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

Hi. Good morning, good afternoon. Welcome to the Rosenblatt Age of AI Tech Summit. I am Mike Genovese, the cloud and communications equipment analyst here and I'm very, very pleased today to be joined by the Chief Financial Officer and Chief Strategy Officer of AAOI, Applied Optoelectronics, Stefan Murry. Nice to see you, Stefan.

Thanks for having me, Mike. It's great to see you again.

Perfect. And we're going to have a 45-minute fireside chat here go over some key industry and company questions. And for the audience, which I'm sure we'll have a nice one here who, if they want to ask questions, on the upper right-hand of the screen, there's an ask a question button. And if you type something in there, it will come to me, and I will ask the question during the session. And in fact, we've already got some questions as I look. So I'll fold these in. I'll start to fold these in. So Stefan, again, thanks for joining. Let's start with, I mean, AAOI in the data center revenue today comes from transceivers, right? So you sell transceivers, but I would argue that at your core, you're a laser maker and an indium phosphide laser maker. And that's why companies want to buy your transceivers because you're lasers. I mean, that's one of the key. It's not the only key reason.

I think there's 2. First of all, yes, I think you're right. That's an astute observation that technology-wise, the foundation of the company is in the lasers. I mean that's where we started. We -- for many, many years, we made lasers and didn't make transceivers or other modules. It's only been in the last 15 or 20 years really that we've been making modules and the lasers. So I think that's a very astute observation that technically, the laser capability goes back further than even the transceiver capacity. And customers do definitely appreciate the fact that we have our own laser fab because it represents a differentiated supply chain for them. It's an additional source of lasers that others don't have access to that gives us greater supply continuity and just basically adds to the availability of lasers, which is currently one of the things that's constraining growth across the industry. However, the other thing that customers, I think, really appreciate is the automation that we've built and developed for the production of the transceivers themselves. So we have the lasers on one side. On the other hand, we also have this highly automated production process for the transceivers, which, to some extent, I think it's fair to say customers don't necessarily care a great deal about exactly how your production process works. However, with all the geopolitical tensions that we've seen, it now becomes very important to them that their supply chain for the transceivers has as high an integrity as possible, meaning they want production ideally to be situated in geographical locales that they view as more stable, less likely to be interrupted by any of the stuff that we've seen over the last 5 or 10 years, right, natural disasters, pandemics, government restrictions, like all these kinds of things come into play. And so I think it's fair to say that most of our customers view the United States as being probably the most secure place in terms of supply chain in which to situate production. And by virtue of the fact that our production process is highly automated, we have a greater likelihood of being able to economically situate production here in the U.S. And that's another thing that's really important to our customers and they're probably growing in importance to our customers relative to where we were a year or 2 ago. So both of those factors, lasers automated transceiver production that can be located in the U.S. Those are the 2 big solid points.

Perfect. And do you find that customers are willing to pay a premium? Or does the price kind of equalize in the market between all the transceivers at 800 at 1.6?

No, they're willing to pay a premium for U.S. production.

Okay. And just because you touched on the geopolitical thing. I mean, we did the conference yesterday and the companies I talked to yesterday like Lumentum and things like that, VIAVI, they don't necessarily think that anything is going to change all that much, but I don't think anybody really knows what's going to happen. Do you have a view on that?

I think there's one person in this country who knows what's going to happen. He's not talking, at least not to me. So I think that's a fair statement. Nobody really knows what's going to happen. I do think there's enough concern about having the supply chain for such a significant component in our AI infrastructure being largely sourced by either from China directly or from companies that are Chinese companies. So I think there is a lot of concern about that. What the government ultimately does about that situation, I can't plan to have any significant insight into. However, I would posit it to you that the actual -- because nobody knows, including our customers, right, to a large extent, it's the uncertainty that's driving their decision making at this point, right? Like to your point, they don't know whether there should be a ban coming, and there's a real possibility that, that could happen. Again, I don't know when. I don't know what likelihood it is, but it's not 0 possibility that, that could happen. And against that backdrop, and by the way, if that were to happen, that would absolutely kill our ability to build new data centers in the U.S. if they were immediately banned from importing from the Chinese, right? So I think against that backdrop, customers are increasingly looking at where their products are produced and by whom and how. And when you start to look at it in that light, AAOI U.S.-based production capacity, currently existing and planned growth becomes very attractive to them and more attractive now than it was perhaps just a couple of weeks ago, even if a ban isn't actually in.

