Applied Optoelectronics, Inc. (AAOI) Q3 2022 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 Third Quarter 2022 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]. I will now turn the call over to Lindsay Savarese, Investor Relations for AOI. Ms. Savarese, you may begin.

Thank you. I'm Lindsay Savarese, Investor Relations for Applied Optoelectronics, and I'm pleased to welcome you to AOI's third quarter 2022 financial results conference call. After the market closed today, AOI issued a press release announcing its third quarter 2022 financial results and provided its outlook for the fourth quarter of 2022. The release is also available on the company's Web site at ao-inc.com. This call is being recorded and webcast live. A link to the recording can be found on the Investor Relations section of the AOI Web site 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 Q3 results, and Stefan will provide financial details and the outlook for the fourth quarter of 2022. 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 statements. 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, levels of activity, performance or achievements of the company or its industries, to differ materially from those expressed or implied in such forward-looking statements. In some cases you can identify forward-looking statements by terminology such as believes, forecasts, anticipates, estimates, intend, predict, expects, plan, may, should, could, would, will, potential or things, or by the negative of those trends or other similar expressions that convey uncertainty of future events or outcomes. The company updates these forward-looking statements on it's current expectations, assumptions, estimate and projections. While the company believes these expectations, assumptions, estimates and projections are reasonable, such forward looking statements are only predictions and involve known and unknown risks and uncertainties. Many of which are beyond the company's control, including important factors, such as risks related to the company's ability to complete the transaction described on this call on the proposed terms and schedule or at all; the risk that certain closing conditions may not be timely satisfied or waived; the failure or delay to receive the required regulatory or other government approvals relating to the transaction; and the occurrence of any event change or other circumstance that could give rise to the termination of the transaction. Forward-looking statements also include statements regarding management's beliefs and expectations related to the expansion of the reach of our products into new markets and customer responses to our innovation, as well as statements regarding the company's outlook for the fourth quarter of 2022. 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, including the company's annual report on form 10-K for the year ended December 31, 2021 and quarterly reports on Form 10-Q. Also, all financial results and other financial measures 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 Web site. I'd like to note the date of our fourth quarter and full year 2022 earnings call is currently scheduled for February 23, 2023. Now, I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics’ Founder, Chairman and CEO. Thompson?

Thank you, Lindsay, and thank you for joining our call today. For the third quarter, total revenue came in below our expectations. We delivered gross margin in line and a narrow non-GAAP loss per share within our expectations. As you may have seen on September 15th, we announced that we have entered into an agreement with Yuhan Optoelectronic Technology for sale of our manufacturing facilities located in the People's Republic of China and certain assets related to AOI transceiver business and multiple channel optical subassembly products. For the Internet, datacenter, telecom and FTD edge markets for purchase price of $150 million, less a holdback amount. We continue to anticipate that the transaction will be completed in 2023, and is subject to customary closing conditions and regulatory approvals. Early feedback from our customers has been positive. We believe that our capability in chip fabrication and the continuity of [Indiscernible] supply chain is of utmost importance to our parents and our customers, and we believe most of them understand and appreciate the rationale behind the proposed [divestiture] of our transceiver manufacturing operation in the [import]. We believe this transition will generate significant proceeds, which will enable us to make serious investments in higher margin and higher growth opportunities. Following the transaction, AOI will have a focused portfolio composed of lasers with manufacturing facility in Taiwan and Sugar Land, Texas. We were able to have maintained our CATV product portfolio, utilizing our current [Taiwan] facilities for production, as well as our current Ningbo facility on a contract basis. Luckily, we believe that the transaction will open up big opportunity for customer expansion with our existing datacenter laser business. Turning to our third quarter results. We delivered revenue of $56.7 million, slightly below our guidance range of $57 million to $60 million due mainly to a faster than anticipated decline in 40G sales. We delivered non-GAAP gross margin of 18% at the high end of our guidance range of 16.5% to 18.5%, and a smaller non-GAAP loss per share of $0.26. Relative to our current range of a loss of $0.27 to $0.32 due to better than expected operating expenses. Total revenue in our CATV segment was a company record of $31.3 million, up 35% year-over-year and 32% sequentially, as we continue to see robust demand in the CATV markets. Total revenue for our datacenter products of $17.7 million decreased 26% year-over-year and 80% sequentially, largely due to a decline in 40G, which is nearing the end of its lifecycle, and 100G push is beginning to slowly decline as customers move to 400G. This was partially offset by an increase in 400G, which more than tripled sequentially from Q2. As anticipated, we believe that this increase in 400G is the beginning of a sustained trend of increase in revenue from this newer product line. With that, I'll turn the call over to Stefan to review the details of our Q3 performance and outlook for Q4. Stefan?

