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Operator
Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to apply optoelectronics third quarter 2022 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. To ask a question, you may press star then one on your telephone keypad. To withdraw from the question queue, please press star then two. 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.
Lindsay Savarese
Thank you. I'm Lindsay Savarese, Investor Relations for Applied Optoelectronics, and I am pleased to welcome you to AOI's third quarter 2022 financial results conference call. After the market closed today, AOI issued a press release announcing its third quarter 2022 financial results and provided its outlook for the fourth quarter of 2022. The release is also available on the company's 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. Stephen Murray, AOI's chief financial officer and chief strategy officer. Thompson will give an overview of AOI's Q3 results, and Stephan will provide financial details and the outlook for the fourth quarter of 2022. A question and answer session will follow our prepared remarks. Before we begin, I would like to remind you to review AOI's Safe Harbor 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 circumstance that could give rise to the termination of the transaction. Forward-looking statements also include statements regarding management's beliefs and expectations related to the expansion of the reach of our products into new markets and customer responses to our innovations. as well as statements regarding the company's outlook for the fourth quarter of 2022. Except as required by law, we assume no obligation to update forward-looking statements for any reason after the date of this earnings call to conform these statements to actual results or to changes in the company's expectations. More information about other risks that may impact the company's business are set forth in the risk factor section of the company's reports on file with the SEC, including the company's annual report on Form 10-K for the year ended December 31, 2021, and quarterly reports on Form 10-Q. Also, all financial results and other financial measures discussed today are on a non-GAAP basis unless specifically noted otherwise. Non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation between our GAAP and non-GAAP measures, as well as a discussion of why we present non-GAAP financial measures, are included in our earnings press release that is available on our website. I'd like to note the date of our fourth quarter and full year 2022 earnings call is currently scheduled for February 23rd, 2023. Now, I would like to turn the call over to Dr. Thompson Lin, applied optoelectronics founder, chairman, and CEO. Thompson?
Lindsay Savarese
Thank you, Lindsay, and thank you for joining our call today. For the third quarter, while revenue came in below our expectations, we deliver cost margin in line and a narrow non-gate loss per share than our expectations. As you may have seen, on September 15th, we announced that we have entered into an agreement with Yuhan Apto Electronic Technology for a sale of our manufacturing facilities located in the People's Republic of China and certain assets related to AY transceiver business, and multiple channel optical sub-assembly products for the Internet Data Center, Telecom, and FTTH markets for a purchase price of $150 million. That's a whole big amount. We continue to anticipate that the transaction will be completed in 2023 and is subject to customary closing conditions and regulatory approvals. Early feedback from our customers has been positive. We believe that our capability in chip fabrication and the continuity of this supply chain is of utmost importance to our data center customers and we believe most of them understand and appreciate the rationale behind the proposed diversity of our transceiver manufacturing operations in the import. We believe this transition will generate significant proceeds, which will enable us to make strategic investments in higher margins and higher growth opportunities. Following the transaction, AOI will have a focused portfolio composed of with manufacturing facility in Taiwan and Sugar Land, Texas. We will also maintain our CATV product portfolio, utilizing our current Taiwan facility for production, as well as our current Limbo facility on a contract basis. Lastly, we believe that the transaction will open up the opportunity for customer expansion with our existing care center laser business. Turning to our third quarter results, we delivered revenue of $56.7 million, slightly below our guidance range of $57 to $60 million. Viewed mainly to affect the general anticipated decline in 40G sales. We delivered an ongoing gross margin of 18% At the high end, our guidance range of 16.5% to 18.5% and a small long-term loss per share of $0.26 relative to our guidance range of a loss of $0.27 to $0.32 due to better than expected operating expenses. For the revenue in our CATB segment, was a company record of $31.3 million, up 35% year-over-year and 32% sequentially, as we continue to see robust demand in the CATV markets. Total revenue for our data center products of $17.7 million decreased 26% year-over-year and 80% sequentially, largely due to a decline in 40G, which is nearing the end of its life cycle, and 100G, which is beginning to slowly decline as customers move to 400G. This was partially offset by an increase in 400G, which more than tripled sequentially from Q2. As anticipated, we believe that this increase in 400G is the beginning of the sustained trend of increasing revenue from this newer product line. With that, I will turn the call over to Stephan to review the details of our Q3 performance and our Q4 statement. Thank you, Thompson.
