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

Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics Business Update Call to discuss the agreement entered into today for the sale of its manufacturing facilities located in the People's Republic of China and certain assets related to its transceiver business and multichannel optical subassembly product for the Internet data center, telecom and FTTH markets. [Operator Instructions] Please note that this call 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, and I am pleased to welcome you to AOI's business update call. After the market closed today, AOI issued a press release announcing its agreement to sell its manufacturing facilities located in the People's Republic of China and certain assets related to its transceiver business and multichannel optical subassembly products for the Internet data center, telecom and FTTH markets. 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. A question-and-answer session will follow with 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, forecasts, anticipates, estimates, intends, predicts, expects, plans, may, should, could, would, will, potential or thinks 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, 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 circumstances 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 innovations as well as statements regarding the company's outlook. Except as required by law, we assume no obligation to update forward-looking statements for any reason after the date of this 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 prior earnings press releases that are available on our website. Now I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO. Thompson?

Thank you, Lindsay, and thank you for joining our call today for an important business development in AOI. In the press release published after market close today, AOI announced that it entered into a definitive agreement with Yuhan Optoelectronics Technology (Shanghai) Corporation (sic) [Yuhan Optoelectronic Technology (Shanghai) Co.] for the sale of its manufacturing facility located in the People's Republic of China and certain assets related to its transceiver business and multi-channel optical subassembly products for the Internet data center, telecom and FTTH markets for a purchase price of $150 million. Subject to certain working capital and other closing adjustments, including the holdback amount, we anticipate that the transaction will be complete in 2023 and is subject to customary closing condition and regulatory approval. We are excited about this transaction as it will enable us to make strategic investment in higher margin and higher growth opportunities, particularly in our fast-growing CATV broadband business and some of our newer laser-related products. Additionally, prior to the closing of this transaction, we anticipate investing between 4% and 10% of proceeds from the transition in exchange for 10% equity interest in Yuhan Optoelectronic Technology. Our management team and Board of Directors have been actively engaged in reviewing our strategy in order to accelerate our path to profitability and drive shareholder value. We believe today's announcement is a great outcome for our shareholders as well as for our partners and customers. Before I turn the call over to Stefan, I want to thank our team in China for their hard work and contributions over the years. I'm confident that this team will continue to strive and will facilitate a smooth transition for our employees, customers and partners. We are proud of the transceiver business that we have built, and we look forward to its growth under Yuhan Optoelectronic Technology ownership. In addition to the sales, we look forward to a new collaboration with Yuhan Optoelectronic Technology through a contract manufacturing agreement for production of certain AOI CATV product, and look forward to continue to supply lasers for the production of Yuhan's data center transceivers. With that, I will turn the call over to Stefan to review the details of the transaction. Stefan?

