Applied Optoelectronics, Inc. Q3 FY2023 Earnings Call

Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics' Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. Please note, this event is being recorded. 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. I am pleased to welcome you to AOI's third quarter 2023 financial results conference call. After the market closed today, AOI issued a press release announcing its third quarter 2023 financial results and provided its outlook for the fourth quarter of 2023. The release is also available on the company's website at ao-inc.com. This call is being recorded and webcast live. A link to the recording can be found on the Investor Relations section of 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 Q3 results, and Stefan will provide financial details and the outlook for the fourth quarter of 2023. 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, levels of activity, performance or achievements of the company, or its industry 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, forecast, anticipates, estimates, intends, predicts, expects, plans, may, should, could, would, will, potential or things or by the negative of those terms or other similar expressions that convey uncertainty of future events or outcomes. The company has based these forward-looking statements on its current expectations, assumptions, estimates 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. 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 2023. 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, 2022, and the company’s quarterly report on Form 10-Q for the quarter ended September 30, 2023. 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 website. I'd like to note that the date of our fourth quarter and full year earnings call is currently scheduled for February 22, 2024. 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. Our third quarter revenue and non-GAAP EPS were in line with our expectations. While our non-GAAP gross margin was better than our expectations, we are pleased by the continued progress we have made on improving our gross margin and by the continued strong growth we saw for our 100G and 400G products in our data center business during Q3. The combination of revenue growth and improving gross margin allows us to generate $3 million in adjusted EBITDA during the quarter. During the third quarter, we delivered revenue of $62.5 million, which was within our guidance range of $60 million to $66 million. We delivered non-GAAP gross margin of 32.5%, above our guidance range of 29.5% to 31%, mainly driven by our favorable product mix shift and contribution from revenue recognized as part of our non-recurring revenue from Microsoft. Our non-GAAP loss per share was $0.05, which was within our guidance range of a loss of $0.06 to earnings of $0.01. Total revenue in our CATV segment was $10.3 million, down 67% year-over-year and up 10% sequentially, in line with our expectations. Total revenue for our data center products of $48.8 million more than doubled year-over-year and increased 77% sequentially, largely due to increased demand for our 100G and 400G products. As we continue to see the ramp-up of our 400G products, revenue for our 100G products nearly tripled year-over-year, while revenue for our 400G products increased more than 10 times in the same period. With that, I will 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, our third quarter revenue and non-GAAP EPS were in line with our expectations, while our non-GAAP gross margin was better than our expectations. We're pleased by the continued progress we have made on improving our gross margin and by the continued strong demand we saw for our 100G and 400G products in our data center business during Q3. The combination of revenue growth and improving gross margin allowed us to generate $3 million in adjusted EBITDA during the quarter. Before turning to discuss our detailed results and outlook, I want to provide an update on 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 Internet Data Center, fiber-to-the-home, and telecom markets. On September 12, 2023, we announced the termination of our purchase agreement with Yuhan Optoelectronic Technology. This decision was based on Yuhan's failure to meet agreed-upon deadlines, and we lost confidence in their ability to complete the transaction. We are exploring additional options with new potential buyers. Turning to the quarter, our total revenue for the third quarter increased 10% year-over-year to $62.5 million, which was in line with our guidance range of $60 million to $66 million. As Thompson mentioned, the increase in revenue was largely due to the growth of our 100G and 400G data center business. During the third quarter, 78% of our revenue was from our data center products, 16% was from our CATV products, with the remaining 6% from fiber-to-the-home, telecom, and others. In line with our expectations, CATV revenue in the third quarter was $10.3 million, which was down 67% year-over-year and up 10% sequentially. We were encouraged by the sequential growth that we saw in our CATV business in Q3. Looking forward, we continue to expect that our near-term CATV business will be down compared to the historic highs we saw in 2021 and 2022, as the MSOs transition to next-generation architecture. We anticipate this transition will begin to take place in 2024. Looking further ahead, we continue to carefully monitor MSO plans to move to DOCSIS 4.0 networks. We believe AOI is a leader in technologies that will enable DOCSIS 4.0, and that our products are well-suited for when the push to install amplifiers and other network elements for DOCSIS 4.0 begins. In line with our new strategy of directly selling to the MSOs, we have continued to expand our product portfolio. Just last month, we announced the launch of QuantumLink, the latest solution within our Quantum bandwidth line of products, designed to provide remote management and monitoring of cable amplifiers that we believe will reshape the cable broadband market. Operators using QuantumLink will have the ability to remotely manage cable broadband amplifiers, ushering in a new era of efficiency and enhanced service quality for our customers. Last month, we attended the Society of Cable Telecommunications Engineering Expo, where we demonstrated our complete line of quantum bandwidth products, including various amplifiers and the QuantumLink control solution I mentioned above. We've received very positive reactions from many of our customers. They are particularly interested in our QuantumLink solution, which several customers have asked to become a standard for the CATV industry. We are pursuing this standardization with cable labs and