Lindsay
As Thompson mentioned, while our revenue came in below our expectations, we delivered gross margin in line with our expectations and a smaller non-gap loss per share relative to our expectations. We're encouraged by the robust demand in the CATV environment, the strength we are seeing in the telecom market, and the early shipments of our 400G products. Our total revenue for the third quarter increased 6% year over year to $56.7 million, which was slightly below our guidance range of $57 to $60 million, primarily due to a faster than anticipated decline in 40G sales. As Thompson mentioned, And as you may have seen, on September 15th, we announced that we have entered into an agreement with Yuhan Optoelectronic Technology for the sale of our manufacturing facilities located in the People's Republic of China and certain assets related to our transceiver business and multi-channel optical sub-assembly products for the data center, telecom, and FTTH markets for a purchase price of $150 million, less a holdback amount that is variable depending on working capital and other conditions at the time of closing. Currently, it would be approximately $7 million, making the total cash consideration for the divestiture approximately $143 million. I will spend a few moments on today's call to provide more detail on the strategic rationale as well as to discuss what AOI looks like as a company post the close of the transaction. As a reminder, we continue to anticipate that the transaction will be completed in 2023 and is subject to customary closing conditions and regulatory approvals, including CFIUS and ODI. We believe that the transaction would have a number of benefits for AOI. First, it would allow us to concentrate our efforts on growing our higher margin optical component chip business. Currently, the vast majority of the optical components produced in our Texas fab are used in the internal production of our transceivers. There are a number of transceiver manufacturers who are currently competitors of ours that we feel could become customers for our optical component products once we no longer compete with them on transceiver production. If successful, we believe that this transaction would allow us to unlock an additional potential market for our optical component products, which typically earn significantly higher gross margins. Second, we believe that this transaction may also unlock potential new revenue in China. Due to tensions with the US, many Chinese companies have a high degree of sensitivity to purchasing key components like transceivers from US companies. We believe that putting our transceiver manufacturing business into the hands of a domestic Chinese owner should enable the new entity to gain additional business with domestic Chinese customers. The benefit to AOI is potentially greater sales of our optical component chips to be used in the production of transceivers for these new customers. Third, we believe that reducing our dependence as a company on operations in China given recent ongoing events is prudent. The business environment there for U.S. companies has grown increasingly challenging, and there is no assurance that these tensions will ease in the foreseeable future. Finally, the significant cash generated by the transaction would enable us to strengthen our balance sheet. It would also allow us to make investments in future product development in our existing markets, as well as potential new ones. After the close of the transaction, we would retain our manufacturing facilities in Taiwan and Sugar Land, Texas. AOI would exit the data center transceiver market and instead we would focus our resources on our data center laser business, our CATV broadband business, and manufacturing of optical components for other markets such as FTTH and sensing. We believe that these remaining businesses should generate free cash flow and can achieve EBITDA break-even once the transaction closes. Turning to what our revenue profile would look like once the transaction is closed, It is difficult to break out what percentage of our overall data center revenue is optical components versus transceivers, given that our optical components are used to manufacture our transceivers. However, based on our internal usage of in-house manufactured optical components, we estimate that roughly 15% of our data center revenue over the trailing 12 months and to September 30 is attributable to these optical components. In addition to this embedded component business, Over the trailing 12 months, we've had direct sales of optical components of approximately $20 million. Post-transaction, as noted above, we believe that there are significant opportunities to increase both our data center optical component revenue and our direct sales of optical components. Lastly, with respect to our margin profile, while we cannot estimate with precision our margin structure after the transaction closes, We believe that at close or within a few quarters afterwards, we can achieve gross margins in the upper 20% range, perhaps approaching 30%. Turning back to the quarter, we secured one new design win, which was in our telecom segment. The single design win in the quarter is lower than is typical, but we continue to have a robust pipeline for new qualifications that we expect to be completed over the next few quarters. We continue to see good customer traction on 400G, As we expected, orders began to ramp up in the third quarter, and we expect continued growth in shipments in Q4. Turning to our third quarter results, 55% of our Q3 revenue was from our CATV products, 31% was from our data center products, with the remaining 14% from FTTH, telecom, and other. In our CATV product segment, the overall demand environment remains robust as MSOs, particularly in North America, continue purchasing additional networking products in order to upgrade their networks. CATV revenue in the third quarter was a company record of $31.3 million, which was up 35% year-over-year and 32% sequentially. Further out, we continue to have good visibility with CATV orders as we see our backlog stretching into mid-2023. We have significantly increased production capacity for our CATV products, demonstrated by our Q3 results, and we believe that we are well-positioned to deliver on the demand that we are seeing. Our Q3 data center revenue came in at $17.7 million, down 26% year-over-year and 18% sequentially. In the third quarter, 