Welcome to the Applied Optoelectronics Second Quarter 2017 Earnings Conference Call. [Operator Instructions]. Please note today's event is being recorded. I would now like to turn the conference over to Maria Riley, Investor Relations for Applied Optoelectronics. Please go ahead.

Thank you. I'm Maria Riley, Applied Optoelectronics Investor Relations and I'm pleased to welcome you to AOI's Second Quarter 2017 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing it's second quarter 2017 financial results and provided it's outlook for the third quarter of 2017. The release is also available on the company's website at ao-inc.com. This call is being recorded and webcast live. I link to that recording can be found on new Investor Relations page of the AOI website and will be archived for one year. Joining us on today's call is Dr. Thompson Lin, AOI's Founder, Chairman and CEO; and Dr. Stefan Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give an overview of AOI's Q2 results and Stefan will provide financial details and the outlook for the third 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 terminologies such as may, will, show, expects, plans, anticipates, believes or estimates and by other 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 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. Also, with the exception of revenue, all financial numbers discussed today are on a non-GAAP basis unless specifically noted otherwise. Non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation between our GAAP and non-GAAP measures as well as a discussion of why we present non-GAAP financial measures are included in our earnings press release that is available on our website. Now, I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO. Thompson?

Thank you, Maria. Thank you for joining us today. The second quarter was another great quarter for AOI. Our year was driven by strong demand for the products and continued improvement in manufacturing cost and capacity expansion which should lead to another quarter of record revenues and record gross margins. Our ability to leverage our vertical integration and proprietary manufacturing process to draw greater efficiencies and short term production [indiscernible] set AOI apart from others in the industry. We're proud of our great result and continued execution in the quarter. And now I would like to thank the AOI team for all of their hard work and dedication. Total revenue grew 112% over Q2 of last year of $117.4 million. This represents all four consecutive quarter of achieving record revenue. Our data center solutions continue to fuel our growth in banner revenue more than doubled year-over-year and with the limit on the ninth consecutive quarter of record in the revenue. Our cable TV solutions also delivered strong growth in the quarter. Cable TV revenue grew 51% of Q2 of last year. Beyond revenue, we achieved a record gross margin of 45.5% and record operating margin of 31.5%. We have increased our operating profit by 963% over last year, demonstrating the strong leverage in our model. This has led to record net income of $31.3 million or $1.54 per diluted share. As we announced in June, we're way on track with our goal to expand capacity to approximately $1 million to qualify liaises per month. In the month of June, we produced over 680,000 basis which represents 67% growth year-to-date. We believe our strong performance is a testament to a strength of this model manufacturing know-how and leadership position in Optix. We will continue to invest in areas that twist drive full capacity expansion and position AOI for continued success. With that, I will turn the call over to Stefan to review the details of our Q2 performance and outlook for Q3. Stefan?

Thank you, Thompson. Total revenue for the second quarter grew 112% year-over-year to reach another record $117.4 million which was above our initial guidance of $106 million to $112 million. The upside in the quarter was driven by our team's ability to improve manufacturing efficiencies and ship ahead of our plan for the quarter. In the month of June, we produced over 680,000 lasers which are used across our product portfolio. We remain on track to achieve our production goal of approximately $1 million, fully qualified lasers per month which will continue to be leveraged across our product portfolio. I would like to remind you that today it takes approximately 6 weeks from the point of laser manufactured to produce a transceiver for our data center customers. Looking at our top line performance in more detail, we continued to see strong demand for our data center products and achieved our ninth consecutive quarter of record data center revenue. Data center revenue in the second quarter grew 141% year-over-year to reach $99.3 million or 85% of Q2 revenue. In this quarter, 57% of our data center revenue was derived from our 40G data center products and 39% was from our 100G products which represents an increase of 62% in 100G sales from the prior quarter. As with last quarter, we saw particular strength in our 100G CWDM product line. Revenue from 100G CWDM products in Q2 increased by 72% compared to Q1, while 100G PCM product increased by 41% sequentially. In general, we expect to continue to see CWDM outperform PSM in terms of growth rate and we expect growth on a dollar basis across both product categories. The cost leadership that we had in CWDM is due in part to AOI's ability to utilize uncooled directly modulated laser diodes to…

