Maria Riley - The Blueshirt Group, Investor Relations Thompson Lin - Founder, President, Chief Executive Officer, and Chairman of the Board Stefan Murry - Chief Financial Officer and Chief Strategy Officer.

Simon Matthew Leopold - Raymond James & Associates, Inc. Paul Silverstein - Cowen & Company Alex Henderson - Needham & Company Mark Kelleher - D.A. Davidson & Co. James Kisner - Loop Capital Markets Richard Shannon - Craig-Hallum Capital Group LLC.

Good day. I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics' Second Quarter 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

[Operator Instructions] Please note that this event is being recorded. I now will turn the 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 Second Quarter 2018 Financial Results Conference Call. After the market close today, AOI issued a press release announcing its second quarter 2018 financial results and provided its outlook for the third 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 Q2 results, and Stefan will provide financial details and the outlook for the third 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 note the date of our third quarter 2018 earnings call is currently scheduled for Wednesday, November 7. Now, I would 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. AOI delivered a strong second quarter, [was the result exceeding] [ph] our expectation, driven by increased demand for our market-leading datacenter products.

In the quarter, we generated revenue of $87.8 million, gross margin of 40.4%, net income of $12.9 million and $0.64 per diluted share. Datacenter was a bright spot in the quarter as we achieved record revenue for our 100G products.

In CATV, the demand environment continues to improve, and we remain encouraged by the customer activity and encouragements we see in the market. We are pleased with the success we have achieved with our marquee customers, but still continue to work to diversify our customer base.

In the quarter, we secured seven design wins, including one with a large datacenter operator in China. We are pleased with our result and continue solid execution in the quarter as the demand environment improves. Looking ahead, we do remain encouraged by the trend we see in the market.

We continue to expect 100G volume will more than double in the second half of this year over the first half, which is based largely on the committed orders we announced in Q1 of this year.

Additionally, we expect 100G volume to double again next year over this year, as data traffic continues to grow, requiring datacenter operators to expand their datacenters and upgrade their infrastructure to keep up with bandwidth demand.

In CATV, we continue to expect additional Remote-PHY and fiber-optic sales, that will drive growth in this segment later this year. We remain confident in our growth prospects and competitive position. AOI has developed and invested in technology and the manufacturing [platform that are ours to be the cross] [ph] leader in this evolving industry.

Our proprietary optical platform goes back a number of years and was specifically designed to be manufactured at scale with high degree of automation. Our platform has been a [applied to data rate] [ph] from 40G to 200G. And we expect it to be used in our 400G products as well.

We also continue to innovate across our optical platform and expand our vertical integration and optimize the cost structure of our transceiver products. For example, between now and end of this year end of this year, we plan to in-source an additional 15% of the bill of materials for our 100G Coarse WDM transceiver products.

We believe our platform proprietary manufacturing process and vertical integration are keys to our success in the market, and remain focused on building on this strong foundation to position AOI for further success. With that, I will turn the call over to Stefan to review the details of our Q2 performance and outlook for Q3.

Stefan?.

Thank you, Thompson. Total revenue for the second quarter was $87.8 million, which was above our guidance range of $75 million to $81 million. As Thompson mentioned, the upside in the quarter was driven by increased demand for our market-leading datacenter products.

Our datacenter revenue came in at $69 million, compared with $99.3 million reported in Q2 of last year. Our performance this quarter was driven by record revenue for our 100G products. In the quarter, 58% of our datacenter revenue was derived from our 100G transceiver products and 39% was from our 40G products.

We are encouraged by the customer traction we are generating with our 100G products. Looking ahead, we remain confident in our opportunities for growth.

As Thompson mentioned, we continue to expect 100G volumes to more than double in the second half of this year over the first half, which is based largely on the committed orders we announced in Q1 of this year. We also expect volumes to double next year over this year.

