U.S. Markets closed

Edited Transcript of AAOI earnings conference call or presentation 21-Feb-18 9:30pm GMT

Q4 2017 Applied Optoelectronics Inc Earnings Call

Sugar Land Feb 27, 2018 (Thomson StreetEvents) -- Edited Transcript of Applied Optoelectronics Inc earnings conference call or presentation Wednesday, February 21, 2018 at 9:30:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Chih-Hsiang Lin

Applied Optoelectronics, Inc. - Founder, Chairman of the Board, CEO and President

* Maria Riley

The Blueshirt Group, LLC - Director

* Stefan J. Murry

Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer

================================================================================

Conference Call Participants

================================================================================

* Fahad Najam

Cowen and Company, LLC, Research Division - Associate

* James Martin Kisner

Loop Capital Markets LLC, Research Division - SVP

* Nickolas Bradley Johnson

Piper Jaffray Companies, Research Division - Research Analyst

* Richard Cutts Shannon

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* Timothy Paul Savageaux

Northland Capital Markets, Research Division - MD & Senior Research Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good afternoon. I will be your conference operator.

At this time, I would like to welcome everyone to Applied Optoelectronics' Fourth Quarter and Year 2017 Earnings Conference Call. (Operator Instructions) Please note that this call is being recorded.

I will now turn the call over to Maria Riley, Investor Relations for AOI. Ms. Riley, you may begin.

--------------------------------------------------------------------------------

Maria Riley, The Blueshirt Group, LLC - Director [2]

--------------------------------------------------------------------------------

Thank you. I'm Maria Riley, Applied Optoelectronics' Investor Relations, and I'm pleased to welcome you to AOI's Fourth Quarter and Year 2017 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its fourth quarter and year 2017 financial results and provided its outlook for the first quarter of 2018. 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 page of the AOI website and will be archived for 1 year.

Joining us on today's call is Dr. Thompson Lin, AOI's Founder, Chairman and CEO; and Dr. Stefan Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give an overview of AOI's Q4 results, and Stefan will provide financial details and the outlook for the first quarter of 2018. 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 to differ materially from those anticipated in such forward-looking statements. You can identify forward-looking statements by terminologies such as may, will, should, expects, plans, anticipates, believes or estimates and by other similar expressions. 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 our risks that may impact the company's business are set forth in the Risk Factors section of the company's reports on file with the SEC.

Also, with exception of revenue, all financial numbers 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 would like to announce that AOI management will attend the Raymond James Institutional Investors Conference in Orlando on March 5. We will also host an investor session at OFC on March 13 at the San Diego Convention Center. This discussion will be webcast live, and a link to the webcast will be available on the Investor Relations page of the AOI website. We hope to have the opportunity to see many of you there.

Lastly, I'd like to note the date of our first quarter of 2018 earnings conference call is currently scheduled for Tuesday, May 8, 2018.

Now I'd like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics' Founder, Chairman and CEO. Thompson?

--------------------------------------------------------------------------------

Chih-Hsiang Lin, Applied Optoelectronics, Inc. - Founder, Chairman of the Board, CEO and President [3]

--------------------------------------------------------------------------------

Thank you, Maria. Thank you, everyone, for joining us today to discuss our fourth quarter and year 2017 results. Our revenue in the quarter came in at $79.9 million, which was slightly below our expectations due to lower demand from our datacenter customers as they continue to evolve their network architectures. Even though our revenue came in slightly below expectations, we maintained our strong gross margins, and increased our non-GAAP profit 16% year-over-year, even in a price sensitive datacenter environment.

Data center revenue was $62 million, which was slightly lower than Q3. In the quarter, we were encouraged to see a rebound in revenue from one of our large datacenter customers. Based on conversations with this customer and our other top datacenter customers, we continue to expect inventory conditions to normalize by the end of the second quarter this year. Notably, we also finalized the largest purchase commitment in AOI's history during the quarter, which we believe demonstrates AOI's leading position as an optics supplier for large datacenter projects.

We have made good progress in diversifying our customer base. For the year, we had three customers who each represented more than 10% of our total revenue, compared with two customers in 2016. Since our last update, we have had four design wins, including three for 100G products, all with existing hyperscale customer.

We also remain focused on building incredible and innovative products, and I'm pleased to announce we were the first to develop an uncooled 100G per lambda PAM4 directly modulated laser, which is key to next-generation 400G transceivers for data center applications.

Just today, we announced a 100G EML laser, which will allow longer transmission distance at 100G and 400G, and will cover virtually all the distances needed by datacenter operators and many telecom applications as well.

