Good afternoon. My name is Jamie and I will be your conference operator today. At this time, I would like to welcome everyone to the Applied Optoelectronics Third Quarter 2019 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 also note this event is being recorded. At this time I’d like to turn the conference call over to Monica Gould, Investor Relations for AOI. Ms. Gould, you may begin..

Thank you. I’m Monica Gould, Applied Optoelectronics Investor Relations, and I’m pleased to welcome you to AOI’s third quarter 2019 financial results conference call. After the market closed today, AOI issued a press release announcing its third quarter 2019 financial results and provided its outlook for the fourth 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 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 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 may 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 fourth 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 the substitute for results prepared in accordance with GAAP.

A reconciliation between their gap and non GAAP measures as well as the discussion of why we present non GAAP financial measures are included our earnings press release that is available on our website.

Before moving to the financial results, I'd like to know that AAOI management will present at the Needham Security Networking Communications Conference in New York on November 12, The Raymond James Technology Conference in New York on December 10, and the Cowen Networking Cybersecurity Summit on December 11.

We hope to have the opportunity to see many of you there. In addition, I'd like to note the date of our fourth quarter 2019 earnings call is currently scheduled for February 25, 2020. Now, I'd like to turn the call over to Dr. Thompson Lin, Applied Optoelectronic's Founder, Chairman and CEO.

Thompson?.

Thank you, Monica, and thank you everyone for joining us today. We are pleased with our continued execution in the quarter. For the second quarter in a row, we delivered revenue in line with our guidance and achieved better than expected results on the bottom line.

AOI delivered revenue of $46.1 million, non-GAAP gross margin of 28.8% and a non-GAAP net loss of $0.15 a share. In looking at the dynamics in the quarter, the datacenter demand environment remained consistent with our expectations. We continue to see early signs of recovery among two of our hyperscale datacenter customers.

We are encouraged by this sign and believe the fundamental need for higher bandwidth within hyperscale datacenters will drive long-term growth. However, in the near term, we remain cautiously optimistic on the hyperscale market as demand continued to stabilize among our customers.

In CATV, we remain encouraged by the growing interest in our Remote PHY product and I'm pleased to report our report significant Remote PHY order in the quarter. Last month, we demonstrated our Remote PHY solutions at SCTE show in New Orleans and had a very positive response from our current and potential customers.

However, the overall cable TV demand environment continues to be soft, resulting in healthy demand for some of our legacy products particularly CATV demand in China remain weak as a result of trade tensions.

We continue to make good progress in diversifying our customer base, and during the quarter, we secured eleven design wins including four from new customers. In summary, we are pleased with our results and improving gross margin, which led to another quarter of better than expected bottom line results.

We remain focused on expanding our relationship with both new and existing customers and maintaining our technology leadership.

We believe our portfolio, proprietary and a geographically diverse manufacturing and vertical integration of the competitive advantage, and we remain confident in our ability to execute on opportunities will have us as a market improve.

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. Our Q3 results were broadly in line with our expectations and reflect improving performance compared with last quarter. During the quarter, we continued on our path of customer diversification, expanded our margins and tightly manage our expenses, leading to a narrower net loss than we had anticipated.

Total revenue for the third quarter was $46.1 million which was within our guidance range. Our datacenter revenue came in at $34 million compared with $39 million in Q3 of last year. In the third quarter, 69% of our datacenter revenue was from our 40G transceiver products and 25% was from our 100G products.

We continue to make good progress with our customers as they work to quality our 400G products for datacenter applications. Datacenter market dynamics played similarly to last quarter, we continue to see early signs of recovery among two of our hyperscale datacenter customers while one customer continues to purchase from us but with reduced demand.

All these improving dynamics are encouraging, we remain cautiously optimistic in the near-term. We had seven design wins in the quarter in our datacenter segment. Of these seven, two are new customers in the quarter and an additional two are incremental wins with the recent new customer. Turning to cable television product segment.