We believe this strong growth is a reflection of accelerating data traffic trends that will require datacenter operators to expand their datacenters and upgrade their infrastructure to keep up with the higher bandwidth demand. We believe the new innovative technologies and techniques that we have developed position us well to build on our momentum.

The cost advantage, time to market and flexibility afforded us through our vertical integration is a significant factor in our success and sets us apart from the competition. As we continue to innovate including our plan to in-source an additional 15% of the bill of materials for our 100G CWDM transceiver products by the end of the year.

We remain focused on providing our customers with the best product at the best cost and have a roadmap for continued cost reductions by additional manufacturing efficiency improvements, and increasing the extent of our vertical integration. We are also adding additional testing steps that are required by certain customers.

In the short-term, these additional steps will constrain our manufacturing throughput somewhat, but we expect to once again have sufficient capacity to meet demand in Q4 of this year. As Thompson mentioned, our proprietary optical platform is also a key factor and optimizing the cost structure of our datacenter transceivers.

The platform was specifically designed to be manufactured in an automated way, did not only provides us with the levers to reduce cost, but also provides a manufacturing process that can be leveraged across many product generations.

The same platform has been leveraged across 40G, 100G as well as 200G, which we just started shipping in volume last quarter. And we expect to leverage this mature, high-quality and low cost platform for many product generations to come.

We also continue to maintain focus on diversifying our customer base, and in the quarter had seven design wins, including a 100G design win with the large datacenter operator in China. We believe our cost leadership and track record of innovation will allow us to be successful in many of these new customer engagements.

Turning to our Cable Television market, we generated revenue of $14.2 million, up 34% sequentially, and similar to the $14.4 million we generated in Q2 of last year. We are pleased with the improving trends we are seeing in CATV, and continue to expect growth in this market, especially later this year when demand picks up for Remote-PHY product.

We have three different customers moving into field trials with our Remote-PHY product. And an additional customer, who was in the demonstration phase with the technology. The broad-based interest in Remote-PHY by the MSO community is encouraging. And our products has already been demonstrated to interoperate with several CMTS vendors.

So we believe that we lead our competitors in terms of time to market for this technology. Our telecom products delivered a record $4.2 million in revenue, representing 35% growth year-over-year, with demand coming from ongoing deployments of advanced mobile telecom networks around the world.

For the quarter, 79% of our revenue was from datacenter products, 16% from CATV products, with remaining 5% from FTTH, telecom and other. In the second quarter, we had three 10% or greater customers in the datacenter business that contributed 52%, 16% and 10% of total revenue respectively. Moving beyond revenue.

We generated a gross margin of 40.4%, which represents an increase of 40 basis points compared with 40% reported last quarter. Our gross margin was in line with expectations and I am pleased with our ability to continue to generate strong gross margins compared to the industry.

Total operating expenses in the quarter were $20.8 million, or 23.7% of revenue compared with $20.1 million or 30.8% of revenue in the prior quarter. The sequential increase was mostly due to higher R&D expense.

As a remainder, we expect R&D to remain at this level over the next few quarters, while we invest in new production technologies that will enable further cost reduction on our transceiver products as well as our next-gen datacenter and CATV products. Operating income in Q2 was $14.7 million compared with operating income of $6 million in Q1 of 2018.

Our operating margin increased in the quarter to 16.8% compared with 9.2% reported last quarter. Non-GAAP net income after-tax for the second quarter was $12.9 million or $0.64 per diluted share compared with $5.6 million or $0.28 per diluted share in Q1 of 2018.

GAAP net income for Q2 was $8 million or $0.40 per diluted share compared with GAAP net income of $2.1 million or $0.11 per diluted share last quarter. The Q2 weighted average fully diluted share count was approximately 20.1 million shares.

We've recognized approximately $0.3 million in tax benefit from employee options that were exercised and restricted stock that vested during the quarter. Turning now to the balance sheet.

We ended Q2 with $77.9 million in total cash, cash equivalents, short-term investments and restricted cash compared with $83.3 million at the end of the previous quarter. As of June 30, we had $93.3 million in inventory, a slight increase from $92.6 million in Q1.