anticipate that this technology may be chosen by MSOs as their preferred control architecture for their upcoming deployments. Lastly, and in line with our new strategy, we are pleased to have secured a distribution relationship with Digicom, a stocking distributor. Digicom will be an exclusive go-to-market supplier of our Quantum12, high-gain balanced triple, and high-gain dual-system amplifiers and line extenders. This relationship enables customers to receive the latest network equipment with optimal quality and faster delivery times. Turning to our data center business, our Q3 data center revenue came in at $48.8 million, which more than doubled year-over-year and was up 77% sequentially, largely due to increased demand for our 100G and 400G products as our customers continued to purchase our existing products. In the third quarter, 74% of our data center revenue was from our 100G products, 13% was from our 200G and 400G transceiver products, and 7% was from our 40G transceiver products. Notably, revenue for our 100G products increased 75% sequentially, while revenue for our 400G products increased 74% sequentially and accounted for just under 11% of our total data center revenue in Q3. Looking ahead, we're encouraged by the strong demand we've been seeing, and we expect Q4 to be similar to Q3. As a reminder, as we have discussed on our prior earnings calls, we signed two agreements with Microsoft earlier this year, including a development program to create next-generation lasers for its data center, both for 400G and beyond, and for the development of their 400G and next-generation active optical cables. While not guaranteed, we believe that the revenue opportunity for our 400G and 800G products could be greater and of longer duration than the revenue contribution we saw from this customer during the peak of the 40G product cycle, suggesting that revenue from these products may exceed $300 million over several years of these build-outs. During the quarter, we received requests from Microsoft to expedite our production ramp for these products, which we are attempting to accommodate. Based on these expedited requests, we believe demand for these products remains strong, and our production teams are working hard to add capacity, which we now expect will allow us to begin shipments later this month, rather than in late December as originally planned. Notably, the revenue increase we saw from Microsoft this quarter is mostly from existing products. As I just mentioned, we still expect to begin shipping initial quantities of the products related to these new agreements to Microsoft by the end of this month for their testing, with production expected to ramp up in December. We also believe that the value proposition we offer to Microsoft is strong with other data center operators, and we are working with several of them to evaluate our technology and qualify our products. This includes our 800G products. During the quarter, we shipped samples of our 800G data center products to two customers. By the end of the year, we expect to ship samples of 800G products to two additional data center customers. This would total four customers evaluating our 800G products by year-end. Now turning to our telecom segment. Revenue from our telecom products of $3 million was down 55% year-over-year and down 27% sequentially, largely driven by softness in 5G demand, particularly in China. Looking ahead, we expect telecom sales to fluctuate around current levels. For the third quarter, our top 10 customers represented 96% of revenue, up from 86% in Q3 of last year. We had two customers each representing more than 10% of revenue, one in the data center market and one in the CATV market, contributing 64% and 12% of our total revenue respectively. In Q3, we generated non-GAAP gross margin of 32.5%, which was above our guidance range of 29.5% to 31% and was up from 24.8% in Q2 of 2023 and up from 18% in Q3 of 2022. The increase in gross margin was driven mainly by our favorable product mix shift and contribution from revenue recognized as part of our non-recurring revenue from Microsoft. We remain committed to the long-term goal of returning gross margin to around 40%, and we believe that this goal is achievable. Total non-GAAP operating expenses in the third quarter were $21.4 million or 34.2% of revenue, which compared to $19.4 million or 34.3% of revenue in Q3 of the prior year, largely driven by increasing legal costs, higher shipping costs, in line with our increased revenue, and increased marketing spend to promote our CATV products. Looking ahead, we expect non-GAAP operating expenses to range from $21 million to $23 million per quarter. Non-GAAP operating loss in the third quarter was $1 million compared to an operating loss of $9.3 million in Q3 of the prior year. GAAP net loss for Q3 was $9 million or a loss of $0.27 per basic share compared with the GAAP net loss of $15.6 million or a loss of $0.56 per basic share in Q3 of 2022. On a non-GAAP basis, net loss for Q3 was $1.7 million or a loss of $0.05 per basic share, which was in line with our guidance range of a loss of $1.9 million to a profit of $0.2 million or a loss per share in the range of $0.06 to earnings of $0.01, and compares to a net loss of $7.1 million or a loss of $0.26 per basic share in Q3 of the prior year. The basic shares outstanding used for computing the net loss in Q3 were $32.8 million. Turning now to the balance sheet, we ended the third quarter with $31.2 million in total cash, cash equivalents, short-term investments, and restricted cash. This compares with $28.6 million at the end of the second quarter of this year. We ended the quarter with total debt, excluding convertible debt, of $46.6 million, down slightly from $46.9 million at the end of the last quarter. As of September 30, we had $67.5 million in inventory compared to $66.3 million at the end of Q2. We made a total of $2.1 million in capital investments in the third quarter, mainly used for production and R&D equipment. We initiated a new at-the-market offering in March. To date, we have raised $43.1 million net of commissions and fees under this program, including $22 million raised in Q3 and $11.2 million raised after the end of the quarter. Moving now to our Q4 outlook. We expect Q4 revenue to be between $63 million and $67 million, and non-GAAP gross margin to be in the range of 34.5% to 36%. Non-GAAP net income is expected to be in the range of a loss of $0.9 million to income of $1.2 million, and non-GAAP income between a loss of $0.02 per basic share and income of $0.04 per basic share, using a weighted average basic share count of approximately 35.1 million shares. With that, I will turn it back over to the operator for the Q&A session.

