Applied Optoelectronics, Inc. (AAOI) Earnings Call Transcript & Summary

Good afternoon. My name is Chris, and I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics Second Quarter 2021 Earnings Conference Call. [Operator Instructions] Please note that this call is being recorded. I would now like to 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 second quarter 2021 financial results conference call. After the market closed today, AOI issued a press release announcing its second quarter 2021 financial results and provided its outlook for the third quarter of 2021. 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 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 Q2 results, and Stefan will provide financial details and the outlook for the third quarter of 2021. 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. In some cases, you can identify forward-looking statements by terminology, such as believes, anticipates, estimates, intends, predicts, expects, plans, may, should, could, would, will or thinks and by other similar expressions that convey uncertainty of future events or outcomes. 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 innovations as well as statements regarding the company's outlook for the third quarter of 2021. 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, 2020. Also, with the exception of revenue, all financials 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. Before moving to the financial results, I'd like to announce that AOI management will virtually participate in one-on-one meetings at the Jefferies Semiconductor IT Hardware and Communications Infrastructure Summit on August 31. We hope to have the opportunity to interact with many of you virtually. Additionally, I'd like to note that the date of our third quarter 2021 earnings call is currently scheduled for November 4, 2021. Now I'd like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO. Thompson?

Thank you, Lindsay. Thank you for joining us today. We delivered revenue and noncore EPS in line with our expectations. However, our gross margin came in slightly below our expectations, mostly due to unfavorable product mix in our CATV segment and increased costs from the component shortage we experienced in the quarter. Total revenue for the second quarter of $54.2 million decreased 16.9% compared to a strong second quarter in the prior year's but was up 9% sequentially. The strong sequential growth was led by our CATV segment, which, this quarter, decreased our data center business, accounting for 51% of total revenue. The overall CATV demand environment remained strong as MSO, particular in North America, continue to upgrade their network. Total revenue for our CATV products increased more than fourfold year-over-year in Q2, and increased 48.1% sequentially of a strong fourth quarter to a record $27.6 million. As we expected, we experienced generally soft Q2 conditions in the data center segment. As a result, total revenue for our data center products of $22.4 million decreased 57.4% year-over-year and 13.7% sequentially. We are pleased to report that we secured 2 new design wins with 2 customers for our 400G products during Q2. In addition to the design wins, we had 5 technical qualifications of our 400 products, which Stefan will discuss in more detail. We are encouraged by the traction we are seeing with our 400G products as our customers start to [ create ]. We expect that order will continue as our customers start to realize the benefit of the performance of our 400G solution. Based on this, we continue to expect our data center business to begin to increase in the second half of the year as our customers begin 400G upgrades and inventory issue around 100G is normalized. Turning to our telecom segment. While we did see a real sign of recovery in Q1, we saw mixed conditions in Q2. With some customers present new order, while others continue to use existing inventory. Overall, we see market conditions in the China telecom markets as continuing to be patchy as the timing and cadence of the 5G rollout there remain somewhat opaque. As a result, revenue from our telecom products of $3.3 million was down 46% year-over-year and 25 6% sequentially. Looking ahead, we believe China will continue to make investments in both their 5G and fiber-to-the-home infrastructure, and we expect higher revenue in the segment in the second half of this year compared to the first half. 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. As Thompson mentioned, we delivered revenue and non-GAAP EPS in line with our expectations. However, our gross margin came in below our expectations, mostly due to unfavorable product mix in our CATV segment and increased costs associated with the component shortages we saw during the quarter. While we continue to see softness in the data center market and conditions in the China 5G market remained somewhat soft, we are pleased with the continued strength and record results we are seeing in the CATV market. And looking ahead, we are encouraged by the traction we are seeing with our 400G products, which we believe will drive growth in our data center business as order volumes ramp later in the year. Notably, we are pleased to report that we secured 2 design wins for our 400G products during Q2. In total, for the second quarter, we secured 3 new design wins among 3 customers, all of which are existing AOI customers. All 3 of the design wins were in our data center business and 2 of the 3 were for 400G, which I'll discuss in more detail shortly. Total revenue of $54.2 million decreased 16.9% compared to a strong second quarter in the prior year and was up 9% sequentially. Our Q2 revenue was in line with our guidance range of $51 million to $56 million. As we expected, the headwinds we saw in Q1 continued into the second quarter in the data center market related to the inventory normalization that followed the shift to working from home early last year. We believe these headwinds will begin to subside in the second half of the year, driven by several of our customers, who will begin to ramp 400G deployments. Additionally, we believe that inventory conditions in our 100G business will begin to normalize later in the year. On the 400G front. As Thompson and I mentioned, we secured 2 new design wins with 2 customers for our 400G products during Q2. One of the design wins was with a data center equipment manufacturer; and the other was with a hyperscale data center operator, both are U.S.