Through continued innovation, we have reduced the average cost of our long-wavelength 100G transceiver products by 36% in the first 4 quarters. And we have a solid roadmap for continued cost reduction in 2018.

Demand for our CATV products increased 7% year-over-year to $14.3 million, and we are very encouraged by the customer activity we see in the market, especially our Remote-PHY product. 2017 was our best year ever for CATV sales, as North American MSOs initiated network upgrade projects. In 2018, we expect additional Remote-PHY and fiber-deep sales that will allow us to continue to see growth in this segment.

In reviewing our results for the year, AOI delivered record revenue of $382 million, an increase of 47% year-over-year, and generated a strong gross margin of 43.7%, which led to non-GAAP earnings growth of 278% over 2016. The first quarter is typically a seasonally low quarter for AOI. Additionally, we still see some inventory headwinds with one of our data center customers. We believe we have a very strong position in both the data center optics and CATV market, and based on customer forecasts, we believe the second half of 2018 will be stronger than the first half. The technologies we've developed and plan to bring to market this year position us well to continue to build on our strong foundation as a leader in the advanced optical technology and expand our footprint within the market.

With that, I will turn the call over to Stefan to review the details of our Q4 performance and outlook for next quarter. Stefan?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [4]

--------------------------------------------------------------------------------

Thank you, Thompson. Total revenue for the fourth quarter was $79.9 million compared with $84.9 million in Q4 last year. As Thompson mentioned, our revenue came in slightly below our expectations due to lower demand from our data center customers, as they continue to evolve their network architectures.

Our data center revenue was $62 million compared with $68.1 million in Q4 of last year. In the quarter, 35% of our data center revenue was derived from our 100G data center products and 58% was from our 40G products.

As Thompson mentioned, in building upon our technology leadership and advanced laser design, we recently announced the development of an uncooled 100G per lambda TAM4 directly modulated laser that is key to next-generation 400G products for the data center. We believe that this solution is the best technical approach to extend the cost leadership AOI has engineered at 40G and 100G to 400G and beyond.

As previously discussed, transceivers built on DML devices are typically less expensive to produce than transceivers that use EML lasers or external modulation. And we believe that having strong in-house capabilities for producing both DML and EML devices will allow us to maintain our cost advantage at 400G. We remain focused on building incredible and innovative products and look forward to showcasing some of these technologies at the upcoming Optical Fiber Communications Conference next month.

Turning to our Cable Television market. Revenue from CATV products increased 7% year-over-year to reach $14.3 million compared with $13.4 million in Q4 of last year. Demand for our CATV products was in line with expectations and driven primarily by ongoing upgrade projects being undertaken by North American Cable TV MSOs as they began the process of overhauling their networks to enable delivery of 1 gigabit per second or higher data speeds in the future. We believe that our Remote-PHY products, along with our other fiber-deep nodes and head-end transmitters will play a significant part in these new deployments and we continue to expect volume shipments of Remote-PHY to start later this year.

Our telecom products delivered revenue of $3.2 million compared with $2.9 million in Q4 of last year. For the quarter, 78% of our revenue was from data center products, 18% from CATV products with the remaining 4% from FTTH, telecom and other.

In the fourth quarter, we had 3 10% or greater customers in the data center business that contributed 33%, 21% and 19% of total revenue, respectively. For the year 2017, these same 3 customers represented 29%, 35% and 14%, respectively, of total revenue.

Moving down the income statement. In the quarter, we maintained a strong gross margin of 41%, which was within the 41% to 45% range that we view as sustainable and represents an increase of 300 basis points compared with the 38% reported in Q4 of last year. I'm very pleased with our ability to continue to generate strong gross margins even in a price-sensitive market. As Thompson mentioned, our commitment to ongoing cost reduction bore fruit in 2017. Over the last 4 quarters, we continued to improve our manufacturing efficiencies and reduced the cost of our long-wavelength 100G transceiver products, an average of 36% compared to the same period in 2016.

Total operating expenses in the quarter were $18.9 million or 23.7% of revenue compared with $18.9 million or 21.2% of revenue in the prior quarter.

Our total OpEx was nearly flat sequentially, we experienced increased spending on R&D, which was offset by lower sales and marketing and G&A expenses.

Looking forward, we expect to see R&D at an elevated level for the next several quarters, as we are investing in developing some new production technologies that will enable continued cost reduction on our core transceiver products as well as continuing to invest in 200G, 400G and Remote-PHY product development.

Operating income in Q4 was $13.8 million compared with operating income of $17 million in Q4 of 2016. Our operating margin in the quarter was 17.3% compared with the 20% reported in Q4 of 2016.

