Applied Optoelectronics, Inc. (AAOI) Q1 2016 Earnings Report, Transcript and Summary

Good day, and welcome to the Applied Optoelectronics First Quarter 2016 Financial Results Conference Call. [Operator Instructions] Please note that this event is being recorded. I would like to turn the conference over to Maria Riley. Please, go ahead.

Thank you. I'm Maria Riley, Applied Optoelectronics' Investor Relations. I'm pleased to welcome you to AOI's First Quarter 2016 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its first quarter 2016 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 that recording can be found on the Investor Relations page of the AOI 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 Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give you an overview of AOI's Q1 results and Stefan will provide financial details and the outlook for the second quarter. 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 terminology such as may, expect, plan or believe and by 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 changes in the company's expectation. More information about other risks that may impact the company's business are set forth in the Risk Factor section of the company's 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 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 remind you that AOI management will host its inaugural Investor Day in their new building and fab in Sugar Land, Texas on June 9. We hope to have the opportunity to see many of you there. Now I'd 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. Looking at our first quarter results. AOI delivered revenue of $50.4 million, representing 57% growth year-over-year and within our guidance of $50 million to $54 million. Our growth was driven by continued demand for our market-leading data center products, offset by lower-than-anticipated CATV revenue. We reported first quarter non-GAAP loss of $0.04 per share, below our original guidance range of earnings between $0.21 and $0.28 per share. Our gross margin was primarily impacted by lower-than-anticipated yields on certain internal stores [indiscernible] light engines. The lower-than-expected yields have largely been resolved, and we expect gross margin of this product to gradually improve as we progress through the second quarter. Additionally, gross margin was lower than our anticipated because 100G transceiver orders were lower than forecasted. Our bottom line results were also impacted by higher-than-expected R&D cost as we will work to simplify and build more automation into a compressed light manufacturing process for both 40G and 100G products to obtain greater efficiency on these products. In addition, we invested in development of our new 100G transceiver design to allow further cost reduction on this product as the volume ramps later in the year. Because we are saying that we are disappointed with our bottom line result, we recognize it is critical to consistently deliver on our online objectives. Due to the complexity of our manufacturing process and our mining footprint in the U.S. and Asia, company internal communication is critical to our ability to accurately forecast results. To this end, we have taken action to improve our internal information systems, and we have brought on additional operation management staff in Asia to support this effort. I would like to note that despite operational change we saw in the first quarter, there was no impact to our customers, and we fulfill customer requirement for the quarter. We believe we have a very strong position in the data center optics market with leading and growing market shift within our customer base. We remain committed to building on our strong foundation as a leader in advanced optical technology and expanding our footprint within the market. We believe the upgrade to 100G in the data should be one of the largest upgrade cycles in upgrades to date. Research [indiscernible] estimates that 100G single mode transceiver unit will grow at a 55% compound annual growth rate from 2015 through 2019. We believe AOI is well positioned to capitalize on this growing long-term trend a few of our strengths include [ph]. First, we're vertically integrated and one of the few company with ability to deliver 25G [indiscernible] laser in high volume. This means we have opportunity to participate in a 100G upgrade cycle in 3 different areas of the supply chain. By fitting lasers, light engines or the full transceiver modules, the adding capacity for our new plant in Houston, later scheduled to come online in Q3, will enable us to spend our revenue to market for 100G. Second, while we expect 100G market to be competitive given the size of our opportunity, we are committed to remain the cost leader. We believe we can continue to be a cost leader in 100G, while at the same time bringing our corporate cost margin back to the level that is above market. As we mentioned to you before, our 100G gross margin is above corporate average, and while competition is increasing, we believe we can maintain the strong margin, even as the market matures. We will leverage our vertical integration proprietary manufacturing process and SFT in advanced optics to drive product innovation, short-term manufacturing time and drive efficiencies. This is area where AOI excels and where we continue to develop. As example, manufacturing engineers have improved cycle time for 100G line in production, approximately 60% faster than the [indiscernible] at which we improve 40G production. And third, we'll go to the market, and we believe we have the pole position with 5 announced 100G transceiver design wins with our 2 largest data center competitors. Moving beyond the intra datacenter market, we are also participating in the 100G datacenter interconnect market by supplying data to a new and growing innovator in the space. While this is a much smaller market than our core datacenter market, we're excited that our devices are helping customers, changing the landscape of this market. In CATV, the fourth quarter continued to be very soft. However, we did see fundamental demand begin to improve as we exited the quarter, and we continue to believe we are well positioned to capture a significant portion of the DOCSIS 3.1 infrastructure spend and node and head-end replacements. Overall, we remain focused on building our strong foundation in the data center and CATV market to draw growth and achieve AOI's financial objectives. With that, I will turn the call over to Stefan to review the details of our Q1 performance and outlook for Q2. Stefan?

