Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics' Third Quarter 2020 Earnings Conference Call. [Operator Instructions] Please note that this call is being recorded. I would now like to turn the call over to Monica Gould, Investor Relations of AOI. Ms. Gould, you may begin..

Thank you. I'm Monica Gould, Investor Relations for Applied Optoelectronics and I'm pleased to welcome you to AOI's Third Quarter 2020 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its third quarter 2020 financial results and provided its outlook for the fourth quarter of 2020.

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 the recording can be found on the Investor Relations section 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 2020. 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 terminology such as believes, anticipates, estimates, intends, predicts, expects, plans, may, should, could, would, will or thinks and by other 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 2020.

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 those 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, including the company's annual report on Form 10-K for the year ended December 31, 2019, and the company's quarterly report on Form 10-Q for the period ended June 30, 2020.

Also with the exception of revenue, all financials 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 virtually present at the Needham Security, Networking and Communications Conference on November 17; the Raymond James Technology Conference on December 8; and the Cowen Networking and Cybersecurity Conference on December 15; and the MKM Partners Conference on December 16.

The presentations at these conferences will be webcast live and links to the webcast will be available on the Investor Relations section of the AOI website. We hope to have the opportunity to interact with many of you virtually.

Additionally, I'd like to note that the date of our fourth quarter 2020 earnings call is currently scheduled for February 25, 2021. Now I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO.

Thompson?.

Thank you, Monica, and thank you, everybody, for joining us today. Our third quarter results were driven by good growth in each of our 3 major business segments. We achieved Q3 revenue of $76.6 million, which was within our guidance of $76 million to $83 million.

Q2 revenue grew 66% compared to the third quarter last year and 70% sequentially, but was at the low end of our guidance range as we began to see some slowing in orders from certain of our data center customers in the later part of the third quarter.

We believe that this slowdown in orders is related to inventory normalization following the surge in demand that was driven by the shift to working from home earlier in the year. Non-GAAP gross margin of 27.4% was above our guidance range of 25% to 26.5% due to favorable product mix coupled with benefit from our cost reduction action.

Non-GAAP net loss of $0.06 per share was in line with our expectations of a loss of $0.20 to a loss of $0.03. Similar to Q2, we saw good demand in the data center market during most of the third quarter. Toward the end of Q3, we started to see some softness from certain payers and customers due to what we believe was digestion of previous orders.

And based on what we see today, we expect headwinds in Q4 as our hyperscale customers adjust their inventory levels downward in response to supply chain disruption that currently appear to be less severe than seen earlier in the year.

Our customer relationship and market share position remains strong and we believe the continued need of higher bandwidth within the data center would drive long-term growth. Additionally, we expect continuing favorable product mix and our cost reduction efforts to further improve our gross margin in Q4.

We are pleased to report that we recently secured our second technical qualification on 400G product with a sizable Tier 2 data center operator who is an existing customer, and we are encouraged by the customer interest we are seeing from this product.

This qualification will be recorded as a design win once we receive an order from this customer for the 400G product which we expect will happen in this quarter. During the quarter, we've had 7 design wins with 6 customers. 2 of the design wins were in our CATV segment, 3 in the datacenter segment and 1 in our telecom segment.

Similar to Q2, we continue to see broad-based demand for our 100G products. Total revenue for 100G products increased almost 350% from Q3 of last year and 13% sequentially. In our CATV segment, the overall demand environment continued to be strong. Total revenue for our CATV products increased 32% year-over-year and 90% sequentially.

As we anticipated, revenue from our telecom products nearly tripled year-over-year in Q3 to a record $8.9 million, almost 44% sequentially driven by increased 5G demand in China.

However, recently, we have been informed by several China telecom customers that 5G deployment, they have been paused by several large network operators while they replan their supply chain following a disruption caused by Huawei's component shortage. We expect this pause will lead into Q1 and therefore expect a reduction in telecom demand in Q4.

Overall, we remain optimistic about telecom spend in 2021 as we believe that China deployment will resume with vigor after the Lunar New Year. We remain confident that our technology leadership in advanced optics gives us a strong competitive position to address our customer needs as demand improves.

We'll continue to manage the business efficiently to drive long-term growth and shareholder value. Before I turn the call over to Stefan, I want to emphasize that we continue to prioritize the health, safety and well-being of our employees as well as that of our customers and suppliers. I'm proud of the hard work that AOI team continued to deliver.

Thank you for your exceptional team work during this challenging period. 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. As Thompson mentioned, our Q3 results were broadly in line with our expectations and reflect continued progress on our revenue and customer diversification efforts and improvement in our gross margin. We saw good growth across each of our 3 major business segments.

Similar to Q2, we saw good demand in the data center market during the third quarter. Notably, our 100G revenue increased nearly 350% from Q3 last year and 13% sequentially.

