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

Simon Leopold - Raymond James & Associates Paul Silverstein - Cowen and Company Mark Kelleher - D.A. Davidson & Co. Alexander Henderson - Needham & Company James Kisner - Loop Capital Markets.

Hello, and welcome to the Applied Optoelectronics' 3Q '18 Financial Results Conference Call. [Operator Instructions]. Please note, this event is being recorded. I'd now like to turn the conference over to Maria Riley, Investor Relations for AOI. Please go ahead, ma'am..

Thank you. I'm Maria Riley, Applied Optoelectronics Investor Relations, and I'm pleased to welcome you to AOI's Third Quarter 2018 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its third quarter 2018 financial results and provided its outlook for the fourth 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 1 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 Q3 results, and Stefan will provide financial details and the outlook for the fourth 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, well, 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 confirm these statements to actual results or to changes in the company's expectations.

More information about other 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 our 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 Needham Network & Security Conference on November 13 and the Raymond James Technology Conference in New York on December 4. We hope to have the opportunity to see many of you there.

Additionally, I'd like to note the date of our fourth quarter 2018 earnings conference call is currently scheduled for Thursday, February 21, 2019. Now I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO.

Thompson?.

Thank you, Maria. Thank you, everyone, for joining us today in reviewing our third quarter results. AOI delivered revenue of $56.4 million and gross margin of 34%, which grew our net income to $2.7 million or $0.14 per diluted shares.

As we announced this September, our revenue was below our expectations due to an issue we identified with a small percentage of 25G lasers, which led to a temporary delay in 1 of digital receiver shipments to a datacenter customer.

As we work to troubleshoot the issues, we enact a solution quickly and with agreement of data customer, resumed shipments. The delay, however, resulted in softer-than-expected datacenter revenue of $39 million. We continue to have active engagement with this customer and believe we have a solid relationship.

Here at AOI, we are committed to a high standard of product quality and customer support. We believe our customer appreciates the measure we take to truly resolve any issues, and our aim is to go above and beyond.

While we are disappointed with our quarter performance, we've been encouraged by the demands we are experiencing with our other datacenter customers. In CATV, we are also pleased with increased activity and interest we are seeing in this market, especially for our Remote-PHY products.

We have continued to focus on expanding the reach of our product to a broad group of customers and diversifying our customer base. We are pleased with the progress we continue to make on this front. Building on the last design wins with the datacenter operator in China that we announced last quarter, in Q3, we secured 7 new design wins.

This brings our total number of design wins to 46 for the year, which includes design wins for datacenter in other segments. We also continue to make progress innovating across our optical platform, expanding our vertical integration.

We believe our platform, propriety manufacturing process and vertical integration are keys to our success in the market, and we remain focused on building on this solid foundations. With that, I will turn the call over to Stefan to review the details of our Q3 performance and outlook for Q4.

Stefan?.

Thank you, Thompson. Total revenue for the third quarter was $56.4 million compared with $88.9 million in the prior year period. Our datacenter revenue was $39 million compared with $65.8 million in Q3 of last year.

As Thompson mentioned, our revenue in the quarter was impacted by a temporary delay in 100G transceiver shipments to a datacenter customer as we work to troubleshoot an issue we identified with a small percentage of 25G lasers. We hold ourselves to a high standard and acted to resolve the quality issue.

We determined less than 1% of the lasers were impacted, implemented a solution and continued shipments using our internally sourced 25G lasers to the customer. We believe the measures we took to resolve this issue reflect our strong commitment to our customers.

Shipments have resumed to this customer, and we continue to have ongoing discussions and active engagement. We currently expect demand from this customer in Q4 to meet our earlier expectations. However, our production capacity in Q4 is expected to continue to lag demand, and this is reflected in our Q4 guidance.

The production capacity in Q4 will be negatively impacted primarily by additional product testing sets that we have implemented in order to further reassure our customer base that we have eliminated any potentially troublesome laser devices from our inventory, including work in process.

Most of these additional testing steps are temporary measures to screen existing inventory. In addition to the reduced production capacity, these costs will also temporarily increase our cost of goods sold and thus negatively impact our gross margin in Q4.

We continue to experience good demand with our other top datacenter customers and began shipping volume orders to a large Chinese datacenter operator. In the quarter, 63% of our datacenter revenue was derived from our 40G transceiver products and 34% was from our 100G products.