Thank you Thompson. As Thompson mentioned, while our revenue came in below our expectations, we delivered gross margin in line with our expectations and a smaller non-GAAP loss per share relative to our expectations. We’re encouraged by the robust demand in the CATV environment, the strength we are seeing in the telecom market and the early shipments of our 400G products. Our total revenue for the third quarter increased 6% year-over-year to $56.7 million, which was slightly below our guidance range of $57 million to $60 million, primarily due to a faster than anticipated decline in 40G sales. As Thompson mentioned and as you may have seen, on September 15th, we announced that we have entered into an agreement with Yuhan Optoelectronic Technology for the sale of our manufacturing facilities located in the People's Republic of China, and certain assets related to our transceiver business and multichannel optical subassembly products for the datacenter telecom and FTTH markets for a purchase price of $150 million, less a holdback amount that is variable depending on working capital and other conditions at the time of closing. Currently, it would be approximately $7 million, making the total cash consideration for the divestiture approximately $143 million. I will spend a few moments on today's call to provide more detail on the strategic rationale as well as to discuss what AOI looks like as a company post the close of the transaction. As a reminder, we continue to anticipate that the transaction will be completed in 2023, and is subject to customary closing conditions and regulatory approvals, including CFIUS and ODI. We believe that the transaction would have a number of benefits for AOI. First, it would allow us to concentrate our efforts on growing our higher margin optical component chip business. Currently, the vast majority of the optical components produced in our Texas fab are used in the internal production of our transceivers. There are a number of transceiver manufacturers who are currently competitors of ours that we feel could become customers for our optical component products once we no longer compete with them on transceiver production. If successful, we believe that this transaction would allow us to unlock an additional potential market for our optical component products, which typically earn significantly higher gross margins. Second, we believe that this transaction may also unlock potential new revenue in China. Due to tensions with the US, many Chinese companies have a high degree of sensitivity to purchasing key components like transceivers from US companies. We believe that putting our transceiver manufacturing business into the hands of a domestic Chinese owner should enable the new entity to gain additional business with domestic Chinese customers. The benefit to AOI is potentially greater sales of our optical component chips to be used in the production of transceivers for these new customers. Third, we believe that reducing our dependence as a company on operations in China, given recent ongoing events, is prudent. The business environment there for US companies has grown increasingly challenging and there is no assurance that these tensions will ease in the foreseeable future. Finally, the significant cash generated by the transaction would enable us to strengthen our balance sheet. It would also allow us to make investments in future product development in our existing markets, as well as potential new ones. After the close of the transaction, we would retain our manufacturing facilities in Taiwan and Sugar Land Texas. AOI would exit the datacenter transceiver market and instead we would focus our resources on our datacenter laser business, our CATV broadband business and manufacturing of optical components for other markets, such as FTTH and sensing. We believe that these remaining businesses should generate free cash flow and can achieve EBITDA breakeven once the transaction closes. Turning to what our revenue profile would look like once the transaction is closed. It is difficult to break out what percentage of our overall datacenter revenue is optical components versus transceivers, given that our optical components are used to manufacture our transceivers. However, based on our internal usage of in-house manufactured optical components, we estimate that roughly 15% of our datacenter revenue over the trailing 12 months ended September 30 is attributable to these optical components. In addition to this embedded component business, over the trailing 12 months, we've had direct sales of optical components of approximately $20 million. Post transaction as noted above we believe that there are significant opportunities to increase both our datacenter optical component revenue and our direct sales of optical components. Lastly, with respect to our margin profile, while we cannot estimate with precision our margin structure after the transaction closes, we believe that at close or within a few quarters afterwards, we can achieve gross margins in the upper 20% range, perhaps approaching 30%. Turning back to the quarter. We secured one new design, which is in our telecom segment. The single design win in the quarter is lower than is typical, but we continue to have a robust pipeline for new qualifications that we expect to be completed over the next few quarters. We continue to see good customer traction on 400G, as we expected orders begin to ramp up in third quarter and we expect continued growth in shipments in Q4. Turning to our third quarter results. 55% of our Q3 revenue was from our CATV products, 31% was from our datacenter products with the remaining 14% from FTTH telecom and other. In our CATV product segment, the overall demand environment remains robust as MSOs, particularly in North America, continue purchasing additional networking products in order to upgrade their networks. CATV revenue in the third quarter was the company record of $31.3 million, which was up 35% year-over-year and 32% sequentially. Further out, we continue to have good visibility with CATV orders as we see our backlog stretching into mid 2023. We have significantly increased production capacity for our CATV products demonstrated by our Q3 results, and we believe that we are well positioned to deliver on the demand that we are seeing. Our Q3 datacenter revenue came in at $17.7 million, down 26% year-over-year and 18% sequentially. In the third quarter, 72% of our datacenter revenue was from our 100G products, 13% was from our 40G transceiver products and 3% was from our 200G and 400G transceiver products. Now turning to our telecom segment. Revenue from our telecom products of $6.8 million was up 32% year-over-year and up 9% sequentially. Telecom revenue continues to be driven mostly by 5G related products, and we believe that revenue from these products will remain relatively consistent over the next few quarters. For the third quarter, our top 10 customers represented 86% of revenue, flat with Q3 of the prior year. We had two 10% or greater customers in the third quarter, one in the CATV market and one in the datacenter market. These customers contributed 50% and 16% of total revenue respectively. In Q3, we generated non-GAAP gross margin of 18%, which was at the high end of our guidance range of 16.5% to 18.5%, and was up from 16.7% in Q2 of 2022 and compared to 19.9% in Q3 of 2021. The increase in gross margin was driven mainly by the anticipated impact of the cost reduction efforts that we initiated early in the year. Total non-GAAP operating expenses in the third quarter are $19.4 million or 34.3% of revenue, down as a total percentage of revenue from $19.3 million or 36.3% of revenue in Q3 of the prior year. R&D expenses decreased 8% year over year to $8.9 million. Looking forward, we expect non-GAAP operating expenses to increase in Q4 by about $3 million. This increase is driven by approximately $3.3 million or approximately $0.12 per share of additional employee bonus accrual related to the China divestiture. This catch up accrual in Q4 is necessary to conform our total year end bonus accrual to current expectations after the announcement of the transaction, but it is not expected to recur after Q4. Looking ahead, we expect non-GAAP operating expenses to moderate next year to between $19 million and $20 million per quarter. Non-GAAP operating loss in the third quarter was $9.3 million compared to an operating loss of $8.7 million in Q3 in the prior year. GAAP net loss for Q3 was $15.6 million or a loss of $0.56 per basic share compared with a GAAP net loss of $15.8 million or a loss of $0.58 per basic share in Q3 of 2021. On a non-GAAP basis, net loss for Q3 was $7.1 million or a loss of $0.26 per basic share, which was better than our guidance range of a loss of $7.6 million to $9.1 million or a loss per share in the range of $0.27 to $0.32 per basic share and compares to a net loss of $5.3 million or a loss of $0.20 per basic share in Q3 of the prior year. The basic shares outstanding used for computing the net loss in Q3 were 27.8 million. Turning now to the balance sheet. We ended the third quarter with $34.6 million in total cash, cash equivalents, short term investments and restricted cash. This compares with $40.7 million at the end of the second quarter. We ended the quarter with total debt of $65.1 million, up from $63.8 million last quarter. As of September 30th, we had $94.3 million in inventory compared to $98.2 million at the end of Q2. Inventory decreased primarily due to utilization of inventory for larger shipments during the quarter. We made a total of $0.8 million in capital investments in the third quarter, almost all in construction and building improvements. Looking ahead for the year we expect between $4 million and $5 million in total CapEx. Moving now to our Q4 outlook. We expect Q4 revenue to be between $58 million and $54 million dollars and non-GAAP gross margin to be in the range of 17% to 19.5%. Non-GAAP net loss is expected to be in the range of $8.1 million to $9.8 million and non-GAAP loss per basic share between $0.28 and $0.34 using a weighted average basic share count of approximately 28.7 million shares. With that, I'll turn it back over to the operator for the Q&A session. Operator?

