Applied Optoelectronics, Inc. (AAOI) Q4 2018 Earnings Report, Transcript and Summary

Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics Fourth quarter and Year 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Please note this call is being recorded. I would now like to turn the call over to Maria Riley, Investor Relations for AOI. Ms. Riley, you may begin.

Thank you. I'm Maria Riley, Applied Optoelectronics' Investor Relations. And I'm pleased to welcome you to AOI's Fourth Quarter and Year 2018 Financial Results Conference Call. After the market close today, AOI issued a press release announcing its fourth quarter and Year 2018 results and provided its outlook for the first quarter of 2019. A release is also available on the company's website at ao-inc.com. This calls being recorded and webcast live. A link to the recording can be found on the Investor Relations page 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 Q4 results, and Stefan will provide financial details and the outlook for the first quarter 2019. A question-and-answer session will follow our prepared remarks. Before we begin, I would like to remind you to review AOI's safe harbor statement. On today's call, management will make forward-looking statements. These forward-looking statements involve risks and uncertainties as well as assumptions and current expectations, which could cause the company's actual results to differ materially from those anticipated in such forward-looking statements. You can identify forward-looking statements by terminologies such as may, will, should, 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, all financial numbers discussed today are on a non-GAAP basis unless specially 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 we will host an Investor Session at OFC on March 5 at the San Diego Convention Center. This discussion will be webcast live and a link to the webcast will be available on the Investor Relations page of the AOI website. We hope to have the opportunity to see many of you there. Lastly, I'd like to note the date of our first quarter of 2019 earnings call is currently scheduled for Wednesday, May 8, 2019. Now, I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO. Thompson?

Thank you, Maria. Good afternoon, everyone, and thank you for joining us today. In summarizing our performance in the quarter, we delivered non-GAAP revenue of $58.9 million and non-GAAP EPS of a loss of $0.02, which was in line with our guidance. However, our gross margin was below our expectations as we incurred higher-than-anticipated cost to resolve the inventory issues we experienced last quarter. Looking ahead, we expect gross margin to begin to gradually improve starting this quarter. For the year, AOI delivered revenue of $268.4 million, generating a gross margin of 35.5% and non-GAAP earnings of $1.04 per diluted share. While 2018 had its challenges for the overall optics market and for AOI, I would like to note a few of our accomplishments that we believe have strengthened our position in the long-term. First, while our customer base continues to be concentrated, we have made progress in our initiative to broaden this base. We started with a large purchase commitment early in the year from a hyperscale datacenter customer based in the U.S. And during the summer, we gained a design win with a large data center operator in China. Diversifying our customer base is a top priority for AOI. And we are pleased with the progress we made on this front in 2018. All in for the year, we secured a total of 26 new design wins, of which 12 were with new customers, including a large U.S. based datacenter customer that we secured this quarter. This compares favorably with 2017, where we had 19 design wins in total and 10 with new customers. We believe that [the emphasis we have put] [ph] on diversifying our customer base has continued to bear fruit. Second, we continue to demonstrate our strong commitment to our customers. [While at times] [ph] this require us to make difficult choices[indiscernible], we believe that our focus on our customers, we are building relationships that can continue to develop in 2019 and beyond. I'm proud to say that we have maintained all of our top customers. Third, we continue to innovate and expand our technology dealership in advanced optics. This included advance in 200G and 400G in the datacenter and Remote PHY for our CATV customers. Just last month, we released a silicon photonics-based 400G optical module that is now currently available for customer sampling. This technology platform will enable our datacenter customers to scale the infrastructure beyond 400G to ultimately 1.6 terabits per second. The customer response has been very positive for our leading-edge suite of products. We remain confident in our ability to monetize our innovation as the market evolves and adopts next-generation technologies. Fourth, we continue our market diversification efforts by shipping products to several telecom customers to be tested for use in next generation 5G mobile networks. Many of these 5G optical products will need to perform well under demanding outdoor temperature conditions. And we believe that our experience in manufacturing optical devices used in similar condition for CATV applications will have us secure a foothold in this market. While we are still early in the 5G cycle, we believe 5G will be significant driver of the high-speed optical component market likely starting later this year. Overall, we are pleased with the technical achievement we have made this year, the progress we met in expanding our customer base, and our continued support of our existing customers. I want to thank the AOI team for their hard work and dedication this year. Before I turn the call over to Stefan to discuss our result in more detail, I would like to make a few comments on the market dynamics we currently see in the datacenter market. Several other industry players has commented in recent weeks about the poor visibility in China and the excess inventory situation in the datacenter market. We are not immune to these dynamics. It is clear from our conversation with our hyperscale datacenter customers, that inventory in the supply chain has gotten ahead of deployment, due in part to the transition to 100G. While it is still early in the year and visibility is limited, we believe that the second half of 2019 will be stronger than the first as inventory is worked out over the next couple of quarters. We also have seen some datacenter customers in China taking a more conservative approach in their CapEx deployment due to concerns of slowing economic growth in their country. [Indiscernible] both of this factor, [indiscernible] outlook and underlying trends driving demands for our product has not changed nor has our status with our customers. We serve some of the most dynamic and rapidly evolving companies in the world, and believe journey for high-speed computing power remain fundamental for their business. With the technology we have developed and plan to bring to market, we believe we are in a strong competitive position to address our customers' needs as demand improves. We remain focused on building on our strong foundation as a leader in advanced optical technology and expanding our footprint within the market. With that, I will turn the call over to Stefan to review the details of our Q4 performance and outlook for next quarter. Stefan?

