Good day and welcome to the Applied Optoelectronics First Quarter 2019 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Maria Riley, Investor Relations for AOI. Please go ahead..

Thank you. I'm Maria Riley, Applied Optoelectronics' Investor Relations, and I'm pleased to welcome you to AOI's first quarter 2019 financial results conference call. After the market closed today, AOI issued a press release announcing its first quarter 2019 financial results and provided its outlook for the second quarter of 2019.

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 outlook for the second quarter of 2019. 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.

In some cases, you can identify forward-looking statements by terminologies such as believes, anticipates, estimates, intends, predicts, expects, plans, may, should, could, will, or thinks and by others similar expressions that convey uncertainty of future events or outcomes.

Forward-looking statements also include statements regarding management's beliefs and expectations related to the expansion of the reach of our products into new markets and customer responses to our innovations, as well as statements regarding the company's outlook for the second quarter of 2019.

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 expectation.

More information about other risks that may impact the company's business are set forth in the Risk Factors section of the company's report on file with the SEC, including the company's annual report on Form 10-K for the year ended December 31, 2018.

Also, with the exception of revenue, all financial measures 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 Stifel Cross-Sector Insight Conference in Boston on June 11th. We hope to have the opportunity to see many of you there. Additionally, I'd like to note the date of our second quarter 2019 earnings call is currently scheduled for Wednesday, August 7, 2019.

Now, I'd like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO.

Thompson?.

Thank you, Maria. And thank you, everyone, for joining us today in reviewing our first quarter results. AOI delivered revenue of $52.7 million, non-GAAP gross margin of 25.5%, and a non-GAAP net loss of $0.27 per share. In looking at the dynamics in the quarter, the demand environment remained consistent with our expectations.

Certain of our data center customer in the US continued to work through excess inventory and some of our customers in China remain conservative in their approach to CapEx deployment.

While these dynamics will influence our performance in the short-term, we continue to believe the fundamental need for higher bandwidth within data center remain intact, with ongoing constructive relationships with our customer to have then address different needs and we continue to forge ahead our effort to drive further growth.

As we had discussed previously, diversifying our customer base is a top priority. We are having ongoing discussion with a new customer about our innovative fiber optics access products. And in the quarter, we secured six design wins, including three with new customers.

All of these customers are outside of our core hyperscale customer base and we are pleased with the progress we continue to make on this front. We also continue to make strides in diversifying and expanding the reach of our innovative products into new markets, such as 5G for mobile telecommunications.

While we are still early in the 5G cycle, we believe it will be an important driver of the high speed optical component markets. In CATV, we remain encouraged by the customer activity and increased interest we have seen for our Remote PHY products.

As a reminder, AOI pioneered this innovative technology and we continue to believe it will play a significant role as cable MSOs evolve and transition to next generation node and headend architectures. We continue to have strong technical engagement with our customers and are in active qualifications with our next generation 400G products.

We had a great showing at OFC where we demonstrated our suite of next generation technology and the customer response was very positive.

We believe our platform, proprietary manufacturing process and vertical integration are keys to our success in this market, and we remain confident in our ability to monetize our innovation as the market improve and move to next generation technology.

With that, I'll turn the call over to Stefan to review the detail of our Q1 performance and outlook for Q2.

Stefan?.

Thank you, Thompson. Overall, the demand environment in the quarter was consistent with our expectations. Total revenue for the first quarter was $52.7 million, which was at the midpoint of our guidance range of $50 million to $55 million. Our data center revenue came in at $38.5 million compared with $50.6 million in Q1 of last year.

In the quarter, 49% of our data center revenue was from our 40G transceiver products and 48% was from our 100G products.

As we discussed in February, we are seeing softness in the data center market as customers work through excess inventory due in part to the transition to 100G as well as customers in China taking a more conservative approach with their CapEx deployment, due to concerns of slowing economic growth.

These dynamics played out in Q1 as expected and we anticipate this softness to continue into Q2 at a more elevated level. However, I will reiterate that we believe that we continue to have good relationships with all of our hyperscale data center customers and that their need for high speed optical connectivity remains fundamental to their business.

