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Operator
Good afternoon. I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics' second quarter 2023 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. All participants, again, have been placed on mute to prevent any background noise. Should you need any assistance, please signal a comfort specialist by pressing star then zero on your telephone keypad. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I will now turn the call over to Lindsay Severese. Investor Relations for AOI. Ms. Savarese, you may begin.
Lindsay Severese
Thank you. I'm Lindsay Savarese, Investor Relations for Applied Optoelectronics. I am pleased to welcome you to AOI's second quarter 2023 financial results conference call. After the market closed today, AOI issued a press release announcing its second quarter 2023 financial results and provided its outlook for the third quarter of 2023. The release is also available on the company's website at ao-inc.com. This call is being recorded and webcast live. A link to the recording can be found on the investor relations section of the AOI website and will be archived for one year. Joining us on today's call is Dr. Thompson Lin, AOI's founder, chairman, and CEO, and Dr. Stephan Murray, AOI's chief financial officer and chief strategy officer. Thompson will give an overview of AOI's Q2 results, and Stephan will provide financial details and the outlook for the third quarter of 2023. A question and answer session will follow our prepared remarks. Before we begin, I would like to remind you to review AOI's Safe Harbor Statement. On today's call, management will make forward-looking statements. These forward-looking statements involve risks and uncertainties, as well as assumptions and current expectations which could cause the company's actual results, levels of activity, performance, or achievements of the company or its industry to differ materially from those expressed or implied in such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as believes, forecast, anticipates, estimates, intends, predicts, expects, plans, may, should, could, would, will, potential, or 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 third quarter of 2023. Except as required by law, we assume no obligation to update forward-looking statements for any reason after the date of this earnings call to conform these statements to actual results or to changes in the company's expectations. More information about other risks that may impact the company's business are set forth in the risk 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, 2022. 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. Before moving to the financial results, I'd like to announce that AOI Management will be attending the HC Wainwright Global Investment Conference on September 11th and the Northland Institutional Investment Conference on September 19th. I'd like to note the date of our third quarter earnings call is currently scheduled for November 9th, 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. Our second quarter revenue was in line with our expectations, while our long-term cost margin and long-term loss per share were better than our expectations. We are pleased by the continued progress we have made on improving our cost margin and are encouraged by the increased demand we saw for our 100G and 400G products in our data center business during Q2. Number three, revenue for our 100G product increased 30% sequentially, while revenue for our 400G product doubled sequentially and counted for 11% of our total data center revenue in Q2. During the second quarter, we delivered revenue of $41.6 million. In line with our guidance range of $40.5 million to $47.5 million, we delivered non-GAAP gross margin of 24.8% above our guidance range of 20.5% to 23.5%, mainly driven by our favorable product mix and our targeted cost reductions. Our non-GAAP loss per share was $0.21, above our guidance range of a loss of $0.23 to $0.31. Total revenue in our CATP segment was $9.3 million, down 61% year-over-year and down 66% sequentially. As a reminder, our Q2 results were negative, impacted, by some inventory built up with certain CATB customers, which led to softer than expected CATB revenue in Q2. We do believe that this inventory digestion in transitory and based on what we are seeing today, we expect our CATB revenue to increase slightly sequentially. Also, it will be down year over year strong Q3 of last year. Total revenue for our data center product of $27.6 million increased 28% year-over-year and increased 35% sequentially, largely due to increased demand for our 100G and 400G products, as we continue to see the run-up of our 400G products. On our last two calls, we discussed an agreement we have signed with Microsoft, who has been a long-term key customer of ours for a development program to make length-generation lasers for its data center, both for energy and beyond. During the second quarter, we signed an additional agreement with Microsoft to provide design and assembly services for active optical cables. We view this country awards as validation of the strength and quality of our cold laser fabrication ability. In total, we believe that this award AOI of over $300 million over seven years. With that, I will turn the call over to Stephan to review the details of our Q2 performance and our work for Q3, Stephan.