-based companies and both our existing AOI customers. As a reminder, for AOI, a design win occurs, when we have successfully completed both the technical qualification of the product as well as received an initial order from the customer. In addition to these 2 design wins, we also have successfully completed technical qualifications on 5 other 400G opportunities. We are optimistic that many of these qualifications will become design wins in the near future once we receive orders for these products from our customers. The technical qualifications are with 2 different data center operators and a data center equipment OEM, all are U.S. based companies. We are encouraged by the traction we are seeing and expect that 400G will begin its ramp with us later in Q3. In the second quarter, 51% of our revenue was from CATV products, 41% was from our data center products, with the remaining 8% from FTTH, telecom and other. In our CATV products segment, the overall demand environment remains very strong as MSOs, particularly in North America, continue to upgrade their networks. We generated revenue of $27.6 million in Q2, up 48.1% sequentially and up 349% from $6.1 million in Q2 of the prior year. We are still seeing component shortages in our CATV business, and we continue to work with our suppliers to improve delivery schedules for these critical components, and in some cases, adding additional suppliers. We anticipate that these shortages will adversely affect our third quarter revenue by about $3 million. As we work to improve our supply chain, we may continue to have longer than usual backlog for several quarters. Our Q2 data center revenue came in at $22.4 million compared with $52.5 million in the second quarter of the prior year. In the second quarter, 33% of our data center revenue was from our 40G transceiver products and 59% was from our 100G products. Turning to our Telecom segment. Revenue from our telecom products of $3.3 million decreased 25.6% sequentially, primarily driven by continued slow demand in China for 5G upgrades there and 46% from $6.2 million in Q2 of the prior year. Looking ahead, we continue to believe China will increase investments in both their 5G and FTTH infrastructure, and we believe we are well positioned to sell lasers into both of these markets. For the second quarter, our top 10 customers represented 86.8% of revenue, consistent with the 86.9% in Q2 of the prior year. We had 4 10% or greater customers in the second quarter, 2 of which were in the data center market and 2 of which were in the CATV market. These customers contributed 24.1%, 21.3%, 11.2% and 10.9% of total revenue, respectively. In Q2, we generated non-GAAP gross margin of 25%, which was below our guidance range of 25.5% to 27.5% for the reasons I mentioned previously and compared favorably to 23.1% in Q2 of the prior year. We expect the downward pressure on gross margin due to unfavorable product mix in our CATV segment to persist through Q3 before starting to recover to a more normal mix in Q4. We are currently uncertain when the increased costs due to supply chain disruptions will subside, but we also see them persisting through Q3, which will also negatively affect gross margin. Total non-GAAP operating expenses in the second quarter were $20 million or 36.9% of revenue compared with $20.6 million or 31.6% of revenue in Q2 of the prior year. Non-GAAP operating loss in the second quarter was $6.5 million compared to an operating loss of $5.6 million in Q2 of the prior year. GAAP net loss for Q2 was $8.2 million or a loss of $0.31 per basic share, compared with a GAAP net loss of $18.6 million or a loss of $0.89 per basic share in Q2 of 2020. On a non-GAAP basis, net loss for Q2 was $4.1 million or a loss of $0.15 per basic share, which was in line with our guidance range of a loss of $3.8 to $5.6 million or a loss in the range of $0.14 to $0.21 per basic share and compares to a net loss of $5 million or a loss of $0.24 per basic share in Q2 of the prior year. The basic shares outstanding used for computing the net loss in Q2 were 26.9 million. Turning now to the balance sheet. We ended the second quarter with $50.5 million in total cash, cash equivalents, short-term investments and restricted cash. This compares with $49.3 million at the end of the first quarter and reflects $5.9 million in cash used for operations. As of June 30, we had $100.4 million in inventory compared to $106.3 million at the end of Q1. Inventory decreased primarily due to utilization of inventory for customer orders. This inventory reduction is consistent with our long-term plan as we focus on rationalizing inventory levels. We made a total of $3.2 million in capital investments in the second quarter, including $2.9 million in production equipment and machinery and an immaterial amount on construction and building improvements. We continue to expect 2021 CapEx will be approximately $16 million, although, as we have noted in prior years, there can be significant variability in this estimate as the year progresses. As we disclosed in February of this year, we initiated a new at-the-market offering. To date, we have raised $0.9 million under this new program. We intend to use these proceeds to continue to make investments in the business and including new equipment and machinery for production and research and development use. Moving now to our Q3 outlook. We expect Q3 revenue to be between $51 million and $56 million and non-GAAP gross margin to be in the range of 19.5% to 21.5%. Non-GAAP net loss is expected to be in the range of $6.9 to $9 million and non-GAAP loss per basic share between $0.25 and $0.33 using a weighted average basic share count of approximately 27.7 million shares. With that, I will turn it back over to the operator for the Q&A session. Operator?