We are focusing our efforts on continuing to foster relationships with both new and existing customers and expanding our technology leadership, which we believe will best position AOI for growth when market conditions improve. In Q1, we continued to have success in diversifying our customer base.

And in the quarter, we secured a total of six new design wins, of which three were with new customers and include an OEM supplier to the hyperscale and enterprise markets, a telecom equipment manufacturer for 5G and a provider of chemical sensors.

Additionally, in building upon our strong foundation as a leader in advanced optical technology, we announced the availability of a 100 gigabit per second per lambda pin photodiode that can be leveraged for 100G and 400G optical transceivers.

With the development of this new technology, AOI now has in-house manufacturing for the two most critical active optical components required to produce 100G and 400G transceivers. This will enable us to maintain low cost and reduce our time-to-market for these products.

We remain focused on building industry-leading products and had a great showing at OFC with our suite of next generation technology, including our 200G and 400G modules, as well as our Remote PHY product and 5G products. At OFC, we launched a 400G optical module that adheres to the requirements of onboard optics.

We were first-to-market with this technology and we are very encouraged by the significant customer interest that we are seeing with this product.

And just last month, we announced the availability of our new 400 gigabit per second, 8-channel, digital-based short reach transceiver that utilizes PAM4 encoding to deliver 50 gigabits per second of data throughput on eight separate multimode optical channels.

Our large data center customers will need 400G solutions that cover distances as short as a few years to as long as several kilometers. Our growing line of 400G products is designed to meet these customer needs, while offering the cost advantages of our manufacturing expertise and vertical integration.

Turning to our CATV market, revenue from CATV products increased 13% year-over-year to $12 million compared with $10.6 million in Q1 of last year. Demand for our CATV products was in line with expectations.

We continued to ship orders for our Remote PHY product and remain in active qualification trials with three additional customers for this technology. Our telecom products delivered revenue of $1.7 million compared with $3.6 million in Q1 of last year.

In telecom, we see 5G network deployments poised to become a large driving factor for the optical industry as a whole. The motivation behind the 5G network upgrade cycle is to offer much higher bandwidth and lower latency to support a higher density of mobile users and enable connectivity to billions of new devices, services and applications.

In order to enable this ubiquitous coverage, mobile operators will need to install a large number of small antennas and a much larger number of optical devices to handle the fronthaul connections between the antenna and a centrally located base station.

Additionally, a midhaul link may be required from a centralized cloud radio access network back into an aggregation point where it connects to the Internet. The types of products required for the fronthaul and midhaul applications are 25 gigabits per second, 50 gigabits per second, and 100 gigabits per second optical transceivers.

The same data rates used in our data center business. Additionally, just like our CATV products, many of these devices will be required to withstand harsh outdoor environments.

We have significant experience and resources available to us to develop the types of optical modules required for this application and we have a highly automated production process for producing such modules, which we believe will be important when volumes begin to ramp.

We are currently in qualification with a number of vendors for both front and midhaul applications. That said, please keep in mind that, given this is an emerging market, the timing of qualification and deployment schedules can be difficult to predict.

For the quarter, 73% of our revenue was from data center products, 23% from CATV products, with the remaining 4% from FTTH, telecom and other.

In the first quarter, we had four 10% or greater customers, three in the data center business that contributed 32%, 19% and 18% of total revenue respectively, and one in the CATV business that contributed 12% of total revenue. Moving beyond revenue, we generated a gross margin of 25.5%, which modestly improved from 24.7% last quarter.

It was slightly below our guidance due to somewhat higher-than-expected production costs on a certain of our transceiver products. Total operating expenses in the quarter were $20.3 million or 38.4% of revenue compared with $18.7 million or 31.8% of revenue in the prior quarter.

We continued to be targeted with our investments with an emphasis on developing and enhancing our next generation of optical products, while also tightly managing expenses. Operating loss in Q1 was $6.8 million compared with an operating loss of $4.2 million in Q4 of 2018.

Non-GAAP net loss after-tax for the first quarter was $5.4 million or a loss of $0.27 per basic share compared with a net income of $5.6 million or $0.28 per diluted share in Q1 of 2018.