Lindsay
Thank you, Thompson. As Thompson mentioned, our second quarter revenue was in line with our expectations, while our non-GAAP gross margin and non-GAAP loss per share were above our expectations. We are pleased by the continued progress we have made to improve our gross margin and expect this trend to continue. We were encouraged by the increased demand we saw for our 100G and 400G products in our data center business during Q2. Lastly, we are excited about our newly formed broadband access group, the strength of talent we have recently added to this team, and believe that we are well positioned to execute on our new strategy to sell our CATV products directly to MSO customers. Before turning to discuss our results and outlook, I want to provide an update on the transaction that we announced last September with Yuhan Optoelectronic Technology. As we have previously discussed, we entered into an agreement with Yuhan for the sale of our manufacturing facilities located in the People's Republic of China and certain assets related to our transceiver business and multichannel optical subassembly products for the data center, telecom, and FTTH markets for a purchase price of $150 million. As a reminder, This transaction is subject to customary closing conditions and regulatory approvals, including CFIUS and ODI. We continue to make progress in preparing the information that will be needed in order to file for the various regulatory approvals that are required in order to finalize the divestiture. Although these filings are not yet complete, we do expect to submit our application to CFIUS within the next 45 days. While the timing of the regulatory approval process is uncertain, Based on our current schedule, we expect the closing timeframe will be early 2024. Turning to the quarter, our total revenue for the second quarter decreased 20% year-over-year to $41.6 million, which was in line with our guidance range of $40.5 million to $47.5 million. The decline in revenue was largely due to the inventory buildup with certain of our CATV customers that we discussed on our Q1 call. During the second quarter, 66% of our revenue was from our data center products, 22% was from our CATV products, with the remaining 11% from FTTH, telecom, and other. In line with our expectations, CATV revenue in the second quarter was $9.3 million, which was down 66% sequentially and 61% year over year. As a reminder, our CATV revenue was negatively impacted as a few of our CATV customers worked through excess inventory that had built up among their various distribution channels. We expect that any inventory buildup will be transitory, and based on what we are seeing today, we expect that our CATV business will increase slightly sequentially, although it will be down year over year off a historically strong Q3 of last year. As a reminder, our CATV revenue in 2021 and 2022 was historically high compared to prior years. We do expect our CATV revenue will rebound to more normal levels, although near-term it will be down compared to those historic highs as the MSOs transition to next-generation architecture. Looking further ahead, we are carefully monitoring MSO plans to move to DOCSIS 4.0 networks. While we are cautiously optimistic as the nature of these upgrade cycles can be lengthy, We continue to believe AOI remains well-positioned to capture a portion of this new infrastructure spend and think our products are well-suited for when the push to install amplifiers and other network elements for DOCSIS 4.0 begins. We believe this transition could happen in early to mid-2024. During the quarter, we announced a change in our strategy to offer our CATV products directly to MSO customers through our recently formed Broadband Access Group. We believe this strategic move will allow us to better serve the MSO needs for reliable, feature-rich amplifiers for their network upgrades. We also expect that this strategy will help us scale our business more efficiently and improve our gross margin further. We believe we could eventually see 10 to 15 points of margin increase as a result of this transition. In line with our new strategy of directly selling to the MSOs, During the quarter, we announced order availability of our quantum bandwidth line extender and system amplifier products. As one of the few companies with large-scale in-house manufacturing capacity for amplifiers, we believe our new products will expand AOI's product portfolio while maintaining the industry-leading quality and reliability of our renowned HFC products. During the quarter and subsequent quarter end, we also added critical talent to our newly formed broadband access group. Notably, and as you may have seen, We appointed Todd McCrum as Senior Vice President and General Manager of the Broadband Access Team. In this newly created position, Todd will lead sales, product development, and marketing of AOI's quantum bandwidth line of broadband access products. Todd's impressive career in broadband has spanned the development of modern hybrid fiber coax networks, and we are thrilled to add him to the team. He previously spent 27 years with Scientific Atlanta and Cisco Systems, including serving as the lead of Cisco's Cable Access Business Unit and Vice President of Marketing. In addition to Todd, within our Broadband Access Group, we also appointed Steve Pedersen as AVP of Business Development, Michael Ballard as Senior Director of Marketing, Al Johnson as Senior Director of Business Development, and most recently, Corey Chapman as Senior Director of Sales