We made a total of $21.2 million in capital investments in the quarter, including $9.9 million in production equipment and machinery, and $9.5 million on construction and building improvements. This brings our total capital investments year-to-date to $30.9 million. We now expect our capital expenditures in 2018 to approach $90 million.

The lower revised CapEx forecast for the year reflects more efficient utilization of existing manufacturing equipment and does not reflect a reduction in expected production capacity. This figure also includes the beginning of construction of our new factory in Ningbo, still currently on schedule to be completed in early 2020.

Lastly, I would like to make a few comments on the tariff situation with China. As you know, AOI operates three different manufacturing locations, only one of which is in China. All three locations are capable of manufacturing transceivers with Taiwan and China both capable of manufacturing these products in high volume.

Because of our vertical integration strategy, we also manufacture many of the components and subassemblies that are used in these modules.

The diversity of our manufacturing operations both geographically and in terms of the types of products manufactured gives us significant flexibility and adapting our production location in order to maximize cost efficiency.

As political condition changed, we believe that we are well-positioned to adapt and will continue to plan for such contingencies. Moving now to our Q3 outlook. We expect Q3 revenue to be between $82 million and $92 million. Non-GAAP gross margin is expected to be in the range of 40% to 41.5%.

Non-GAAP net income is expected to be in the range of $11.1 million to $15.2 million. And non-GAAP EPS between $0.54 per share and $0.75 per share using weighted average fully diluted share count of approximately 20.4 million shares. We expect our Q3 effective tax rate on our non-GAAP net income to be between 6% and 12%.

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

Yes, thank you. We will now begin the question-and-answer session. [Operator Instructions] At this time, we will pause momentarily to assemble the roster. And the first question comes from Simon Leopold with Raymond James..

Great. Thank you for taking the question here. I wanted to just follow-up on your commentary around tariff. In that, I understand you've got some flexibility in terms of when you manufacture. But it does appear you are investing in adding capacity in the China facility, in a scenario that we now see in place.

I think the $34 billion or so of existing tariffs. Do you have exposure to those or do you simply have exposure to proposed tariffs above and beyond that? I'm looking for a little bit more detail and an understanding of, if tariffs come in place, could you manufacture what you need out of Taiwan and the U.S.

without having a penalty?.

Hey, Simon. So the initial $34 billion tariff list, none of our products are on there, at least none of our major products. We are still doing an analysis on all of the smaller ones, but there is basically no impact from the initial tariff list. Some of our products are on the subsequent larger, $200 billion tariff list.

And the point of what we were trying to say in the prepared remarks is that we do have capability to manufacture those products in both locations. And we think there will be minimal impact from those tariffs on AOI's business, if any..

Okay. So minimal impact, I think that's the additional color I was looking for.

I also was hoping you could update us on the competitive landscape and maybe some color in terms of at-your-top customers, are you the primary supplier, a secondary supplier? Does a secondary supplier always exist? And how has that changed over the last quarter or two? Thank you..

Yeah, so as it has been for the - I mean, last several quarters, I mean, we believe we continue to maintain a leadership position with our major customers. I don't think there has been any major changes in our competitive positioning relative to the competition.

And I do think that the tariff situation, since you brought that up, I think that customers are aware of those tariffs. It's certainly something that they are concerned about, because anything that adds cost to their total cost of ownership for their equipment is something they're concerned about.

And so, I think AOI's flexibility is also something that they find attractive..

And you've talked about a customer, who in the past was your largest customer, probably isn't today. That customer, I believe was absorbing inventory and had also some architectural shifts. I think the adoption of smart-NICs was one of the factors affecting some of the demand for transceivers.

Can you give us a snapshot of where you see your previous top customers' position today in terms of inventory and purchasing patterns, the outlook? Thank you..