Non-GAAP net income after-tax for the fourth quarter was $17.9 million or $0.89 per diluted share, up 16% from the $15.5 million or $0.84 per diluted share in Q4 of 2016.

GAAP net income for Q4 was $5.7 million or $0.28 per diluted share compared with GAAP net income of $14.2 million or $0.77 per diluted share in Q4 of last year. The Q4 weighted average fully diluted share count was approximately 20.1 million shares. The reduction in GAAP net income this quarter was primarily driven by effects of the Tax Reform and Jobs Act, which was enacted in the U.S. in December 2017.

AOI was significantly affected by several provisions in this new tax law. First, the new law introduced a onetime gain repatriation transition tax, which is a tax on previously untaxed accumulated and current earnings and profits of our foreign subsidiaries. Our provisional estimate is that this repatriation tax will result in a onetime income tax expense of approximately $9 million, which we recorded in the quarter in accordance with GAAP. We were able to partially offset this transition tax with foreign tax credits of approximately $4 million, making the net additional U.S. tax due on foreign earnings approximately $5.1 million. We do not expect this transition tax to result in additional cash tax payable, however. A second significant effect of the new tax law was the need to reduce the value of our deferred tax assets, which mostly consists of prior periods accumulated net operating losses. These tax assets were reduced in value due to the new lower statutory tax rate of 21% in the U.S., which resulted in a onetime charge of approximately $3 million in Q4. Both of these effects as well as other lesser impacts of the new tax law are expected to be nonrecurring and therefore, we have adjusted our non-GAAP measures to eliminate the effect of these onetime adjustments.

During the quarter, we also recognized approximately $4.6 million in R&D tax credits and approximately $1.5 million in excess tax benefits from employee options that were exercised during the quarter.

With the new tax law in place, I would like to take a few moments to provide some updates on AOI's income tax expense going forward. I should emphasize that the changes included in the Tax Act are broad and complex, and there is significant work yet to be done, as we continue to refine our estimates. As such, new guidance on the tax law continues to be issue and I urge you to consult the tax section of our 10-K for more information.

AOI operates in 3 main taxable jurisdictions: the United States, Taiwan and China. Based upon our income tax in each of these jurisdictions, we estimate our 2018 overall annual effective tax rate on a GAAP basis at approximately 25.7%, excluding the effects of various discrete items we may have. In any given tax periods, there are various discrete items that cannot be reasonably estimated and can result in a tax rate in that period that may vary significantly from the estimated tax rate previously mentioned. For AOI, the most significant of these items involve R&D tax credits and any tax expense or benefit that may arise from share-based compensation. Under U.S. GAAP, the income tax effects of share-based compensation are now reported in income tax expense or benefit from continuing operations. As we cannot estimate when an employee might exercise options, or what the stock price might be at that time, we are unable to include estimates of these items in our effective tax rate calculation. As a result, our tax expense in any quarter may vary from our estimates. As most of our employee options were granted in periods, where our stock prices were lower than it has been recently, the difference between the booked expense, which is recognized at the time of print and the tax expense, which is recognized at the time of issuance or exercise has generally resulted in a tax benefit.

Turning now to the balance sheet. We ended Q4 with $84 million in total cash, cash equivalents, short-term investments and restricted cash compared with $72 million at the end of the previous quarter. As of December 31, we had $75.8 million in inventory, an increase of $1.2 million from Q3.

Our cash generated from operations totaled $84.3 million for the year. We made a total of $20.4 million in capital investments in the quarter, including $11.1 million in production equipment and machinery and $8.7 million on construction and building improvements, most of which was spent purchasing land-use rights for our new factory in China. This brings our total capital investments for the year to $67 million.

Looking ahead, we expect capital expenditures in 2018 to increase to approximately $109 million with the construction of our new factory in China, accounting for most of the increase over 2017 CapEx levels.

Construction on this new factory should commence in Q2 of this year and we expect it to be completed in 2020. The location of the new factory is immediately adjacent to our existing facility in Ningbo. The purpose for the new facility is to increase our production capacity by adding approximately 322,000 square feet of production space as well as additional housing for workers that will be needed to staff the new factory. This new facility will add to our existing footprint in Ningbo, which consists of approximately 459,000 square feet.

Moving now to our Q1 outlook. We expect Q1 revenue to be between $67 million and $71 million. As a reminder, we have fewer production days in Q1 as a result of the Chinese New Year holiday, which results in lower production capacity in Q1 compared to Q4. Demand from our transceiver customers in Q1 is expected to exceed our production capacity this quarter due to the effects of the New Year holiday in China.

