Good day, and welcome to the Applied Optoelectronics Third Quarter 2014 Financial Results Conference Call. Today's conference is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to Maria Riley. Please go ahead, ma'am.

Thank you, operator. I'm Maria Riley, Applied Optoelectronics' Investor Relations, and I am pleased to welcome you to AOI's Third Quarter 2014 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its Q3 2014 financial results. 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 AOI's website and will be archived for 90 days. Joining us on today's call is Dr. Thompson Lin, AOI's Founder, Chairman and CEO; and Dr. Stefan Murray, 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 an update on AOI's strategy and markets. A question-and-answer session will follow our prepared remarks. Before we begin, I would like to remind you to review AOI's Safe Harbor statement. On today's call, management will make forward-looking statements. These forward-looking statements involve risks and uncertainties, as well as assumptions and current expectations, which could cause the company's actual results to differ materially from those anticipated in such forward-looking statements. You can identify forward-looking statements by terminologies such as may, expect, plan or believe and similar expressions. Except as required by law, we assume no obligation to update forward-looking statements for any reason after the date of this earnings call to conform these statements to actual results or to change 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 prospectus and other quarterly reports on file with the SEC. Also, with the exception of revenue, all financial numbers discussed today are on a non-GAAP basis, unless specifically noted otherwise. Non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation between our GAAP and our non-GAAP measures, as well as discussion of why we present non-GAAP financial measures, are included in our press release that is available on our website. Now I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' President, Founder and CEO. Thompson?

Thank you, Maria. Thank you for joining us today. AOI delivered another record quarter in Q3 as we continued to execute according to our plan. We achieved our sixth consecutive quarter of record revenue and a record-high non-GAAP net income of $3.1 million or $0.20 per share, 33% higher than in Q2. Our gross margin was 33.3%, which is slightly lower than what we expected earlier in the quarter, right in line with our long-term operating model. Looking at our performance in more detail. Third quarter revenue grew 76% year-over-year and 12% sequentially to reach a record $36.5 million. Our data center revenue grew 12% sequentially to reach $20.1 million. This is up significantly when we compare it to the $3.2 million we reported in the third quarter of last year. Our largest data center customers continue to exceed expectations, and we are pleased with the initial results from the sales and marketing investments we made over the past few quarters. We expect to continue those investments and are working hard to further diversify our data center customer base. Our cable TV revenue grew 15% sequentially, mostly driven by strength in emerging market products and revenue stemming from recent design wins. Our DOCSIS 3.1 development is on track, and we expect to see revenue from this development starting Q1 2015. The revenue growth for our data center and cable TV products was offset by a $0.5 million decline in fiber-to-the-home revenue as sales to our conventional customers decreased. As we mentioned last quarter, this customer had pushed out its WDM-PON plan by a couple of quarters. However, we were recently informed that the WDM-PON deployment plan had further changed, and as a result, we are adjusting our near-term fiber-to-the-home sales expectations. Stefan will provide you more details on the recent…

Thank you. As Thompson noted, total third quarter revenue grew 76% year-over-year and 12% sequentially to reach record revenue of $36.5 million. Our top line growth was driven by our continued strong sales in the data center market and an increase in CATV revenue. However, the growth in these markets was offset by a $0.5 million or 16% decline in our FTTH revenue, as our large FTTH customer pulled back WDM-PON spending. As we reported last quarter, we were expecting this customer to push out its WDM-PON deployment schedule by a couple of quarters, and we were delaying our plans to build out 3 additional manufacturing lines in Taiwan. However, there has been a new development. With the change in management, we believe this customer has chosen to forgo the scalability and lower cost provided by WDM-PON to focus on accelerating their near-term deployment schedule. As a result, we believe they will continue to deploy their current technology longer than previously envisioned. Given our current lack of visibility, we are excluding them from our near-term FTTH revenue expectations, and production plans for both the OLT and ONU transceivers. We are currently forecasting annual FTTH revenue to decrease by approximately 60% in 2015, which excludes revenue from this customer and revenue from any potential new customers. As we mentioned last quarter, we have had new inquiries about our WDM-PON technology for several potential customers, and we are increasingly encouraged by these discussions. So generating revenue from any of these new inquiries would be additive to our current FTTH forecast. Turning to our CATV market. Revenue from CATV products in the third quarter was within our expectations at $12.2 million, up 15% from Q2. The sequential increase in CATV revenue was driven by recent design wins and continued modest growth in CATV…

[Operator Instructions] We'll take our first question from Simon Leopold with Raymond James.

A handful of things I'd like to ask. One is, when you were talking about the fiber-to-the-home business not turning out as you once expected, I think you mentioned you expected a decline in 2015 of about 60%. I wanted to just double-check that I've heard you correctly. In other words, you're looking at 2015 revenue of $4 million to $5 million from FTTH?