We continue to work diligently to diversify our customer base and remain in active qualification for our 100G and 200G products with customers outside of our core hyperscale customer base. In the quarter, we secured 7 design wins, including 4 design wins with 2 large U.S.-based equipment manufacturers.

This brings our total number of design wins to 46 for the year, which includes design wins for datacenter and other segments. As a reminder, our transceiver customer base has historically been focused on direct sales to datacenter customers.

So these design wins with the equipment OEMs are an important step as we continue our push to diversify our customer base. In our cable TV business, we continued our momentum in the quarter due to ongoing upgrade projects. We generated revenue of $14.3 million, up slightly sequentially and below the record $18.9 million reported in Q3 of last year.

We are very encouraged by the customer activity we see in this market, especially with our Remote-PHY product. We are currently in trials with 5 customers for our Remote-PHY product, and these trials appear to be going well.

At the recent SCTE Expo Conference in Atlanta, AOI was the first company to demonstrate Remote-PHY capability to 1.7 gigahertz, which is a significant technical achievement that will allow MSOs to unlock additional revenue-generating spectrum already installed in their plants. This technology was well received by many attendees at the conference.

Our telecom products delivered $2.7 million in revenue compared with $3.5 million generated in Q3 of last year. For the quarter, 69% of our revenue was from datacenter products, 25% from CATV products, with the remaining 6% from FTTH telecom and other.

In the third quarter, we had 4 10% or greater customers; 3 in the datacenter business that contributed 31%, 22% and 15% of total revenue, respectively; and 1 in the CATV business that contributed 15% of total revenue. Moving beyond revenue. We generated a gross margin of 34%, a decrease from the 40.4% reported last quarter.

Our gross margin came in below our expectations due primarily to capacity underutilization while we worked to resolve the inventory issue we experienced this quarter. Additionally, we incurred approximately $1.5 million in inventory write-downs related to the quality issue.

Looking ahead, we expect our gross margin to decline in Q4 due to the temporary increases in testing costs I mentioned earlier. We expect these additional costs to largely be eliminated by the end of the year and margins are expected to improve starting in Q1. Longer term, we remain committed to our 40% gross margin target.

Total operating expenses in the quarter were $22.8 million or 40.4% of revenue compared with $20.8 million or 23.7% of revenue in the prior quarter. The sequential increase was mostly due to higher R&D expense incurred to troubleshoot and resolve the issue we experienced in the quarter.

We expect R&D to remain at an elevated level for a few quarters as we continue to invest in new technologies and improve our execution. Our operating loss in Q3 was $3.6 million compared with operating income of $14.7 million in Q2 of 2018.

Non-GAAP net income after tax for the third quarter was $2.7 million or $0.14 per diluted share compared with income of $12.9 million or $0.64 per diluted share in Q2 of 2018. GAAP net loss for Q3 was $3.7 million or a loss of $0.19 per diluted share compared with GAAP net income of $8 million or $0.40 per diluted share last quarter.

The Q3 weighted average fully diluted share count was approximately 20.2 million shares. We recognized approximately $0.6 million in tax benefit from employee options that were exercised and restricted stock divested during the quarter. Turning now to the balance sheet.

We ended Q3 with $64.1 million in total cash, cash equivalents, short-term investments and restricted cash compared with $77.9 million at the end of the previous quarter. As of September 30, we had $107.9 million in inventory, an increase from $93.3 million in Q2.

The increase is largely due to products in production that could not be completed during the quarter due to additional reliability testing time required. Operating cash flow in the quarter totaled $7.5 million compared with $8.1 million in Q3 of last year.

We made a total of $21.4 million in capital investments in the quarter, including $14 million in production equipment and machinery and $6.7 million on construction and building improvements. This brings our total capital investments year-to-date to $57.9 million.

Before turning to our outlook, I would like to make a few comments on the tariff situation with China. AOI uses a variety of raw materials and manufactures a diverse set of products. While a small number of these are on the tariffs list, we believe there will be minimal impact overall from tariffs on AOI's business.

If the tariff situation changes, we continue to believe that we are well positioned to adapt and plan for such contingencies. As you know, all 3 of our locations are capable of manufacturing transceivers, with Taiwan and China both capable of manufacturing these products in high volume. Moving now to our Q4 outlook.