Engineering for our Quantum Bandwidth line of products. All four of these business professionals have had impressive careers with extensive experience that we believe will greatly contribute to the success of our broadband access group. We are excited by the strength of talent that we have added at the leadership level, and we have also made significant strides in building out the rest of the broadband access team. We are focused on executing on our new strategy and believe we are well positioned with the right products and a deep bench of talent. Turning to our data center business. In Q2, data center revenue came in at $27.6 million, up 28% year-over-year and up 35% sequentially, largely due to increased demand for our 100G and 400G products. In the second quarter, 75% of our data center revenue was from our 100G products, 12% was from our 200G and 400G transceiver products, and 5% was from our 40G transceiver products. Revenue for our 100G products increased 30% sequentially, while revenue for our 400G products doubled sequentially and accounted for 11% of our total data center revenue in Q2. Looking ahead, we're encouraged by the increased demand we have been seeing and expect continued sequential growth of our data center business in Q3. As Thompson mentioned, On our last two earnings calls, we discussed how we signed an agreement with Microsoft for a development program to make next generation lasers for its data center, both for 400G and beyond. During the second quarter, we signed an additional development agreement with Microsoft to provide design and assembly services for active optical cables. Our recent 8K filings give additional data. We expect to begin shipping initial quantities of these products to Microsoft by the end of this year for their testing with production ramping early next year. We view these contract awards as validation of the strength and quality of our core laser fabrication ability and our design and manufacturing expertise for these advanced high-speed interconnect products. As many of you know, Microsoft has been a long-term key customer of ours. While not guaranteed, we believe that the revenue opportunity for our 400G and 800G products could be greater and have a longer duration than the revenue contribution we saw from this customer during the peak of the 40G product cycle, which would imply revenue from these products exceeding $300 million over the several years of these build-outs. We also believe that the value proposition that we offer to Microsoft is just as strong with other data center operators, and we are working with several of them to evaluate our technology and qualify our products. We are also seeing positive inbound interest from other potential customers for our lasers, and we believe we are well-positioned to grow this business. I'd like to particularly highlight one new source of laser revenue in this quarter. During the quarter, we received our first volume order for LIDAR lasers to be used in a transportation application. The order was approximately $1 million worth of lasers to be delivered over the next few quarters, so it's not immediately material financially, but we feel that the LIDAR business has the potential to grow substantially in the three- to five-year timeframe, and we view this initial volume order as indicative of the success of the development program for our Frequency Modulated Continuous Wave, or FMCW, LiDAR lasers. We believe that we will secure additional orders for these lasers over time as other customers begin to roll out FMCW LiDAR technology. Now turning to our telecom segment. Revenue from our telecom products of $4.2 million was down 33% year-over-year and up 14% sequentially. Looking ahead, we expect telecom sales to remain roughly flat to up slightly in Q3. For the second quarter, our top 10 customers represented 88% of revenue, up from 87% in Q2 of last year. We had two greater than 10% customers, one in the data center market and one in the CATV market, which contributed 29% and 13% of our total revenue, respectively. In Q2, we generated non-GAAP gross margin of 24.8%, which was above our guidance range of 20.5% to 23.5% and was up from 23.2% in Q1 of 2023 and up from 16.7% in Q2 of 2022. The increase in gross margin was driven mainly by our favorable product mix, our cost reduction efforts, and the benefit of some of the intentional actions we have taken to improve our bottom line that we have discussed on our prior couple of earnings calls. These actions included the exit of several low-profit legacy products, shifting R&D resources away from some low-margin projects to focus our resources on areas where we can maximize margin, and some success in executing price increases with some customers. We were pleased with the execution we made on increasing our gross margin and expect this trend to continue. We remain committed to the long-term goal of returning gross margin to around 40% and believe that this goal is achievable. In line with our expectations, total non-GAAP operating expenses in the second quarter were $19 million, or 45.8% of revenue, which compared to $18.2 million, or 34.9% of revenue, in Q2 of the prior year. With the new additions in our broadband access group and additional activity we plan to promote our CATV products, we expect a modest uptick in non-GAAP operating expenses to $21 million per quarter starting in Q3 of 2023. Non-GAAP operating loss in the second quarter was $8.7 million, compared to an operating loss of $9.5 million in Q2 of the prior year. GAAP net loss for Q2 