We expect Q1 non-GAAP gross margin to be in the range of 40.5% to 41.5%. Net income is expected to be in the range of $5.6 million to $6.8 million and non-GAAP EPS between $0.28 per share and $0.34 per share using a weighted average fully diluted share count of approximately 20.2 million shares. We expect our Q1 effective tax rate on our non-GAAP net income to be between 6% and 10%.

With that, I will turn it back over to the operator for the Q&A session. Operator?

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question comes from Simon Leopold of Raymond James.

--------------------------------------------------------------------------------

Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [2]

--------------------------------------------------------------------------------

Just a quick clarification on the supply agreement you announced with Facebook today. The agreement references a date in December. Just want to get a clear understanding of sort of the timing. And it's not really clear to us what's in there. I know, a lot of it has to be redacted, I get that. Is this -- is it 100 gig? Is there a mix in there? Any insight you can give us in terms of what the details are behind what Facebook is purchasing from you?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [3]

--------------------------------------------------------------------------------

Well, Simon, as you can imagine, we have pretty detailed nondisclosure agreements with our customers. So really, all we can say is what's in the agreement as redacted. What I can say is, as we noted, it represents a 3-year timeframe with a minimum commitment for the first year that represents, at a minimum $125 million for one product family. Not all the products, but just one product family. But as far as which product that is, or any of the other details, unfortunately, due to the nondisclosure agreements, we really can't say more than that.

--------------------------------------------------------------------------------

Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [4]

--------------------------------------------------------------------------------

Okay, understood. And in terms of the results this quarter, I appreciate the disclosure between 40 and 100 gig. But the trends are not what we would've expected with it, looks like your 100 gig revenue was down. It's down as a percent, while the 40 gig business seems to be holding up better and grew. Just completely the opposite of what trend we would expect. Could you help us understand what's going on either in the quarter and then in terms of the longer-term trend between 40 and 100?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [5]

--------------------------------------------------------------------------------

Well, as we've noted, I think, before, the long-term trend is certainly for more 100 gig and less 40 gig. So 100 gig is gradually overtaking 40 gig. Now in any given quarter, as there are customers -- we have multiple different customers who are buying different things for different parts of their networks at different times. So in any given quarter, the interplay between all of those things could result in some deviations from that long-term trend. But long term, we still expect 100 gig to certainly grow and 40 gig to gradually decline.

--------------------------------------------------------------------------------

Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [6]

--------------------------------------------------------------------------------

And does something explain what happened in this particular quarter to skew it so much in favor of 40 gig? Is it customer specific? Help me understand that.

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [7]

--------------------------------------------------------------------------------

It's largely customer specific. And for that reason, I can't really give you a whole lot of insight into it. But again, the longer trend is what you would expect 100 gig growing and 40 gig declining.

--------------------------------------------------------------------------------

Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [8]

--------------------------------------------------------------------------------

And one last one, please. Could you just comment on the dynamics you are seeing in the competitive environment. We hear a lot of noise. It's hard to decide for a fact from fiction, any commentary you can offer on how the competitive environment has evolved over the last several months?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [9]

--------------------------------------------------------------------------------

Sure. So in terms of competition, I mean, I don't think we've seen any new entrants as far as competitors go. I think the cast of competitors is similar to what we've seen. There have been some recent comments by some of our competitors that they are minimizing or changing their strategy with respect to, particularly to 100 gig that should result in less pricing pressure, perhaps, in 2018 compared to what we saw in 2017, which is what -- which is consistent with what we've said before that we see 2018 -- the rate of decline of pricing in 2018 being less than what we saw in 2017. So I think that's sort of what we're seeing. I think the real wild card for us is, as we've mentioned before is -- so you've seen this purchase commitment that we talked about today, and I mentioned earlier and in the 8-K that it is a minimum commitment. This is how we operate with some of our other customers as well, in the sense that AOI, typically gets a share oftentimes a leading share with our customers. As sort of a minimum commitment, but often times, depending on what competitors can actually produce and ship in a given quarter, we may have opportunities to take additional share. And so the interplay between what we can produce and what our customers can produce this year will ultimately determine the overall market share for the year.

--------------------------------------------------------------------------------

Operator [10]

--------------------------------------------------------------------------------

Our next question comes from James Kisner of Loop Capital.

--------------------------------------------------------------------------------

James Martin Kisner, Loop Capital Markets LLC, Research Division - SVP [11]

--------------------------------------------------------------------------------

So I think you mentioned inventories choosing one customer having impact to your, I think. Maybe you could talk about just, sort of, to quantify that to some degree. I mean, just $10 million, $30 million what's the overhang there? Sounds like you also, kind of, expect that Q2 -- obviously, you're not going to be growing. But you actually say its the second half is going to be bigger than the first half. I don't know if you'd help us with bandwidth here at all. I mean, could this be a growth year on a full year basis for you, just given 100 gig is ramping, and these issues are going to temporary? Just any color on that would be helpful.