Thank you, Thompson. Non-GAAP revenue for the fourth quarter was $58.9 million, which was in line with our guidance range of $56 million to $63 million. Our datacenter revenue came in at $42.6 million, compared with $62 million in Q4 of last year. In the quarter, 60% of our datacenter revenue was derived from our 100G datacenter products and 38% was from our 40G products. Our production capacity remained constrained in the quarter due to the additional product testing steps. We implemented last quarter to screen for any potentially troublesome laser devices from our inventory, including work-in-process. As discussed last quarter, we identified and remedied the root cause of the problem that affected a small number of our lasers and we added additional testing steps including temporary steps to screen existing inventory. We remain on track to return to normal lead times by the end of this quarter. This quarter we also issued a $900,000 credit to a customer. We expect this credit to be non-recurring and have therefore adjusted it out of our GAAP revenue. As Thompson mentioned based on conversations with our hyperscale datacenter customers, we believe there was some inventory build-up in the supply chain as customers transitioned to 100G. We believe this will obfuscate demand and visibility in 2019. We currently expect demand in the first two quarters of the year will be sequentially down from our most recent quarters. We currently expect the second half of the year to improve over the first; however, we are still early in the year and visibility is limited. We continue to shift to and have good relationships with all of our hyperscale customers and believe we are in a solid position to expand our business with them when market conditions improve. We continue to have strong technical engagement with our customers and are making good progress on developing our next generation of datacenter products. Last month, we announced the release of a silicon photonics-based 400G optical module that is now currently available for customer sampling. These modules adhere to the requirements of onboard optics and incorporates several new technologies, including, an advanced silicon photonics-based optical subassembly that is the result of years of R&D effort by AOI and our technology partners. This next generation module is significant because the suite of technologies it incorporates will enable future similar modules to scale beyond 400G ultimately to 1.6 terabits per second, thereby enabling continued scaling of our customer's infrastructure. We gathered very positive feedback while demonstrating early prototypes at the European conference on Optical Communications last year and look forward to seeing the customer response after showcasing this technology at OFC next month. We believe the new and innovative technologies that we have developed and cost reduction efforts position us well to continue to expand the reach of our products to a broad group of datacenter customers, and diversify our customer base. While we will always rely on a relatively concentrated number of customers, diversifying our customer base remains a top priority. In the quarter, we had three design wins, including one with a large U.S. based datacenter customer, which is a new customer to AOI. This brings our total number of design wins to 26 for the year, including 12 with new customers to AOI. This exceeds our 2017 totals in both number of design wins and new customer wins demonstrating the effectiveness of our continuing efforts to diversify our customer base. In our cable television business, we remain encouraged by the customer activity in this market. We generated revenue of $12.7 million, compared with $14.3 million reported in Q4 of last year. This was a result of some weakness in demand mainly in Europe and Asia, partially offset by demand from North American MSOs. In the quarter, we started to ship volume orders for our Remote PHY product and we remain in active qualification trials with four additional