Thank you, Thompson. Total revenue for the first quarter grew 67% year-over-year to reach $50.4 million within the original guidance of $50 million to $54 million. We continue to see strong demand for our data center products. Data center revenue in the first quarter grew to $39 million, representing growth of 139% year-over-year and ahead of our record performance last quarter. Our data center growth this quarter was primarily driven by continued 40G sales to our 2 largest data center customers. We also expanded the number of 100G shipments by 30% compared with fourth quarter. However, as Thompson mention, we're starting to see customers push out forecast for 100G transceivers. This is due to the delay in market availability of advanced 100G chipsets required for switches and routers. Current forecasts from our customers indicate that we should expect to see strong growth for our 100G transceivers once the enhanced chipsets are more broadly available in the back half of the year. Despite this near-term delay, longer-term customer forecasts for 100G products have remained consistent. We continue to be in active qualification with the existing and new hyperscale data center customers for other 100G products, and we continue to expect decisions to be made sometime in the first half of the year. We are particularly encouraged by results coming from one of our new hyperscale engagements, and we look forward to sharing more information about this opportunity in the future. Turning to our CATV market. Revenue from CATV products in the first quarter was $7.7 million, down 36% year-over-year when compared with $12 million in Q1 of last year. While we had expected a sequential seasonal decline in CATV, revenue for these products was lower-than-expected due to the same dynamics we saw in Q4, which included lower international sales, especially in Latin America, and consolidation among our CATV customers in the U.S. As Thompson mentioned, this was our lowest CATV revenue in many years, but fundamental demand began to improve as we exited the quarter. While we believe Q1 to be the bottom for CATV, please recall that in Q2 of 2015, we had very strong demand from Latin America, and thus, we are facing a stiff comparable quarter last year, and we expect to see a year-over-year decline in CATV revenue compared to the same quarter last year. We continue to believe DOCSIS 3.1 will be a significant growth catalyst for our CATV business, and widespread deployment is expected to begin in mid-2016. Ahead of this demand, at the end of Q1, we began to see a resumption in normal order flow from one of our CATV customers, who had previously slowed markedly. As the CATV market leader, we believe AOI remains very well positioned to capture a significant portion of the DOCSIS 3.1 infrastructure spend directed towards node and head-end replacement. Revenue for our FTTH segment came in at approximately $421,000. Revenue in this segment is expected to continue to fluctuate quarterly in the $0.1 million to $2 million range in the near-term. Our telecom segment delivered revenue of $3.1 million, up 80% year-over-year, driven by recent design wins with several of our telecom customers. For the quarter, 77% of our revenue was from data center products, 15% from CATV products, with the remaining 8% from FTTH, telecom and other. In the first quarter, we had 2 10% or greater customers in the data center business that contributed 52% and 25% of total revenue. Moving down the income statement. Q1 total gross margin was 28.3%, a decrease of 120 basis points when compared with the 29.5% reported in Q4 of 2015 and a decrease of 490 basis points from the 33.2% reported in Q1 of last year. Our consolidated Q1 gross margin was primarily impacted by lower-than-expected yields as we ramped new capacity and trained new staff for certain long-reach 40G and 100G light engines. During the quarter, we experienced a higher-than-expected turnover in production line workers in our Ningbo, China factory. While in the first quarter, we always expect to see a seasonally higher level of turnover in China because of the lunar New Year, the turnover this first quarter was double what we normally see. As a result, we experienced lower-than-expected yields and longer manufacturing times as we brought in and trained new production line workers. I would like to reiterate that despite these operational challenges, there was no impact to our customers, and we fulfilled customer requirements for the quarter. The activities we undertook to simplify and automate more of the manufacturing process for light engines along with the design activity for our cost-reduced 100G transceivers caused our R&D expense to increase in the quarter by approximately $2.2 million. We expect these investments to yield improved yields and lower manufacturing costs. We also believe these investments will help enable us to maintain our cost leadership in 100G products, even with anticipated volume-driven price reductions in the future. In total, R&D expense was $8.3 million or 16.4% of revenue compared with $5.9 million or 11.1% of revenue in the prior quarter. Sales and marketing expense was $1.6 million or 3.2% of revenue, in line with the $1.6 million or 3% of revenue in the prior quarter. G&A expense was $4.9 million or 9.7% of total revenue and increased slightly from $4.5 million or 8.5% of revenue in Q4 of last year. The increase in G&A was mostly from annual compensation increases and additional headcount added in Q1. This brings total operating expenses in the first quarter to $14.8 million or 29.3% of revenue, up approximately $2.8 million when compared with $12 million or 22.6% of revenue in the prior quarter with the majority of the increase in R&D. On a year-over-year basis, total operating expense as a percent of revenue decreased by 510 basis points compared with the first quarter of 2015. Non-GAAP operating loss in Q1 was $0.5 million compared with operating income of $3.6 million in the prior quarter and operating loss of $0.3 million in Q1 of last year. Non-GAAP net loss after tax for the first quarter was $0.6 million compared with net income of $3.9 million in the prior quarter and $0.3 million in Q1 of last year. We reported a non-GAAP net loss of $0.04 per share compared with non-GAAP net income of $0.22 per diluted share in the prior quarter and $0.02 in Q1 of last year. GAAP net loss for Q1 was $1.3 million or $0.08 per share compared with GAAP net income of $2.7 million or $0.15 per share in the prior quarter. The Q1 weighted average basic share count was approximately $16.9 million. Turning now to the balance sheet. We ended Q1 with $58.5 million in total cash, cash equivalents, short-term investments and restricted cash compared with $40.7 million at the end of the previous quarter. Accounts receivable decreased to $34.9 million compared with $38.8 million last quarter, and accounts payable decreased approximately $3.6 million over Q4. We made a total of $16.9 million in capital investments in the quarter, including $7.6 million in production, equipment and machinery and $8 million on construction and building improvements, mostly for our new production facility in Sugar Land. As of March 31, we had $60.3 million in inventory, a decrease of approximately $6 million from Q4. The decrease in inventory is due to improved supply chain management procedures that were implemented over the last several quarters. Moving to our outlook. We expect Q2 revenue to be between $49.5 million and $52 million, representing flat to 5% year-over-year growth. We expect Q2 non-GAAP gross margin to be in the range of 29.5% to 31%. Non-GAAP net income is expected to be in the range of $0.7 million to $1.5 million and non-GAAP EPS between $0.04 per share and $0.08 per share, using a weighted average fully diluted share count of approximately 17.9 million shares. With that, I will turn it back over to the operator for the Q&A session. Operator?

