Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to the Applied Optoelectronics Second Quarter 2019 Earnings Conference Call. All lines have been placed in mute to prevent any background noise. [Operator Instructions] Please note this event is being recorded.

I now 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 2019 financial results conference call. After the market closed today, AOI issued a press release announcing its second quarter 2019 financial results and provided its outlook for the third 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 Q2 results and Stefan will provide financial details and outlook for the third 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, would, 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 third 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 reports 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 numbers discussed today are on a non-GAAP basis, unless specifically noted otherwise. Non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP.

A reconciliation between our GAAP and non-GAAP measures as well as a discussion of why we present non-GAAP financial measures are included in our earnings press release that is available on our website. Before moving to the financial results, I'd like to announce that AOI management will attend the D.A.

Davidson Technology Conference in New York on September 4th, and the Dougherty & Company 2019 Institutional Investor Conference in Minneapolis on September 3rd. We hope to have the opportunity to see many of you there.

Additionally, I'd like to note the date of our third quarter 2019 earnings call is currently scheduled for Wednesday, November 6, 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. We are pleased with our execution. During the quarter, we delivered revenue in line with our guidance and achieved better than expected results on the bottom-line. AOI delivered revenue of $43.4 million. Non-GAAP gross margin of 27.2%, and non-GAAP loss of $0.26 per share.

In looking at the dynamics in the quarter, the datacenter demand environment remained consistent with our expectations. We are starting to see early signs of recovery among two of our hyperscale datacenter customers, while one customer has yet to begin a recovery.

We are encouraged by [indiscernible] recovery and believe the fundamental need for higher bandwidth within hyperscale datacenter will drive long term growth. However, in the short term we remain cautiously optimistic on the market dynamics and the demand environment continue to stabilize among our hyperscale customers.

In CATV, we remain encouraged by the customer activity, a specialty interest in our Remote PHY products. However, the overall CATV market demand continued to be soft, resulted in tepid [ph] demand for some of our legacy product.

Additionally, CATV demand in China is weaker than we had expected, as a result of trade tensions, diversifying our customer base remain a top priority for AOI. In the quarter we secured five new design wins, including four with an equipment OEM for datacenters and one with a datacenter operator.

In summary, we are pleased with our execution this quarter which contributed to our better than expected bottom-line results. We remain focused on fostering relationship with both existing and new customers and expanding our technology lealerships.

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

With that, I would turn the call over to Stefan to review the details of our Q2 performance and outlook for Q3.

Stefan?.

Thank you, Thompson. Overall the demand environment in the quarter was consistent with our expectations. Total revenue for the second quarter was $43.4 million, which was above the midpoint of our guidance range of $40 million to $45 million. Our datacenter revenue came in at $31.8 million, compared with $69 million in Q2 of last year.

In the quarter, 72% of our datacenter revenue was from our 40G transceiver products and 23% was from our 100G products. The datacenter market dynamics played out in Q2 as expected.

We are starting to see early signs of recovery among two of our hyperscale datacenter customers, while one customer continues to purchase product from us, but with reduced demand. As Thompson mentioned, while we are encouraged by these early signs of recovery, we remain cautiously optimistic on the near-term market dynamics.

We continue to believe that we have good relationships with all of our hyperscale datacenter 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 existing and new customers and expanding our technology leadership, which we believe will best position AOI for growth when market conditions improve.

We are also encouraged by the pace and quality of the design wins we are seeing with new customers, many of whom are datacenter operators or equipment OEMs that supply the datacenter vertical.

Building upon our strong foundation as a leader in advanced optical technology, we recently showcase the ability of AOIs 400G QSFP transceivers to break out into four individual 100G FR transceivers and interoperate with a leading 12.8 terabyte per second switch fabric basic ASIC.

As datacenter operators continue to demand greater bandwidth, the migration from 100G to 400G will be the next major step in datacenter architecture. As datacenter customers add 400G connectivity to their 100G infrastructure, they are looking for validated and interoperable solutions to gain confidence and reduce deployment timelines.

We are very pleased to have a solution with the demonstrated interoperability that our customers demand. Turning to our cable television market.

Revenue from CATV products decreased 31% year-over-year to $9.8 million, compared with $14.2 million in Q2 of last year, as demand has weakened somewhat with North American MSOs and the China CATV market continues to lag expectations due to trade tensions and concerns about domestic economic growth in China.

Despite these near-term challenges, MSOs, particularly those in North America continue to forge plans for distributed access architectures. We believe that our Remote PHY product is a key enabling technologies for these new distributed access networks and we are excited about the customer interest in Remote PHY.