Revenue for CATV products decreased 38% year-over-year to $8.8 million from $14.3 million in Q3 of last year, primarily driven by weakened demand from our North American MSO customers, combined with historically high revenue quarter last year.

Given limited competition in their markets, we believe that MSOs are delaying upgrades pending the availability of new technologies such as DOCSIS 4.0. Despite these near-term challenges, we are pleased to report a significant order for our Remote PHY gear form our largest CATV customer.

We had a very positive reaction to our latest Remote PHY product at the Society for Cable Telecommunication Engineers or SCTE conference last month in New Orleans. In addition to our standard Remote PHY products, we also demonstrated a pathway to Extended Spectrum DOCSIS using our Remote PHY technology.

Extended spectrum DOCSIS represents a key technology behind the emerging DOCSIS 4.0 standard, which we believe will be formalized by the end of the year. Once finalized, we believe this latest DOCSIS standard will be a catalyst for future upgrades.

We were near in technologies like Remote PHY that will enable DOCISI 4.0, and we believe we are well position to capitalize on this implementation once it began.

Revenues from our telecom products increased slightly to $2.9 million from $2.7 million in Q3 last year, reflecting the traction that we are making with our newer customer set as this business continues to incrementally grow. We believe that AOI is well positioned to grow share as 5G continues to rollout, and we are optimistic about the future.

We also believe that increased competition from 5G will be another catalyst to increase cable spending. In addition to the seven design wins in the datacenter segment, we had three design wins in our telecom segment during Q3 including one design win related to 5G optical modules with the major supplier of 5G networking equipment.

This 5G win was also with the new customer to AOI. For the quarter, 74% of our revenue was from datacenter products, 19% from CATV products with the remaining 6% from the FTTH telecom and other.

In the third quarter, we had three 10% or greater customers, two in the datacenter market that contributed 44% and 20% of total revenue respectively, and one in the CATV that contributed 10% of total revenue.

In total for the quarter, we secured 11 new design wins among 8 customers, 4 of them are new to AAOI, bringing our year-to-date new design wins to 22.

As a reminder, for all of 2018, we secured a then record 26 design wins, so our total of 11 wins this quarter demonstrates an acceleration of our design win activity and one that we believe derives from the effort that we have put into further diversifying our customer base.

Illustrating the effectiveness of our diversification efforts, in Q3, our top 10 customers combined to account for 88.3% of our revenue compared to 92.9% in the same quarter last year. On a year-to-date basis, the concentration of revenue among our top 10 customers decreased from 94% to 89%.

This decreasing revenue concentration is in line with our expectations and we think reflects the positive trend for our business. In Q3, we generated a gross margin of 28.8%, up from 27.2% last quarter and at the high end of our guidance range of 27% to 29%, primarily driven by operational efficiencies and a favorable product mix.

Total operating expenses in the quarter declined to $18.4 million or 39.9% of revenue from $19.5 million or 44.9% of revenue in the prior quarter, reflecting our efficient expense management. In the third quarter, we also received economic incentives from the China government. These totaled $1.1 million and are accounted for as other income.

Operating loss in the third quarter was $5.1 million compared to an operating loss of $7.7 million in Q2. GAAP net loss for Q3 was $8.8 million or a loss of $0.44 per basic share compared with the GAAP net loss of $11.4 million or $0.57 per basic share in Q2.

Non-GAAP net loss after-tax for the third quarter was $2.9 million or a loss of $0.15 per basic share, which was favorable to our guidance range of a loss of $4.2 million to $5.7 million or $0.21 to $0.28 per share and reflects an improvement over Q2's net loss of $5.2 million or $0.26 per basic share.

The basic shares outstanding used for computing the net loss in Q3 were $20 million. Turning now to the balance sheet, we ended the third quarter with $72.4 million in total cash, cash equivalents, short-term investments and restricted cash compared with $84 million at the end of the previous quarter.

This reflects $5.8 million in cash used for operations. As of September 30, we had $82.1 million in inventory compared to $81.5 million in Q2. The modest increase was driven primarily by an increase in 40G orders, which requires inventory additions to meet demand. We continue to believe that inventory levels will rationalize over the long term.