However, later in the quarter, we started to see some softness in deliveries as our customers began to catch up with the surge in demand in the first half of the year and focused on digesting previous orders. Based on what we see today, we expect headwinds in Q4 as certain of our hyperscale customers adjust their inventory to more normal levels.

We anticipate that revenue will be down sequentially in Q4. However, we believe that in the next few quarters, as inventory at our customers returns to normal level, we will resume revenue growth in this segment. We continue to have good relationships with our data center customers.

We believe the fundamental needs for higher bandwidth within hyperscale data center will drive long-term growth, particularly during this time as our customers remain focused on improving network performance in light of the increased traffic related to the shift towards working from home.

And we expect our gross margins to further benefit in Q4 from continued favorable product mix and our cost reduction efforts. Turning to our quarterly performance. Total revenue for the third quarter of $76.6 million was in line with our guidance range.

Revenue increased 66% year-over-year and 17% sequentially, driven by growth in all of our business segments. Our data center revenue rose 5% sequentially and 63% year-over-year to $55.3 million and accounted for 72% of our total revenue.

In the third quarter, 28% of our data center revenue was from our 40G transceiver products and 68% was from our 100G products. We are pleased with our progress on our customer diversification efforts. Overall for the quarter, our top 10 customers represented 84.9% of revenue, which compares to 88.3% in Q3 of last year.

We had 2 10% or greater customers in the quarter, both of which were in the datacenter segment. These customers contributed 40% and 10% of total revenue, respectively. During the third quarter, in addition to the 10% or greater customers, we had 3 other customers who each contributed between 5% and 10% of total revenue.

2 of these customers were in our datacenter segment and 1 in CATV. This compared to 2 10% or greater customers and 1 customer between 5% and 10% in Q3 of last year. Our top 5 customers represented 75% of our revenue compared to 82% in Q3 of last year. Turning to our CATV products segment.

We generated revenue of $11.6 million, up 90% sequentially and up 32% from $8.8 million in Q3 of last year. As expected, we began shipping newly designed line extender amplifier products in the quarter and plan to ship initial quantities of system amplifier products in Q4.

Demand from North American MSOs for HFC equipment appears to be stronger than it has been in several years and we currently expect this demand to continue for at least the next several quarters as MSOs upgrade their networks, particularly to address congestion in the return path.

Revenue from our telecom products more than tripled to a record $8.9 million from $2.9 million in Q3 of last year, driven by increased 5G demand in China. Revenue from our telecom products accounted for 12% of total revenue, reflecting an increase of 44% from the second quarter and 209% from Q3 of last year.

Gross margin in our telecom segment also continued to expand, up 230 basis points sequentially. This growth in revenue combined with increase in gross margin is one of the factors that contributed to the favorable product mix that allowed us to exceed our gross margin guidance in Q3.

However, as Thompson mentioned earlier, recently we have been informed by several of our China telecom customers that 5G deployment there has been paused by several large network operators as they replan their supply chains following the disruption caused by Huawei's component shortages.

We anticipate that revenue will be down sequentially in Q4, however, we believe that growth will resume in Q1. Overall, we remain optimistic about telecom spend in 2021 as we believe that China deployments will resume with vigor after the Lunar New Year.

The recent notable highlight in our FTTH segment is our involvement working on the 25GS-PON MSA alongside Nokia and 3 Asia Pacific service providers. We are pleased to be working on this MSA which positions us well in the next-generation PON ecosystem, and we believe this could be a long-term growth driver for our fiber to the home segment.

In Q3, we generated non-GAAP gross margin of 27.4% compared to 28.8% in Q3 of the prior year. Gross margin was above our guidance range of 25% to 26.5% due to a favorable product mix coupled with benefits from our cost reduction actions.

We expect these benefits and our product mix to further improve our gross margin in Q4, which we anticipate could approach 29%. Total non-GAAP operating expenses in the third quarter were $22.3 million or 29.1% of revenue compared with $18.4 million or 39.9% of revenue in Q3 of last year.

Operating expenses as a percent of overall revenue decreased from last year and reflect our efficient expense management. Non-GAAP operating loss in the third quarter was $1.3 million compared to an operating loss of $5.1 million in Q3 last year.

GAAP net loss for Q3 was $9.6 million or a loss of $0.42 per basic share compared with a GAAP net loss of $8.8 million or $0.44 per basic share in Q3 of last year.

On a non-GAAP basis, net loss for Q3 was $1.4 million or a loss of $0.06 per basic share, which was at the high end of our guidance range of a loss of $0.6 to $4.6 million or a loss of $0.03 to $0.20 per basic share and compares to a net loss of $2.9 million or a loss of $0.15 per basic share in Q3 of last year.

The basic shares outstanding used for computing the net loss in Q3 were 22.7 million. Turning now to the balance sheet. We ended the third quarter with $58.1 million in total cash, cash equivalents, short-term investments and restricted cash.