Yes, Simon, that's correct. Basically what that's based on is, as we said in the call, I mean, we have limited visibility into next year's revenue from that segment and so, basically, we're taking out the WDM-PON from the foundational customer and what's left is the remaining revenue in the FTTH segment. And your math is correct.

Okay. And basically, I'm trying to get an understanding of what changed. Did the alternatives become more cost-effective? Was it that WDM-PON was considered to have too much technology risk because it was new? What's different now than prior expectations?

Yes. So first of all, I should emphasize that we have no indication that this is related to any kind of technology deficiency or anything else. What seems to have changed is the amount of risk that the customer is willing to take relative to near-term deployments, that is we still think that WDM-PON is the most cost-effective way to deliver 1-gigabit-per-second services, and there's nothing that's changed in that regard. However, it seems like the customer has decided to continue to deploy its existing technology even though we believe that's a more expensive way to get the job done, preferring that primarily on the basis of the fact that it's sort of a known quantity from a deployment scenario, large-scale deployment scenario. And WDM-PON is relatively -- because of the newness of the technology, it's relatively unknown with respect to large deployment.

And then what do you expect in the December quarter? Do you expect it to be down to $1 million and change in the December quarter? Or will it be more of a gradual ramp?

Well, we don't -- we're not -- we can't give forward guidance by segment like that, but what I will say is that we -- we're going to continue to deliver according to some of the open orders and contractual obligations that we have agreed to. And so there will be some revenue in Q4, but the precise level, I can't comment.

And just one last one before I hand it over to somebody else. When you look at your data center opportunities, the 100-gig market is certainly active, but it also sounds like it's been very competitive among the participants. How are you thinking about price competitiveness and your ability to play in the 100-gig data center market?

Thanks, Simon. That's a great question. So the very important point to keep in mind is that because of our vertical integration, particularly our in-house laser manufacturing and the advanced light engines, which again is the optical subassembly for these 40-gig and 100-gig transceivers, that puts AOI, relatively speaking, in a better competitive position. So whatever price declines there are, we don't see that translating into margin declines. We think we can maintain the margin because, again, we have a sort of built-in structural advantage based on our vertical integration at our light engine production capacity. And so that being said, I think that the history that we've had with 40 gig is that prices fall fairly in line with what we expected going into it. There's obviously some price decline but it's in line with what we expect.

We'll take our next question from Paul Silverstein with Cowen and Company.

Was the 10% customer this quarter the same as last quarter?

Yes.

And how many -- can you remind us how many data center customers you have right now?

We have 4.

Four. Stefan, can you reference -- am I wrong? I thought last quarter you had referenced a new, as-yet unnamed customer, which would make 5.

Well, what we had said was that we had a new customer that was under qualification, and that's the same customer that we're still in qualification with right now that we talked about on the call.

All right. And then I apologize, but there were another -- did I hear you say you had design wins with another 3 customers or did I mishear?

We had 3 design wins with an undisclosed number of customers, but they're among our existing customer base.

So they're all among the -- the design wins are all among the existing customers?

Correct. That's right.

All right. And then on the gross margin side, in terms of pricing, was there a decision because of the loss of that key WDM-PON customer? Was there a decision to be more aggressive in price concessions in order to bulk up the Data Center Business as one would expect?

No, no.

So there was no trade-off involved?

No, not at all.

All right. And just if I go back a quarter ago, and I apologize if I don't remember this correctly, but I think a quarter ago when pricing came up in the Q&A, you guys were pretty adamant that the price environment was pretty benign. There was nothing extraordinary, unusual. The stepped-up price concession, I mean, maybe that's -- maybe I'm mischaracterizing it in terms of what the price concession was. But let me ask the question more directly, if we look at pricing, can you give us some sense for what historically the degree of price degradation had been and what it was this go-around?

Well, it's worth mentioning, really, the price decline that we're talking about was specific to one particular product. That was our 10-gigabit-per-second transceivers. And really, it was specific to one product with one customer, okay? We don't -- I wouldn't read anything into that for 40 gigabits or certainly 100 gigabits per second, as I mentioned to Simon's question earlier. Those are different animals because they involve light engine technology, and they're much more dependent on the edge-emitting laser technology that AOI had, okay? The price decline that we saw on the 10-gigabit-per-second product, really, I mean, it was not an enormous price decline. On the last call, we did indicate that we were fairly confident we wouldn't see -- we would see very little, if any, price decline. Obviously, that turned out to be a little bit optimistic. But the price decline that we did see was not enormous. And it's worth mentioning, too, that even with that, I mean, we continue to have among, if not, the highest gross margin in the optical peers that we have. So it's not like it was a disastrous thing, but it did account for that slight 1% miss in overall gross margin.