The first question comes from Jeff Coach with Raymond James. Please go ahead.

Thank you. I have a quick question regarding the Microsoft income that's not recurring. Can you provide some details about the amount for the quarter and what is factored into the guidance? It would be helpful to understand how we should view that in relation to the ramp. Thank you.

Yes. Well, I can't comment on the exact amount of nonrecurring engineering costs that would be covered under our nondisclosure agreement with Microsoft. So it was not the primary contributor to the increase in gross margin.

Okay. Great. And then maybe you can just give some color on the segments, like kind of how you're thinking about some of the other segments going into December?

We are quite excited about the progress we are making in the datacenter business. Microsoft is increasing their demand for the new products we've been discussing based on our new contracts, which is very encouraging for us. While there is a limit to how quickly we can ramp up production, we are optimistic about the rise in demand we are experiencing. We are also pleased with our advancements in 800G technology, having already sampled it to several customers and expecting to reach more before the end of the year. This progress has us excited. On the cable TV front, we acknowledge that the overall situation in cable has been subdued compared to a year or two ago, but we are heartened by the sequential increase in revenue and the success of our new direct sales model to MSOs. The acceptance of our new technologies, like Quantum Link, has been outstanding. These two segments make up the majority of our business. The Telecom market is seeing slower activity, particularly with the 5G business in China, and we do not foresee a short-term recovery there. However, the two segments that contribute most to our revenue are both moving in a favorable direction.

So, do you anticipate seeing cable TV grow sequentially into December? Or do you believe we will continue to experience sequential growth? Additionally, when do you expect an inflection point, such as with DOCSIS 4.0, is that more likely to be in 2024?