GAAP net loss for Q1 was $10.5 million or a loss of $0.53 per basic share compared with GAAP net income of $2.1 million or $0.11 per diluted share in Q1 of last year. The basic shares outstanding used for computing the net loss in Q1 were 19.9 million shares.

Turning now to the balance sheet, we ended Q1 with $77.5 million in total cash, cash equivalents, short-term investments and restricted cash compared with $58 million at the end of the previous quarter. This includes net proceeds of approximately $76.4 million from the convertible notes due in 2024, which priced at 5% coupon in February.

We incurred approximately $4.1 million in fees and expenses associated with the offering, which we anticipate amortizing ratably over the five-year life of the notes in accordance with GAAP. Our cash balance was offset by a paydown of $38.2 million to extinguish our capital expenditure loan and real estate term loan with BB&T.

As of March 31, we had $84.5 million in inventory, a decrease of $8.8 million from Q4. This inventory reduction is consistent with our long-term plan as we continue to rationalize inventory levels.

We made a total of $12.8 million in capital investments in the quarter, including $7.2 million in production equipment and machinery, and $5.3 million on construction and building improvement.

Looking ahead, we now expect capital expenditures in 2019 to be approximately $52 million, which factors in a continuation of the construction of our new factory in China. We continue to monitor end market conditions and may adjust our spending plans as necessary.

Moving now to our Q2 outlook, we expect Q2 revenue to be between $40 million and $45 million and non-GAAP gross margin to be in the range of 25% to 27%.

Non-GAAP net loss is expected to be in the range of $6.9 million to $8.6 million and non-GAAP loss per share between $0.35 per share and $0.43 per share using a weighted average basic share count of approximately 19.9 million shares. With that, I will turn it back over to the operator for the Q&A session.

Operator?.

Thank you. [Operator Instructions]. And our first question today comes from Simon Leopold with Raymond James. Please go ahead..

Great. Thank you. I want to ask one sort of nearer term and a longer-term question.

First, on the nearer term, could you give us an update on what you're seeing competitively, particularly in silicon photonics technologies? And, I guess, the context to this is, coming out of the optical show in March, we not only heard from Intel, who's been dabbling in this area for a long time, but Cisco had made an acquisition and Juniper has talked about launching some products.

So, maybe some update, overall competitive environment, but place some context around silicon photonics? And then I've got a follow-up..

Okay, Simon. I would say, in this quarter, we haven't seen any sort of meaningful shift with respect to the competitive environment, especially as it pertains to silicon photonics. You noted a couple of companies who have made investments in silicon photonics.

All of those companies had some activity in the past, either as a company that they're currently with or as previous firms. In other words, they're not new entrants to the industry.

And I haven't really seen any meaningful shift in terms of the way that those types of companies are approaching the market or the way that our technologies differentiate themselves.

I think as we've noted in past conference calls and conferences that we believe our technology competes very favorably with silicon photonics in terms of cost, in terms of flexibility and in terms of our ability to make modifications of things to the products throughout their lifecycle, which can also help us to maintain an attractive cost throughout the lifecycle of the product.

But as far as it goes, I haven't seen too much shift really in the competitive environment there.

And your follow-on question?.

Yes. I wanted to talk a little bit more about how you see the 5G market developing. I think I appreciate the fact that the hardened optics [ph] makes this a great opportunity for your technology, but we hear suggestions that this will be a very competitive market with a lot of varied entrants maybe from emerging markets like China.

And so, I'm sort of struggling to figure out the dynamic of how big is this opportunity and how does it compare to other markets you've played in? Thank you..

So, I think it's a little early to parse out the competitive environment. I think you're right, Simon, it's going to be a competitive market. There's no doubt about that. I would note that, as you've seen in our data center market, we've been able to compete favorably in highly competitive markets.

So, I think the fact that it's competitive is really a reflection of the fact that the market is sizable and it's one where optics is going to play a very critical role. So, we think that it's an exciting market and the competitiveness in that market really just reflects that.

As far as how does this relate to margins and things, I think it's a little bit early to say. As we noted in our prepared remarks, we're pretty early in the 5G cycle. We think we have very attractive technologies not only at the module level, but at the laser and photodiode level and optical sub-assembly level.