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

So a lot of it is sort of arguments you've helped, I think, offset with the detail you provided in terms of 100 gig and 40 gig breakouts, so I appreciate that level of detail. One of the aspects I'm sort of struggling with is this idea that you are 100 gig business is heavily biased towards your second biggest customer and you don't have meaningful 100 gig in your biggest customer. If you can get a better understanding of maybe what the different customers are buying and why?

Well Simon, we have meaningfully 100 gig revenue with our largest customers as well as our other customers. We can get to customer specific on exactly what variety of products we do have as you can imagine nondisclosure agreements of these customers that prevent us from telling exactly what types or what quantities of these types of products they are buying. However, we do have meaningful mutual 100 gig sales with all 3 of our large data center customers.

Great, appreciate that. And in terms of the gross margin guidance, I would've thought that if you had not to buy a sequential volume decline and I don't think you do and you're indicating what I would really would be a favorable mix, meaning that you're going to see more 100 gig in September and less 40 gig and making this assumption that 100 gig is better gross margin, so maybe that's flawed. Can you help me understand what are the drivers for the lower sequential gross margins in September than June?

We've some price reductions as we mentioned in the prepared remarks that took -- that are taking effect during Q3.

And that's suggestive is it correct to assume that 100 gig gross margins are better than 40 gig? Or is that flawed assumption?

That's generally true. Although, again, you have to look at product by product basis to see the details which of course we can't go into it at this point.

Okay. And did indicate that you expect sequential improvement again in December, maybe help us understand sort of the basis for your confidence. Are these committed orders? Is this based on the windows of guidance you're getting from your customers? Or is it based on the third customer coming back into 10% ranks. Help us understand the drivers for confidence in 4Q?

We expect to see strong growth from 2 out of the 3 large data center customers that we have and resumption of growth from our largest customer. In addition to that, yes, one of these are committed orders. There are some committed orders out there, not all of that expectation is committed at this point. But we do have a significant amount of committed orders and good forecast from all 3 of our customers.

Great. And one last if I may and I'll be blunt you answer as you see fit, but this argument that may come -- that it's disrupting the market by partnering with contract manufactured selling to your customers and crushing pricing. If you could help us understand how you view the competitive landscape against a player that is selling lasers and ICs into a contract manufacture into ultimately webscale?

Sure. So first of all we don't believe that the make on Cybernet alliance is actually producing anything or is likely to produce any products or any meaningful quantities, certainly, in the next quarter or 2, probably longer than that. In addition to that, in the long term and in the short term, we don't see any cost advantage to this model. AOI, as we mentioned, is currently very highly vertical integrated on the most expensive components meaning the lasers. As we announced in the call, we also intend to produce other optical components that we currently don't produce internally which will further enhance the extent of our vertical integration and we think is a significant cost even against the make-on fiber net [ph] business model or any of the other competitive business models that we're aware of.

The next question will come from Paul Silverstein of Cowen & Company.

So Thompson, to what percent of content today is fully internal. So when you talk about bringing in-house certain components that currently being done by you, can you quantify for us how much is truly vertically integrated? And what percentage of the transceivers today are outside of Applied Opto?

I'm not quite sure I completely understand your question, Paul. We produce all of the transceivers that we're selling today are produced internally. If you're asking exactly which parts and what dollar content is currently internally sourced, I don't have an exact figure for you.

That is the question to be clear.

I understand, but I don't have a figure for you, it varies depending on the particular type of product. And also, to be honest with the time because, as we mentioned, we're making improvements in further vertical integrating what we manufacture in-house. So it's kind of a moving target. But certainly, we produce the lasers that we use. At least the DFB lasers that produced, the directed modulated DFBs and some of the EMLs as well and we produce a number of the PC board assemblies and other optical components internally.