was $16.9 million, or a loss of 57 cents per basic share, compared with a GAAP net loss of $14.5 million, or a loss of 52 cents per basic share in Q2 of 2022. On a non-GAAP basis, Net loss for Q2 was $6.1 million, or a loss of $0.21 per basic share, which was better than our guidance range of a loss of $6.8 million to $9 million, or a loss per share in the range of $0.23 to $0.31 per basic share, and compares to a net loss of $7.6 million, or a loss of $0.28 per basic share in Q2 of the prior year. The basic shares outstanding used for computing the net loss in Q2 were $29.5 million. Turning now to the balance sheet. We ended the second quarter with $28.6 million in total cash, cash equivalents, short-term investments, and restricted cash. This compares with $26.9 million at the end of the first quarter of this year. We ended the quarter with total debt excluding convertible debt of $46.9 million, down from $70.1 million at the end of last quarter. As of June 30, we had $66.3 million in inventory compared to $70.2 million at the end of Q1. Inventory decreased due to consumption of inventory for customer orders. We made a total of $1 million in capital investments in the second quarter, which is mainly used for production and R&D equipment. As we disclosed in March, we initiated a new at-the-market offering. To date, we have raised $9.9 million net of commissions and fees under this new program, all of which was raised in Q2. Moving now to our Q3 outlook. We expect Q3 revenue to be between $60 million and $66 million, and non-GAAP gross margin to be in the range of 29.5% to 31%. Non-GAAP net income is expected to be in the range of a loss of $1.9 million to income of $0.2 million, and non-GAAP income between the loss of six cents per basic share and income of one cent per basic share using a weighted average basic share count of approximately 33.1 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. If at any time your question has been addressed and you would like to withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. The first question comes from Simon Leopold with Raymond James. Please go ahead.
Simon Leopold
Thanks for taking the question. You've given us a lot of good modeling information here, and I'd like to just clarify something I think is implied in that you suggested that the CATV business would be up a little bit sequentially, telecom would be flat to slightly up, and so kind of backing out that into your total revenue forecast suggests your data center business is up sequentially by something on the order of 70%. And you didn't mention that explicitly, but you've kind of guided us this way. Can you just clarify what your expectation is there?
Lindsay
Sure, Simon. You're pretty good at math. The uptick there is mainly from the data center business, as you surmised.
Simon Leopold
Great. Thank you. And you talked about the Microsoft project timings. being the end of this year, so it's not coming from the new Microsoft Awards. Could you give us some color on what's driving this big jump?
Lindsay
Well, I mean, we've continued to see very strong results in our existing 100G and 400G products, and that's where this uptick is coming from. We've talked about, you know, over the last, gosh, probably at least a year that we felt like our 400G was starting to ramp and was in that ramping phase, and that's indeed what we're seeing right now. 400G is continuing to ramp, while at the same time we're seeing very strong results from 100G as well. So both of those things are kind of firing on all cylinders. As you noted, the revenue increase that we're seeing is primarily not coming from the new Microsoft contracts. It's mostly coming from existing products.
Lindsay Savarese
And don't forget, I think because of AI, the customer team is stronger. And AI at the same time is getting pretty strong market share.
Simon Leopold
Great. And then just pivoting now to the cable business, just others who are in that market have talked about some of the transitional effects. And you've been pretty clear in talking about excess inventory and as a factor. And I wanted to maybe see if you could talk a little bit about the transitions of technology and how that might be playing into it, specifically the deployment of DOCSIS 4.0 and basically the debate between full duplex and extended spectrum. Is that a factor that sort of amplifies or creates a greater pause in this market? Is that we're sort of burning off old technology ahead of new technology. Could you help me understand that?
Lindsay
I don't think that's a big factor right now. I think that the bigger factor just has to do with the distribution channel. I think I mentioned on the previous earnings call, with the interest rate environment, many of the distributors are taking a hard look at how much inventory that they carry. So I think it has more to do with sort of financial effects and just the raw amount of inventory that's out there as opposed to looking ahead and saying, well, we might not need these products because DOCSIS 4.0 is coming on board. There's going to be a long tail, I would anticipate, with the existing sort of 1.2 gigahertz DOCSIS 3.1 type of products. So I'm not hearing from distributors that they're concerned about the inventory level that they have due to concerns they won't be able to sell it efficiently. It's more about, well, I just don't know what the right level of inventory is at this point, given the financial situation and interest rates and what have you.
Simon Leopold
Great. Thanks for taking the questions.