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [12]

--------------------------------------------------------------------------------

Sure. So as far as the inventory goes, I can't really give you a lot of insight into that. Because it's the inventories that the customers have on hand. We've got a pretty good idea from them about what they're forecasts in terms of purchasing look like. And then as far as growth prospects for the year, I think first of all, it's very important to emphasize that we remain very confident in our position as the leading supplier of data center optics to all of our major hyperscale data center customers. I think, as you've seen in the last few press releases that we put out, we have a very strong product roadmap, really leading technology in the industry in terms of laser and receiver technology for not only 100 gig but 400 gig and beyond. So as we talk about growth prospects this year, it's not only about our existing hyperscale customers where we continue to have a very strong position, but also about our prospects for bringing on new customers. And we do have a number of recent design wins and a number of qualifications that are ongoing that we hope to bring in as new customer revenue later on in the year. And so I think, what I would expect to see is, continued strong business from our 3 hyperscale customers and layering on top of that, some new customers in the data center and perhaps, other areas as well. And then it's worth mentioning too, our Cable TV segment has been a very strong grower this year, and the prospects for growth in Cable TV remain excellent. We have strong growth coming from upgrade projects in North America from several MSOs as well as some international growth. And later on in the year, we expect our Remote-PHY products to begin to ship in volume. And that's the product line that I think will contribute meaningfully to our revenue in the back half of the year, I suspect in all of those market segments this year.

--------------------------------------------------------------------------------

James Martin Kisner, Loop Capital Markets LLC, Research Division - SVP [13]

--------------------------------------------------------------------------------

Just to clarify this to you, I mean, it sounds like June should be up sequentially, right? I mean, demand is exceeding supply in March, and you won't have the Chinese New Year in June, and just -- and as you know, the inventory overhang is here, but I just want to make sure that, that assumption is right, that June should be up somewhat meaningfully here versus March?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [14]

--------------------------------------------------------------------------------

I mean, the key -- we don't -- we only guide one quarter out, so I can't comment specifically on that. But I do think there's -- well, should be less impactful in a negative sense for us in the next quarter. For example, a lack of Chinese New Year and other things that you mentioned.

--------------------------------------------------------------------------------

James Martin Kisner, Loop Capital Markets LLC, Research Division - SVP [15]

--------------------------------------------------------------------------------

Okay, just one more to sneak in here. I mean, the CapEx spending you're talking about is a pretty big step-up. I'm just wondering -- and the plan is not going to be done here until 2020. So should we think about '18 as being kind of a peak year for CapEx, or what is -- and I guess, also, what's the sort of headwind to gross margin, I think around depreciation expense, as we kind of move through the year, could you help us a little bit on the CapEx plans?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [16]

--------------------------------------------------------------------------------

Yes. So this year, we'll -- it's the heaviest CapEx year that we've had as a company. I think it's worth pointing out, the last time that we had a major step-up in CapEx was when invested in production facilities here in Sugarland. And I think that's worked out very well for us. We were able to expand our capacity and take advantage of the increase in data center business in particular that we saw as well as position ourselves well for the next couple of years. This new factory, as you mentioned, will come online in 2020. It's designed to fuel our growth for the period beginning in 2020 and beyond. As far as whether this is a peak year in CapEx, we've often said that we look at CapEx on a pretty short-term basis. I mean, obviously, this particular chunk of CapEx related to the building is a longer-term investment, but generally speaking, our annual CapEx budgets are decided, based on what we see our near-term revenue prospects. So I can't really give you a sense of whether we think 2019 or 2020 will be higher or lower. But I can say that step-ups or increases in CapEx, generally are associated with bright outlook for us in terms of future revenue. And this particular step-up in CapEx is no exception.

--------------------------------------------------------------------------------

Operator [17]

--------------------------------------------------------------------------------

Our next question comes from Fahad Najam of Cowan and Company.

--------------------------------------------------------------------------------

Fahad Najam, Cowen and Company, LLC, Research Division - Associate [18]

--------------------------------------------------------------------------------

Stefan and Thompson, just a couple of quick questions. One, maybe I misheard, but you addressed that regarding the inventory buildup, is it just one particular customer or is it more than one customer that has the inventory buildup?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [19]

--------------------------------------------------------------------------------

It's just one customer.