Right. So you're cutting in and out there a little bit, but I think I understood your question to be on cable TV. Do we expect to see some sequential growth into Q4? And I think you could tell from the guide, we don't expect dramatic growth in cable, but there's probably some opportunity for some growth there. As we discussed, the cable market will recover or we expect the cable market to recover substantially during the DOCSIS 4.0 introduction, which will happen in the middle part of next year. In the meantime, we are seeing some customers that are finally starting to burn through their inventory of DOCSIS 3.1 products, the 1.2 gigahertz. So I expect to see some sort of modest improvement there, but the dramatic uptick we expect to see will be with DOCSIS 4.0 in the middle part of next year.

Yes, this is Thompson. We anticipate very strong growth for CATV next year starting around the end of Q2 or in Q3. More importantly, we expect a significant improvement in gross margin. The focus is not on volume but on enhancing gross margin.

Terrific. Appreciate the time. Thanks.

The next question comes from Tim Savageaux with Northland Capital Markets. Please go ahead.

Hey good afternoon. And congrats on the results and the positive EBITDA in particular. I have a question about the kind of pull-in that we're seeing from Microsoft in terms of 400-gig AOC type demands. And I guess one would be, to what extent is that a factor in your guidance for Q4? And I assume, given you're ramping up production this month and through December, that looks like to set you up for a full quarter of production, perhaps in Q1. And I'd love if you can give us a sense of what that looks like for you guys from a revenue standpoint or what might that look like? Thanks.

Sure. Regarding your question about Q4, we are just starting production this quarter, so we don't anticipate it to significantly impact revenue. We have been highlighting this to emphasize the strong demand for our products from Microsoft, as well as from other data center operators. While we are doing our best to increase production capacity, it will take some time to fully ramp up, and we won't be at full capacity at the start of Q1. There will be an increase in production during that quarter as we work to meet the targets set for us. This ramp-up will not be completed in a month or even in one quarter, but we expect to see improvements throughout the year. One positive aspect for us is that Microsoft is seeking faster production of these products in larger quantities, which is very encouraging.

I wanted to follow up on the 800 gig front where you've seen some progress with customer samples. Given that you’re likely in the early stages, are you able to share when you expect customer evaluations of these products to occur? Could we see shipments starting in 2024?

Yes.

Okay. That was pretty clear. I'll try again then, which is any sense of timing on that within calendar 2024.

Yes, I think it's a little too early to say right now. As you pointed out, we're in early stages on it. I would say the demand picture for 800G looks pretty strong, and we're certainly having constructive discussions with the customers. But how long it will take and the qualification process is still unclear. However, I do expect it to occur in 2024.

Yes, so maybe sometime in Q2 or Q3 next year. The year of qualification will take easily, four to six months or longer. But I want to emphasize that we are working closely with several big customers, about 1.6T with 200G per Lambda. They all believe we are the technology leader. The demand will be very strong too. Maybe it’s from Q3 or Q4 next year. So it's not just about 800G; there's a lot of activity for the data center, especially the high-speed transceiver technology due to strong AI demand.

Got it. And let's stay on this topic for a second. And Stefan, you described four customers evaluating the products. Can you give us any indications of the type of customers those might be—large, cloud operators, networking OEMs, what have you?

Mostly large cloud operators, with at least one OEM that supplies some of the large cloud operators. It's all cloud-related, whether directly or through an OEM that supplies.

And one big AI company. You know what I'm talking about. So I don't know how you define it. It's not a cloud operator, but it's really, they may become the number one customer in the world for the data center transceiver.

Okay. Great. And last one for me and maybe kind of related to that, I mean, can you give us a sense of how to assess total opportunity for AI-related transceivers or AOCs? And how has that assessment of market opportunity evolved for you guys over the past quarter or so?

I don't know. The number sounds crazy, okay. What we heard is for AI, we are talking about maybe at least minimum six to eight million volumes with very good ASPs, more than $600 or $700. So you can see the opportunity next year.