[Operator Instructions] And our first question comes from Simon Leopold of Raymond James.

This is Victor Chiu in for Simon Leopold. So I guess I'll just start off and ask about the gross margin issue and the outlook. I think most of us were surprised, I guess, to the extent that the issues continue to persist, even into your second quarter guidance. So first with the operational issues that you had the same as the constrained production reduction issues that you had last quarter with the long-range 40G transceivers, and were there any additional issues that came up or are you...

Yes. No. I'm sorry, I didn't mean to cut you off there. I mean no, I mean, the gross margin issue that we saw this quarter, a lot of it had to do with higher-than-expected turnover in staff in our China factory as we mentioned. The number of employees -- seasonally in Q1, we always lose some employees in China due to the Lunar New Year, but this year, the amount of turnover that we saw was double what we normally see in the first quarter. So we had a lot of new staff that we had to bring on and train during the quarter, and that resulted in additional cost in terms of training cost, yield loss that we had to overcome as we were training these new employees and hiring expenses, that sort of thing. So that was a big contributor to the shortfall in the quarter.

Well, what about the issues that you experienced last quarter? Did that have any impact at all this quarter or...

Well, I -- no, I'm sorry, finish your question there.

Did that have any impact this quarter? And is that largely issue rectified? And if not, how much longer are you -- are we looking at before you get to a normalized production rate?

Yes. So I think the yield issues that we experienced last quarter, those issues have been largely resolved. And the remaining issues that we had in this quarter were really kind of unique to the first quarter. We did note that we had lower-than-expected 100-gig orders, even though that brings our -- that brings our corporate gross -- the 100-gig margins are actually higher than our corporate margins, so that also was a contributor to the lower-than-expected gross margin in this quarter. And those issues, we expect to be resolved over the next few quarters, as I mentioned.

Okay. Just moving onto 100G. Could you give us a sense of how many units you shipped this quarter? And if there were any new customers in? Just a little bit surprised that the demand is shifting out a little bit. So if you could just maybe speak about that some?

Well, we said we shipped about 30% more units than we shipped last quarter. Last quarter, we talked about shipping around 10,000 units, so 30% more than 10,000-or-so was what we shipped this quarter. As far as what we expect in the future, as we mentioned in the earlier remarks, in order for our customers to utilize the optical devices that we manufacture, they plug those optics into switches and servers that they purchase from other companies. There's a chipset that's used in the switch, which we don't manufacture, and we don't purchase, but it's another piece of the 100-gig ecosystem, if you will. And that switch chipset -- it's our understanding -- we don't buy that chipset directly, but it's our understanding based on what our customers were telling us that the widespread availability of an enhanced version that has additional features of that chipset is going to be shipped out by 2 quarters or so, roughly till the end of Q3. And so for that reason, they need less of the optical modules that we manufacture than they had earlier thought they would need. But longer-term demand, we expect to be as strong as we ever thought it would be.