customers with this technology. Our telecom products delivered revenue of $2.8 million, compared with $3.2 million in Q4 of last year. For the quarter 72% of our revenue was from datacenter products, 21% from CATV products with the remaining 7% from FTTH, telecom and other. In the quarter, we had 4 10% or greater customers; 3 in the datacenter business that contributed 38%, 18% and 11% of total revenue respectively, and one in the CATV business that contributed 11% of total revenue. For the year 2018, these same four customers represented 39%, 22%, 12% and 10% respectively of total revenue. Moving beyond revenue, in the quarter, we generated gross margin of 24.7% compared with a 34% recorded last quarter. Our gross margin came in below our expectations due to higher than anticipated costs incurred while we worked to resolve the inventory issue we experienced last quarter. Looking ahead, we expect gross margin to improve gradually starting this quarter. Total operating expenses in the quarter were $18.7 million or 31.8% of revenue compared with $22.8 million or 40.4% of revenue in the prior quarter. In the quarter, our operating expenses decreased sequentially due to lower bonus accruals as a result of our performance in the year. Operating loss in Q4 was $4.2 million, compared with an operating loss of $3.6 million in the prior quarter. Non-GAAP net loss after tax for the fourth quarter was $0.5 million or loss of $0.02 per basic share, compared with a net income of $17.9 million or $0.89 per diluted share in Q4 of 2017. GAAP net loss for Q4 was $8.6 million or a loss of $0.43 per basic share compared with the GAAP net income of $5.7 million or $0.28 per diluted share in Q4 of last year. The basic shares outstanding used for computing the net loss in Q4 were $19.8 million shares. Turning now to the balance sheet, we ended Q4 with $58 million in total cash, cash equivalents, short-term investments and restricted cash, compared with $64.1 million at the end of the previous quarter. As of December 31, we had $93.3 million in the inventory, a decrease from $107.9 million in Q3. Our cash balance reflects the use of approximately $11.6 million in cash to fund operations during the quarter. We made a total of $19.6 in capital investments in the quarter, including $17.2 million in production equipment and machinery and $1.6 million on construction and building improvements. This brings our total capital investments for the year to approximately $77.4 million, which was below our most recent $90 million CapEx forecast as we reduced purchases of certain equipment to maintain production volume in line with demand, all at the same time investing in the additional testing equipment needed to meet the new testing requirements implemented last quarter. Looking ahead, we expect capital expenditures in 2019 to be approximately $56 million, which factors in a continuation of the construction of our new factory in China. We continue to monitor end market conditions and may adjust our spending plans as necessary. Our total debt at year end was $84 million, up from approximately $50 million at the end of 2017. Much of this debt is associated with our capital expansion activities with maturities extending out several years. Just as we continuously monitor our spending plans to match market conditions, we regularly assess our capital structure to ensure we have the right mix of funding for current operations and future expansion. Moving now to our Q1 outlook, we expect Q1 revenue to be between $50 million and $55 million. We expect Q1 non-GAAP gross margin to be in the range of 26.5% to 28.5%. Net loss is expected to be in the range of $3.7 million to $5.8 million, and non-GAAP loss per share between $0.18 per share and $0.29 per share, using a weighted average basic share count of approximately 19.9 million shares. We expect our Q1 effective tax rate on our non-GAAP net income to be between 32% and 40%. With that, I will turn it back over to the operator for the Q&A session. Operator?