We made a total of $6.1 million in capital investments in the quarter including $1.8 million in production equipment and machinery, and $4.2 million on construction and building improvements. Looking ahead, we now expect capital expenditures in 2019 to be approximately $46 million.

The reduction in CapEx outlook for the year is largely related to delays in the construction of our plant in China. We still expect many of these expenses to be incurred in Q1 of 2020. Before turning to our outlook, I would like to provide an update on the ongoing China trade and tariff dynamics.

During the quarter, one of our largest customers qualified our Taiwan factory for shipments of datacenter products. As we have discussed previously, we believe that our ability to manufacture datacenter transceivers in both our Taiwan and China factories provides us with an ability to navigate the current trade tensions between the U.S. and China.

Looking forward, we believe we are well positioned to balance production between both our Taiwan and China factories as we look to minimize the impact for both our U.S.-based customers as well as our customers in China.

Moving now to our Q4 outlook, we expect Q4 revenue to be between $46 million and $49 million and non-GAAP gross margin to be in the range of 26.5% to 29%.

Non-GAAP net loss is expected to be in the range of $4.3 million to $5.9 million and non-GAAP per share between $0.21 per share and $0.30 per share, using a weighted average basic share count of approximately 20.1 million shares. With that, I’ll turn it back over to the operator for the Q&A session.

Operator?.

Ladies and gentlemen, at this time we will begin the question-and-answer session. [Operator Instructions] Our first question today comes from Samik Chatterjee of JPMorgan. Please go ahead with your question..

This is actually Bharat on for Samik. So the first question I had was, one of the networking equipment companies that reported in this earnings season has highlighted delayed spending and push out of the refresh cycle at one large hyperscale customer which also happens to be your big customer.

So, just wanted to check, does that dynamic impacting AOI all? And any insight that you can provide that would be helpful? And then I have a follow up. Thanks..

If I understand your question correctly and I think we’re talking about the same customer then I think, yes, that reflects the same thing that we’ve seen. I will note, I mean, AOI has been pretty consistent about saying that this customer was facing some oversupply, over inventory conditions for the last several quarters.

And I think we’re just starting to hear that maybe now from some other companies. So, yes, I think that’s the same situation that you’re referring to..

And then some of the feedback that we’ve also heard from the supply chain is that, one of your larger competitors is being more price aggressive in order to take more market share.

Is that the same dynamic that you’re seeing? Or are you seeing pricing environment more challenging than usual, any updates that would be helpful?.

No, we haven’t seen any real change in the pricing dynamic. We’ve been in obviously and we continue to be in a competitive pricing environment. It's been that way since the datacenter market really started to grow I think a few years ago.

But we haven’t seen any change, I wouldn’t characterize any of our other competitors is being more price competitive than before. If anything I think we’re likely to see somewhat reduced price competition from some of the industry consolidation that we’ve seen less suppliers makes the need for price competition there somewhat less on the margin.

I’m not saying we predict the big change there, but certainly I don’t think it's getting any worse..

Our next question comes from Simon Leopold from Raymond James. Please go ahead with your question..

I have two. First one is, around the cable space and the cable weakness.

I’m imagining there are two headwinds and I want to see, if you can help me understand the effect of each, one being the overall weaker CapEx spending, the other is some indication that at least some of your customer cable OEMs are trying to exit some of their legacy products which I presume you’ve been involved in.

So, just trying to get a sense of how much of this is sort of the top down spending challenges versus maybe bottoms up changes or adjustments in your customers' product portfolios?.

Yes, fine. That's a good question. Thank you. I think the overall effect has really been driven right now by just the weaker spending environment.

I think that weaker spending environment along with particular business challenges for various of the OEM suppliers, has resulted I think in some of the suppliers, taking a hard look at what their strategy is going to be moving forward.

I wouldn't necessarily characterize that as a getting out of the business, but they're certainly looking at which product line makes sense and how that fits into their overall business strategy. And so, anytime there is these kind of shifts going on I think it represents a combination of some risks and some opportunities.