Operator
Sure. Again, if you have a question, please press star then one on a touch tone phone. The next question comes from Tim Sevago with Northland Capital Markets. Please go ahead.
Tim Sevago
Hi, good afternoon and congratulations on the outlook in particular.
Simon
I wanted to follow up with some questions there. I see there's a good bit of deferred revenue that has been added to your balance sheet here, both short-term and a little long-term. And I was wondering if part of that revenue increase might be some of the NRE or project development payments coming out of Microsoft in addition to product revenue and If that's the case, I'm wondering if you could try and quantify that. And I imagine that would have a real positive impact on gross margins as well. Or is this just all module revenue driving this increase?
Lindsay
Are you talking about in the guidance? How much NRE revenue or development revenue are we counting on?
Simon
That's right.
Lindsay
Okay. Okay. So there is some of that in there. For nondisclosure reasons, I can't give you the exact total in there, but there is some of that in there. But really, the bulk of the increase in margin is coming from increased margins on the products that we're selling, as we mentioned in our prepared remarks. It's not primarily being driven by NRE revenue.
Tim Sevago
That's a relatively small amount that's included in guidance. Okay, great.
Simon
And so would you say the same thing about product revenue being the bulk of the increase, the sequential increase in data center, and within that, do you expect to see these dynamics continue around 400 gig and 100 gig in terms of outsize? Where do you expect, I guess, over the next few quarters, your 400 gig revenue to go, or say, I guess you'd classify 200 gig plus as a percent of total data center revenue?
Lindsay
Yeah, I expect that 400 gig, and you're correct in saying it's 200 gig plus, but for us, that's almost entirely 400 gig. We don't have a lot of 200 gig business. We expect that to continue to grow both in absolute dollars and as a percent of data center revenue. That being said, I mean, I think 100 gig is continuing to track very well as well, so I think both of those things are looking good, as I mentioned when Simon asked earlier. You had another question there, Tim. I'm sorry, I forgot. I think basically we're just asking, I think the first part of the question, if I remember, was just basically asking, is this really truly product revenue that's driving the increase in revenue as well as gross margin? And the answer is, yeah, it's product revenue that's driving it. I mean, we're selling a lot more 100 gig and 400 gig in data center space. Cable TV, as we mentioned, is down a little bit, but we do anticipate that to tick up a little bit sequentially in the guidance. And that's what's really driving the growth.
Simon
Great. And maybe you could ask a question about kind of what's happening at Microsoft, your biggest data center customer. So on the one hand, you look to be developing this active optical cable product for what I assume to be a very high-speed application, 800 gig, I'd suppose, maybe 400 as well. associated with an AI build-out, and yet you're also prior to that seeing some pretty strong increases in volumes and maybe pricing as well, given the gross margin movement on the current module product. I wonder if you can kind of relate those two things. I mean, we've seen Microsoft with a pretty dramatic uptick in spending here this quarter that's expected to continue really for the next several quarters. So from your perspective, I'd be interested on kind of what's happening sort of short-term versus medium-term there with regard to data center connectivity demand.
Lindsay
Well, without going into too many details that would be difficult to disclose publicly due to our relationship there, I think your observation that Microsoft has been investing heavily is a very apt explanation. You know, the fact that they're... that AI is really driving their network needs right now is extremely important to them and keeping up with the demand there is very, very critical to their operations. And so they're definitely adding a lot of optical modules, a lot of interconnect modules now. And their expectation based on the contracts that we've supplied in terms of active optical cables certainly would indicate to us that they expect to continue to see strong demand mainly driven by AI applications, although certainly the sort of general purpose compute is also a part of that. And it would seem to imply that, you know, that's expected to be, you know, in pretty strong demand for Microsoft for several years, at least, as we noted in our prepared remarks. I mean, if you kind of look at Some of the forecasts that we've received from them and the contractual, the minimum contractual levels of manufacturing that they've asked us to prepare, that would imply revenue of $300 million plus over the next few years, you know, just in those products, not counting existing, you know, other types of business that they might have.
spk02
So it's a pretty sizable opportunity for us. Great. Thanks very much. Thank you.
Operator
At this time, I will turn the call over to Dr. Thompson Lin for closing remarks.
Lindsay Savarese
Again, 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 seeing many of you at our upcoming investment conference and update you on our next learning quote.
Operator
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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