Applied Optoelectronics, Inc.

Good day, and welcome to the Applied Opto-Electronics Third Quarter 2024 Financial Results Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's remarks, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your touch-tone phone. To withdraw your question, please press star, then two. Please note this event is being recorded. I would now like to turn the conference over to Cassidy Patterson, Investor Relations for AOI. Mrs. Patterson, you may begin.

Thank you. I'm Cassidy Patterson, Investor Relations for Applied Optoelectronics. I'm pleased to welcome you to AOI's third quarter 2024 financial results conference call. After the market closed today, AOI issued a press release announcing its third quarter 2024 financial financial results and provided its outlook for the fourth quarter of 2024. 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 Q3 results, and Stephan will provide financial details and the outlook for the fourth quarter of 2024. A question and answer session will follow our prepared remarks. Before we begin, I'd 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 achievement 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, suggests, intends, predicts, expects, plans, may, should, could, would, will, potentially, or thinks, or by the negative of those terms or 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. Forward-looking statements also include statements regarding management's beliefs and expectations related to the expansion of the reach of its products into new markets and customer responses to its innovations, as well as statements regarding the company's outlook for the fourth quarter of 2024. Except as required by law, AOI assumes no obligation to update these 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 businesses are set forth in the Risk Factor section of AOI's report on file with the SEC, including the company's annual report on Form 10-K 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 the company's earnings press release that is available on AOI's website. Before moving to the financial results, I'd like to note that AOI management is attending the Needham Virtual Security Networking and Communications Conference on November 19th, the Roth 13th Annual Technology Event on November 20th in New York, the Raymond James TMT and Consumer Conference on December 10th in New York, and Northam's Virtual Growth Conference on December 12th. We'd like to note that the date of AOI's fourth quarter and full year 2024 earnings call is currently scheduled for February 26, 2025. Now I'd like to turn the call over to Dr. Thompson Lin, AOI's founder, chairman, and CEO. Thompson?

Thank you, Cassidy, and thank you for joining our call today. We had a solid third quarter performance as we ran up production capacity to meet our customer rollout schedules. We recorded strong double-digit sequential growth in our data center business, driven by new wins for our 400G products, while our CATV business more than tripled from the second quarter as our customers actively transitioned to new architectures. In the third quarter, we delivered revenue of $65.2 million, which was a high end of our guidance range of $60 million to $66 million. We recorded non-GAAP gross margin of 25%, which was in line with our guidance range of 24% to 26%. Our non-GAAP loss per share of 21 cents was larger than expected, and above our guidance range, our loss of 14 cents to 20 cents per share due primarily to accelerate R&D spending due to greater than anticipated new customer requests, especially in our data center business, where we saw notable interest in our 1.6 terabit transceivers. Total revenue for our data center products of $40.9 million was down 16% year-over-year, but up 90% sequentially. Revenue for our warranty products decreased 24% year-over-year, while revenue for our 400G products increased 114% in the same period. We are pleased to report that we have begun to receive initial orders for 400G products from another large, high-scale customer, and we are very excited about this new customer interaction. We have already begun shipment on these relatively small initial orders. We expect additional orders from this customer in this quarter and into 2025 for both 400G and 800G products. Total revenue in our CATV segment was $20.9 million, which was up 104% year-over-year and lost 260% sequentially, largely driven by shipment of our 1.8 GHz amplifiers for our major MSO customers. As we have discussed on our prior earning calls, our MSO customers are in the process of transition from DOSIS 3.1 to DOSIS 4.0. This initial ramp in CATV sales in Q3 was in line with our expectations, and we continue to expect additional growth as MSO upgrades increase in intensity next year. With that, I will turn the call over to Stephan to review the details of our Q3 performance and our report for Q4. Stephan.