And Paul, this is Thompson. Announce we just are making that 25G PDN and 1PD array, that's very significant to the build materials. We naturally decide that we were making some other expense module in 22 is by Q4 early Q1. So basically, what 100G transceivers data center would always say more than 60% would be by our sales in the future could be even as high as 70% for cold start be similar. So we're making quite a start also besides the IC.

I believe Thompson is talking about, when he says 60% of 70%, I believe he is referring to the dollar content of the cost, the bill material -- percentage of the bill material produced internally.

Got it. I know pricing is always a sensitive topic, but since you spoke referenced the price declines in Q3, can you give us any sense of quantification?

It's not across the board. It's with certain customers on certain products though we can't comment on it directly, but it is a factor for us. It's not something that is not unanticipated, as we mentioned in the script, that that's been communicated with the customer and negotiated for some time. And most importantly, we're not meaningful lowering, in fact, we're raising our gross margin guidance on a long term basis which we think is a significant testament to the fact that even in the price of -- even in the face of price competition, we're very confident in our ability to continue to maintain these margins which frankly haven't been seen in the industry and really aren't by any company outside of AOI. We're very proud of where we're in the gross margin, I think, the fact that we can sustain that over the long term, even with the price reductions that we know we're going to be out there in this industry is a testament to our confidence in our business models and our confidence in our ability to be the cost leader.

Stefan can I -- if I said this before my apologies, but I assumed it's implied by the gross margin guidance what was the degree -- last question, was the degree of price reductions less, more or consistent with what you're expecting?

Absolutely consistent with what we're expecting.

The next question comes from Troy Jensen of Piper.

Two question from me guys. So first of all can you dig in a little bit more on the 200G product. Just curious to know form factors -- is this any more detail would be great?

The product that we have is going into a new customer, as we mentioned. It's the exact product that we showed at our OSE booth, if you were there. So you know you can go back and look at the press release around that time to see more details about what the product is, but -- and it is going into a new customer. And as we mentioned in the script, we have multiple other customers that are going to qualifying this product in near future this quarter.

So more than 10 active qualifications with many new customers and I want to emphasize this and other similar customers this is the precise customer some of them is big OEM including our that hyper security data center customer and the one difference including CWDM, PSM, AWS. AOI is forcing market and we're very complete product list.

So if I heard that correctly? You said more than 10 trials for both cases gone on improvement?

That's what we are saying--

14 active with new customers -- our existing customer base.

All right. One follow-up with the prior prying than I planned pricing reductions. Have you historically had Q3 price negotiations? Or is it kind of new that the customers are approaching through now?

No. As we're said for years, I mean the pricing negotiations that we have with our customers are on an ongoing basis and they occur no particularly time throughout the year. That is they occur randomly throughout the year whenever it's appropriate. But this price negotiations that we have undergone are something that we do in advance with the customer and we know what those prices are expected to be on a go forward basis.

The next question comes from Mark Kelleher of D.A. Davidson.

Great. Just looking at the 40G. If you look at the data center revenue in total, is up 25% sequentially. You give the 100 gig up 62% sequentially. So currently 40G was down pretty significantly. Are you expecting that to accelerate, moderate? What do you expect that downward tax to look like over the next couple of quarters?

Well, our customers are moving away from 40 gig into 100 gig which is something that we've said and it shouldn't be a surprise anybody in the industry, I think, that the transition is occurring. For several quarters, we've said, that we expected that our revenue to crossover meaning 100 gig will start to exceed 40 gig revenue and like Q3 and Q4, we continue to believe that. The rate of reduction or the speed at which that process is occurring, particularly in Q3, is a little bit surprising to us, but it's definitely the trend is clearly not unexpected. And what we're seeing is consistent with that trend just a little bit faster than what we have expected.