And we intend to compete with all the players that we are aware of, including those that are in China and elsewhere using our technologies and we think we can compete favorably there..

Great. Thank you for taking my questions..

Thank you, Simon..

And our next question comes from Mark Kelleher with D.A. Davidson. Please go ahead..

Great. Yeah. Thanks for taking these questions.

Wanted to just talk about the main business, the data center demand, what are your customers telling you about the excess inventory situation? Is this a one quarter situation? Is this a whole year situation? What do you think the cycle is there? And then, with respect to China, is there an opportunity in the data center market in China to kind of offset some of our weakness in the US?.

So, as far as what customers are saying, I don't think that there's a common cadence across all customers. As you can imagine, inventory levels are not uniform across all different customers, and so we're hearing different things from different customers.

Some customers are saying this is going to be a relatively short-term thing and others frankly just aren't giving us a lot of really good visibility into when the situation improves.

As far as the data center market in China, as we noted on our prepared remarks, we have had a number of design wins with data center operators in China and we have some active qualifications ongoing for future – what we hope will be future design wins in that area.

There is some potential that those customers could offset some of the weakness that we're seeing in the US. That hasn't proven to be the case so far. But I think that it's one of the reasons why – I think there is hope and optimism surrounding the next few quarters.

But we ought to get through this period of weakness in the US data center market first..

And then on the cable side, the Remote PHY, you had a pretty nice growth there on the cable TV side.

Is that some sign that the – there's some thawing in the cable market? Is that demand finally coming through?.

I think that there's some signs that the thawing is occurring. I think it's too early to say we're back into a robust growth period yet, but I think that we do expect cable TV to continue to improve. That market is notoriously sort of lumpy and difficult to predict, however.

And so, I think, overall, we think that there's some good tailwinds in cable TV driven by Remote PHY. But, again, on any given quarter, the results can be kind of up and down as we've seen over the past several years really..

Okay, great. Thanks..

[Operator Instructions]. And our next question comes from Richard Shannon with Craig-Hallum. Please go ahead..

Hi, Stefan, Thompson. Thanks for taking my questions. Probably just a couple for me. Stefan, I know you're loathe to typically to talk more than one quarter out, but wanted to see if you have any thoughts relative to some other companies who had data set exposure and their thoughts about the second half of the year.

Are you seeing any sign of visibility or stabilization that might lead you to think your data center revenues can improve in the third quarter versus the second?.

Well, I think there's a lot of reasons for optimism. We noted that we have some very important new technologies that we've talked about, 400G, et cetera. There are some customers that are talking aggressively about deploying that. I won't put a precise timeframe on it, which is really part of the problem with visibility.

While I do believe that there's a number of very exciting things that are going to happen in the data center market, it's very difficult to predict the timing especially with respect to inventory because that's one of the more opaque things that our customers are relatively less inclined to talk about with us.

They're very interested in talking with us, as you can imagine, about new technologies and their deployment plans for those new technologies, but are a little bit less interested in talking to us about the specifics of their inventory situation. So, that's a little bit hard to get a concrete read on.

It would be a very questionable thing to say that data center companies are not going to eventually continue to invest in their infrastructure. They got out a little bit ahead of themselves, I think, in terms of buying inventory and that's what we're digesting right now, but it seems to me that it's really only a matter of time till growth resumes.

It's just hard to put a precise timeframe on that..

Okay. Well, it's fair enough based on what we've been hearing otherwise. My second and last question, Stefan, is, obviously, you guys are trying to grow into – to get to back to breakeven here.

I wonder if you could help us kind of sketch out how you get there in terms of revenues, gross margins, OpEx? And also, maybe that revenue contribution you'd expect – obviously, I would assume data center would be a big part of that where you'd expect new products like 200 and 400 gig or 5G or outside of your main cloud customer base that you have today.

Can you guys just help us understand how you expect to get there?.

Well, I think what we've seen so far, operating expenses have been relatively stable over the last few quarters, if you take out some of the extraordinary items that we have. So, if you kind of run that forward, you can get an idea where we need to be in terms of gross margin and revenue to cover those operating expenses.