Thank you, Thompson. As Thompson mentioned, our revenue and non-GAAP gross margin for the third quarter were in line with our expectations. Our non-GAAP loss per share was unfavorable compared to our expectations due to higher than expected operating expenses as we accelerated R&D spending due to greater than anticipated new customer requests, especially in our data center business, where we saw notable interest in our 1.6 terabit transceivers after our strong showing at the European Conference on Communications in Frankfurt in September. During the third quarter, we continued to execute on many of the initiatives that we laid out earlier this year. We discussed on our Q2 call how we had begun to receive orders for the 400G products from another large hyperscale customer. This quarter, we continued to receive new orders from this customer, and we remain very excited about this opportunity. We have already begun shipments on these relatively small initial orders, and we expect additional orders from this customer in the fourth quarter and into 2025 for both 400G and 800G products. We also discussed on our Q2 call how we had begun to receive forecasted orders for the Vixel-based 400G active optical cables for which Microsoft provided development funding last year. We have continued to see additional orders and shipments for our AOC products and new forecasts that indicate stronger growth in 2025. Lastly, in our CATB business, in line with our expectations, we saw a vast improvement in our CATB results in Q3. Our MSO customers need to place these orders in order to stock their distribution pipelines ahead of their more aggressive upgrade plans in 2025. Turning to our third quarter results, our total revenue was $65.2 million, which was up 4% year-over-year and up 51% sequentially, and was at the high end of our guidance range of $60 million to $66 million. During the third quarter, 63% of revenue was from our data center products, 32% was from CATV products, with the remaining 5% from FTTH, telecom, and other. In our data center business, Q3 revenue came in at $40.9 million, which decreased 16% year-over-year and increased 19% sequentially. The decline in revenue from Q3 2023 is largely due to price reductions with certain customers that took effect earlier this year, along with non-recurring engineering revenue from Microsoft last year, which did not recur this year. The sequential increase is due to new customer wins in the past several quarters, along with the continued growth of 400G with existing customers. In the third quarter, 67% of data center revenue was from 100G products, 27% was from 200G and 400G transceiver products, and 4% was from 40G transceiver products. As we have discussed on several prior earnings calls, we signed two agreements with Microsoft in 2023 for the development of 400G products and beyond. This included a development program to make next-generation lasers for its data centers and for the development of its 400G and next-generation active optical cables. While not guaranteed, we continue to believe that the revenue opportunity for our 400G and 800G products could be greater and longer duration than the revenue contribution we saw from this customer during the peak of the 40G product cycle, which suggests that revenue from these products may exceed $300 million over the several years of these build-ups. In Q3, we are pleased to report that we saw a slight increase in business as we received additional orders and began shipments for our AOC products. Looking ahead, we continue to believe that this business will ramp further in Q4 and into 2025. As our data center customers work on building out their next generation AI-focused data center architectures, we remain very active in our 800G qualification efforts with several hyperscale customers. We continue to believe that we will begin to receive orders for 800G products in Q4 of this year, with a ramp expected thereafter. In our CATV business, revenue in the third quarter was $20.9 million, which was up 104% year-over-year and up 260% sequentially. As I mentioned before, this significant increase is due to the ramp in orders for our 1.8 gigahertz amplifier products. We continue to believe our CATV revenue will ramp further in Q4 and into 2025. I'd like to take a moment to provide some additional color on the upcoming DOCSIS 4.0 transition. As MSOs look to expand upstream bandwidth by increasing the frequency content available for upstream transmission, they need to change and replace their current amplifiers and nodes. By using DOCSIS 4.0, which expands frequencies up to 1.8 gigahertz, MSOs are able to replace their current hardware without cutting into their downstream bandwidth. As I mentioned before, while some MSOs have stated that they do not plan to deploy DOCSIS 4.0 upgrades until 2025 or later, we have begun delivering initial orders so that they are capable of deployments when they are ready to make the transition. With this in mind, however, the timing of deployment by our MSO customers of our amplifiers does not depend on the timing of DOCSIS 4.0. In fact, we believe at least one major MSO is committed to an amp-first strategy, whereby amplifiers capable of DOCSIS 4.0 are deployed ahead of the nodes and RPDs that will be needed to fully enable DOCSIS 4.0 in the future. By deploying new amps, an MSO can enable higher bandwidth splits in the upstream direction, which provides much-needed additional bandwidth. In addition, MSOs could take advantage of AOI's revolutionary quantum link technology to gain insight into their network operation, and we believe improve their customers' experience while reducing maintenance spend, all while waiting for DOCSIS 4.0 nodes and RPD hardware to be available. Now turning to our telecom segment. Revenue from our telecom products of $2.8 million was down 9% year-over-year and up 18% sequentially. Looking ahead, we continue to expect telecom sales to