We expect to receive our first significant orders for our Remote PHY product soon. Our telecom products delivered revenue of $1.6 million, compared with $4.2 million in Q2 of last year, reflecting lower sales in China, given geopolitical trade tensions.

In telecom, we continue to see 5G network deployments poised to become a large driving factor for the optical industry as a whole. We believe AOI is well-positioned to grow our share as the 5G optics market develops, given our deep optical expertise in harsh outdoor environments and our highly automated module production process.

We remain in qualification with a number of vendors for both front and mid haul applications. With that said, please keep in mind that given this is an emerging market, the timing of qualification and deployment schedules are difficult to predict.

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

In the second quarter we had three 10% or greater customers, two in the datacenter business that contributed 30% and 29% of total revenue respectively, and one in the CATV business that contributed 14% of total revenue.

We continued to build on our earlier success in diversifying our customer base and are pleased with the steady progress we have made. In the quarter, we secured a total of five new design wins, among two U.S. based datacenter customers, one of which is a datacenter operator.

I will also note that several of these design wins expand on a new customer relationship we secured last quarter with an OEM supplier to the hyperscale and enterprise markets. Moving beyond revenue, we generated gross margin of 27.2%, a 170 basis point improvement from 25.5% reported last quarter and slightly higher than our guidance.

Total operating expenses in the quarter were $19.5 million or 44.9% of revenue, compared with $20.3 million or 38.4% 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 Q2 was $7.7 million, compared with an operating loss of $6.8 million in Q1. Non-GAAAP net loss after tax for the second quarter was $5.2 million or a loss of $0.26 per basic share, which was better than our guidance. This compares to net income of $12.9 million or $0.64 per diluted share in Q2 of 2018.

GAAP net loss for Q2 was $11.4 million or a loss of $0.57 per basic share, compared with GAAP net income of $8 million or $0.40 per diluted share in Q2 of last year. The basic shares outstanding used for computing the net loss in Q2 were 19.9 million shares. Turning now to the balance sheet.

We ended Q2 with $84 million in total cash, cash equivalents, short term investments and restricted cash compared with $77.5 million at the end of the previous quarter. This reflects $7.2 million in cash generated from operations. As of June 30, we had $81.5 million in inventory, a decrease of $3 million from Q1.

This inventory reduction is consistent with our long-term plan as we continue to rationalize inventory levels. We made a total of $13.5 million in capital investments in the quarter, including $6.2 million in production equipment and machinery and $6.9 million on construction and building improvements.

Looking ahead, we now expect capital expenditures in 2019 to be approximately $56 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 Q3 outlook.

We expect Q3 revenue to be between $46 million and $49 million and non-GAAP gross margin to be in the range of 27% to 29%.

Non-GAAP net loss is expected to be in the range of $4.2 million to $5.7 million and non-GAAP loss per share between $0.21 per share and $0.28 per share using a weighted average basic share count of approximately 20 million shares. With that, I'll turn it back over to the operator for the Q&A session.

Operator?.

Yes, thank you. [Operator Instructions] The first question comes from Simon Leopold with Raymond James..

Great. Thank you for taking the question. Just a quick clarification if I might, I think you mentioned your 10% customers, like I didn't get down the color you offered on that.

Could you just repeat that comment?.

Yeah. We had three 10% customers during the quarter, two were in the datacenter business they contributed 30% and 29% respectively of total revenue. And then there was one customer in the CATV business that was 14% of total revenue..

Great. Thank you very much for that, sorry. So on the cable TV business, clearly, we've heard from the major operators spending less money, but it seems as if we're still very early in the fiber deep Remote PHY.

And so I think you made a comment suggesting that you were only just beginning to ship your Remote PHY boxes, if you could give us a sense of how you see this playing out.

And I guess what I'm really getting at is, how should we think about the trending of this business both near-term through third quarter and then really looking at kind of 2020?.

Yeah. So the comment that we made, I think you know, on the last few conference calls we've mentioned that we have been selling Remote PHY products.

The comment that we made is that we're expecting to start getting our first - what we would term sort of significant orders, that is you know, something that - that would be the beginning of more of an ongoing business for those Remote PHY products and one that we hope would grow into a larger number over time.

As far as the overall cadence on cable TV, I think if you look, you know, year-over-year what we've seen is primarily related to China slowing down. We've seen some slowdown in North America in the last quarter or two. So it depends if you're looking on a sequential basis or year-over-year in terms of what's causing the downturn.

You know, when we look ahead, I think, we're looking for the North American MSOs to begin to invest in these distributed access architectures. And as I've mentioned in our prepared remarks, you know, we're a technology leader in Remote PHY, which is a key aspect of these distributed access architectures moving forward.

So you know, it's hard to say exactly when they're going to do that. I think they're poised to.