Yeah, so as we said last quarter, I think we expected the inventory to normalize with that particular customer. I mean, that's what we've seen, the inventory is down to what I would consider to be a normal level, consistent with the amount of business that we see and expect to see from that customer..

Great. And one last one and this may be difficult to answer. But maybe some blue sky thoughts.

When you look at these hyper-scale operators and their CapEx investment, when they build a new datacenter, acquire the land, do the construction and have a shell of a building, how long, what's the period of time that you've observed it takes them to then fill the building with electronics? How long is the tail for AOI, once the structure is built? Thank you..

Well, Simon, I think that's not something that I can easily comment on. I think it probably depends customer to customer. To be clear, we don't always have a lot of insight into which specific datacenter and what building stage it is, and that sort of thing. So it's not really something I can speculate on.

I know that the customers as anybody just trying to make a large capital investment. The customers are very eager to get the datacenters turned on as quickly as possible. Often times, there is a lot of pressure on us to deliver quickly in situations where they're building a lot of new datacenters.

So I know that there is a need to get that CapEx deployed and operational as quickly as possible. But as to how long that takes, I couldn't speculate an exact length of timing..

Yeah, understood. Thank you for taking my questions..

Thanks, Simon..

Thank you. And the next question comes from Paul Silverstein with Cowen..

Thanks, guys. First off, I assume the significant EPS spread reflect the concentration of your business in the lack of - a better way to put it, lack of significant visibility or is there something else in that spread? And then, I've got a couple of follow-ups..

No, I mean, the spread is - I think you're referring to the spread between the lower end and the higher end of the guidance range, being a little bit wider this quarter. I think it just reflects our desire to be prudent and make sure that - given the uncertainties that we see, that we're encompassing all the range of possibilities..

So, nothing extraordinary, Stefan?.

No, not..

Maybe other than you're being more conservative than usual?.

I don't know if it's - I guess, you could say it's more conservative than usual. I think we're attending to - try to encompass the range of possibilities that we see out there. And, I guess, you could say that's more conservative, sure..

All right. And then two related questions, first off, pricing environment, so the 100G, 40G, any update you can provide us with, if [ph] there is an update. And then on the other side of the equation, I heard your comments about cost reduction in general.

I'm hoping you can give us some quantification of the recent - or reminder of the cost reduction to date and any quantification of cost reduction going forward in the future..

So the pricing environment maintains - it's consistent with what we expected. I wouldn't say there is anything surprising in the pricing environment that we've seen or we're seeing in terms of our expectations for the pricing going forward.

In terms of the cost reduction, I think what we said is that, we've had - historically, we've obviously been able to reduce the cost at a rate that is very close to the price reduction and we expect to continue to be able to do so..

One final one for me, with respect to the seven design wins, especially the big one in China, I know it's hard predicting timing, but any sense you can give us for when you expect that to roll out, initial roll out and meaningful revenue? And I know that's not necessarily one and the same..

Just as reminder, I mean, for us a design-win, when we announce a design-win it means we've already got orders. And in fact, we're already shipping to this customer right now. And now, as with any large new customer engagement, it doesn't happen overnight, it takes some time.

But we have meaningful revenue that we expect to get from this customer in this quarter and I would anticipate that overtime they'll continue to grow..

I appreciate. I'll pass the line. Thank you..

Thank you..

Thank you. And the next question comes from Alex Henderson with Needham & Company..

Great. First question I'd like to ask is just around the 400 gig timeline. It seems like that it's got a lot of attention on the street. But it still seems like it's kind of back half of next year before that starts to become a meaningful factor. So is that consistent with your expectations.

And how would you expect the 100 gig trajectory to manage through that initial ramp of 400 gig? I would assume that 400 gig will be small to really undermine the 100 gig growth anytime, even in the 2019 timeframe.

Is that right way to think about it?.

Yeah, Alex, so I think the 400 gig, it depends a little bit on which customer you talk to as to their urgency behind 400 gig. There are some customers who are pushing very hard for 400 gig. We've had customers in house very recently, evaluating our 400 gig solution.