We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Simon Leopold at Raymond James.

Thank you for taking the question here. I think that you made this in the prepared remarks, but I just want to make sure that I clarify. I believe you stated that your relationships with your key web-scale customers remain sound. I know there's been a lot of speculation that the Facebook deal that you talked about a year ago has either been revised or changed or canceled. Could you just clarify your standing with Facebook, please?

Yeah, Simon. So, I can't obviously comment due to non-disclosure agreements on specific individual customers. However, as we pointed out in our prepared remarks, and I'll say again, we believe all of our major hyperscale datacenter customer relationships remain intact.

Great. And just to follow on, when you talked about the inventory that's in the channel, is this concentrated with one customer, two customers, three customers? How should we think about the concentration of the inventory buildup you referred to?

Well, I think, first of all, we're not the only company that's reported that's talked about this a little bit. I think what we're seeing is kind of consistent across the industry. But we see some buildup of inventory across multiple customers, obviously, to a greater or lesser extent depending on which customer you're talking about.

Thanks. And one last one if I might, you recently filed an 8-K regarding modifying some loan agreements, a credit line, credit agreement. And one sentence in there caught my attention that the bank is asking for monthly financial reports rather than quarterly reports, that kind of surprised me. That's sort of a classic yellow flag that somebody's concerned about cash flow. Could you help us understand what was behind that?

Actually, I mean, the bank has been requesting that for some time. And I had previously agreed to it at some point when we did another loan agreement. I mean, I didn't want to amend just for that one item. I don't think there's really much more to it than that.

Okay. Thank you for taking the questions.

Next question is from Fahad Najam at Cowen.

Thanks for taking my question. Stefan, if you could help us understand in terms of the broader picture, the dynamics in 100 gig PSM-4, the pricing environment, and then also the pricing environment by CWDM? Or do you see the same level of heightened price decline as you saw last year? Is it beginning to normalize? And then, maybe you can be a little bit more granular about product markets that might help us understand what's happening beyond the inventory issues.

Yeah. Well, Fahad, as you know, we don't guide more than one quarter out and generally not on a product by product basis. I think overall in terms of pricing, what we expect to see this year is for pricing declines to be similar to what they were last year, perhaps a little bit less, but about the same number. And as far as how that's going to break out between CWDM and PSM, again, we're not going to give that sort of guidance on that sort of a granular basis.

If I may ask you, sticking with the broader picture, a number of - there's been a certain degree of consolidation in this space. Luxtera got acquired by Cisco, which is a customer of yours for CATV products. You've got Oclaro that got acquired by Lumentum; ColorChip, which was in the process of being sold to some Chinese buyers, apparently now in financial distress. To that extent, any change in the market and competitive dynamics? Are you seeing a noticeable development in that front? And also, can you comment on any prospective risk of share losses that your customers, do you think you are maintaining your share or is it just purely a function of quarterly ebbs and flows?

Okay. So, there's a couple questions embedded in there. I'll try to address them one at a time. First of all, regarding kind of the broader topic of consolidation, I think it's fair to say that customers generally want to have a variety of suppliers to choose from. When that group shrinks, they have less choice. And perhaps, that could bode well for AOI. But I think ultimately, their decision is really based on the same kind of decision-making metrics that they've always used in the past and that we've always talked about, things like the technology roadmap, how well your roadmap aligns with their future needs, and price and quality, things like that. So, on balance, I think the consolidation is probably neutral. But it doesn't hurt AOI I would say. You asked specifically about Luxtera or Cisco's acquisition of Luxtera. I think I can just say on that front that AOI hasn't supplied any products to Cisco that would compete with Luxtera's products. As you mentioned in your question, we're a supplier mainly of cable TV product so - and to my knowledge Luxtera didn't have any those products. So I don't think there's really any risk to AOI's business there. And there was one more question in there, I forgot what it was. I'm sorry, could you repeat that.