Okay. And then just generally, you talked a little bit about the [indiscernible] competitive situation, How about just generally you're seeing other competitors come into the market? Or be more aggressive on pricing, anything?

I wouldn't say we're seeing any new customer -- new competitors coming in the market. I think the competitor -- the competitive base that's been out there for some time is still the same definitely see. As far as pricing aggressiveness, if you will, again, I don't see really any changes. This has been an aggressively price-sensitive market for quite some time. I don't think there's really a change in aggressiveness if you will of competitive with effective pricing.

Okay. And last question. You're generating 680,000 lasers in a quarter. What percent of the laser do you think you have? What percent of market share you think that represents?

I don't have an estimate for the total number of lasers that are produced out there. What we -- we've certainly see the need to continue to grow to that 1 million lasers per month level that we outlined earlier. We're making good progress on that. We think we see the need for that capacity and then some over the next few years. So we continue to make and let you know about our progress on that regard.

Would all amplified surround the table to making laser in about six weeks to mix transceiver. Another point is that the site data center, we have many customers for the AOT and Michel and fiber to market. So right now, we need to increase our capacity to make this customer demand to Q1, Q2 automotive capacity was limited, so that's why we're already pushing this customer for that. Okay? And number three points is we still believe that the market leaders in 40G and 100G long-distance transceiver the by market share, we don't really know what to the market share what percentage is sort of.

And varies by product.

The next question comes from Richard Shannon of Craig-Hallum.

Just follow-up on the 40 gig topic here, sounds like you've got one customer's talking about lowering forecast for 40 gig. Any indication of other customers -- other major cloud customers also taking down there 40 gig in the near future and does your fourth quarter guidance, are you talking about revenue growth and planning another significant step down?

Other customers are also reducing there 40 gig. As you would've expect, as they transition to 100 gig. We've known about that and we've expected, as I mentioned on last answer. So the only surprise this quarter is the extent to which one customer is decreasing their forecast or the speed at which they're decreasing their forecast for 40G. That's the only unexpected thing that's come about. The rest of it is.

Okay. And then you talk about growth for the fourth quarter here. Is there anyway -- Stefan as you can help us think about gross margins, I guess, directionally to the range you've given us for the third quarter. You talked about revenue growth and if there is more 100 gig, those seem to be positive drivers for gross margins. Is there any reason why we wouldn't assume a gross margins that we set high for fourth quarter as well?

I mean, we're not in the habit of giving forward guidance several quarters out in terms of gross margin. I think, it's significant that we just raised our long term target range that we think we can sustain this level of gross margin for the foreseeable future. It will potentially bounce up and down a little bit around that 41% to 45% range that we outlined. But I think that's a significant testament again to the confidence that we have in this business model that we're able to maintain those kind of gross margins for the foreseeable future. So I won't comment on specifically what we expect to see in the fourth quarter, but it's certainly -- there's no reason to believe it'll be below the range that we've outlined.

Okay, perfect and I agree it's an impressive range that, you can keep that up you'd like to keep but I'd love the assumption to keep if I can Stefan. I wish you've done some modeling on your cost structure and price declines there. Wondering if you can give us a sense of what kind of price reduction year-in-year declines that you can still keep up that range of gross margins on? Is that like -- can you sustain 20% pricing declines per year or greater that? Any sense of what pace that -- what you can absorb do that would be appropriate?

Our competitors love to know what they have to do to bottom tick us on the price. Yes, I'm not going to comment on that.

What we have mentioned in the past 4 quarters. We have reduced outright the caused by 46%, grown Q2 last year to Q2 this year. This for phase and how much we can reduce our costs.

And as we outlined, we're making some serious investments to continue to in source the remaining portion of the bill of material that's not already in source. So we have the ability to continue to push down that cost.

Okay, perfect. Last quick question from me on CapEx. Did I hear you say you're expecting to spend $85 million this year and you spent $26 million in chain so far this year?

That's correct. $40 million of that spend is going to be in production, equipment and machine the amount past due.