All right. One last question and then I'll pass it on. The obvious question, relative to what just happened with the WDM-PON customer, I recognize each customer is different, but if we were to look at the communications you have with your data center customers, the degree of visibility you have into those deployments and the confidence in the associated risk that one or more of them, especially the 20-plus -- the 10-plus percent customer that there's a change going forward. We understand there's no guarantees in your business, unfortunately. But can you give us some better insight in terms of the degree of visibility?

Yes, I think that's a really good question. The -- and I want to emphasize again the situation with the WDM-PON really had to do with risk or perceived risk in deploying a new technology and their desire to avoid that risk, okay? In the data center side of the business, that doesn't exist. I mean, 10 gig, 40 gig and even 100 gig, these are well-known technologies that are being developed or have been developed in tandem with the customers. So there isn't that kind of unknown deployment technology risk that we see with the WDM-PON. So we don't really see that being a factor in the 40-gig or 100-gig data center production at all.

All right. And I'm going to apologize to you and the others on the call, but I'm going to ask one more question, if I may. Certainly, on the Data Center side, can you give us some sense -- I understand there are customer confidences, which limit you'll say, but can you give us some sense for the depth of penetration in the other 3 customers? I think the one you've got 10-plus percent has been a 10% customer. That was -- correct me if I'm wrong, but that was your earliest data center win. Where are you at with the others? What's the likelihood that one or more of the other 3 will step up and become significantly more prominent in terms of revenue generation in the not-too-distant future?

Sure. We're well penetrated in the other accounts. The reality of the current data center market, especially the Web 2.0 market, is that our one 10% customer is just much larger in terms of purchasing of optics compared to almost everybody else in the industry. So I think we're still -- we still have very good market share. I don't think we've lost any market share with our other customers in that segment. But the scale of their business, the scope of their business in terms of optical transceivers is just a lot smaller than our large 10%-plus customer. And so that's why -- I mean, whatever gains we see with those other customers are kind of mapped by the tremendous growth that we're seeing from our top customer.

Have your other customers all grown in dollars?

Not all of them have. Some have and some haven't. The ones that haven't, it's been because of a change in -- as they go from 1 to 10 to 40 or 40 to 100, it's been that intervening transition period that's been causing them to decline a little bit. Not anything related to market share loss.

We'll take the next question from Troy Jensen with Piper Jaffray.

Stefan, just want to follow up on Paul's questions. On the ASP erosion, I mean, a lot of your competitors do help us out and they give us a quarterly reduction or an annual price cut in the 10% to 15% range, some of them say. Could you just quantify a little bit, what do you mean by not enormous?

Less than 10%.

Less than 10% annual reduction?

Yes, it's less than 10%. In fact, it seems to be -- this particular customer tends to look at pricing on an annual basis, and so that we believe this will be the price reduction for the year going forward, and it was less than 10%.

Okay, perfect. And then how big is 40G as a percentage of data center?

It's about 37% of data center revenue.

37%, okay. And then my last question for you just, can you help us out with Q1 seasonality? I know you've been a nice high-growth company here and some people have seasonality in Q1. Any color on that would be extremely helpful.

Well, the seasonality that we have seen historically has been basically exclusively related to the cable TV segment, okay? So right away, you could see as the cable TV segment has become relatively less as a percentage of our total revenue, that would imply somewhat less seasonality compared to what we've seen in the past. I don't expect that we're going to see that type of seasonality, for example, in the data center market. At least we haven't seen that historically. The cable market itself is likely to continue to be somewhat seasonal, although there's this overlying impact of the DOCSIS 3.1 and the new products that we're bringing to market for that. And I would expect, to some extent, that customers buying inventory of these new DOCSIS 3.1 products and preparing for field trials and things like that may not necessarily experience the same degree of seasonality that we would see from normal cable TV deployment in Q1.

So last year, you guys were up actually almost 5% sequentially in March. I mean, is that possible again? Do you expect to be flat or down slightly? Any color as we're putting our models together would be helpful.

Yes, we really don't give that kind of forward-looking guidance. But again, I would just think a little bit about the trends and the data center relative to cable TV in terms of revenue.

And so you're saying data center does not have seasonality?

We haven't seen seasonality in data center in Q1, no.

Our next question will come from Krishna Shankar with Roth Capital.

Yes. Can you talk about the Data Center business? And I think last quarter, you mentioned you might potentially have a couple more new customers. Can you talk about your diversification within the data center business? And any new customers coming on?

Yes. So we still have the 4 customers that we talked about before. We mentioned that we have another customer, a fifth customer, that has several products that are currently under qualification that we expect to complete qualification within this quarter, that is Q4. And so that would be a fifth data center customer. That fifth customer we've also talked about in the past is a customer that is sizable enough that we think they could have significantly more buying power than certainly at least 2 out of the other 4 customers that we have right now. That is, it's a scope that's much larger than 3 out of the 4 data center customers that we currently have.