72% of our data center revenue was from our 100G products, 13% was from our 40G transceiver products, and 3% was from our 200G and 400G transceiver products. Now turning to our telecom segment. Revenue from our telecom products of $6.8 million was up 32% year-over-year and up 9% sequentially. Telecom revenue continues to be driven mostly by 5G-related products, and we believe that revenue from these products will remain relatively consistent over the next few quarters. For the third quarter, our top 10 customers represented 86% of revenue, flat with Q3 of the prior year. We had two 10% or greater customers in the third quarter, one in the CATV market and one in the data center market. These customers contributed 50% and 16% of total revenue, respectively. In Q3, we generated non-GAAP gross margin of 18%, which was at the high end of our guidance range of 16.5% to 18.5%, and was up from 16.7% in Q2 of 2022 and compared to 19.9% in Q3 of 2021. The increase in gross margin was driven mainly by the anticipated impact of the cost reduction efforts that we initiated early in the year. Total non-GAAP operating expenses in the third quarter were $19.4 million, or 34.3% of revenue, down as a total percentage of revenue from $19.3 million or 36.3% of revenue in Q3 of the prior year. R&D expenses decreased 8% year-over-year to $8.9 million. Looking forward, we expect non-GAAP operating expenses to increase in Q4 by about $3 million. This increase is driven by approximately $3.3 million or approximately 12 cents per share of additional employee bonus accrual related to the China divestiture. This catch-up accrual in Q4 is necessary to conform our total year-end bonus accrual to current expectations after the announcement of the transaction, but it is not expected to recur after Q4. Looking ahead, we expect non-GAAP operating expenses to moderate next year to between $19 million and $20 million per quarter. Non-GAAP operating loss in the third quarter was $9.3 million compared to an operating loss of $8.7 million in Q3 in the prior year. Gap net loss for Q3 was $15.6 million, or a loss of 56 cents per basic share, compared with a gap net loss of $15.8 million, or a loss of 58 cents per basic share in Q3 of 2021. On a non-gap basis, net loss for Q3 was $7.1 million, or a loss of 26 cents per basic share, which was better than our guidance range of a loss of $7.6 million to $9.1 million, or loss per share in the range of 27 cents to 32 cents per basic share, and compares to a net loss of $5.3 million, or a loss of 20 cents per basic share, in Q3 of the prior year. The basic shares outstanding used for computing the net loss in Q3 were 27.8 million. Turning now to the balance sheet, we ended the third quarter with $34.6 million in total cash, cash equivalents, short-term investments, and restricted cash. This compares with $40.7 million at the end of the second quarter. We ended the quarter with total debt of $65.1 million, up from $63.8 million last quarter. As of September 30, we had $94.3 million in inventory compared to $98.2 million at the end of Q2. Inventory decreased primarily due to utilization of inventory for larger shipments during the quarter. We made a total of $0.8 million in capital investments in the third quarter. almost all in construction and building improvements. Looking ahead for the year, we expect between $4 million and $5 million in total capex. Moving now to our Q4 outlook. We expect Q4 revenue to be between $58 million and $64 million, and non-GAAP gross margin to be in the range of 17% to 19.5%. Non-GAAP net loss is expected to be in the range of $8.1 million to $9.8 million, and non-GAAP loss per basic share between $0.28 and $0.34 using a weighted average basic share count of approximately 28.7 million shares. With that, I will turn it back over to the operator for the Q&A session. Operator?
Operator
We will now begin the question and answer session. To ask a question, you may press star then 1 on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw from the question queue, please press star then 2. At this time, we will pause momentarily to assemble our roster.
spk01
Again, if you have a question, please press star then 1. We have a question from Ethan Wydell of B Reilly.
Operator
Please go ahead.
spk06
Hi, this is Ethan calling in for Dave Kang. Thanks for taking my question. I just have one on my end. So we've seen some hyperscalers announcing pretty robust CapEx spend plans surrounding their data infrastructure build-out. So I was hoping you could provide a little additional color regarding overall obstacle demand, especially as it pertains to hyperscalers. Thanks.
Lindsay
Sure. Well, you know, as we noted, I think what we're seeing in the market right now with particularly with the hyperscalers, is that our 400G business is beginning to ramp. As we noted in our prepared remarks earlier, I mean, it was up more than three times sequentially. You know, and we have a pretty strong order backlog for those products, which, you know, we've anticipated, and I think we've communicated that, you know, the last couple quarters that we expected to see 400G ramping in the second half of the year. So it's good that we're actually, you know, experiencing what we projected to see earlier in the year. So, you know, I think the spending environment for the hyperscalers generally is, as you noted, you know, fairly robust in terms of optical component spend. You know, we're monitoring that based on, you know, our viewpoint moving forward on sort of macro conditions and how that's going to affect things. But right now where we stand, it looks like, you know, the spending plans for next year are starting to crystallize a little bit on the part of our customers. And, again, you know, we think the 400-gig ramp is good evidence that that's going to be positive for us moving forward.
spk06
Good to hear that.
spk00
Thank you. Thank you.
spk01
Again, if you have a question, please press star then 1. This concludes our question and answer session.
Operator
I would like to turn the conference back over to Dr. Thompson Lin for closing remarks.
Lindsay Savarese
Okay. Thank you for joining us today. As always, we want to extend a thank you to our investors, customers, and employees for your continued support. We look forward to updating you on our progress next quarter.
Operator
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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