders in this early in the year.

But there's still a lot of work to do before we can confidently project what we're going to be for the whole year..

Okay, that's helpful. I guess, on inventory again, comment on that. You previously thought that you hope normal level in the first half and change obviously.

But any thoughts on the trajectory of inventory and what am I looking a couple quarters now either from a day standpoint or just an absolute kind of rough level inventory?.

Well, I think the inventory will come down on a dollar basis. As I mentioned we had some inventory build in our vendor management warehouse as well as some inventory and work in process and inventory in transit, meaning stuff that we have shipped prior to the end of the quarter that wasn't received at the customer by the end of the quarter.

So those things were the biggest source of the inventory increase over the last quarter included those things will burn down over the next quarter or two..

Okay. And just kind of last one here on the cables. I guess, it looks like maybe there was a bit of an inventory correction in your customer, a minor one and amendment of your biggest customers reported and talk about access and see that in Q1, recognizing Q1 is usually kind of seasonality weak for access that's unusual.

But has your guidance on would grow sequentially, I got the sense where you said that later this year in September, December you expect to grow year-over-year kind of from that as well?.

The commentary that we had for later this year relative to cable was specifically about the Remot-PHY that will start ramping this year. We do expect sequential growth in cable.

And it's worth mentioning too that part of the reason why our cable results were a little bit lower than would have otherwise been is that we did divert some of the personnel in China that were working on cable-TV products and put them on producing some of the datacenter products again, to try to make sure that we have minimal slippage on our datacenter delivery.

So there were some cable-TV orders also that we couldn't deliver in the quarter due to the manpower issues that we discussed earlier..

Okay. And I'm sorry, I lied. One last one.

Can you give any sense for the mix of TAM4 sequentially I know you don't disclose I'm just curious about the overall mix?.

Yes. I mean, we continue to see a trend towards more CWDM and less PSM. I think that's been a pretty consistent theme of ours for a number of quarters. I think there's others in the industry that have said similar things but this is his intimate to AOI. With us for the exact percentage as you know, we don't disclose that..

Our next question comes from Fahad Najam Cowen and Company..

But just one question on in terms of, if we delve into 100 gig CWDM4 versus PSM4, can you just help us in terms of understanding if CWDM4 made a portion of the mix?.

Well, again, we don't really break out. What we have as it is over time we expect CWDM to continue to grow and PSM will gradually decline..

Okay, appreciate that. And then circling back to a comment that Thompson had made earlier where you said that you expect the 1Q '18 to be the bottom in terms of demand from datacenters.

Can you help us understand in terms of the second half outlook, are you expecting growth from all your major cloud customers? And, in particular, with this one customer that's been what, 14% of your revenue, this seems to have been declining down.

Do you expect that particular cloud customer to start to ramp in the second half?.

This is Stefan. As you know, we have none disclosure agreements with our customers. We really can't talk about customer specific issues like that. What matters to us I think is that in aggregate we're seeing strong bookings ledger for the second half.

And as you mentioned a lot of that is, on the basis of contract that we have in place a referral confident in those numbers. What the other customers are doing obviously remains to be seen. There's student work to get them - to get their numbers anyway, but it's certainly it's not something that we're going to break out in the call..

I want to add on is you can notice, we have many design wins every quarter, and we have still many new customer on the [indiscernible]. We believe we can have [indiscernible] customer in this year, and we believe our market share will increase compared to last year..

All right, so just I understood, Stefan your response and Thompson, your response.

In terms of the second half outlook, you're expecting a broad base improvement from all your cloud customers?.

We're expecting a broad base improvement. Yes. Cloud-based customers together, we're expecting improvement there..

Got it, got it. Appreciate that. One more if I may come in terms of the new design wins, the 10 new design wins - I'm sorry, the nine new design wins, can you tell us a little bit more about these design wins.

Is it a Tier 1 NEM suppliers? Are they additional cloud suppliers? Just more qualitative insights on those can you give us?.

It's a mix. There are some that are datacenter operators, cloud tech datacenter operators and there are some that are OEMs. It's a good mix, which I think it's important to us and in one of the things that we're working very hard to do is to continue to diversify our customer base.

So that means different types of products, different types of customers, different types of end markets. And so making inroads into having design wins in some cloud-type customers but other cloud-type customers as well is important to us and I think we're making good progress there..

[Operator Instructions]. Our next question comes from Richard Shannon from Craig-Hallum Capital Group..

Maybe just one or kind of a two-parter here. You talked about some nine design wins in the quarter, five for 100 gig.

Wonder if you could tell us whether there any of them CWDM4 full spec, and if so, any of those helping you with your positive outlook for the second half of the year?.

We do have some design wins for CWDM and we actually don't remember off the top of my head if they were full spec or the like..

No, no. Most of them are full spec..

Full spec, I think is correct. And as far as whether it's contributing to our positive outlook for the year, yes, absolutely. I mean, I think it's worth noting, there's some of these design wins that could be really material to revenue, either in the second half are beyond. And there are some that the certainly smaller.

I don't want to oversell the design wins are huge ones but there's certainly some that can be material..

Okay. One last question for me. Wonder if you can discuss the opportunities you're seeing with the supplier to China cloud operators.

Customer base that hasn't existed with your volumes today but seems like it could be an opportunity once we can discuss what you're seeing there?.

Yes, we think we're making pretty good inroads into the China operators. I mean, by and large, those China cloud operators are smaller and scaled and certainly, many of the cloud titans that are sort of our traditional customer base. So we're making good inroads.

I think we had a number of design wins and some design win activity that's still ongoing but is looking very good. But again, compared to our large cloud titans, most of those Chinese companies are somewhat smaller in scale..

And our next question is a follow-up from James Kisner from Loop Capital..

So on 40 gig, can you just gave there's an updated perspective on kind of how fast that rolls off? So should be kind of taking revenue out of that 40 gig bucket as you put in 100 gig? Or is there maybe kind of a longer tailwind? Just any kind of texture on how we should model 40 gig will be helpful..

Well, I can't go too much into more detail on what we've already said. We think it'll decline. What's going on is that it's a little bit customer specific is we have some customers that are already transitioned virtually 100% to 100 gig. We have other customers that are continuing to use 40 gig.

I think it's probably fair to say that if you look back see a year ago or so, that 40 gig is probably hanging in there a little stronger than we would have thought at that time. But again, it's kind of customer specific. It's not across-the-board, the 40 gig is important to some customers and less important to others..

And ladies and gentlemen, at this time, this will conclude today's question-and-answer session. I'd like to turn the conference call back over to Dr. Thompson Lin for any closing remarks..

Okay. Thank you for joining us today. As always, we thank our investors, customers and employees for your continued support, and we look forward to seeing you at our upcoming conference..

Ladies and gentlemen, the conference has now concluded. We thank you for joining today's presentation. You may now disconnect your lines..