If you can comment on your respective share at your hyperscale customers. Do you think you are maintaining share at each of those customers?

So, again, we obviously can't comment on specific customers. What I can say is we have a very good relationships with all of our large hyperscale customers, as we mentioned in our prepared remarks. And I think what we're really excited about now is as those customers start to look ahead to 200G and particularly 400G, the level of discussion that we're having, very detailed discussion and the tenor of that discussion, I think is very promising for us so we're excited about that transition. And I think there's no indication that we're not going to be a major part of our customers plans both in the near term and in the longer term.

Appreciate the answers, I will cede the floor.

[Operator Instructions] Our next question comes from Dave Kang at B Riley.

Hey, guys this is actually Lee Krowl filling in for Dave Kang. Thanks for taking my questions. First off, I just wanted to ask, maybe it's a little more trivial. But with this tepid near-term demand trend, is it your expectation that you'll still be able to double 100G volume in 2019 versus - relative to your prior comments?

When we say that the demand picture in the second half of the year particularly is uncertain that's exactly what I mean and I wouldn't want to put a mark on the map so to speak in terms of where we think we can go. I think there's - the near-term demand is looking muted. That's for sure. There are some very positive developments that could happen in the second half of the year that we're working through with some of our customers to try to see how that goes. We've talked in the last few earnings calls and actually if you go back for a year or so about an increasing cadence of new design wins and to the extent that some of those design wins could start to contribute, particularly later in the year, that could be very exciting. But again, the visibility is limited as we said and I wouldn't want to - I wouldn't want to give you an indication based on that limited visibility.

Got it. And then I guess you sort of answered it, but you kind of indicated Q1 ticks down, leading into Q2 kind of, indicating the trough in terms of revenue, but are there any specific demand drivers in the second half you could point to that would give you the confidence that revenue can grow sequentially in Q3?

Yeah, I mean we're hearing indications of early adoption of 400-gig technology by certain customers, for example. And we're also very excited about the progress that we're making in terms of 5G technology. Now that's probably more of a 2020 thing. But that telecom market is one where we haven't been a major player previously. And I think it doesn't take a lot of design wins and sales into that market to really improve our dynamic there. So we talked also about Remote-PHY, I think there's every indication in the cable TV market that Remote-PHY technology is going to be a bigger part of the second half of the year certainly than it is in the first. So there's a number of positive demand trends there. I think counterbalancing that obviously is - the uncertainty surrounding, particularly, China. Again, we're certainly not the only company that's talked about an uncertain demand environment in China. I think many of our customers there are looking at the potential of a slowing economy over there and sort of reevaluating their plans around what they think that means for their business. And they're all in a process of trying to make that determination. And so, I suppose the upside of the number of design wins and things that we have. The downside risk is we're not quite sure how things in China are going to go. I will point out, in terms of China, historically, we have not been - you know, a large percentage of our revenue has not been derived from China. A number of our newer design wins have been, however, in China. And so, it's not so much that we're going be losing existing business there, but there's some of the design wins that we expected to kick in earlier in the year now look like they may be a little later in the year. And the extent to which they occur is a little difficult to calibrate at this point.

Got it. And then just a last one from me. Could you maybe talk about the inventory situation and maybe delineate the inventory backup in the channel 40G relative to 100G?

I think the inventory backup is probably more about 100G than it is about 40G. But I can't really quantify that exact backup for you.

Got it. Thank you for taking my questions.

No problem.

The next question is from Richard Shannon at Craig-Hallum.

Thanks, Thompson and Stefan for taking my questions. I apologize. I jumped on the call a little late so I may have missed some things. First of all, Stefan, did I hear you say that 100-gig was 72% of data center?