We expect Q4 revenue to be between $56 million and $63 million. Non-GAAP gross margin is expected to be in the range of 30% to 31%.

Non-GAAP net income is expected to be in the range of a loss of $1.5 million to income of $0.7 million, and non-GAAP EPS between the loss of $0.07 per share and earnings of $0.04 per share, using a weighted average fully diluted share count of approximately 20.1 million shares. We expect a Q4 income tax benefit of between $1.4 million and $2 million.

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

Operator?.

[Operator Instructions]. The first question comes from Simon Leopold with Raymond James..

So as I understand it, the fourth quarter is affected by the capacity limitation. Basically, the bottleneck is around the new quality control and testing that you have to do in order to assure that you've resolved all the problems.

Is that the correct way to think about it?.

Yes, Simon, that's correct. And just to put a little more color on it, as we mentioned, the additional testing steps -- a lot of the additional testing steps that we're implementing in the quarter are temporary steps, that is we're having to screen existing inventory, work in process, and that's what's temporarily affecting us in Q4.

There will be some ongoing additional testing steps, but those are expected to be much less than what we're seeing in the fourth quarter..

So presumably, this prevents you from achieving the $125 million commitment that you disclosed in the 8-K at the beginning of the year.

And I guess what I'd like to try to understand is, how does that dovetail into the contractual agreements? Is there some catch-up that then shows up at some point in 2019? Is the contract voided because of the issues? Could you help us understand the relationship between these two events?.

What I could say is that we think we'll probably deliver around $90 million of that $125 million in this year, and we continue to have a very strong relationship with this customer as well as our other datacenter customers. And we're working through this issue with them..

I guess, what I don't understand is, is there -- based on the way the contract's structured, is there sort of a make good whereas in basically the gap between $90 million and $125 million, that $35 million, does that get added to a 2019? Should we think of it that way? Or should we think of it as that business has gone? How should we treat that?.

And I can't give you too many specifics on it other than, I mean, to point out that the contract was filed along with the 8-K, so you can read most of those provisions in there. There isn't a specific provision in there to my knowledge that would be consistent with a sort of catch-up in the way that you're describing it.

However, as I mentioned, this customer continues to work very closely with us and they've agreed to take the commitment that they had given us in the fourth quarter, and we're still working with them on the time periods on that..

Great. And you did address this in your prepared remarks, but I want to make crystal clear that I understand.

In terms of the gross margin in the fourth quarter, it's really the effect of the extra testing that when you talked about the 40% gross margin is your long-term target, I presume, essentially, the pricing environment, your pricing agreements and commitments are unchanged from your prior assumptions and, therefore, once you get past this extra testing and these certifications that you're going for quality control, that the ultimate pricing environment and that 40% kind of gross margin is what we should think about beyond the fourth quarter?.

Yes. That's correct. I mean, the additional testing steps are what's negatively impacting us in the fourth quarter. The pricing environment was consistent with what we had expected, and we think that we can get back to that 40% gross margin target sometime in the future..

And just one last one, if I might.

In terms of the shortfall in your revenue versus what we all once expected, is it your sense that essentially the demand was unmet? Or do you suspect or have reason to believe that a competitor took that business?.

I think it's reasonable to believe that some of the business went to a competitor in the quarter.

I mean, I -- obviously, all of our customers have needs in terms of their datacenter requirements, and if one of their suppliers can't deliver it, then I think it wouldn't be surprising to see that a competitor picked up that share, at least temporarily..

And the next question comes from Paul Silverstein with Cowen and Company..

Stefan, I'm sorry to revisit the issue but I suspect we're all going to be revisiting the issue on this call.

In terms of the specific problem, I think where you referenced 25G lasers, can you give us anymore insight why was this isolated to that particular customer? I assume there is 1 or more lines that are dedicated to that customer as opposed to other customers.

But what is the nature of the issue? And with respect to your other customers, I assume there's concern if you had an issue with 1 customer, even if it was a small number of lasers, why aren't other customers concerned? Why should they believe this is isolated and, therefore, is not a larger issue? And why shouldn't that in turn impact your revenue with those customers now and in the future? What is that you can share with us?.

Yes, I think, Paul, basically, obviously I can't go into too many customer-specific details about this because we're covered by nondisclosure agreements with virtually all of our customers, but in very broad terms, every customer that we have has different sort of requirements, they operate in different environments and they have different expectations in terms of the performance of these devices.