Right. So going back to the lasers. I think what you're making, I believe, right, are CW lasers for silicon photonics transceivers. And when you compare -- I just -- when you compare yourself and your sort of laser making capabilities to, say, Lumentum, Coherent, Broadcom. And we're talking about 100-milliwatt laser, 70-milliwatt lasers. Do you think everybody is about equal? Or does the laser actually become a differentiation? Or are they all about the same?

Well, I mean I think there are certain technical advantages that our lasers have, especially at higher powers when you look at like CPO type lasers, which are in the 300 to perhaps even 400-milliwatt variety. What matters there is the amount of power that you can get into a very narrow line with not to get overly technical, but basically, they want a very tight power spectrum. And our lasers are among the best in that respect. Now that being said, I think everybody that you mentioned which probably is an exhaustive list of all the companies that actually have 300 or 400-milliwatt lasers and it's not that big a list is my point. But I think all of us are able to make lasers that are good enough for the applications and probably sufficiently capable that it's not a decision-making criteria for our customers. I think they'll buy anybody that meets the specification. We are relatively smaller and production capacity, especially for the larger chip sizes that are used in those high-power lasers. So that's the main differentiator for us is our production capacity currently is just a lot smaller than Lumentum, certainty Coherent probably and even Broadcom. So that's where we're working to try to improve is by increasing our capacity on the laser production. But from a design standpoint, from a specification standpoint, I think we're as good or better than anybody else, arguably better in some way.

So could you make the 300-milliwatt lasers and ship them today if you are -- if you have the capacity? I mean the technology is there. This is just about --

Absolutely. I mean we are shipping small quantities for evaluation and whatever to customers today. I mean, there's no problem with our ability to produce these products other than the fact that we just don't have enough capacity right now to meet some of the demand that we're seeing or hearing about.

And when you -- I think you said on the earnings, right, you said like we're not going to be the very first -- well, because, right, some companies are shipping for scale out this year, right, before the end of this year. And so that's not you. But then by the end of next year or early '28, there's the next phase for scale up. So is that what you kind of meant by that will be in the second phase, meaning scale up? Or do you also -- or do you mean the second phase of scale up?

Well, I think there'll be a second phase of scale out as well. I think to a large extent, a big reason why AAOI is not a bigger player in the first phase, what's going -- as we point out the early shipments, the stuff that's happening this year and early next year is just simply what I said, we don't have enough capacity to provide a meaningful market share to our potential customers. So they have to work with somebody who is able to supply product regardless of whether they like us or how good our product is compared to anybody else's if you can't produce enough of it to be commercially useful to them, then they have to go elsewhere, right? As we begin to add capacity, and we have been adding capacity, but specifically into the latter half of next year when we see our capacity increasing meaningfully enough that we can supply all the lasers that we need for the transceivers and have additional capacity for the CPO or NPO or whatever type of laser that we're producing for those newer applications. That I think that's where we really will start to see our participation in that market start to grow. And that's kind of what I meant. It wasn't specifically tied to scale up versus scale out, but it does sort of coincide to some extent with that scale up opportunity, which is what we're going to see, in my opinion, probably a very sharp increase in the overall market size for these optics. So it's timely that we're going to have additional production capacity right about the time that the market size is going to grow dramatically.

Have you looked at the content difference between scale out and scale up? Because I mean, what I'm seeing is that a scale-out switch might have 16 optical engines, whereas a scale out, right? The scale-up rack might have 5x as many optical engines. It might have 10x as many optical engines, Some optical engine has 8 lasers. So I mean it just seems like the content opportunity and scale, not only is it a bigger market, but people are saying, "Oh, it's double the content per rack." But I'm thinking it might be 10x the content per rack.

No, I mean we tend to think of it as an order of magnitude-ish increase as well. And then the other thing that you hinted at, but just to make it a little more explicit is the size, the die size of those lasers is much larger as well. So when you look at the capacity as an industry that we have to produce those lasers, I mean, you're talking about, let's just call it, roughly an order of magnitude increase in the number of lasers and 5 or 6x larger size per laser. So when you look at the amount of wafer real estate that needs to be processed and fabricated into lasers, it's an enormous increase related to scale up compared to where we are today, which is why you see a lot of these investments from us and from our competitors in the laser space being made because there is not enough capacity in the industry right now to even come close to meeting the demand from scale up, much less the scale-out and regular opportunities that we see today. So it's a big amount of increasing capacity that's needed and the industry is responding to that along with us.