I believe that's right. Let me just check the number here. Datacenter was 72% of our revenue. You are asking about 100-gig versus 40-gig?

Yes, please.

Let me find that number for you. 60% of our datacenter revenue is from 100-gig and 38% from 40-gig.

Okay. So 60% is up quite a bit from 34% the prior quarter then, right?

That's correct. Yep.

Okay, excellent. This year, you talked about a design win with a large U.S. datacenter customer. Can you describe that in any detail, like specifically on speed and how you expect that to progress to eventually generating volume revenues there?

I can't give too many details, if you can imagine. We're under a non-disclosure agreement with this customer. But the customer - I would classify this customer as a recognizable name, but it's not one that is as big, in terms of scale, as some of our other, larger hyperscale datacenter customers. So this is a smaller customer. And it's likely to not be contributing as meaningfully, certainly, as some of our other, larger datacenter customers. However, I think it's worth pointing out that what we're really trying to demonstrate here is that our efforts toward broadening our customer base are being successful. So we're adding new customers. We're getting design wins and new business coming from these customers. And yes, it's fair to say that many of those customers aren't going be as big as some of our previously announced large, hyperscale customers. There just aren't that many of those types of customers out there. But over time, incrementally with a lot of hard work and attention to these customers' needs, we're managing to gain a strong foothold in a wider swath of customers, which I think long-term is really what's very healthy for AOI.

Okay. That's helpful. Thanks for that. A couple more from me, Stefan, can you help us understand the exposure, I don't know if you want to talk about it in terms of when you'll see it or mix - at the end of the year or whatever. But your contributions you could see from 200 gig and 400 gig.

Yeah, so 200 gig, I think we've been pretty consistent in saying that 200 gig, it's going to be a relatively small market. I think that we're not seeing - there are a few customers who are certainly interested in it, some who've purchased from us or are purchasing from us. But I think it's likely to remain a relatively small part of the market. I think 400 gig is a much bigger potential market. I think that's the next steppingstone for a lot of our customers. And as I've said earlier, I think we see a lot of interest in 400 gig from some customers. Some customers are indicating that they would like to see that 400 gig in production later in the year. And we'll see, we're certainly working very hard to achieve that timeframe. And I'm sure our competitors are as well, so that hopefully that ecosystem will be there. And hopefully, the customer decides to take that leap because I think it's an important steppingstone for AOI and the industry.

Okay, helpful. My last question, probably for you, Stefan, on gross margins, I don't have all the details given I was just traveling to get to my office here. But how should we think about gross margins trending from the levels of first quarter guidance? I think you said it's going to grow in the second quarter. And then thinking about the context of where you have been in the last couple quarters and your previously communicated goals of - I think it was in the high-30s or low-40s. I honestly can't remember. If you can help us think about the context of gross margins with that that'd be great, please.

Yeah. So we do expect gross margins to gradually improve starting this quarter. And I think a lot of the uncertainty that we have regarding sort of revenue and general market conditions also extends a little bit to gross margin. But I think generally speaking, what we'd expect to see is improvement in gross margins throughout the year. In order to get to those higher gross margins, I mean, we need to work our way through all the additional testing measures that we talked about. As we said in our prepared remarks that's going to be - that should be largely finished by the end of this quarter. And we're going to continue in-sourcing more of the bill of materials that we've been building in line with our previous goals. I think some of those in-sourcing efforts kind of took a backseat towards the additional testing and implementing some of the changes to our processes that needed to be implemented. And as we resume that I think we'll be able to see some of the benefits of that fall into the gross margin line as well. And as far as kind of where we see gross margins going in the future, again, I think the range of high-30s to low-40s is an achievable range for us. I don't want to put a timeframe on when we can get there, but I think it's achievable.

Okay. Thank you for that. That's all the questions from me. I'll jump out of the line.

At this time, we show no further questions. And I will turn the call over to Dr. Thompson Lin for closing remarks.

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