[Operator Instructions] We have a question from Ethan Widell of B. Riley.

This is Ethan calling in for Dave Kang. I just have one on my end. So we've seen some hyper scalars announcing pretty robust CapEx plans surrounding their data infrastructure buildout. So I was hoping you could provide a little additional color regarding overall optical demand, especially as it pertains to hyper scalars?

Well, as we noted, I think what we're seeing in the market right now, particularly with the hyper scalers is that our 400G business is beginning to ramp, as we noted, in our prepared remarks earlier. I mean, it was up more than 3 times sequentially. We have a pretty strong order backlog for those products, which we've anticipated and I think we've communicated that the last couple of quarters that we expected to see 400 gig ramping in the second half of the year. So it's good that we're actually experiencing what we projected to see earlier in the year. So I think the spending environment for the hyper scalers generally is, as you noted, fairly robust in terms of optical components spent. We're monitoring that based on our viewpoint moving forward on sort of macro conditions and how that's going to affect things. But right now where we stand, it looks like the spending plans for next year are starting to crystallize a little bit on the part of our customers. And again, we think the 400 gig ramp is good evidence that that's going to be a positive for us moving forward.

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Dr. Thompson Lin for closing remarks.

Okay. Thank you for joining us today. As always, we want to extend a thank you to our investors, customers and employees for your continued support. We look forward to updating you on our progress next quarter.

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