And again, that's a very general statement, I recognize that, but I can't be more specific given the nondisclosure agreements that we have in place. But -- so within that context, right, every customer has different requirements, environments and expectations. We haven't seen this problem cropping up with other customers.

We've been proactive in going out to all of our major customers and discussing with them what we found, and I think the one thing that I could say is, I'm very proud of the team that we have here in terms of addressing this issue very quickly.

I think our customers appreciated not only the speed at which we were able to address the problem but our proactiveness, if you will, in going out and talking to the other customers and giving them the data, being very transparent about what we found..

So Stefan, the direct follow-up question would be, I trust you don't believe that the issues impacted your business with other customers? Or has it?.

I don't believe it has affected our business with other customers..

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

Maybe we could talk more generally about the competitive environment. You mentioned that you thought maybe some competitor had taken some of that market share there.

What are the pricing trends you're seeing? Are they consistent with what you've been expecting? Are you seeing any new competitors coming to the market?.

No. Pricing trends are consistent with what we had expected. And no, I don't really see any new competitors coming into the market..

All right.

The new Chinese datacenter customer, you said that just began ramping in the quarter?.

That's correct, yes..

And do you expect that datacenter customer to be similar in opportunity to the U.S.

datacenter customers?.

Yes. It's a customer that definitely has the potential to be as big as any of the other datacenter customers that we have in the U.S. It's one of the very largest datacenter operators in the world..

Okay. And maybe just a few thoughts on the CATV. Talk about what your expectations are there? I know you kind of highlighted that a little bit..

Yes, I think, we just recently finished the SCTE, Society of Cable Telecommunications Engineers Expo, which is sort of a technology conference for the cable TV business. It was earlier in October. And we had very good commentary, very good receptivity, I guess you could say, to our Remote-PHY product.

In particular, we were showcasing a 1.7 gigahertz Remote-PHY product at the show. To my knowledge, we were the only supplier that had such a product, and I think we're seeing very positive trends in the cable business. A number of the MSOs are either undergoing upgrade projects currently or are about to embark on upgrade projects.

That's true for North American MSOs as well as MSOs in Europe and Latin America as well. And we're seeing very positive signs in terms of both our existing products or sort of DOCSIS 3.1 product and this emerging new Remote-PHY product..

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

I was hoping you could talk conceptually about how we should be thinking about the CY19 time frame relative to the resolution of this issue.

And what the snapback might look like? Is it reasonable to think that as we get through -- fully through the testing process and start to move into '19, that ultimately you would get back to the type of numbers that had been out on the street beforehand than the expectations that you'd kind of implied for next year where you would be seeing a doubling of demand in a 100 gig from '18 to '19? Or alternatively, are we so constrained by the current situation that we haven't been able to add capacity at a rate that would have got us to that 2019 level that means that we'll be operating at a much lower level because we haven't been able to take our resources and ramp them in the third quarter and fourth quarter because of the troubleshooting problems?.

No. As I mentioned earlier, the additional testing that we've implemented is primarily confined to part of the third quarter and the fourth quarter. Beyond that, there won't be a lot of additional testing that we'll be doing, and certainly it's consistent with our ability to continue to ramp our production capacity.

If you look at our overall -- we don't give specific guidance more than 1 quarter out as you're aware, but in general, we still think that the volumes can double next year compared to this year.

Now admittedly that's on a little bit lower base now because we're -- we missed some of the volume shipments that we expected to have in the third and fourth quarter, but we still expect it to be able to double into next year..

Is it reasonable to say that you thought or you think you could double relative to your prior expectations before you ran into this issue? In other words, the true capacity would be there to supply the original expectations.

If you -- once this totally is resolved, assuming it's resolved by year-end, therefore, we'd be back to prior thought process to double your volume from the original expectations as opposed to from the lower base..

So the capacity will be put in place as needed to be able to achieve the demand that we see at the time. We don't have to add capacity now to have it ready by the end of next year, for example. So we're continuing to evaluate the needed capacity and add it as we need to.

With respect to doubling it, it's really too hard -- too early to have the crystal ball for the entire year, next year, I think there are certainly scenarios where we could double based on our prior expectations, but we feel comfortable saying we think we can double given where we actually came out in 2018 or where we expect to come out 2018..