fluctuate from quarter to quarter. For the third quarter, our top 10 customers represented 96% of revenue, in line with Q3 of last year. We had three greater than 10% customers, two in the data center market, which contributed 41% and 16% of total revenue, respectively, and one in the CATV market, which contributed 34% of total revenue. In addition to these three customers, we have had meaningful conversations with an additional hyperscale customer who has begun to reengage with us in preparation for future data center upgrades. We believe we are in a position to ramp production to meet their needs and have already received some small initial orders with additional orders expected in Q4 and into 2025. In Q3, we generated non-GAAP gross margin of 25%, which was within our guidance range of 24% to 26%, and was up from 22.5% in Q2 of 2024 and down from 32.5% in Q3 of 2023. Looking ahead, we expect gross margins to improve as we see the impact of manufacturing efficiencies in our CATV production and improving product mix. We remain committed to our long-term goal of returning our non-GAAP gross margin to around 40% and continue to believe that this goal is achievable. Total non-GAAP operating expenses in the third quarter were $27.9 million, or 42.9% of revenue, which compared to $21.4 million, or 34.2% of revenue in Q3 of the prior year, primarily due to accelerated R&D spending due to greater than anticipated new customer requests, especially in our data center business, where we saw notable interest in our 1.6 terabit transceivers. also increasing year-over-year or R&D expenses related to our 1.8 gigahertz CATV amplifier products, and additional expenses related to expedited shipping costs for the production ramp-up of these products, and non-recurring trade show expenses that were incurred in the third quarter, which we do not expect to incur in the fourth quarter. Looking ahead, we expect non-GAAP operating expenses to tick up slightly next quarter and range from $28 million to $30 million this due to higher R&D spend largely generated by additional new customer opportunities we are pursuing. Non-GAAP operating loss in the third quarter was $11.7 million, compared to an operating loss of $1 million in Q3 of the prior year. GAAP net loss for Q3 was $17.8 million, or a loss of 42 cents per basic share, compared with GAAP net loss of $9 million, or a loss of 27 cents per basic share in Q3 of 2023. On a non-GAAP basis, net loss for Q3 was $8.8 million, or 21 cents per share, which was unfavorable to our guidance range of a loss of $5.9 million to $8.6 million, or loss per share in the range of 14 cents to 20 cents per basic share. This compares to a non-GAAP net loss of $1.7 million, or a loss of 5 cents per basic share in Q3 of the prior year. The fully diluted shares outstanding used for computing the earnings per share in Q3 were 42.3 million. Turning now to the balance sheet, we ended the third quarter with $41.4 million in total cash, cash equivalents, short-term investments, and restricted cash. This compares with $16.1 million at the end of the second quarter. We ended the quarter with total debt, excluding convertible debt, of $39.4 million, compared to $27.5 million at the end of last quarter. As of September 30, we had $64.4 million in inventory, which compared to $54.3 million at the end of Q2. The increase in inventory is primarily for raw materials to be used for anticipated Q4 production. We made a total of $11.4 million in capital investments in the third quarter, which was mainly used for production and R&D equipment, as well as building improvements to accommodate new production capacity. Looking ahead, we expect to make sizable CapEx investments over the next several quarters as we prepare for increased 400G, 800G, and 1.6 terabit data center product production in 2025. We expect to finance these investments through a combination of cash on hand, cash generated from operations, and some equity sales, including possible strategic investments that we are discussing. We believe that we are poised for a sustained period of growth in both our data center and CATV businesses and that these capital commitments will be transformational to our company as we execute on these opportunities. As we disclosed in August, we increased the size of our existing at-the-market offering with a total of $60 million authorized. To date, we have raised $59.9 million net of commissions and fees under this new program, including $38.6 million raised in Q3. Moving now to our Q4 outlook. We expect Q4 revenue to be between $94 million and $104 million, and non-GAAP gross margin to be in the range of 27.5% to 29.5%. We expect operating expenses to remain elevated in the near term in the range of $28 million to $30 million, resulting in non-GAAP net income expected to be in the range of a loss of $1.9 million to income of $1.7 million, and non-GAAP earnings per share between a loss of 4 cents per share and earnings of 4 cents per share, using a weighted average basic share count of approximately 46 million shares. Looking ahead, we remain optimistic about the long-term demand drivers for both our data center and CATV businesses. We believe that we're well positioned to benefit from the tailwinds driven by the adoption of generative AI, which we continue to believe will require our data center customers to deploy more infrastructure, including more optical interconnects. Due to our US-based production ability and our automated manufacturing capabilities and experience, we believe we are uniquely positioned to help our customers meet these significant demands. Also, we believe that we are very well positioned with the right team product portfolio, and strategy in place as our CATV customers transition to next-generation architectures and implement new technologies to improve their network's performance. With that, I will turn it back over to the operator for the Q&A session. Operator?

Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we'll pause momentarily to assemble our roster. Our first question comes from Michael Genovese from Rosenblatt. Please go ahead.

Great, thanks, and congratulations on the revenues and the outlook. I guess my first question is, is this on 400G, right? I mean, it seems like maybe you've seen this coming for a little while, that there's higher 400G demand now from multiple customers. What do you think is driving that, and do you think that that's sustainable, or will it start to roll off when we go to higher speeds?

No. It's being driven by demand from our data center customers for interconnections, primarily for their AI networks, and I would not anticipate that that demand is going to decrease in the near term or even medium term. 400 gig is what they're using for their next generation architectures for these applications, and we expect the demand to continue and perhaps even grow from here. As I mentioned, we have at least one new customer that's only beginning to purchase 400 gig from us, and I think there's significant room to ramp with that customer, as well as potentially an overall growth in the market as more AI gets deployed.

Okay, great. I guess on 800G... Can you comment, you know, what kind of transceivers you expect to be selling within this discussion of Vixels, EMLs, and silicon photonics? Will you participate in, you know, all three or one or two more than the other?

You know, our primary focus has been historical for us, mainly on the edumating technology, so that would be the electroabsorption modulated lasers, and also on the silicon photonics-based solutions. Both of those are the ones that we're pursuing most aggressively. You know, we do have some interest in VIXL-based solutions, and we do have our own capability for manufacturing VIXL. So, you know, there will probably be some sales, but we're expecting the bulk of the demand that we're going to satisfy to be on the longer-distance transmitters. Right.

And then based on all your comments, I mean, it seems like, you know, I guess maybe if we include Oracle as number five, but if we're really talking about the four kind of household names on hyperscalers. It sounds like three are customers now and the other one you're talking to. Is that fair?

Again, you know, without talking about different names, I think, you know, we do think we have three out of the top five data center customers, yes.

Okay. And then just finally for me, just kind of help us understand, I mean, the cable's good and I guess that will get bigger and then the Is 800G and then 1.6, does that drive higher margins? What's the outlook for margins over time? Any detail you give there would be helpful. And I'll pass it on. Thank you.

Sure. So cable TV margins right now are higher than data center margins. We do expect cable TV margins to improve. As we noted in our prepared remarks earlier, you know, there's economies of scale, efficiencies, and things that we need to wring out of the manufacturing process there, and we expect that to happen over the next couple of quarters. So there's some room for improvement on the cable TV margins. With respect to data center, yes, the transition to 800G and 1.6 terabit should be accretive to gross margin as well. So that's, again, you know, as we said in our prepared remarks, We think a 40% margin is a good long-term target for us to have, and growth in both energy, 1.6 terabits, and cable is really what it's going to take to get there.

Thanks so much.

You're welcome.

The next question comes from Tim Savageau from Northlink Capital Markets. Please go ahead.

Hey, good afternoon. Sorry about that. I just want to talk about the guidance here. You're obviously looking for a pretty sharp uptick here in the Q4. I think on the last call you said you expected cable to be a primary driver in Q3, which it looks like it was, and maybe shifting back over to data center in Q4 as the primary growth driver. So the question is, does that remain the case? And then is you know, maybe try and comment on some details on what's driving that. Sounds like ASCs at Microsoft should be ramping up, also your new 400 gig transceiver customer. You mentioned you also expect some 800 gig revenue. If you look at that, I don't know if it's 30 million or so sequential increase in data center, can you give a sense of what are the different factors and or customers driving that?

Yeah, so overall our expectations regarding Q4 are pretty much what we communicated last time. We do see continued growth in cable, but we also see strong growth in the data center, largely driven by 400G at this point, as has been the case for a while for us. We do actually see some continuing strength in 100G as well, interestingly enough. And then the 800G will be a factor for us a little bit in Q4, but it won't likely be material in Q4, but it should start to ramp in Q1. So that's kind of how things break down. And then, of course, the cable, again, as I said earlier, the margins on cable should start to improve in Q4 and Q1 as well.

Okay, great. I just want to make sure I understand your customer commentary. I don't know if you snuck a new hyperscaler in there in the comments. You've had another 10% customer outside of Microsoft these last couple of quarters that I think you've described as a hyperscaler in the past. I gather, you know, given your commentary about fairly early days and your new 400 gig customer that, you know, you haven't seen those sorts of volumes yet. I guess, you know, would you expect to in Q4 and might, might that customer rise to the 10% level? And outside of those three, are we missing anybody else in terms of advanced engagements from a hyperscale perspective?