And I think that they're very interested in seeing that solution into production as quickly as possible. Then we have other customers that really frankly are still getting their feet wet in 100 gig and aren't likely to be pushing 400 gig anytime soon. So I think there is a diversity among the different customers.

I would say back-half of next year is probably a reasonable timeframe to see any kind of meaningful revenue from that, although, again, some customers would like it earlier.

But I think realistically as we saw with 100 gig, customer desire to have it doesn't necessarily translate into the entire ecosystem being ready to actually supply it in meaningful quantity.

So I think we're looking at back-half of next year for some customers and longer than that for other customers, so which gets to your second question about kind of the tail or the timeframe for shifting over. I think that 100 gig is - has a long road in front of it. I think there is long ways to go before that gets meaningfully supplanted by 400 gig.

Again, certain customers may move a little faster, certain customers may move a little slower in that direction. But I think there is quite a lot of growth continuing in 100 gig for the foreseeable future..

The second question I for you is really around the pricing structure, the rate of decline last year and the back half versus what seems like somewhat of a moderation of that rate of decline in the first half.

And it sounds like you're suggesting that that moderation is going to persistent to the back half still declining, but at a more normalized rate.

Have we seen some of the large players that have been trying to get into the market moderate the aggressiveness of the price? Or has it been a challenge for some of those players to deliver the product? How do you see the competitive landscape relative to the ability to execute versus aggressiveness, and pricing if you could press between those two?.

Well, I think, I guess, probably best way for me to put it is, there seems to be a number of competitors, who perhaps have been very aggressive on price to try to get business, but really have had difficulties scaling up to the level of demand that's required.

So when you talk about price pressure, I think, you have to take both the quoted price that you will from the competitor and their ability to actually deliver. They have had both of those conditions in order for it to be a meaningful threat for us.

And I think, AOI's scale, our demonstrated track record over multiple product generations in the datacenter. And the knowledge that we have and how to switch from one generation to products, say, 40 gig to 100 gig, and manage through those transitions.

I think, that something that our customers find value in, and not all of our competitors I think have that value of experience. And so, I think some of them are perhaps struggling to meet the demand that they've encountered by their pricing..

And one last question, then I'll see the floor.

Any comments around PSM? Is that now pretty much a non - a de minimis portion of your business at this point? Or are you still involved with that?.

We are still shipping PSM, I mean, as we've said for a number of quarters, I mean, CWDM, we feel like is a more attractive technology in most applications from most of our customers.

And we have expected for some time that CWDM products would predominate over PSM and we probably take even greater share, and that's what we're seeing and I don't expect that to change..

Right. Thank you. Very helpful..

Thank you. And the next question comes from Mark Kelleher with D.A. Davidson..

Great. Thanks for taking the questions.

When you sign the contract - the supply contract with Facebook, the thinking I think there with Facebook was that there may be a situation where supply was in question? With the new deal, you've got ramping in China, how close do you think you're going to be running to full capacity?.

Well, as you noted in our prepared remarks, I mean, we are basically running at full capacity this quarter. And we're going to running our intention is to run very close to capacity.

So we are investing a new production facilities, you noted in our prepared remarks as well that we continue to have a very aggressive capital expenditure plan for this year, not quite as high as we had forecasted earlier, but that's because we think we get more efficiency out of the existing expenditures that we're planning on making.

But it's still a 40% increase or so over the last year, in terms of the level of CapEx, and last year was our previous record year. So we're clearly continue to invest in additional manufacturing, and our goal is to keep pace with the demand that we see as conditions improve..

And the China facility, isn't do online until the end of 2019, is that correct?.

Early 2020..

Early 2020. So you are looking to double volumes in 2019 without the China facility..

That's correct..

Okay, [therefore we are talking with] [ph] adding more equipment, more important is automation, so we can increase the circular [ph] lot both in Taiwan and China. So the investments only for China works through, we are investing a lot of CapEx in Taiwan too, the special automation..