The next question will come from Brian Alger of Roth Capital Partners.

For the past several quarters we've been talking about an industry that has been supply constrained, given the pull back in the 40 gig demand and you guys ability to shift your capacity. Will you describe the current environment as balanced? Or are we still sitting in a situation where whatever you produce you can sell?

We're going to be selling everything we can produce in this quarter. As Thompson mentioned, part of the challenge that we had is we have -- in any given quarter, we have several hundred thousand lasers that are sold into other application besides the 100 gig and 40 gig transceivers. And so those applications have actually been suffering in terms of long lead times and customers have been very unhappy. So we're going to be able to catch up a little on some of those other things that we have in where the lead times have been pushing out. And in addition to that, we also need to build up some buffer inventory what we believe would be a strong fourth quarter. So we're not going to be holding back on sales or building lasers during the quarter.

And comes okay, be a lot of designing capability for 100G and 200G new products of. So we need to be ready for the demand for Q1 and Q2 next year's two.

All right. It seems like you have clearly have a pretty good handle on what's going on with 100G and next generation type of designs with your customers. I'm curious as to how you seem to have been caught offguard in terms of the decline on 40 gig. Is that something that transferred from a customer recently? Or is that something that was communicated in the middle of the quarter?

It's recent development. And again, it's not that we didn't expect 40 gig to decline with this customer or the other customers, we knew it would. It's just coming a little bit faster which you know, in the end, means a faster transition to 100 gigs which is not a bad thing. But obviously, in this particular quarter, it's happened faster than we expected.

Understand. I think we all expect the transition to a current it's a positive certainly for you guys given your product portfolio. I guess where I'm going with this is it's a bit unusual for company to preannounce a very strong [indiscernible] and then to have something like this come in a couple of weeks later from that announcement and I'm just -- it seems like may be you guys weren't informed after your positive preannouncement?

That is true, but just to be clear, the preannouncement is made when we see the results of the quarter differing materially from the last guidance that we put out with the Street. That's why we preannounce. It's not an indication of future, it's an indication that the past has been very different from what we last guided the Street. In other words, we don't want -- when we know that there is different information from what we've previously guided for. We want to get that information in the hands of investors as quickly as positive. That's what investors have asked us to do and we think that's the right thing to do. But that's not necessarily an indication of any particular thing about the future. In this case, the information that we got about the 40 gig actually did happen post the preannouncement, but that wouldn't necessarily change our thinking about whether or not to preannounced.

The next question comes from Alex Henderson of Needham Company.

I wanted to talk a little bit about the mechanics around the production of 40 gig versus 100 gig related products. So to the extent that you have a quick slowdown in 40 gig, what is the change over time that it takes for you to take that capacity that you would have otherwise have allocated to 40 gig based components and then shifted over to the 100 gig product line? Is the reason the 40 gig decline is a problem is because it's created a mismatch between where your demand is and where your production is? And therefore, as you resolve that mismatch, you rebound pretty quickly on the production of transceivers that than have a better match to the end market demand? Because I'm having a hard time understanding how you would have substantial increase in laser production and positive makeshift unless you have a mismatch?

Well, it doesn't take us that long to switch over the production. But as Thompson mentioned, there's about a 6 week time from when we produce a laser to when actually gets shift out of the transceiver. And so the time to actually shift over the production is not long, but the time to -- between doing that shift and when you start to see the end product transceivers coming-out is about 6 weeks.

No problem to change from 20 to 25 DNAs it takes another 6 weeks record growth and progress last year.

So again, if you have a 6-week differential, you should be able over the course of the quarter to re-align your production to the end market demand mix and therefore, as you go into the fourth quarter, I would think that you would be able then to match closely your laser and transceiver production to the mix of demand you're getting from the field and therefore, you should not have any issues on weakness on 40 gig in 3Q impacting 4Q. Logically, that would follow. Is that not reasonable line of logic?