[Operator Instructions] Today's first question comes from Simon Leopold with Raymond James.

I want to start out first, just if you could clarify the CATV headwind, you quantified it as $3 million headwind due to supply constraints. I guess there are a couple of ways one could interpret that. But I think what I'm imagining you're suggesting is looking at this quarter's sales of roughly $27.5 million and subtracting $3 million from that. But alternatively, I could sort of think of, hey, I was imagining it would be $30 million, but with $3 million of headwinds, it will be $27 million. So I guess I'm trying to understand the baseline or maybe a little bit finer detail the impact of that headwind you highlighted.

Yes, Simon, thanks for bringing that up. So I think the answer is it's more like the latter scenario that you had, not necessarily that those numbers are what we had in mind. But what we were saying is that relative to what we could otherwise deliver, that is based on orders and requested delivery schedules and shipping schedules and all that, we could have delivered $3 million more in our cable TV segment, but for the fact that those raw materials are constrained at this point.

And let me just clarify that. Is that $3 million hit in the June quarter? Or is that $3 million headwind in your forecast for September?

It's forecast for the September quarter. So we're saying in the next quarter, in the third quarter, the one that we're in currently, we would have been able to deliver, based on our current forecast, approximately $3 million more revenue than we now believe that we can due to component shortages.

Great. And I want to see if maybe you could help us understand how to think about your opportunities in the 400-gig market, and where you see, essentially, competing with ZR products? Because I imagine there's -- your products are probably cheaper than the ZR's, but have shorter reach. And so just trying to get a better idea of how you're thinking about sizing that market opportunity in, let's say, 2022.

Sure. So first of all, I mean, we're pretty excited about the progress that we made in the 400-gig market. We highlighted the -- not only the 2 design wins that we had in the quarter, but also the fact that we have 5 technical qualifications, which, as we noted, is a significant milestone. I would say the technical qualification is typically the biggest hurdle to get over in logging a design win. The remaining hurdle would be really just receiving an order, which typically involves getting set up with proper purchasing codes and negotiating some pricing and things like that. So those hurdles are relatively low. The technical qualification is really the key piece that I think typically takes the longest. So we're pretty excited about the progress that we have with those 2 design wins and the 5 technical qualifications. With respect to your question about kind of where we fit in, in the ecosystem. I think, as you mentioned, our products are positioned to be a lower-cost version of 400-gig that can be used primarily in intra-data center applications. So distance is up to a couple of kilometers as opposed to longer distances than that, which is where ZR is typically targeted. Now ZR, of course, we'll work at shorter distances, but at a higher price, as you noted. And as far as the market sizing for next year, I can point you to some third-party estimates and things like that for the overall market size. I think what we're hearing from our particular customer base is that they're going to begin implementing 400-gig later in the third quarter and into the fourth quarter. My anticipation is that, that'll be a relatively slow incremental ramp throughout that time because that's typically how it goes with these customers when they try to implement a new technology like 400-gig. They don't instantly start to implement that technology. They put it in incrementally, test it, make sure everything's working as expected and then begin to ramp up after that. So this kind of 2 phase ramp is what I would expect there. And the second phase, which would probably be a stronger ramp is probably sometime in the middle part of next year.

Great. And then just maybe a quick one, if I might, is we've seen awards coming out of China for 5G technology. There was a 700 megahertz award a few weeks ago. And then more recently, China Unicom and Telecom made tenders for RAN. Just wondering how we can maybe look at those events in terms of helping, give us some sense of when your China business related to the 5G backhaul, front haul should improve?