What size wafers are you using?

So we're a 4-inch right now. All of our equipment, all of our fab equipment that we purchased in the last, I don't know, a year or 2 is all capable of going to 6-inch. So we can turn on a 6-inch production at some point in the future when it's economically viable to do so. But right now, we're not at that point, so we're at 4-inch.

Actually like hearing that. I talked to Wupen about this yesterday from Lumentum. And he said that 4-inch is really just solid and the cost and the economics make sense. I mean the early guys working with 6-inch just the yields are bad and the economics are bad. So I think waiting is probably a good idea.

Yes. No, we would agree with that assessment. I think 6-inch sounds good on paper. And at some point, I think it will be economically viable. But for us, it's a very simple decision. When 6-inch is cheaper when it's basically cheaper to produce lasers at 6-inch that it is a 4-inch full switch to 6-inch, but that is not the case now. And we don't have a defined time frame set in stone where on this date, we're going to switch over to 6-inch. We're going to evaluate the 4-inch yields as they evolve. We're going to begin work on 6-inch to start to get our yield metrics and laser qualification and things like that done. And then over time, as those 2 factors, as we learn more on both of those fronts when it becomes economically more advantageous to go to 6-inch and we have 6-inch substrate availability, which is another issue, then we'll switch over to 6-inch, but there's no particular time frame that we have for making that decision.

So stepping back from CPO here for a minute. And just getting back to transceivers in 800G. I think you said in the third quarter, you expect about a 5x increase in sales there, which would, I think, get you into kind of the mid-60s and $1 million in revenue for 800G. First of all, how many customers -- just because this is a question that the audience is asking, how many customers are contributing to that 800G revenue? But more importantly, what changes between 2Q and 3Q? I mean what investments did you make how long ago that you now have the material, the capacity to be. And any more detail on sort of what's different this quarter versus last quarter, so that you can 5x the 800G?

There's 2 major hyperscale customers that are both purchasing meaningful quantities of 800G. And then there are several others that are smaller that are either purchasing or about to start purchasing smaller quantities. But really, the volume is being driven principally by 2 large hyperscale customers. The question of what changed from 2Q to 3Q is simply the fact that we've added additional capacity. And we've talked about this for at least the last year that we are adding capacity. Now the capacity for this year that's being added is mainly in our Taiwan factory. We have a huge amount of real estate here in the Houston area that we are beginning to build capacity here -- but that really won't start to come online. I mean, the very first increment of it will start to come online later this year. But really, that's more of a 2027 and even into 2028 thing where we're going to see more of that U.S. capacity coming upward. So right now, the additional capacity that we've added that allows us to go from a few million dollars in 800G sales a quarter to our projection that you mentioned for Q3 and into Q4, that ramp is coming mainly out of our additional capacity in our Taiwan plant. And that's the thing that's changed that's allowed us to grow that revenue.

Okay. I want to hit some of these questions in the audience that always -- aren't the questions that I would ask. So I mean sometimes, but I want to hit these. So to the extent that you can answer that makes sense. What is the capacity utilization or what -- sorry, what is the capacity of a single automated line? And what is the realistic capacity utilization?

We tend to think about our production planning in terms of 100,000 units per month capacity. It's -- that's kind of -- I guess that's what you would call a line. We don't really look at it that way exactly, but it's sort of a unit of production, additional capacity, and that's 100,000 pieces per month. And as far as what's the realistic utilization, I mean it's going to be pretty high. There's some planned downtime for equipment maintenance and things like that. But the plan is to run those machines pretty much 24/7, again, with some downtime for necessary maintenance and things like that. It's the advantage of having an automated process is it's -- it can be run pretty much all the time, right? It doesn't require sleep and bathroom breaks and things like that.

So are you at about 200,000 units of capacity right now and then the end of the year target of 650,000. Is that correct?

Probably a little more than 200,000. We were 200,000 kind of at the end of last quarter. So we're probably a little more than that now. But we're on that pathway between 200,000 and 650,000.