So the 10% customer that we have this quarter on the data center is the same 10% customer that we had last quarter. That helps. and that would imply that this new hyperscale customer, which is really a re-engaging customer from, I mean, it's not a brand new customer to us. It's one that was formerly a pretty sizable customer for us, but we're sort of re-engaging with them. You know, I think they'll likely grow in Q4. It's unclear that they're going to grow. I would not expect them to be a 10% customer in Q4, especially, you know, given the revenue growth that we're seeing, that the bar to get to 10% certainly becomes But we definitely think that they can ramp to be a 10% customer in the next few quarters.

Okay, great. And maybe last one for me. You've kind of estimated – well, let me go to another one. You mentioned elevated CapEx and capacity expansion. From a revenue capacity perspective – Where are you in the U.S. right now and where will these capacity investments take you over the next few quarters?

You know, we haven't disclosed a specific revenue number coming out of the U.S. As you can imagine, our manufacturing operations are pretty integrated across multiple different locations. In other words, we're doing different operations in different places, but we do expect to continue to invest primarily in the U.S. and Taiwan for manufacturing capacity over the next few quarters, as we noted in our prepared remarks. And that will allow us to continue to execute on the revenue growth trajectory that we outlined.

Great. Thanks. Well, congrats on the results and the outlook especially. Appreciate it. Thank you.

Again, if you have a question, please press star, then 1. Our next question comes from Jeff Cook from Raymond James. Please go ahead.

Yeah, thanks, guys. Jeff and for Simon. It sounded like maybe I misheard, but it sounded like maybe the Microsoft supply revenue this quarter was maybe slightly weaker than what we were thinking. I mean, it was up. It sounded like it was up, but maybe it was only like less than $5 million still. Is that fair? And do you think that – If that is the case, are you still confident in, you know, reaching, trying to reach like, I don't know, like low 20 million run rate next quarter for that business?

So, yeah, it was below 5 million in this quarter. With respect to next quarter, you know, it's hard to say. It's ramping a little slower than we expected. That is a fair statement. But, you know, we are still committed to reaching that $25 million per quarter level. It's just unclear which order that's going to occur in at this point. So it's more about timing. What we are seeing is a lot of increase in demand, as I mentioned earlier, for the 400 gig transceiver solutions. And, again, surprisingly, some strength in 100G as well.

Yeah, I was going to ask you about that, too. Especially the 400 gig, you know, I guess there's – the thinking is that, you know, everybody wants 800 gig for the back end. So 400 gig, I'm surprised it's not more front end. And then strength of 100 gig sounds like maybe, you know, maybe there's a catch up in, you know, like I guess the legacy, maybe the legacy data center investment. But are you guys seeing that at all?

Yeah, I think on both accounts, yes. I mean, you know, It's easy for people to focus on one technology, I think, and say, okay, this is where the growth is going to be. But the reality is many of our hyperscale customers are growing their infrastructure in multiple different ways. It's not just one thing that they're doing. They're growing their existing infrastructure, and they're growing their new AI-focused infrastructure at the same time. So we're excited about all those opportunities. The reason why I highlighted the 100 gig is really that I want to draw people's attention to the fact that, you know, there's still some significant business opportunities and growth, you know, even outside the AI while we continue to focus our efforts and most of the industry on AI growth.

Got it, got it. Yeah, and maybe just to help on, a little bit of help on the gross margin, like, you know, go first next quarter, like, is the, you said that Cat TV is running above average at this point. Is that, as we go today, should that be up again? Or where do you think the magnitude of the improvement, where's the biggest part? Yeah, thanks.

Jeff, I'm sorry. You kind of broke up a little bit there. I understood you're asking about gross margins and what's driving the gross margin growth in Q4. I'll go ahead and answer that and then hope that was the question that you asked. So, yeah, I mean, you know, CATV, as I mentioned earlier, you know, we just started ramping this 1.8 gig product line. You could see, you know, going from almost zero to, you know, 21, almost $21 million in the quarter for those products. I mean, that's a sizable ramp. And as you can imagine, when we, you know, in the initial phases of that ramp, not everything is, you know, the efficiency in the manufacturing is not where we want it to be initially. And so as we go forward in Q4 and in later quarters, we do expect there to be continued expansion in the gross margin in CATV. In addition, on the data center side, again, seeing more contribution from 400G and especially some initial contribution from 800G, which we expect to ramp next year, will improve gross margins in that segment as well.

Got it. Great. Thank you. All right. Thank you.

At this time, we have no further questions, and I will turn the call over to Dr. Thompson Lin for closing remarks.

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. As we discussed today, we believe the long-term demand driver remains strong for both our data center and CATV business And we believe we are well positioned to capitalize on this opportunity. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.