If I understand your comment or question you're saying that by the end of the quarter, we should have our resources realigned in going into the fourth quarter that shouldn't be an overhead or something from the makeshift. If that's your question the answer is yes. Yes, that's correct.

So if you're expecting the 40 gig to fall off to the level that you have in the fourth quarter anyway then this is a temporary wobble in demand and you should be able to power through it as you go into the final quarter of the year. Is it right way to think about it?

Yes and that's why we said we expect to see sequential growth in the fourth quarter. I think we're pretty clear about putting that out there.

Clearly the Street is expecting have a sequential growth of third quarter it would imply a fairly robust rebound into the fourth quarter if you had that balance I would think. Is that not a reasonable way to think about it?

Yes, I think it's a reasonable thing to think about it, absolutely.

Okay. In terms of the mix I'd assume that you're getting a benefit on price -- on average selling price not just from the mix in 40 gig to 100 gig, but also a mix from PSM to CWDM for and that ultimately will help offset considerable amount of pricing between those 2. Is that also reasonable to think about it?

That's correct.

And then finally, how do I think about the volume increases. I normally think about a 20 -- 15% decline in pricing meaning about 25% volume increase to offset it in this industry over number of years. If you're producing volume growth, it's substantially greater than that, does that scale near literally? Or is it -- is there a big diminishing benefit as you go from instead of 25% growth say 50% growth rate in volume? Would the impact to margins be comparable benefit to margins?

I'm not really sure I follow your question, but maybe I can try to restate it. Are you asking, do we see sort of economies of scale coming from larger production quantities and therefore lower costs associated for example with chip production or what have you as we scale production is that?

Well clearly you do that. The question is if I get x amount of benefit from 25% increase in volume, is it 2x improvement in costs on a 50% increase? Or is it substantially diminished benefit on the second increase in volume?

That's a pretty complicated question, Alex. I mean, there's, obviously, sort of an asymptote here. There's a minimum cost that you can get for any component. And so, as you get higher and higher you start to approach that. But I can't tell you where we're in that curve at the present time. So I know I'm not answering your question, but I don't have a good way to answer that question based on the information that we have.

But what we can say is that we're making more long transceivers in Q3 in Q2 and we're making more long transceivers in Q4 than Q3 for sure and it is by one percentage but for sure we had price reduction but even so although our [indiscernible].

One last question if I could. Your friends who reported earlier this week, talked about getting to 8 million lasers a month and they were talking about the new fab coming on stream in the September -- late September timeframe which would allow them to get to that production in 4Q. I guess my question is that seems awfully aggressive timeline to bring a fab on stream and be able to actually lasers off of it. I know you guys have a lot of experience in bringing that kind of stuff up and I would think the length of time to go from new fab launching to actually having qualified lasers that can be put into transceivers and sold to customers would be more like 6 or even 9 months. How would you view that timeline that was offered up?

Yes, I think that's very aggressive. As you point out, just to do the qualification effort requires several thousand hours of qualification testing time at a minimum.

Minimum 3,000 to 5,000 hours, minimum.

And that's just time after the laser and the modules have already been made and assembled where they have to be tested. And so that's several months just sitting there doing the testing not to mention actually having to bring the fab up make the way for and all the rest of it. I think that's a pretty aggressive time frame.

And prom actually we don't need of vest investors growth of all the capacity for processing, quality of special testing so we don't really know. The number three-point is I don't know if our cost a lot of are so many days so it's good for them. If they can find that customer from religion they would have an argument already. As I say, we remember we're market leaders in 40G long-range transceiver and transceiver and we're making our own basis. And I believe we have way iterator market share. First to market strong growing next year that we work for everybody in this market. Not only AOI Automotive News Company, the recruiter ingrowth by 300% next year or four percent next year, that's great.

This concludes our question-and-answer session. I would like to turn the conference back over to Thompson Lin for any closing remarks.

Okay and thank you for joining us today. As always, we thank our investors, customers and employees for your continued support.