Okay. And with regard to gross margins, I know you had some pricing negotiations in Q3. Can you talk about the trend in sort of Data Center gross margins? Are you at a level now where they could be stable? Or do we expect more pricing pressure in the Data Center business?

Yes. So our large customer, the one that we've been mostly talking about, historically has done -- has looked at pricing on an annual basis. And we've just undergone that pricing discussion recently, as we talked about. So I mean, you can never completely see the future, but we haven't experienced them wanting to have multiple price negotiations in a year. And so I would expect that, relatively speaking, we should be -- we should have the pricing pretty well set for the year.

Okay. And my final question, on fiber-to-the-home, any other customers or deployments that you're engaged with now that could diversify you away from that one lead customer?

Yes. I mean, we don't really want to talk about specific deployments or specific customers. But as we talked about, we do have multiple customers that we're in discussions with. Even prior to our interaction with this primary customer, we've had several other customers that we've been shipping WDM-PON, our sort of gen-1 WDM-PON products to. And we do believe that those customers will continue. So we'll still continue to see some business from WDM-PON. It will obviously be at a significantly reduced scale for some time until we can backfill new customers in that segment.

[Operator Instructions] We'll go next to Richard Shannon with Craig-Hallum.

A few questions from me. Maybe just a quick question on the fourth quarter sales guidance. You seem to be suggesting fiber-to-the-home will be down significantly. Within the other 2 important segments, Data Center and Cable TV, can you kind of flesh out to the extent to which you're able to, about the sequential trends there? I'm assuming data center will grow faster, but just want to get any more clarification there, please.

Yes. I mean, we don't really break out the forward guidance by segment. I think that we've guided for cable TV to be sort of flat to down slightly from 2013, so you can kind of get an idea on where that revenue is going to be. We've got 3 quarters there, and you can kind of figure out where the fourth quarter will be based on the guidance, I think. And take a swag on the data center side of the revenue, and then that leaves you with the growth in the FTTH.

Okay, fair enough. Second question, on CapEx, you gave us a number for this year, was clearly front-end loading some data center investments that may have been coming next year. How should we think about modeling that for next year? Clearly, you won't have much, if any, fiber-to-the-home or at least visibility into that. So how should we think about that number for next year?

Well, we're not giving forward guidance on the CapEx, at least at this point. What I can say is that for us, CapEx, we invest CapEx very strategically based on near-term customer demand trend. So we're not buying a bunch of equipment or investing in a lot of things that are way out in the future. We buy equipment or production capacity when we see a customer demand. In this case, for example, it was heavily invested in 40-gigabit-per-second products because we saw our customer demand for 40-gigabit-per-second product increase much faster than what we had projected. So we invested strategically in 40-gigabit-per-second production capacity so that we had sufficient capacity to meet the demand. And so when we look at CapEx for next year, I think what we're going to be looking to do is to invest certainly in 100-gigabit-per-second production, perhaps in 40-gigabit-per-second production if we see continued increase in that segment. And to the extent that we get new customer interaction on WDM-PON or a resumption in interaction with our existing customer in WDM-PON, we may invest in that equipment as well. I mean, most of the time, our goal is to operate very, very close to 100% capacity, that is we want to be fully utilizing all of our equipment. And as a result, when we see increases in demand, that fairly quickly translates into the need to buy new equipment, which we do on a strategic basis when we see that demand come out.

Okay, so that's fair enough. So one last question from me, Stefan. In the Data Center segment, can you give us a sense of your additions in sales and marketing in that sector? I think you've hired a Taiwan-based VP there. Give us a sense of what the sales funnel looks like. How broad of a customer base are you aiming towards? Is it like the top dozen guys out there, 2 dozen? Or really, how far and wide are you spreading your wings there?

Yes, I mean, we're looking certainly at the top 5 or 6 largest data center operators, for sure. But we are -- where we have opportunities to pick up business from others, we're certainly very interested in doing that. We're not limiting ourselves completely to just those top 5 or 6. And those opportunities do come up from time to time where we see opportunities to pick up business from maybe smaller players. But it's still diversification, and I think that's still a useful part of our strategy, so we'll continue to broaden even out beyond some of the top names that you might hear. But our focus still clearly is on the guys that can buy the most products.

And ladies and gentlemen, that does conclude our question-and-answer session. At this time, I'll turn the call back over to Thompson Lin for closing comments.

Okay. Thank you for joining us today. We are very pleased with our Q3 results and tremendous growth in 2014. We believe we are very well positioned in optical access market, and we will continue to focus on leveraging our technology leadership and vertical integration to drive growth on the top and bottom line. As always, we thank you for your support.

Ladies and gentlemen, that does conclude today's call, and we thank you for your participation.