--------------------------------------------------------------------------------

Fahad Najam, Cowen and Company, LLC, Research Division - Associate [20]

--------------------------------------------------------------------------------

It's just one customer. So regarding the weakness that you cited from your data center customers, if -- hopefully, I got my math right, if your customer, which was 19% this quarter and the one that was 33% this quarter, seems to have sequentially come down. Is there any particular seasonality that drives this sequential weakness in the fourth quarter? Or you would think that that's something to do with outside of seasonality?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [21]

--------------------------------------------------------------------------------

Yes. I can't really comment on, obviously, specific customers and their trends. But I think it's not reasonable to expect that in any given quarter, there can be a lot of things that affect a particular customer's purchasing partners, timing of orders, specific things that they're doing within their data centers, what type of products they're deploying in the mix. So there's a lot of things that can affect that on a short-term basis. But longer term, I think we've seen strong growth from our hyperscale customers, and we would expect to continue to see their volume growth in the future.

--------------------------------------------------------------------------------

Fahad Najam, Cowen and Company, LLC, Research Division - Associate [22]

--------------------------------------------------------------------------------

Got it. Now switching on to margins. In light of this new production facility that you're building, I just wanted to, kind of, get a sense on how that would impact your overall -- how should we think about the margins going forward? Is there like, a minimum threshold for fixed cost that you need to absorb in. Is that fixed cost is going to be higher as a result of this new incremental facility and how should we think about margins, the minimum volume that you're require to dive your targeted 40 -- 45 -- 41% to 45% margin, if you were to maintain that?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [23]

--------------------------------------------------------------------------------

I'm not quite sure I follow all of your question there. We've said that we expect margins to maintain in that range of 41% to 45%, in general for the foreseeable future. So that's where we expect it to be. Obviously, I can't comment at this point. We're talking about a factory that might come online in 2020. So I can't tell you, specifically, how much product we expect to produce in there at that time, or what our margin on this products is likely to be. It's quite a ways into the future. So not sure that answers your questions, but...

--------------------------------------------------------------------------------

Fahad Najam, Cowen and Company, LLC, Research Division - Associate [24]

--------------------------------------------------------------------------------

Let me rephrase what I was trying to ask. What I was trying to get to was that today you have a minimum fixed cost that you have in -- as a result of this new facility, we would expect the minimum fixed cost to increase and I was just trying to see in terms of your projection, how much minimum volume you would require to offset that incremental fixed cost. And two, I'm just making sure if my assumptions are correct that this would actually increase your overall fixed cost.

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [25]

--------------------------------------------------------------------------------

Well, I mean, it will increase our overall fixed cost. We'll have additional depreciation, for example, on the new factory. So that is true. I think that -- I mean, you could probably do the math on the investments that we're making and the depreciation and time period that were talking about. But that's relatively minor compared to the total assets of the company right now and the depreciation of assets we've had. So I'm not sure, I'm -- again, I'm not sure I'm answering your question, but that's about as far as I can go.

--------------------------------------------------------------------------------

Operator [26]

--------------------------------------------------------------------------------

Our next question comes from Tim Savageaux of Northland Capital Markets.

--------------------------------------------------------------------------------

Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [27]

--------------------------------------------------------------------------------

Questions on product mix, I guess, to some degree following on, kind of, the 40 versus the 100 gig discussion. I wonder, did you make any comments on PSM4 versus CWDM4 within 100 gig trend there, either in the quarter or maybe more importantly, in the outlook, whether you have any commentary about 40 versus 100 gig? Assuming data center is responsible for most of the sequential decline that you're forecasting there. Do you expect any, sort of, change in that mix 40 versus 100? And then within 100, anything notable from a CWDM versus PSM standpoint for either the quarter or the outlook?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [28]

--------------------------------------------------------------------------------

So as I mentioned earlier, we expect 100 gig to continue to grow and 40 gig to, sort of, decline. So that's what we expect in terms of trends between 40 and 100. Within 100 gig, as you know, we have CWDM and PSM. We didn't give any specific numbers. But we have said in the past, and we continue to believe that CWDM is really -- represents -- for most of our customers represents the product of choice, particularly, as the price differential between CWDM and PSM has reduced, customers tend to buy more CWDM than PSM. And that's not to say, there's not going to be a mix there. But we do expect CWDM to continue to grow in prominence within that 100 gig segment.

--------------------------------------------------------------------------------

Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [29]

--------------------------------------------------------------------------------

I guess, follow-up with the sort of continue-to-grow comment. I think that's true, kind of, on a year-over-year basis for 100 gig. But I think you did have your lowest 100-gig quarter of the year in Q4. And I think your revenue has gone around 40% sequentially. So I guess, what I was getting at is, do you expect -- extent you expect to continue growth in 100 gig, kind of, on a year-over-year basis, say, call it, off a base of $120 million, to the extent you just did 22 that would imply a pretty significant step-up, I would assume. I don't know whether that would be starting in Q1 or what will be driving that? So given that framework, I guess, my real question was, do you expect 100 gig to grow in Q1 sequentially? And I just have a brief follow-up on pricing after that.