Okay. And that's leaves to me my next question. Can you just kind of run us through the vertical integration plan that you've got, I know, you've talked about certain components - certain components you're going to be manufacturing internally.

Can you just review the timing of bringing those inside?.

Well, I don't want to get too specific on that, I think, I am sure many of the competitors would love to know our specific plans, but how we're going to continue to reduce costs. I don't really want to provide that information publically.

But what I can say is, look, there is a large amount of the bill of materials that we still do not manufacture in-house. We can bring more than in-house.

I think, as Thompson mentioned in addition to bringing those components in-house, and we did talk about on the call the fact that we plan to bring about 15% more of the bill of materials in-house by the end of the year.

But in addition to just in-sourcing more parts, very important is continuing to improve the automation, improving the yields, and making the manufacturing process more efficient.

I think that's going to be an increasingly important part of our cost reduction strategy moving forward and this one that I think we spend a lot of time and a lot of efforts fine tuning over the last year two..

All right. And one last numbers question, just to check something. You said 58% of the datacenter revenue was 100 gig, 39% 40 gig. I think that leaves 3%.

Is that 3% 200 gig?.

Some of its 200 gig and some of it is some 10 gig still remaining..

Okay. Thanks. That's it..

Thank you. And the next question comes from James Kisner with Loop Capital Markets..

So just a quick housekeeping.

Do you guys, was the cash from operations figure?.

It's in our 8-K. You can look at it. I can give the number if you want..

Yes, I want..

Yeah, it's about $22 million - sorry, minus $4 million for the quarter..

Okay..

That was Q1, I'm sorry, $22 million for the quarter, net cash using divided by operations..

Okay. So I just want to clarify something, I know you said most of times now 100 gig is like double half over half and you've outperformed this Q2, and sounds like the 100 gig was a big driver of that. I'm just wondering given that now, you perhaps have outperformed 100 gig volumes at the front half.

Does that mean that your sort of forecast for the second half is sort of gone up what we thought it might be volume wise for 100 gig, versus where it was a quarter ago?.

No, I don't think our outlook has changed much from a quarter-ago. I think, the fact that we have a large portion of our business that's coming from, I would say, secure - more secured contracts, we've had in the past makes our visibility a little bit better typically. And so I think, nothing has changed really in our outlook from before..

Okay.

Can you talk about the impact of currency on your margins both gross and operating here, I guess net income margin in this last quarter, and the impact on, do you expect in your guidance?.

Yeah, I mean the currency consideration doesn't change margin for us too much. We have most of our raw materials and things that we purchased are in U.S. dollars. And we have - I wouldn't say exactly equal flow, but we have flow both directions between dollars and renminbi, and dollars and new Taiwan dollars.

So it doesn't have a great impact on our gross profit..

Okay. Last one….

Okay, that for the operating expense or the difficult [ph] in China..

Yes, yeah. [indiscernible] Thompson was pointing out that it does lower our - the depreciating RMB lowers our labor cost obviously in China..

Okay.

And also this has been a topic in the past about your customers, you're kind of in run going to the manufacturing partners and making their own white box transceivers in this quarter, obviously, I'm sure you saw that the competitor, another player in this space talked about that becoming a more serious effort again after kind of head fate [ph] 18 months ago.

I'm just wondering, if you give any updated thoughts on that, is that something that you're going to be worried about at all? Just any updated thoughts on kind of white box transceiver idea would be helpful. Thanks..

Well, I think, making transceivers is a very technically difficult proposition, it's not like electronic manufacturing, where it's kind of got a standardized process that virtually any factory can perform.

In optical manufacturing there are specialized processes and in particular for us and for the designs that these very high performance high-speed modules. There is quite a lot of specialized equipment and know how that goes into doing it. So it's not as easy as it may seem to manufacture of these transceivers.