I think the risk is that customers may exit certain products that we are involved in. On the other hand that doesn't result in an overall reduction in demand for those products necessarily. It just means that that those products have to go somewhere else.

And so we're pretty we're actually pretty optimistic that as all this plays out that there will be no opportunities for us whether they're with our same partners or other partners or how that's going to play out remains to be seen, but I think it's going to present significant opportunities.

And when the cable industry begins to grow, again, I think those opportunities will become apparent..

And then my follow-up is to get your perspectives on the 400 gig market in terms of timing and how that plays into your question. And couple of thoughts I want to take your impression of is, one of the large OEMs, suggested that 400 gig would happen later, suggesting it begins in the second half of '20 but becomes material in '21.

I didn't think that was any different but things suggested that was later.

And then I presume for you if 400 gig happens later, is that a good thing because you get to read the sales of 100 gig longer and 40 gig longer? Or do you want to tap in sooner to be able to participate in that market? Could you help us understand your expectations and sort of the implications for you? Thank you..

Sure. So, I think the schedule on 400G, again I want to caution, not every OEM not every supplier or every, and customer is on the exact same schedule of course. So you have to keep that in mind.

But I do think that not unlike what we saw at 100 gig and indeed even at 40 gig where the initial expectations for deployment schedules were little bit optimistic. I think we're seeing the same thing at 400 gig where there a lot of end customers of network equipment operators that wanted to have 400 gig in the network sooner.

I think that as we've seen in the previous cycles, sometimes those the amount of work and the technology that needs to be ready doesn't always move according to their plan. So I would agree with you.

I don't really think that's necessarily later than what we had expected, but I think it's a fair statement that it's perhaps later than what from the operators may have otherwise liked. When it comes to, what's that effect on the AAOI? I think you're right. We would expect to see a continuation of business for 40G and 100G until the 400G is there.

I don't think the delay is a bad thing for AAOI. I think certainly we've got a good footprint in the 40 gig and 100 gig space.

We expect to be a good player a leading player in the 400 gig space as well, but the delay, if there is one to the extent that there is a delay I think it's sort of neutral for us and we'll look forward to continued strong sales of 100G and 40g until that time..

Our next question comes from Richard Shannon from Craig-Hallum. Please go ahead with your question..

Well Thompson, Stefan, thanks for taking my question. I guess first one on your design which I think you talked about seven in last quarter, seven from datacenter and four that were new customers.

Maybe within the datacenter, could you characterize the types of wins here, the 100 gig or above? And anything about the new customers you can tell us for their Tier 1, Tier 2s or cloud guys or anything like that?.

Yes. So the design wins in the quarter were -- for the datacenter space were pretty much all 100 gig type of design wins. We continue to be very active in the 400 gig qualifications. Those are ongoing, as the previous question was asked about the schedule we would expect those qualifications to be wrapping here in the next quarter or two.

And then maybe some limited trials and then a wider spread deployment in the second half of 2020. And so that schedule again it sort of broadly in line with what we’ve expected, but the design wins that we’re seeing now are largely for 100 gig.

And we did disclose the fact that several of those will with new customers, which I think is very important because it represents or reflects by the fact that all the efforts that we put in and all the information we’ve talked to you about in the past, regarding the efforts that we put into diversifying our customer base, are actually playing out not only within the datacenter space, but it is becoming less dependent on just a few large datacenter operators, but the branching out to a wider swap of the datacenter space.

But we also talked about the fact that some of our design wins are coming from areas outside of the datacenter like telecom and in particular 5G related telecom qualification. And I think those are also important for customer diversification going forward..

Okay. Thanks for the detail. One more question for me on the cable TV side. You mentioned the large order and I believe you said, it's something it would be recognized outside this quarter.

Maybe just couple of things there, maybe you can kind of give us essential the size of the order? And to the extent you think this conveys a much better environment for at least for your cable business as it relates to Remote PHY as get into next year, because obviously this year hasn’t been the investor in the cable TV business?.