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [30]

--------------------------------------------------------------------------------

Yes, we don't give guidance by particular product within the segment. So can't comment on that.

--------------------------------------------------------------------------------

Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [31]

--------------------------------------------------------------------------------

Okay. So final question for me then, what you did comment on was, expecting a more favorable pricing environment in '18 versus '17. That again, I guess, counter to a lot of what we've heard in terms of concerns from silicon photonics based competitors and some pretty aggressive pricing. I wonder, did that pricing hit in late '17, and maybe that's why '18 looks better? Or in general, if you could talk about the dynamics around the pricing environment given that it would appear that some of these aggressive or would be aggressive price leaders are having problems delivering, which you would think would be, constructive for pricing. I wonder, is that's sort of what behind your more favorable outlook?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [32]

--------------------------------------------------------------------------------

Sure. Just to be clear, I didn't -- when you say more favorable outlook, were several, that the rate of price decline should decrease in 2018 versus 2017. That's not to say that we expect prices to be more favorable and other words higher for us. Expect a decline, its just we expecting them to decline at a lower rate that as a percentage of decline this year would likely be less than it was last year, just want everybody to understand, make sure that we're on the same page. Why we believe that? Well, first of all, for us, we can look at our purchase contracts and purchase prices that we've negotiated with customers and just look at was those clients are for those customers that we already have agreements with. And so, that gives us a fairly high degree of confidence already.

In addition, as you mentioned, there are competitors who several of whom have already said that they intend to minimize their activities in 100 gig, partly because of the pricing environment, perhaps, in 2017. And then our platform, as we've said many times, and our -- the way that we've engineered our company and our products to be able to produce these types of high-performance, transceiver products with very attractive cost profiles and our ability to continue to squeeze costs out of those products as we move forward, also gives us some strong degree of confidence that we can maintain our gross margins, even in -- what has been and will likely to remain a fairly competitive price environment.

--------------------------------------------------------------------------------

Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [33]

--------------------------------------------------------------------------------

(technical difficulty)

'17 versus '18?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [34]

--------------------------------------------------------------------------------

No, I can't give you. I'm sure competitors would love to know that we forward price or products for 2018. So I won't go there. What I can say is that we reduced our cost on our 100 gig products by 36% in the last quarter -- last 4 quarters. So I mean, I think we're not done yet. There's more cost reduction that we can do, as we noted in our call, we're spending some money on R&D to bring on some of those efforts. So we're prepared for the price, we're well prepared for the pricing environment that we expect to see this year. And we stand behind our 41% to 45% gross margin target while we do that.

--------------------------------------------------------------------------------

Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [35]

--------------------------------------------------------------------------------

Okay. Really last one. I'm -- I apologize for this, but -- and you wouldn't say that, that pricing environment in '17, or would you contributed to relatively weak 100 gig results in Q4, either as a result of price declines or maybe walking away from business that you felt was unattractive from a pricing standpoint?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [36]

--------------------------------------------------------------------------------

Well, no. Were not walking away from business that we felt is unattractive. We would do that. I mean, we're prepared to do that, but that has not been a factor for us, because our costs are very attractive and were able to get good gross margins even as the pricing declines. What -- it is a fact, of course that as the price comes down, the revenue will decline unless units go up, but at least the same -- this price is declining. So that is, I mean, is in that sense, it certainly headwind that we have to work against. But again, I think the more important thing is really can we maintain our gross margins in this pricing environment and we've been able to do that.

--------------------------------------------------------------------------------

Operator [37]

--------------------------------------------------------------------------------

Our next question comes from Richard Shannon from Craig-Hallum.

--------------------------------------------------------------------------------

Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [38]

--------------------------------------------------------------------------------

Probably just a few for me. First one is, kind of, talking on the 100 gig topic here. I'll maybe ask the questions slightly different manner. Stefan if you'll respond to it. But you think about modeling a 40 versus 100 gig, I think in the last quarter, I think, you said 38 versus 56 percentage points of the data center revenues. When does that crossover? Do you expect that to crossover this year anyway that you can comment on it in that manner?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [39]

--------------------------------------------------------------------------------

Well, it crossed over in Q3 in the sense that 100 gig was higher than 40 gig for us in Q3. Q4 was a little bit different. Q1, I would -- again, we don't -- were not going to give you forward guidance on that, but I have said that longer-term trend is for CWDM to predominate -- I'm sorry, for -- CWDM to predominate but also for 100 gig to dominate over 40 gig in the future.