And I think some of the competitors that have attempted to do this in the past have had let's just say mixed result. I am very confident in the work and that we put into cost reduction, automating our production, really fine tuning those things and there is still more work on going in that respect.

And so, I think, we are in a good place relative to the competitive business strategies that we see out there..

And I can see something missing in this model is not radio, who is responsible for year loss for the automation, for the manufacturing process improvement, who is responsible for the quality issue? This is not clear. I think, there is still many issues in this model. I don't think it really work. All right.

And I believe it comes from manufacturer like people in Taiwan. I don't believe there will be responsible for this kind of job. So who will it be responsible, okay. Will be the end-customer responsible for this, but I don't think really do they have the right people to take the order to see, it's become a lot of empower. It's not easy.

And AOI is a very healthy, always been many years. So how do to automation we know how to improve the process. This is very important. The year could be very big different between company from 72% to 95%, is a huge difference. So whose is responsible. So there's many questions that need to be answered..

Thank you..

Thank you. And the next question comes from Richard Shannon from Craig-Hallum..

Hi, Thompson, Stefan, thanks for taking my questions. A couple for me, first of all, Stefan, I think, in your prepared remarks, you talked about a headwind for the quarter due to testing going on.

Can you help us understand, what's going on there and when does that headwind evade?.

Yeah, so we were saying in the prepared remarks, is that we are implementing some additional testing procedures, as we continue to diversify our customer base. Different customers have different requirements in terms of what they expect to see relative to design testing and so on and so forth.

So we're undertaking some additional testing steps in the manufacturing. So that will - what it does is it adds a few days to our manufacturing throughput. It takes a little bit longer to manufacture the transceivers, it doesn't - it's not going to meaningfully impact of the cost of the modules.

But it will link them the time that it takes to manufacture them. So in this quarter we expect that to constraint our production. In other words, there will be more demand than we can supply in this quarter, but as we said in our prepared remarks by the fourth quarter - early in the fourth quarter we expect that to be normalize..

Okay.

And is that referring to, is that something you're doing for a current customer or a new one? And is that with what one specific SKU or over across multiple ones?.

It applies the multiple SKUs and it applies the multiple customers. It's data that we need to take to get a large enough sample size for some of the statistical analysis that we need to do for certain customers, including some existing and new customers, so we're doing that across the board..

Got it. Okay. Makes sense. Another question again in datacenter, your 40 gig revenues have stayed, I would say, largely flattish for a few quarters, you talked about that that product line eventually trailing off.

Any updates on your thought process there, is that continuing current levels or is that you see any eminent decline there?.

I think, it's going to continue to tail off, but I don't see an eminent falling off of the cliff, I think, we said for some time that 40 gig. Actually, 40 gig has been somewhat surprising in its resilience, but it's a testament I think to the fact that the economics of 40 gig. And some instances for certain customers are still very good.

So I wouldn't expected to dramatically drop off any time in the near future. But I would expect over time to that it will continue to tail off gradually..

Okay. Helpful. Next question for me. You mentioned the expectation of doubling your volume in 100 gig in 2019 over 2018.

When you say volume is that sales or units comment?.

That's unit..

Yeah, okay.

And then follow-up on that specific topic is, do you expect this doubling, is that to happen over kind of a broader base of customers, do you think it will be more narrow profile?.

Well, we see a number of customers - I mean, it's a combination of factors, right. We see some customers that I think are anticipating growth in their infrastructure. So that is purchasing more products from us next year.

And we also see new customers like the China datacenter customer that we talked about that we expect to come onboard that will contribute. So it's not just one factor, it's a preponderance of the multiple different things that we are looking at..

Okay.

Last question for me, you mentioned 200 gig that you're shipping into a design win for production volume or testing? And then, what's your expectation of kind of ramp of that over some period of time, next two to four quarters or so?.

It's for - I would say - I guess, you could call it field trials or sort of advanced deployment testing. And as far as the ramp-up, 200 gig, I think, our viewpoint on 200 gig is that it's not going to be widely used. I think there is going to be a few customers who have interest in it. Many customers, it's not the direction that they're heading.