Yes. So, the order was actually -- I mean, it’s the beginning of several orders than we expect to be hopefully more or less continuous stream of new order for the Remote PHY. In the quarter, I think the magnitude of the orders in sum was the low single-digit million and it will be delivered over the next couple of quarters.

So, maybe that amount of revenue doesn’t necessarily move the needle that much although it's relatively significant for our cable TV segment given where is that right now.

But I think more than that, it reflects a strong statement about the acceptability and the necessity of Remote PHY, as a new technology and the fact that is starting to get adopted by MSOs. I believe there is at least two end customers MSOs who are involved in this order.

So it's not just coming from one MSO, but there is some -- at the begging of the some broad base demand for Remote PHY among the MSO community. So, I think that’s probably maybe the message more than the revenue from that specific group of initial orders..

Okay. Appreciate the detail..

I’m sorry, you asked also about kind of what is this means to the overall cable TV business, I guess with AOI and I would say, certainly, 2019 has been challenging year in the cable space as you noted. And as others who’ve already reported even this cycle have also reported relatively weak results perhaps even unexpected the weak results.

As we talked about in our prepared remarks earlier, I think what's happening in cable right now is really a combination of MSOs just kind of reducing their overall spending, largely because the competitive threat is probably somewhat less than they would perceived to be a year or two ago.

But the other factor is that they care is the fact that new technology is continued to become available when we highlighted DOCSIS 4.0 in particular Extended Spectrum DOCSIS, which is a subset of DOCSIS 4.0 standard. And those new technologies as we view as vendor community start to bring those new technologies to availability.

MSOs are justifiably reluctant to invest in older technologies when they know that the new technology is imminent. And I think it's a combination of competitive dynamics and new technology development that's leading to a relatively weak condition right now.

Now all are being set, 5G I think as it starts to become a real maybe not an actual threat but at least the perception of that being a near term threat.

We'll start to drive the MSOs, and I think the availability of technologies like DOCSIS 4.0 that will enhance the bandwidth, dramatically enhance the bandwidth delivery capability of HFC network, that will also spur a desire by the MSOs to invest in upgrading the networks..

[Operator Instructions] Our next question comes from Tim Savageaux from Northland Capital Markets. Please go ahead with your question..

Thanks, good afternoon.

Couple of questions, first with regard to a 100 gig transceivers, which remains at a pretty reduced level, I wonder if you could characterize that or update us as a function of overall spending and customers or a function of market share and kind of competitive intensity? Should we be focused on a broader return and spending to see a recovery there or just something need to happen on the market share side?.

No. I think market share has been very stable, Tim. I don't think that's meaningfully changed. In fact, if you look at the bigger picture as we highlighted in our prepared remarks, we're actually gaining new customers for 400G. A number of the design wins that we had as we talked about in previous question have to do with 100G design win.

So I think actually we're very positive dynamics in 100G. The 100G business this quarter, the actual unit sales were up 49% sequentially. So a quite a far from it being a reduction.

I mean if you look at year-over-year decline and that's a true statement, but I think on a sequential basis, as we talked about last quarter we thought that Q2 represented kind of a low point in particular for 100G sales but for datacenter overall. And I think so far at least proven to be true, 100G sales were up sharply.

And in terms of units and as we see the third of our three large datacenter customers starting to pull out of the reduced ordering cycle that they've been in, I think that will be positive for the 100G business. And certainly the new customers that we won this quarter will also be positive for the 100G business..

Okay. And kind of unrelated question here.

Talking about 400 gig, do you expect to be able to maintain a vertically integrated strategy with regard lasers as we move to 400 gig?.

Yes, that’s our expectation. We believe we have the right devices for the 400 gig price. As we talked about we’re in qualification on lot of those products right now and things are going well..

And ladies and gentlemen, at this time I’m showing no additional questions. I’d like to turn the conference call back over to Dr. Thompson Lin for closing remarks..

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

Ladies and gentlemen that does conclude today’s conference call. We thank you for joining. You may now disconnect your lines..