And do you think that there is any lingering share losses as a result of this with the core customer that you were working with to resolve the issue with? Or is this just a dividend-ly trajectory in your back to where you would have been otherwise once it's fully resolved?.

It's hard to say right now. We're still working through this, and I can't really say for sure at this point.

What I can say what's really important for us is continuing to diversify our customer base, right? And we've made great success, and as Thompson highlighted and I mentioned in my remarks as well, we have 7 design wins in the quarter, 3 of those were for 200-gig products.

Several of them were with a new class of customers that is large equipment manufacturers as opposed to datacenter operators. So I feel very good where we are with our efforts in terms of customer diversification, both in terms of new products, new customers and new classes of customers, that is non-datacenter operators, for example.

So I think that effort is what's been taking primacy for us. It's our most important effort right now, besides, of course, getting back on track relative to deliveries to the customers that we have now. And I think, long term, that's really the most important thing for all of us to keep in mind for our business..

And one last question, I know you don't guide out to '19, but for the tax rate, I think you talked about 16% in the past.

Is that still kind of the ballpark that you are thinking for '19?.

It sounds about right. Actually, we haven't done our planning process in detail for 2019. So it's a bit early to give you a precise guess on the tax rate, but that sounds not unreasonable..

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

I just wanted to talk about the balance sheet a little bit. It looks like you burned some cash here. I'm just wondering -- in Q3, wondering what your expecting for cash burn in Q4.

And obviously, inventory buildup, a little of that product issue, are you anticipating you might have to write some of that off? Or do you expecting to be able to sell it all? And just kind of relatedly, what are your plans for CapEx? Are they adapted at all here just given the cash flow pressure in near term?.

That is a couple questions embedded in there. First of all, in terms of the cash balance, it was lower at the end of the quarter. A lot of that went into inventories.

We mentioned we have a lot of inventory that was partway through the manufacturing process and we weren't able to ship all of that out or complete the manufacturing and ship it all out in the quarter. So we expect that will come back down from here. We think Q3 was probably the high-water mark in terms of inventory.

So that will start turning back into cash, I think, as we move forward. You asked the question about capital expenditures, and as I kind of mentioned in my previous answer, we are evaluating our capital expenditures and the need to add additional equipment and what have you as we see the demand's shaping up.

So we don't have to buy equipment a year in advance in most cases, for example. We can do that much quicker as we see the demand's shaping up. So really, our CapEx is defined by what we see in terms of demand over the next couple of quarters, and we'll continue to adjust that as we need to.

And I thought there was another question embedded -- oh, you asked about inventory write-downs. We had about $1.5 million of inventory write-downs or reserves in the quarter. I suspect that should be -- most of that should already be -- I mean that's already flushed out in the balance sheet.

Now I wouldn't expect huge inventory adjustments in the fourth quarter but a lot of that depends on the testing that we have ongoing at this point..

Okay. It helps. And just sort of be -- you view this a little bit better. I mean, you can always talk about slowing hyperscale, I mean, in general and just given you're not shipping. Recently, maybe you 2 didn't have a good view on that.

But just, in general, thoughts on the hyperscale demand environment as we exit the year and begin kind of Q1? Is it -- are you seeing kind of a slowdown that others are also seeing?.

I mean, a lot of people have had slowdowns or talked about slowdowns in particular customers. What matters for us, I think, is that we have a few datacenter customers but we don't have all of them yet. And in particular, we talked about this Chinese datacenter operator and a few other operators that we're working very diligently to get.

So I think what matters to us mostly is continuing to diversify and adding new customers. And so whatever happens with our existing customer base, these customers, of course, are very, very -- they are very quick to react, they are very diligent about managing their needs in terms of bandwidth.

And so as we -- they change their forecast up and down all the time, and if so, the best thing that we can do to react to that, I think, is to get a more diversified customer base and make sure that we can average out any fluctuations that we might see over a larger number of customers.

And particularly, if we can get customers that are in different segments, like, for example, the equipment manufactures that we talked about earlier, they're primarily selling to an enterprise-type datacenter market, so that's a completely different dynamic and, I think, one that will help continue to further allow us to minimize our risk associated with any one large customer..

And this concludes our question-and-answer session, so I would like to turn the floor back to Thompson Lin for any closing comments..

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

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