And so, we obviously need to see revenues increased to some extent. And we also believe that we can continue to see some gross margin uptake and that that will also contribute to profitability. But as far as putting us precise numbers on that, we don't have sort of an updated model that we've put out there yet..

Okay. That's fair enough. I think that's all the question for me. Thank you..

And our next question comes from Liz Pate with Cowen and Company. Please go ahead..

Hi. Thanks for taking my question. My first question is, you've talked about a number of new design wins this past quarter and the prior quarter.

Are those translating into any meaningful revenue at this point for you?.

Well, they are certainly translating into revenue. What your level of meaningful, I guess, you'd have to sort of define that a little bit. But we've seen some of these design wins that are contributing in the millions of dollar range.

Obviously, low-single-digit millions given the overall revenue picture, but certainly some of the recent design wins are contributing.

For us, a design win occurs when we've not only completed the technical qualification of the product and also the pricing and other negotiations that go on as part of the qualification process, but also when we've actually received orders.

So, sort of by definition for us, all of our design wins are contributing revenue or will contribute revenue very shortly after the design win. How much of that is sort of meaningful, I guess, again, sort of depends on your definition, but all of those design wins are contributing revenue essentially..

Right.

And in terms of the customer profile, are there tier 1s in there amongst the new customers?.

I think there are some recognizable names in there, yes..

Okay.

I guess, my last question is on the pricing trends that you're seeing, incremental price erosion over the past 90 days, anything to point to the ordinary and kind of what you expected, just any comments up there?.

Sure. I think pricing has been pretty consistent with our expectations. No changes to what we've said there. Previously we said, last year, we saw price reduction in our core 100 gigabit per second product line of about 20% and we've said that we expect to see about that same number this year, and that's still our current expectation..

Great. Thank you very much..

Thank you..

And our next question comes from Dave Kang with B. Riley FBR. Please go ahead..

Great. Thanks. This is Lee Krowl filling in for Dave. Thanks for taking my questions. Two, if I may. First, in the past, you guys have kind of talked about verticalization efforts in an effort to kind of aid gross margin.

Obviously, with margins where they are today, curious if you kind of had some updated thoughts on the strategies that will kind of help trend gross margins higher as it relates to verticalization?.

Sure. We noted in our prepared remarks, for example, that we've developed a new line of photodiodes. As you know, the two principal active optical components that define the performance of an optical transceiver or, frankly, any optical link really are the laser and the photodiode. And for many years, we've manufactured the lasers.

It's only more recently that we've begun to manufacture the photodiodes, the corresponding receiving element within the optical transceiver. And so, that's an example of where that vertical integration strategy is continuing to – we're continuing to work forward on that strategy.

As far as how we see the gross margin trending up, vertical integration certainly plays a part there, but in addition to that, I think seeing capacity utilization return back to normal levels and getting through some of the additional testing that we put in place in previous quarters, all those things will also contribute to the gross margin.

So, it's not just one thing that we need to do, we've got several knobs that we will turn to continue to see improvement in gross margin..

Got it.

And then, I guess, with the Chinese facility, could you maybe just remind us when you expect it to be complete, whether that's fully encapsulated in the CapEx number you guys guided to? And then, just as it relates to the Chinese market, will that position you more competitively or with better visibility, building increased operations there?.

As far as what that facility does for us, yes, I think it positions us well for the Chinese market. As we mentioned there are some sizable markets in China. For example, the 5G market, I think, is going to be first active probably in China or at least certainly one of the largest markets for 5G is going to be in China.

And having a Chinese – an expanded presence in China will no doubt help us in that area. And also, the data center operators in China are becoming more larger scale and more advanced in their infrastructure, similar to what we've seen with some of our domestic, US-based and European-based operators.

And so, having the capability and expanded capability in China to be able to produce more of those advanced products in-country for them will also be important to that business as well. So, we think both the telecom and data center business can benefit from that expanded presence in China..

Got it. Thank you for taking my questions..

Thank you..

And this will conclude our question-and-answer session. I would like to turn the conference back over to Thompson Lin for any closing remarks..

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

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