This compares with $58.9 million at the end of the second quarter and reflects $6.1 million in cash used for operations. As of September 30, we had $111.4 million in inventory compared to $97.3 million in Q2.

The increase was driven mainly by the buildup of raw material and semi-finished goods inventory, which we are preparing prior to year-end and in anticipation of the Lunar New Year holiday.

We made a total of $3.5 million in capital investments in the quarter, including $1.2 million in production equipment and machinery and $2.2 million on construction and building improvements. This was below our expectations as we continue to tightly manage CapEx.

However, as we discussed on the Q2 call, we did resume spending on our new China facility in Q3. We now expect total 2020 capital expenditures to be below our prior expectations as we continue to tightly manage our CapEx plans. Currently, we expect 2020 CapEx to be approximately $22 million, down from our previous estimate of $42 million.

The reduction is mostly due to a reduction in equipment purchases and building improvements as we work with our customers to anticipate the timing of the 400G ramp next year. We will continue to reevaluate our spending needs as our plans evolve.

Before we turn to our outlook, I would like to provide a quick update on the at-the-market offering we announced in February. To date, we have raised $23.2 million in gross proceeds under this program, including $8.9 million raised in Q3.

The as we have stated previously, we intend to use these proceeds to continue to make investments in the business, including new equipment and machinery for production and research and development use. Moving now to our Q4 outlook.

We expect Q4 revenue to be between $50 million and $55 million and non-GAAP gross margin to be in the range of 28.5% to 29.5%. Net loss is expected to be in the range of $4.5 million to $5.8 million and non-GAAP loss per basic share between $0.19 and $0.25 using a weighted average basic share count of approximately 23.5 million shares.

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

Operator?.

[Operator Instructions] Our first question comes from Dave Kang with B. Riley..

I just have a quick one on the 400G and 100G products. I was wondering if you guys could give a little color around the pricing environment.

Do you guys see any weakness in pricing there? Also, how is the demand looking? Can you guys give any color around that? Like what are customers' demands looking like going forward? And how do you guys view strength in that product?.

Sure. So regarding your first question on the pricing environment. It's been pretty stable. I mean within our expectations. No big change in that. Regarding your question on demand, as we talked about in our prepared remarks, I think there's some near-term headwinds in -- from some of the hyperscale customers.

We've seen -- basically, I think what's going on here is that several of them kind of anticipated more supply chain disruption during COVID than actually occurred. So they prepared extra inventory in anticipation that there would be some problems.

Those problems maybe didn't materialize as much as they thought they might and so they're going to adjust their inventories back to more normal levels. Now that's what's going on. And that will take the next couple of quarters to normalize itself, we think..

Okay. Great.

And on the 200- and 400-gig products, how was progress looking? How are qualifications coming along? And how does the demand and pricing environment look for that going forward?.

Sure. So I mean, 200-gig products are -- they're not probably the next mainstream product, as we've talked about in our previous earnings calls and other investor communications. We think 400-gig is really where the next-generation is going to land pretty squarely. We do have some 200-gig sales but it's relatively minor.

As far as 400 gigs, the qualifications that are ongoing there, well we had some good progress on that this quarter. We did finish a -- successfully completed a qualification effort from one of our data center operators this quarter for 400G. That's our second qualification.

The other one was announced I believe in Q2 -- I'm sorry, it was announced in our -- in Q2 for our Q1 call. So that's our second 400-gig qualification. And we think that speaks pretty highly of our technology and our ability to gain traction in that market.

We do see the 400-gig market beginning to pick up in earnest probably the middle part of next year. We're still working with our customers to ascertain the exact time frame there. But it's starting to feel more solid that we'll start to see some orders in the middle part of next year..

Okay. Sorry, go ahead..

No, no. That's it. I think I answered the question..

Our next question comes from Paul Silverstein with Cowen..

Stefan, Thompson, how does demand for 5G look outside of China?.

Right now, I mean, the demand that we're seeing is primarily in China. There's probably demand outside of that but it's not something that we have much exposure to at this point..

So it's more -- Stefan, if I hear you correctly, you just don't have much exposure outside of China that's why your revenue is highly leveraged in 5G China, not so much or very little to 5G outside of China..

Yes. But my suspicion is that there's not -- I mean there's obviously 5G activity going on in China, but I want to be really clear that when we talk about 5G, what we're really talking about is ultra-wideband 5G.

There's clearly 5G deployments going on in areas outside of China, but for the most part, the front-haul and mid-haul links in those applications are similar to 4G. So there's not a need for the kind of high-bandwidth optics that we're supplying. Those optics are needed in the ultra-wideband 5G which right now is primarily being deployed in China.

So it's not that we necessarily don't have inroads or the capability to sell in other parts of the world, it's just that the ultra-wideband type of 5G deployments are not really that active outside of China..

[Operator Instructions] At this time, we have no further questions. I will now turn the call over to Dr. Thompson Lin for closing remarks..

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

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