I think some of the slowdown that we're seeing now among the North American MSOs is probably related to you know, the immediacy of their transition to this Remote PHY based architecture that is - you know, they're kind of minimizing their investments in legacy networks, while they look to add Remote PHY.

The precise timing behind that is difficult to predict. I think we're probably - it's probably not a Q3 or Q4 kind of thing before we start to see a real resurgence. But it's a little hard to predict at this point..

So I guess, I'm sort of reflecting back on the cable TV business in 2017 where it was very much transmission oriented. You did about $60 million. I'm just wondering if we should think about that as a reasonable expectation for 2020 or at least the timeframe where these initiatives really get going.

Is that a reasonable way to think about that line of business?.

I mean, you know, again, I want to give you a sort of precise number. I think there's every reason to believe we can get back to levels similar to or greater than what we've been at in the historical period. It does require this transition to Remote PHY.

I think that happened in North America and you know, like I said I would expect that that would happen in 2020, although the cable TV market is notoriously difficult to project, specifically the timing of when they start to get going.

I think the overall trend we can be fairly certain of, but exactly when they get going and how fast they ramp up it's still a bit tough to forecast..

Thank you. And just one more if I might. You mentioned the 400 gig products starting to come out. Just if you could help us think about how you could be competitive versus the silicon photonics variants that are coming out from some of the OEMs and some of the larger semiconductor companies.

Just wondering how silicon photonics sort of plays into the competitive landscape when you're in a market at 400 gig inside the datacenter? Thank you..

Sure. I mean, silicon photonics is not a new technology. As you know, you know, we've had silicon photonics at 100 gig and there's been silicon photonic solutions at lower data rates even before that.

Our competitive advantage is built upon our vertical integration that is our ability to manufacture a significant port of the cost driving elements of the transceiver in-house and also on our manufacturing expertise.

I think we've talked extensively in the past about our automated manufacturing processes and you know, our platform technology that has allowed us to automate those processes.

So it's not just the automation itself, but it's having a design for our 100G products and our 400G products and even future generations where we can manufacture those in an automated way in a very cost effective manufacturing process and that's what gives us the ability to compete with those other technologies..

And Simon. This is Thompson and I want to emphasize for 400G and 100G making DMA [ph] in-house would give us – give AOI strong growth advantage, all right, compared to 100G used in the DMA..

Great. Thank you very much for taking my questions. Appreciate that..

Thanks, Simon..

Thank you. And the next question comes from Samik Chatterjee with JPMorgan..

Hi. Thanks for taking my question. If I could just start off with a clarification as well, I know you mentioned the 100 gig and 400 - 40 gig makes in the datacenter revenues. Could you just repeat that? Sorry I missed that..

Sure, no problem. The 72% of the datacenter revenue was from 40G and 23% was 100G in the quarter..

Got it. And so I think that kind of implies a decline in the 100 gig mix, overall a strong decline in the revenues.

Is that primarily driven by the kind of the lack of recovery that you see - you saw with one of the hyperscale customer or datacenter customers as you call them or was that more driven by something else that I'm not really thinking about..

No, it's almost entirely driven by the one customer who has yet to recover. We are seeing strength in our 40G which I think is actually - it's a good thing for AOI. We've been a leader at 40G for some time.

The fact that our customers continue to be interested in 40G and continue to find new use cases for 40G and are continuing to buy significant quantities of 40G, I think is very, very good for us. But the 100G downturn is not related to other customers, its pretty much isolated to one customer..

Got it. And just question on the tariffs, like it would propose 10% tariff now on incremental goods coming from - imported from China.

Are you expecting any impact to your gross margins? Additionally I believe you have a facility in Taiwan, are you seeing any pickup in interest from customers and expanding – or expanding kind of their business in that facility.

And if you were to ask to expand capacity there how much flexible capacity do you have there?.

So, we are - we do have a facility in Taiwan that can manufacturer the datacenter transceivers. In fact, it does - already manufacturing a portion of our datacenter transceivers.

We have had significant interest from customers in our ability to manufacture in Taiwan and what we can do is move some of the manufacturing operations between our Taiwan and China factories such that we can add additional capacity if needed as these tariffs come on board.

In other words, what I mean is we can take some of the manufacturing for other ancillary products that are maybe not datacenter related, move those to China and increase the capacity in Taiwan for the datacenter products.

And where we stand right now, you know, we think we're pretty well positioned to be able to manufacture what the customers are asking us in the Taiwan factory. At least for customers that are U.S. based. I mean, I want to remind everyone that even among the U.S. hyperscale customers, not all of their transceiver usage is actually in the U.S.