Thank you, Thompson. As Thompson mentioned, in a press release published after market closed today, we announced that AOI has entered into a definitive agreement with Yuhan Optoelectronic Technology (Shanghai) Co. for the sale of its manufacturing facilities located in the People's Republic of China and certain assets related to its transceiver business and multichannel optical subassembly products for the Internet data center, telecom and FTTH markets for a purchase price of $150 million, subject to certain working capital and other closing adjustments, including a holdback amount. We anticipate that the transaction will be completed in 2023 and is subject to customary closing conditions and regulatory approvals, including CFIUS in the U.S. and ODI in China. After careful consideration, we concluded that it's in the best interest of the company and our shareholders to exit the data center transceiver market, which has recently been a lower-margin business for us, and focus our resources on our data center laser business, our CATV broadband business and the manufacturing of lasers and laser components for other markets such as FTTH and sensing. We believe that these remaining businesses will generate free cash flow and can achieve EBITDA breakeven once the transaction closes. As a result, we believe that operating expenses will be reduced by nearly 40% after the completion of this transaction. Our focus as we plan for AOI's future is to continue to look for additional OpEx savings while maintaining a strong commitment to R&D, which is the lifeblood of our company. We will discuss these plans in more detail in subsequent earnings conference calls, including on our Q3 earnings call, which is currently scheduled for November 3. The significant proceeds we expect to receive from this transaction would enable us to make strategic investments in higher margin and higher growth opportunities and give us the financial flexibility to accelerate our growth, particularly in our data center laser business, our fast-growing CATV broadband business and some of our newer laser-related products. Additionally, prior to the closing of this transaction, we anticipate investing an amount equal to between 4% and 10% of the proceeds from the transaction in exchange for a 10% equity interest in Yuhan Optoelectronic Technology. In addition to the sale, we are looking forward to a new collaboration with Yuhan Optoelectronic Technology through a contract manufacturing agreement. We expect to continue to use the manufacturing facilities in China on a contract basis to produce certain CATV products. I believe that this transaction should best be understood as a strengthened commitment to the data center business, which will be accomplished by enabling us to focus greater resources on the design and manufacturing of data center lasers. The sale agreement includes transfer of our 40G, 100G, 200G and 400G transceivers for intra data centers. However, we will maintain all of our data center laser manufacturing capability, which is entirely housed in our fab facility in Sugar Land, Texas. This fab will not be affected by this transaction. Included in the sale are our manufacturing facilities in China, which have approximately 1,200 full-time employees. We currently anticipate these employees will become employees of Yuhan after the completion of the sale. Revenue for our data center segment was approximately $92 million for the trailing 12 months ended June 30, 2022. Since we have historically utilized our lasers in the production of our transceiver products, we have not broken out revenue within our data center segment for our laser business. On completion of the sale, our data center revenue will be comprised of revenue from the sales of our data center lasers and laser components for data centers. We look forward to continuing to supply data center lasers for the production of Yuhan's data center transceivers. We understand that Yuhan Optoelectronic Technology (Shanghai) Co. expects to utilize AOI's lasers in the production of their data center transceiver products. We believe that this transaction opens up new opportunities for customer expansion within our data center laser business as our production capacity for lasers will no longer be dedicated solely for internally used devices. This completes my financial overview of the transaction. With that, I'll turn it back over to the operator for the Q&A session. Operator?

Our first question comes from Simon Leopold with Raymond James.

Great. First off, it's my recollection, and maybe it's dated, is the problem that the vast majority of your cable TV infrastructure was manufactured outside of the China -- in the China facility and that your Taiwan and Sugar Land facilities were more associated with transceivers and lasers. And maybe I'm just out of date, but is that incorrect? Or have you shifted cable manufacturing out of China already? Or will you be heavily reliant on Yuhan as a contract manufacturer?

Right. That's a great question, Simon. Thanks for asking. As we noted in our prepared remarks, we do have an arrangement with Yuhan to continue to produce any of the cable TV products that we currently produce there. However, as we've noted in prior earnings calls, also we have been building capabilities to produce cable TV products in our Taiwan facility as well. And so moving forward, we're going to be evaluating the manufacturing operations for cable TV products in light of those 2 different manufacturing locations.

And I'm guessing that you're not prepared to provide essentially a pro forma variation of your financials. So you're not able to tell us how much revenue we can sort of back out given you're still doing lasers for the data center but not transceivers. It's a little bit, I think, tricky for us to rebuild the models given the information we have. Is there any other quantitative detail you can offer?

Right. We're still working through some of those numbers. And as I noted in our prepared remarks, we'll share those on subsequent calls. We did note that the data center transceiver business overall was about a $92 million business trailing 12 months from the last quarterly report. Typically, the laser part of that would represent 10% to 15% of that spend. There can be a lot of nuance there based on product mix and what have you. And so we're going to be providing more guidance as soon as we can. But at this point, that's all we can share.

Yes. That's helpful. And then just one last one. Do you know how this transaction would alter your book value given that you're divesting yourself in some assets but getting some cash. I imagine it's depreciated. Do you have an update on what the book value will be after this transaction?

I don't have that number at this point. We'll be -- again, we'll be able to report more of that data as we get into the next earnings call.

The next question comes from Paul Silverstein with Cowen and Co.

I appreciate that it's preciously early, but picking up where Simon left off, any sense for what the margin profile will look like certainly after the close of the transaction. In addition, any sense for what the cash flow breakeven revenue level would be post transaction. And then I've got some follow-ups.

Right. Well, I did notice that -- I mean I noted in our prepared remarks that our models, our preliminary models, which again are subject to a lot of variation, not the least of which because it's a forecast for some indeterminate time next year when this closes. But we do -- they do indicate that we should be EBITDA positive and cash -- generating free cash flow after the close of this transaction. But as far as the revenue level and such that we've assumed in that, I'll have to refine those estimates and share them with you at a future date.

I'm not trying to give you a hard time, but I'm curious when you all prepared the press release you made a statement and you expect to be FCF and EBITDA positive. I assume you had some revenue level in mind. It wasn't as simple as plus transaction will be EBITDA-positive revenue. I mean the 2 seem to be related, no?