Yes. That's a great question, Simon. I mean the 5G market is a little bit hard to make out right now. As we noted in our earlier remarks, some of our customers in China have begun ordering more products from us, which implies that their inventory levels are down to whatever level they think is comfortable, and they're placing new orders. Other customers haven't yet started to place those new orders yet. So I think we're my -- the way I'm interpreting that is that we're in a period where new orders are starting to flow from -- either new orders are starting to flow from the carriers like China Telecom and China Unicom or that there's line of sight to those new orders and some of our vendors are getting ready, while other vendors probably still have some buffer inventory that they want to draw down before they start to place new orders. So it feels like that should start to turn with more of our customers in this quarter or certainly by the fourth quarter. And the data points that you gave around the new bandwidth awards and new product orders coming out of China Telecom and China Unicom, I think those are significant data points to point also in that direction of a gradual recovery in the next quarter or 2.

The next question comes from Alex Henderson with Needham.

Stefan, can you give us a little bit of granularity around what your thoughts are between the data center and CATV and the guide for 3Q? What is -- what are we assuming there? Is the spike up in 2Q an abnormal spike, and it's going to stabilize or decline sequentially back to a more normalized growth or revenue level? Or is that a new base that we' be growing the CATV off of? And clearly, it's nice getting 400-gig wins, but the data center business declining sequentially into what is normally a seasonally strong quarter, is that now a trend line where it's -- you should expect the 40-gig to roll over a little bit faster going forward as people don't want a 40-gig product in their -- to put into their networks? A little help there.

Sure. So I'll take your first question first, which is what's the trajectory for cable TV. As I noted in our prepared remarks, our cable TV revenue is limited over the next quarter or perhaps beyond by component availability. And we talked about the magnitude of that in the third quarter being about $3 million. So you can get a pretty good picture that at least in Q3, and I would say that after that -- in subsequent quarters after that, depending on component availability, we should be at about that level as well. So I think we're kind of at a new level in cable TV, and there's opportunities to grow from there, particularly as we overcome some of these supply constraints, which is currently the limiting factor to deliver revenue there. At the same time then, your second question is about the trajectory in datacom. And I do think Q2 probably represents the low point in datacom revenue for us, at least the local minimum. That is, I think we'll see some incremental improvement in datacom. And as we noted in our prepared remarks, that's going to be driven by 2 factors. One is the 400G design wins and our beginning that first phase ramp that I spoke with Simon about earlier in the 400G business. And at the same time, I also expect to see some recovery in our 100G business as some of the customers that had previously purchased inventory are finally getting that inventory back down to a level that they think is appropriate to begin placing new orders. So those 2 factors, I think, can drive some incremental growth in the data center business.

So it sounds like data center up modestly a couple of million dollars. You're talking about the other ones probably. Telecom, it sounds like it's up a little bit sequentially off of a fairly low base. So that would suggest that you do expected a little bit of a retrenchment in the CATV to get to your guide, I would assume.

Yes. That's correct. And we highlighted that, that's largely due to component shortages.

Okay. I got it. That's perfect. I wanted to go back to the inventory. Your inventory carry rate is very high relative to your revenue base and relative to industry standards. And I get it that in this environment, that's probably not a bad thing. But do we have any concerns about having, potentially, any issues of having too much of, say, older product or lower speed products that might not be applicable to the future demand picture? Do you have the right inventory in that mix?

I think we do. If you remember, in some prior quarters, we've talked a lot about the fact that our 400G platform, our 100G platform and our 40G platform share a lot of commonality in terms of the design and the parts. And so to that extent, there's inventory of raw materials and things that may have been applicable to even 40G products that we could still continue to use in 100G. And certainly, cable TV, while some of the older generation products are maybe slower selling than the current stuff, there's still a lot of demand even for older generation products. So we feel pretty good about the inventory that we have. I should say, we feel good about the quality of the inventory that we have. Now your point about inventory level being high is well taken. We did bulk up on inventory quite a bit in the -- actually, even prior to COVID, in the Chinese New Year period going back last spring. And I think that, that -- we probably got a little bit ahead of our skis in terms of the amount of inventory that we have. To your point, it's comforting to have that inventory around with all the uncertainties that we've endured in the last year. But we do want to continue to draw that inventory level down. We've made some significant progress in that regard. I mean we've pulled our inventory. I think it maxed out at around $113 million, and we're down to just about $100 million at the end of the quarter. So I mean, that's good progress. I want to continue to make progress on that regard and bring that inventory level down to a number that I think would be more appropriate for the business, which is probably in the $80 million vicinity.

One technical question. You said $0.9 million of mark-to-market that the market issued. Was that shared?

That's dollars. That's the amount of net proceeds.

The next question comes from Sam Peterman with Craig-Hallum.