So we won't necessarily be manufacturing all of our datacenter transceivers in Taiwan, but for the ones that need to be imported into the U.S., it's certainly a possibility for us to manufacture those in Taiwan and that's our plan, should the tariffs come in place..

Got it. Thank you for taking my question..

You're welcome..

Thank you. [Operator Instructions] And the next question comes from Fahad Najam with Cowen and Company..

Hi, Stefan. Hi, Thompson.

I apologize for the tough question, but did I hear you correctly that 100G was 23% of the other total revenue?.

Yes, you did..

if I look at the broader landscape going forward, what - why should investors believe that you would meaningfully have any success in 100 gig and 40 gig rolls off when you have had little to no meaningful success of late and so quality issue with your leaders in 100 gig, what would you - what would you tell investors.

Do you have hope in your story? Apologies for the broad ended question, but I am just struggling to see how – if you are not succeeding in 100 gig, how will you succeed in 400 gig?.

Well, I think it's a mischaracterization to say that we're not succeeding in 100 gig. As you noted, we have sizable sales of 100 gig last year. In fact, it was our largest selling product line by far. I would not call that, not having success.

What I would say is that you know, different customers purchase different applications and different data rates for different applications at different times.

Not every customer as we've noted in our prepared remarks has yet begun a recovery cycle and we would expect that – and that recovery cycle if they're still you know, purchasing large quantities of 100G, that is if they haven't moved on to 400G then we'd expect to be a part of that.

Now, with respect to your sort of more blunt question about you know, why would we be a player 400G? We are actively involved in a number of qualifications right now.

I think if customers had decided they weren't going to use AOI or they weren't attracted by what AOI had to offer, they're not going to waste their effort and resource working with us on these qualification efforts.

Now those qualifications are ongoing, I can't tell you for sure what the results of all those are going to be, but so far, the results are good and you know, I would expect that they would - some of them at least would be concluded successfully, maybe and perhaps all of them.

The other thing I'd like say is, I mean, you know, 40G and 100G weren’t our first data rates, we've been involved in the datacenter market for a long, long time. We've been a leader in the datacenter market for a long time and I don't see any reason why 400G would be materially different.

As Thompson mentioned earlier, technologies like our electro -absorption modulated laser or EAML are critical to not only to the performance, but to the cost structure of the 400G transceivers and by having that technology in-house we think that gives us a really good position to be not only a technology leader, but a cost leader in 400G, as we were at 100G, as we were a 40G, as we were at 10G, as we expect to be at a 800G when that comes to fruition in the future.

So I think it's wrong to say we haven't been successful and the technology that we've developed for 400G is very compelling, which is why we have ongoing qualifications going with customers..

But maybe I add further two points. One, for EAML, what does EAML, there are very surprise, okay, compared to 25G EAML So I'll make EAML in-house. Of course, it’s very be, much, much bigger than 25G EAML or 100G transceiver, number one.

Number two, yes, we had quality issues, we have managed it, we solved the problem and in the past few quarters we have many design wins of 100G transceiver with many new customer, okay, not only in U.S., including Asia, including many big equipment OEM company and many hyperscale operator, okay, worldwide.

The slowdown related to this specific customer is not the quality issues, is that demand really slow down, okay. And we are confident and we believe when that demand come back, we’ll be one of the major suppliers, okay, in the future, it could be sometime next year. All right..

All right. If I may add on the 200 gig, I know 400 gig is still a second half 2020 for you, most of your customers, but two of the largest hyperscale cloud titans are moving with 200 gig in the [indiscernible] one of them happens to be a customer of yours.

Are they doing any 200 gig, are you shipping 200 gig, do you have any share in 200 gig at the moment?.

Yes, we've been shipping to 200 gigs since last year. It's not a huge quantity. Obviously if you look at the percentages for the 40 gig and 100 gig, but we do have design with 200 gig..

Thank you. And the next question comes from Michelle Waller with Needham & Company..

Hi, guys. I'm on with for Alex Henderson. Just a quick question on the gross margins, do you guys give any color - can you guys give any color on 40 gig gross margins or 100 gig.

We're just trying to wonder here you know, gross margins are positive for 100 gig or no?.

Oh, they're definitely positive for 100 gig. We don't give specific guidance on you know, individual product, gross margins, but certainly they are positive..

Okay..

You know, the goal [indiscernible] 100 gig are pretty good. So we say we have best cost advantage compared to other suppliers because of the vertical integration because of the automation of the transceiver manufacture in Taiwan and China..

I am sorry, was there a follow on question?.

No. That's good for me. Thanks..

All right. Very good. Thank you..

Thank you. And as there are no more questions, I would like to turn the call back to Thompson Lin for any closing remarks..

Again, 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..

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