[Operator Instructions] Our next question comes from Troy Jensen of Piper Jaffray.

Stefan, to be -- just to follow-up on the question about the silicon. Is it -- it's the Tomahawk chipset you're referencing, correct?

Well, we don't want to comment on specific issues with other companies. It would be a chipset that would do the same functions as the tomahawk chipset, right? It's the main chip in the switch.

Okay. And then when I look at your guidance here for the June quarter, up slightly sequentially and year-over-year. Can you just talk about the data center piece of that? Do you expect that to grow sequentially because you did comment that cable is going bound to be below last year, and there is big spread between the 7-or-so million and 16 million you did a year ago. Could you help us out directionally for the growth rate for cable TV and DC in your Q2 guidance?

Yes. Unfortunately, I mean, we don't really give guidance by segment, as you know. So I won't comment on that directly. I think, as we said in the earlier remarks, I mean, we did see a resurgence in cable TV orders toward the end of the quarter. And we think we've hit sort of the bottom in terms of cable TV revenue. So I would expect that to be up sequentially, but we have -- as I also mentioned, we have a pretty stiff comparable quarter last year in Q2 in cable because of orders coming out of Latin America that clearly are going to be constrained due to the ongoing currency situation down there. So that's why we don't think cable is going to be as robust as it was in Q2 of last year. But as far as the data center side of the business, I think, we continue to see strong growth in 40-gig products. This was, I think, our fourth or fifth quarter in a row of increased data center revenue. So we're -- we've been doing a really good job, I think, in executing in the data center side of the business. Nothing that's going on in the 100-gig is related to any shortcomings in AOI product or anything like that. It's just an issue with the switch chipsets, and so we think that's going to be pushed out until Q3.

Do you think data center will grow sequentially, I guess, is what I was trying to get to?

There are scenarios where it could, and there are scenarios were they won't, and we haven't given guidance on that.

Was your book-to-bill greater than 1 in the quarter?

Yes.

All right. And then last question from me. Can you just talk about the 100G design wins and number of 100G customers?

We have 5 design wins in 100G, and they're with our 2 largest data center customers.

[Operator Instructions] Our next question comes from Krishna Shankar of Roth Capital.

Yes. Stefan, is some of the gross margin guidance for Q2 impacted by the higher cost of goods in Q1? And are you selling, in effect, higher cost products in Q2, which is, again, continuing to depress gross margins?

Yes, there's some of that effect. I mean, clearly, we didn't exit the quarter with 0 inventory. And so there is some of that higher margin product that will bleed through the end of the quarter. So that is one of the facts.

And you folks feel now that the production yield issues, the new operators sort of being trained, you're at a point where yields are starting to stabilize and you're still able meet demand for your 2 largest customers? And do you have any additional 40G customers that you have the capacity to serve with your production now?

So your question is about 40-gig customers. We do have, obviously, other 40-gig customers other than the top 2, but they are relatively small, and we've been able to meet all of their demand in the quarter, all the demand that we saw we were able to meet, which isn't to say we didn't have any backlog at the end of the quarter, we did exit the quarter with backlog, but the point is what the customers needed during the quarter, we were able to deliver, both at 40-gig and 100-gig.

Okay. And then the production yield issues have -- you have stabilized now and you're running at sort of normalized production yield levels now?

Yes, I think the production yields improved a lot during the quarter. I think that there is still some room for improvement. And we mentioned in our earlier remarks about the investments that we made on the R&D side to further improve the manufacturing process to make the cycle time shorter, improve yields and that short of thing. And so we would expect that those efforts will pay off in further manufacturing improvements in the future, but the yield certainly improved substantially during the quarter.

Okay. And my final question is on the competitive environment, both for 40G and 100G. Can you comment on that, both for the 40G and 100G market?

Yes. We haven't seen any real shifts in the competitive environment for either of those products. They continue -- same competitors that we've seen before continue to be there.

And, I guess, as you said, you've been able to retain your customers and continue to have the dominant share of their 40G and now for the 100G also. You haven't lost any customers during this Q1 production issues?

Exactly. All of these issues that we had, I mean, while they certainly, negatively impacted our financials, the customers got the products that they needed with exceptional quality, very good on-time delivery. We didn't have any issues that are related to anything that the customers would experience. So I think they remain just as happy as they always have been with AOI.

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

Okay. Thank you for joining us today. As always, we thank our investors, customers and employees for your continued support, and we look forward to seeing you at the Investor Day in June.

And ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.