Thanks, everyone.

The next question is from Dave Kang with B. Riley FBR. Please go ahead.

Thank you, good afternoon. First question is on cable TV. So you said by the middle of next year, we should be expecting a very strong recovery. Are we talking about prior peak of, like, say, $30 million or so per quarter? Is that what we should be expecting or not quite there yet?

I mean without putting a specific quarter on it, yes, certainly, the expectation is that we can exceed the prior peak levels because at that point, we weren't really in an upgrade cycle, right? It was just a sort of business-as-usual case. As we move into an upgrade cycle, which we think will happen, driven by the growth in DOCSIS 4.0, I would say that the opportunity there is significantly larger than the previous peak for sure. Not to mention the fact that because of the business model change, our ASPs are going to be higher because we're not selling through a middleman essentially. So not only will we have higher unit demand, but ASPs will be higher as well.

Well, let me say that I would say by Q4 next year, our CATV business should be more than $40 million in Q4 next year, which indicates very good gross margins, I would say around 40%.

Okay. And then just on the data center, 100 gig. I'm a little surprised why that was so strong because others are saying it's really 800 gig that's enjoying strong demand, whereas 100 gig is not considered to be part of AI. Some say 100 gig is weak. So are you just gaining market share? And how should we think about going forward? Should we be expecting 100 gig to be flat and eventually decay? Can you just talk about the next, what to expect over the next couple of years?

Sure. I think in 100 gig, we're taking market share. I think there's been some increase in purchasing with maybe a couple of customers, but I think we're gaining market share there. We've talked about some of the dynamics, for example, that being a U.S.-based manufacturer gives us some advantages in attracting more interest than in the past relative to some of our competition in China. That's helpful in gaining this market share. As far as how that plays out in the future, I mean, I think what we saw at 40 gig is that older technology has a very long tail. I mean it lasts a long time, and that's what I expect with 100 gig as well. I think that eventually, 100-gig will decline as 400-gig begins to grow, but I don't think it's going to be dramatic. I mean, I kind of feel like we tell the same story every time there's a technology transition, right? Wall Street tends to think one technology comes on and the other goes away immediately. We always caution that, no, that's not what happens. It's a gradual shift. The new technology tends to come on relatively quickly, but the old one tends to last a long time because there are already a number of switches out there that haven't been fully populated yet. They're going to fill out those ports and those switches. That suggests a long period of relatively flat, or maybe slightly down, but generally flat demand. So I would caution against removing 100 gig from the picture as quickly as you might be tempted to.

Got it. And just wanted to clarify, did you say that for the fourth quarter, we should expect similar revenue mix with the third quarter? Did I hear that right?

We're just saying that the datacenter portion of it will be consistent with Q3, right?

No, but yes, we're going to see some growth, but the mix will be different because we're going to see much more 400 gig than 100 gig.

Got it. And my last question regards the termination fee of $3 million. Who is responsible for that?

We believe that Yuhan is responsible for the breakup fee. We're pursuing them for the payment of that.

Next, we have a follow-up question from Jeff Coach with Raymond James. Please go ahead.

Yes. Just really quickly, I just want to talk about your thoughts on data center going into March. Is it ridiculous to think that you could be up sequentially? I know historically that's not the strongest seasonally.

I mean I think it's not ridiculous to think because, again, the 400-gig business that we're talking about, the new programs with Microsoft will be ramping during the quarter. Historically, Q1 is sort of a challenging quarter due to seasonality. A large part of that is because historically, most of our datacenter products have been made in China, and we do have Chinese New Year, both in China and Taiwan. In this case, we're producing more of these products in Taiwan and even in the U.S., which should lessen the impact of Lunar New Year. That, in combination with the fact that the 400-gig will be ramping in terms of production capacity paints a good picture for us in the March quarter.

Great. Thank you so much.

At this time, we have no further questions. And I will turn the call over to Dr. Thompson Lin, AOI's Founder, Chairman, and CEO, 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. We will continue to support. We look forward to updating you on our next earnings call.

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