Yes, they are. But there's also various different scenarios under which we looked at it, and we have to refine those scenarios before we can try to pin down revenue numbers for you.

All right. So I guess your message is you're going to focus -- you will endeavor to drive the priority we'll be getting to EBITDA positive and FCF positive as opposed to revenue -- as opposed to drive revenue for revenue's sake. I mean that, clearly, is going to be the focus [indiscernible]

Paul, sorry to interrupt there. You were finishing your question. Go ahead.

No, no, go ahead.

Yes. So the focus on this transaction is to improve and speed up our path to profitability, as we noted in our prepared remarks. That's what we're focused on. And so we're heavily focused on being able to make the investments that we want to make in businesses that we think are going to be more profitable than the assembly of data center transceivers. The laser business, for example, for data centers and other applications, which we're going to maintain in its entirety post transaction, that's an example of something where we think that we can drive additional revenue opportunities and expanded gross margin relative to the assembly operations and things that are being performed in China currently. And so that's definitely our focus is improving margin and improving profitability post transaction.

Got it. A couple more, if I may. I assume by definition, given that you've struck the deal and announced it, you believe that CFIUS will not be a significant hurdle in precluding this deal from getting done. And you're selling assets, significant assets to a Chinese entity, that would seem to be nontrivial. But why don't I let you respond?

Right. We've looked to that, and we've had experts in that area look at it. And you can never can tell with CFIUS. It's a little bit of a black box, obviously. But the feeling is that this has a pretty good chance of being able to make it through the review.

The 4% to 10% contemplated investment, is that a requirement? And why -- what's driving that? And what determines whether it's 4% or 10%?

It's still -- the amount of the investment is still under negotiation and discussion. The thinking there is -- first of all, I mean, this company is going to be a significant partner for us, as we mentioned, both in terms of the contract manufacturing business as well as a significant customer for us. And we do feel like that there's opportunities for this company to grow. And to the extent that we can maintain some investment in there, we'd like to be able to get some return on that investment as well.

All right. One last one for me. With respect to the manufacturing relationship, can you remind us what the historical relationship with Yuhan has been? And are they -- the commitments going forward in terms of you using them as a contract manufacturer, is it -- is that a hard commitment? Are you obligated to use them? And are they obligated to manufacturing in your behalf? What's the nature of that commitment going forward? And what's been the historical relationship?

So we don't have any historical relationship with Yuhan other than as a part of this transaction. As far as the commitments in terms of manufacturing, we have -- we don't have a hard commitment. There are some exclusivity provisions which are sort of detailed in some of the documents you can read in the 8-K, that hinge on us using them and then performing activities of contract manufacturing for us. But outside of that, there's no obligation for us to continue to use them. As I noted, we've been growing our manufacturing operations, for example, in Taiwan. But we think the Ningbo factory for us has done a really good job over many years. They're very skilled in the manufacturing operations that we have. And so we don't see any reason why we would need or want to move manufacturing away from them any time soon. But we have the capability to do so should we desire to.

[Operator Instructions] The next question comes from Tim Savageaux of Northland Capital Markets.

Well, first, congratulations on just a spectacular transaction. So very dynamic and I think very much in the right direction. In terms of several of your -- a couple of your much larger peers, and I think this has been the case historically too. If you're just making a laser or a device, those gross margins can start with a 5 or even more. Is that what you expect in terms of a stand-alone laser supplier, something in that range? Or do you have any guidance for us for what that margin profile would look from them on the laser-only part of the business? And I've got a follow-up on cable TV.

Yes. I think I can't make a comment at this point on kind of where our specific forward expectations are in terms of gross margin, as I've mentioned earlier when I was answering Simon's questions. That's -- those are a little difficult to pin down precisely at this point. However, I think your observation about the industry, in general, that margins can be in the 50% or higher range is certainly consistent with our thinking on that. Now clearly, different types of lasers and different types of applications have somewhat different margin profiles, but that's certainly a reasonable observation regarding the industry.

Right. Well, good. And given your metric, you're 10% to 15%, I mean, it depends -- kind of leads into my second question, which is, where from your current business standpoint, I guess the assumption might be that data center transceiver margins are below the corporate average in cable TV above. That's sort of part of my question there. But it looks like you're targeting something like 20% of the BOM, or 20% of cost of goods sold, maybe a little less than that if you're assuming datacom transceiver gross margins of 10%, 20%. I don't know where they are. But that seems to make sense. But maybe just start on that question about cable TV is going to be the biggest part of the revenue going forward. Can you make any comments on where the -- where you expect those margins to be or where they are relative to your overall margins currently?

Well, I mean, cable TV makes up about half of our business. And we don't -- we haven't historically broken out margins by segment there. It's -- and we have noted pretty consistently in prior calls that the cable TV segment, in particular, has a lot of product mix involved in it. I mean it's not as much one monolithic product as some of the data center business is. So it's a little hard to pin that down. But I would say it's -- the cable TV margins are not that far off from the corporate average. They're reasonably close to the corporate average. Now the data center business is a little more nuanced than that because there's a lot of intercompany technology that gets transferred around. So so it's a little difficult to say how much of the margin is comprised of data center transceiver manufacturing operations versus the margin that derives from the laser itself. Right?

Right. Understood. And I guess, last question for me, and just let me know if this is the right way to think about it. But let's make it easy and say you've got $100 million of data center revenue last 12 months. And if those margins are -- I'm hearing you on the intercompany stuff, but module margins maybe in the teens. I mean is it possible that, obviously, you're foregoing a lot of revenue. But given our previous discussion about gross margin levels, is it possible that you won't be foregoing any gross profit dollars, which is to say, even at this lower revenue level, margins are high enough where it's -- can be kind of awash with regard to where you come out on a gross profit absolute dollar standpoint.

Well, I think as I said earlier, it's a little early for us to give a lot of details in terms of our outlook for that. Is it possible? Maybe. I think it would be a stretch. Our real expectation here also, which I noted in our prepared remarks, is that I think we can grow the data center laser business. If you think about it, right now, we're sort of limited. We used the vast majority, pretty much all of our laser production for internal use. And now that we will not be producing transceivers in the future once the transaction closes, we'll have the opportunity to [ dissolve ] this transaction. The other important part of this transaction is that there are certain customers in China who we've noted on previous earnings calls that for political reasons or preference reasons -- they saw what happened with Huawei when the U.S. government essentially shut down certain U.S. [Audio Gap] very skittish, I would say, about having key technology elements coming from U.S. companies for that reason. They know that it's just one phone call away from the Department of Commerce before they could potentially have that revenue shut off. So I think -- or rather that source of supply shut off. So I think the opportunity for Yuhan post transaction to grow the data center business by expanding sales to some of the large Chinese data center operators is another avenue by which I think we can actually increase revenue. So our expectation is not that data center laser revenue is going to sort of remain consistent after this. I think we're expecting growth. And obviously, the gross margin will expand from current levels in the data center because it's -- as you noted, laser gross margins are significantly higher. So we think this is a really positive transaction and enhances our ability to get to profitability not just by increasing our gross profit margin, but also increasing our revenue opportunities. And those expand even further down the line.

The key of this transaction, the Yuhan [indiscernible] China, I think they will have a lot of opportunity in the China market. Not only they are selling green fiber-to-the-home and maybe telecom, okay? For sure, we will still manage data supplier. They will have AOI laser's revenue and gross margin. I think that is a win-win position, that's whole purpose. I think the value is much more than the $150 million we can see. And that's whole purpose, then we can really expand out the overall market in transceiver and laser without limitation. Yes.

Yes. Got it. And just last one for me. We should also, in addition to your trailing data center revenue, you'll also be selling -- you've got $25 million or so, $20 million, $25 million of telecom, fiber-to-the-home other revenue. You'll be selling lasers into that. Should we be thinking about that the same way from a content standpoint?

Actually, right now, quite a lot actually is not transceiver, a lot of laser already. But some of them actually -- quite a lot of them actually are on the laser business, not transceiver business. And that's why right now, I think we are not really too excited too much in China market for fiber-to-the-home and telecom because of the -- as a U.S. supplier, there has some limitation over there. That's the current -- the number you see, actually, quite a lot of them are laser already. But in the future, after the transaction, then Yuhan can do transceiver and they will -- as in they will use majority of AOI lasers. So that we have additional revenue on top of what we can see.

Okay. So that's interesting. So that's currently mostly laser revenue. So you're going to keep that by and large.

Yes, it's correct.

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

Again, thank you for joining our call, especially on such short notice. As always, we want to extend the same 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.