--------------------------------------------------------------------------------

Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [40]

--------------------------------------------------------------------------------

Okay. Fair enough, I'll follow-up offline on that one. But Stefan, may be discussion about the TAM here. We've talked a little bit about share and pricing out there, but what about the unit market growth. Can you give us a sense of what that market looks like growing this year. I'm more interested in 100 gig really if you can characterize or quantify that in any way would be great, please.

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [41]

--------------------------------------------------------------------------------

I think, for us, the most important thing is -- as we've talked about earlier, our ability to attract new customers. I mean, at this point, we have commanding a share among the hyperscale customers. Who represent a good portion of the market, but there's certainly a large base of customers out there, besides the hyperscale customers that we already have. And I think that's where we're really focusing our efforts, as we look to, particularly to the second half of 2018. Of course, we're going to continue to serve and serve well our existing hyperscale data center customers. But the opportunity is to expand our customer base is one that we've been working very, very diligently on, really over the last year. We've talked about the number of design wins and things that we have. And in fact, those will start to generate revenue. And so when you look at the overall market size for us, I think we still got a long way to go before we have to worry about overall market growth, kind of, limiting the rate at which we can grow. Our rate of growth is dependent on how well we can bring on new customers as well as, obviously, continue to serve the existing customers that we have with our existing products and new products, like our 400 gig products (inaudible).

--------------------------------------------------------------------------------

Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [42]

--------------------------------------------------------------------------------

Okay, fair enough. Last question for me, on the EML laser that you announced, when do we see that in products demoed and announced and then eventually, generating revenues?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [43]

--------------------------------------------------------------------------------

I will have it at OFC for demo purposes, which will be the middle of March, as you know, about 3 weeks from now. As far as when it'll be in products, it's going to be a cornerstone of our 400 gig product line. And we'll expect to start to see that, certainly, in demo, by next year for sure.

--------------------------------------------------------------------------------

Operator [44]

--------------------------------------------------------------------------------

(Operator Instructions) Our next question comes from Nick Johnson of Piper Jaffray

--------------------------------------------------------------------------------

Nickolas Bradley Johnson, Piper Jaffray Companies, Research Division - Research Analyst [45]

--------------------------------------------------------------------------------

Just follow back on CWDM products. I guess, what we're hearing from competitors, the customers are turning more towards the CWDM versus traditionally more longer-reach product, as they maybe getting up to the 10 kilometer range. So I'm curious, if you're seeing the same. And if so, when are you expecting a larger customer base here? New customers entering this? Can you just dive into that a little bit deeper?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [46]

--------------------------------------------------------------------------------

Yes. So first of all, I agree with your comments that CWDM is likely to become more important to customers in the future. I think, we said just about as much earlier in the call. I think we're very well positioned in this market for CWDM. It's worth noting that -- the primary difference between CWDM and PSM is that CWDM uses 4 different lasers, 4 different colors, 4 different lambdas of lasers. Our ability to manufacture those lasers in-house gives us a significant advantage, both in terms of costs and our ability to manage inventory and lead times for those CWDM devices. So I think, you're right, CWDM is predominate. And I also think, we're well positioned for this.

--------------------------------------------------------------------------------

Unidentified Analyst [47]

--------------------------------------------------------------------------------

Okay, but the revenues for CWDM were I'm assuming, down in the quarter than if 100G was down? Is that correct? I think in the past, you've also broken out, CWDM and PSM4 at least said if they're up or down by a certain percentage, are you guys able to break that out at all?

--------------------------------------------------------------------------------

Stefan J. Murry, Applied Optoelectronics, Inc. - CFO and Chief Strategy Officer [48]

--------------------------------------------------------------------------------

So as I said, at any given quarter, there can be timing of orders, the particular products that are being ordered, where customers are ordering, and for what segment of their data data center. So it makes that difficult to project. But the trend, certainly, is for more CWDM and less PSM.

--------------------------------------------------------------------------------

Operator [49]

--------------------------------------------------------------------------------

At this time, we have no further questions. And I would like to turn the call over to Dr. Thompson Lin for any closing remarks.

--------------------------------------------------------------------------------

Chih-Hsiang Lin, Applied Optoelectronics, Inc. - Founder, Chairman of the Board, CEO and President [50]

--------------------------------------------------------------------------------

Okay. Thank you for joining us today. As always, we thank all the investors, customers and employees for your continued support.

--------------------------------------------------------------------------------

Operator [51]

--------------------------------------------------------------------------------

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