So help us understand the difference between the capacity you have right this moment, but the actual -- the revenues you could ship this quarter. And then tied into that question, for the $471 million per month target for data center transceivers in the second half of '27. I just want to double-click on that, if that's a -- because you talked about it as a revenue target not a capacity target. And is that a real expectation that you would expect to have 100% of that revenue in that time frame?

That's our current expectation, yes. I mean it's not going to be -- I can say this. I mean, based on our discussions with customers and the demand is not the limiting factor. I mean we can actually do more revenue than that if we had more capacity at that point or sooner, right? So our customers are aggressively trying to work with us to expand our capacity as fast as possible because their demand is growing very, very fast. And it really honestly outstrips our ability to build capacity fast enough. So yes, that is intended to be a revenue number, and it's basically gated by how fast we can add additional capacity and to some extent, supply chain, the expectations. I mean, there's not an unlimited amount of supply of everything that we need to build those modules, but those are the limiting factors, not demand.

Do you -- I mean, could you even take another data -- large data center transceiver customer, if another hyperscaler came to you and said, "We want your lasers, we want your U.S. production, and we want to buy lots and lots of transceivers for you." Would you bring them in the door or would you have to turn them away?

I mean it would be difficult right now, honestly. We would love to have a couple of other data center customers. I would say there's probably some large data center customers that would be very interested in working with us. But we have to be very careful to not overcommit. We're still relatively small in this industry. And we have to be careful not to overcommit. The last thing we would want to do is not be able to meet our commitments to our existing supplier or existing customers because we got ourselves out over our SKUs with new customer engagement. So we're talking to them we're trying to find a way to intercept with their demand. Maybe it's CPO, maybe it's some other newer technology that's a little ways out that we can try to build some capacity and intercept for them. But to answer your question directly, today, if another customer came to us and some have had said, we need x number of units. We have to say, sorry, were really sold out through -- at least through second half of next year and beyond. Maybe we have some opportunities to add certain types of things, but not until then.

When we do this a year from now, do you think you'll be saying we're still relatively small in the industry because you're going to grow a lot, but the industry is going to grow a lot. So how do you -- what do you think a year from now, you'll say?

The way I see it with our capacity expansion plans and the way we see the market going, really the best we could hope to achieve is somewhere around 20% and market share. So I don't know if you would call that small necessarily, it's certainly a big improvement from where we are today. But it's not like we're anticipating being sort of the dominant player or whatever. We're still one of the smaller players.

That's big. I don't think any U.S. vendor right now has 20% market share. So I think that that's actually pretty big.

Fair enough. It depends on how you look at it, I mean there are certainly companies out there that are going to be a lot bigger than us, although they may not be U.S. companies, right?

Yes. And then 1.6, right? I mean I think that -- so obviously, one customer has -- there's been an announced $200 million order. I think you'll have some revenue this quarter, and you sort of talked about a $70 million to $80 million in the fourth quarter against that order. And then I think the rest kind of slips into the first half of next year, and then we get more orders from that customer. So 2 questions, which to just flesh out what I just said, particularly the confidence in delivering and then what the new -- the new -- the next orders could be. But then also I think you probably have qualification trials going on now for other -- at least one other big 1.6T customer. And so when would be the timing where we could hear some news on another 1.6 customer? So I know that's a lot of questions ask all at once.

Well, yes, I won't really give an estimate on the timing for another 1.6 customer. It's hard to predict, but it's not based on our ability or inability to qualify those products based on their schedule on when they need those products, right? Right now, that customer is focusing on 800G getting ramped up on that. They're looking at 1.6, but not for a full qualification at this point. So I'll defer that part of the question. The first part of your question is, when do we see additional orders. I mean, the orders are going to come regularly, and we're not going to be publishing every order that we get from here on out. The purpose of those first press release was just to let everybody know that, in fact, we are starting to get orders from 1.6T. But after -- as we satisfy those orders, we're anticipating getting continuous stream of orders to utilize the capacity that we're building. So those are just the getting phases, if you will.

Okay. Back to some questions from the audience, since we're talking about capacity, any more new fabs planned to expand the laser supply beyond what is being built right now? Or I know there's another more general question. So what are the plans for capacity expansion?