400 gig is clearly a bigger - 400 gig shares wider acceptance I would say in the customer base. But for us 200 gig is important because it is a stepping stone for us to get to 400 gig and I think that's probably the most significant part for us..

Got it. Okay, that makes sense. I think that's all the question for me. Thanks for taking those..

You're welcome..

Thank you. And the last question is a follow-up from Paul Silverstein with Cowen..

Hey, I appreciate you taking the follow-up. I just want to clarify, I hope you clarify. With respect to the comment about you being maxed out on volume, on supply, I know you've got new supply that's going to be coming online.

But, Stefan, going back to your comments about China not being in meaningful risk and your ability to move manufacturing around, I'm just trying to reconcile, if you are maxed out at all of our facilities, it doesn't - what am I missing in terms of your room to move manufacturing around if need be?.

Well, I don't want to get too specific on our plans, Paul, because, look, there is a lot of - there is a lot that's still up in the air here with respect to the tariff situation. I mean, as I mentioned, the tariffs aren't even passed yet, as you know.

So what I'm saying is there are a number of different manufacturing steps that go into the manufacturing process for these transceivers as you know. Currently, we do all of those steps in several locations.

One possible thing that we could do, for example, is do a portion of that manufacturing in one location and then move into a different location to do the rest of the manufacturing. We could also segregate it by customers.

We do have significant customers in China and other parts of the world that are not subject to tariffs, so for example, many of our - even our U.S. customers, many of them have operations in Europe or other places that would not be subject to the tariff.

So we could potentially manufacture products for places or customers that are not coming back to the U.S. in China and do other customers or other geographical locations in Taiwan. So there are a lot of things what we can do. I was merely pointing out….

But the other point is there is still R&D space. If we use all R&D space in Taiwan, in China, we can more than double our capacity for transceiver. And for us, with the 40G going down, we can convert 40G transceiver manufacturing capacity into 100G next year.

So otherwise, I can probably think about is the resource space and new China facility will not be ready until 2020. But that's not the point. We got more equipment in Taiwan, increase capacity in Taiwan..

Got it. [One] [ph] guys, one last clarification. Stefan, I heard your comments that you don't want to get into the details in the bill of materials in terms of in-scouring. But I just want to clarify something.

I think the last time you publically referenced the percentage of the BOM that you had brought in-house to your plant and so I thought the number was 60% to 65%. Maybe my memory is not serving me.

But the 15% you referenced today, is that new and different on top what you previously announced or is that part and parcel of what you had previously announced?.

I think that - I don't have that statement in front of me either, Paul. But I think what we're talking about previously was that, we see ourselves being able to eventually in-source 60% to 65%. The 15% is what we have plans to do between now and the end of the year..

15% is just on top of wherever you're at?.

On top of where we are - yeah, at the end of Q - in other words, how much is the bill of materials - say, we had a $100 bill of materials, right. And at the end of Q2, say $50 of it was already in-sourced.

Adding 15% additional to that we get us up to 65% of the bill of materials in sourced, right? That's what I'm trying to say, by the end of the year..

Right, and are those the numbers or you're just giving us the hypothetical?.

Oh, no, no. That's just - it's a mathematical example. I'm just trying to provide you clarity into the math that I'm trying to - that I'm going through in the earnings call. Those are not….

Understood and you clearly don't want to provide those exact numbers, is that correct?.

Yes, I'm confident that there are a lot of people out there in our competitive universe that would love to know exactly what our cost is and what it will be by the end of the year. But we're not going to get that information out..

Just wanted to give you the option, all right, I appreciate it. Thanks, guys..

Thanks, Paul..

Thank you. And this concludes our question-and-answer session. I would like to return the conference to Dr. Thompson Lin for any closing remarks..

Okay. And thank you for joining us today. As always, we thank our investors, customers, employees for your continued support..

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines..