Maria Riley - Investor Relations Thompson Lin - Founder, Chairman an CEO Stefan Murry - CFO and Chief Strategy Officer

Mauricio Canjura - Raymond James Richard Shannon - Craig-Hallum

Thank you. I'm Maria Riley, Applied Optoelectronics Investor Relations, and I'm pleased to welcome you to AOI's Third Quarter 2016 Financial Results Conference Call.

After the market closed today, AOI issued a press release announcing its third quarter 2016 financial results and provided its outlook for the fourth quarter. 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 that recording can be found on the Investor Relations page 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.

Stefan Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give an overview of AOI's Q3 results and Stefan will provide financial details and an outlook for the fourth quarter.

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 terminology, such as may, well, should, expect, plan, anticipate, believe or estimate 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 confirm these statements to actual results or to changes in the company's expectation.

More information about other risks that may impact the company's business is set forth in the Risk Factor section of the company's reports on file with the SEC. Also, with the 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 our 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.

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

Thompson?

Thank you, Maria. Thank you for joining us today.

AOI deliver a strong third quarter with record revenue and we adjusted both our top and bottom line guidance. We grew revenue 23% over last year to reach a record $70.1 million, which was way above our updated guidance range of $63 million to $65 million.

Our results were driven by appropriate increase in demand and strong execution by the AOI team. We grew datacenter revenue 37% over last year and achieve record datacenter revenue for the sixth consecutive quarter.

In CAT, we achieved revenue of $12.9 million which was up 35% sequentially as cable provider continues to upgrade their network to fiber optic architecture with DOCSIS3.1. Our non-GAAP gross margin in the quarter improved 170 basis point sequentially to 33.1% driven by our improved execution and cost leadership.

We delivered improved profitability with non cash earning per share of $0.38 way above our updated guidance range of $0.26 to $0.29 per share. And lastly we may progress in expanding our customer footprint during the quarter as we announced in late August with few initial orders with a new hyper scale datacenter for our 40G and 100G datacenter product.

We believe these initial orders are testament to our leadership and growing brand in the datacenter optics market and we are excited about opportunity to demonstrate our capabilities to list new customers as a relationship deepen overtime. In summary, AOI delivered an outstanding third quarter and we are very pleased with our performance.

With our new Sugar Land facility online and fully operational, we will able to scale to meet demand and I am especially proud of our team's ability to execute in the high demand environment. Our goals in a quarter demonstrate our growing market share in advanced optics and reflect our continued commitment to operational excellence.

We remain focused on building our momentum to drive growth and achieve our long-term financial objective. With that I'll turn call over to Stefan to review the details of our Q3 performance and outlook for Q4.

Stefan?

Thank you, Thompson. Total revenue for the third quarter grew 23% year-over-year to reach a record $70.1 million, well above our updated guidance range of $63 million to $65 million.

Our results in the quarter were driven by strong accelerated demand for our market-leading datacenter and cable TV products and strong execution by the AOI team. Datacenter revenue in the third quarter grew to a record $52.9 million, which represents an increase of 37% year-over-year.

Our growth in the quarter was driven by record demand for both our 40G and 100G products. In this quarter, 77% of our datacenter revenue was derived from our 40G datacenter product.

And 14% was from our 100G product. Overall, we are very encouraged by the accelerated demand we are seeing from our datacenter customers.

As Thompson mentioned, during the quarter we made progress in extending our customer footprint. After an extensive period of product testing and qualification, we received initial orders for our market leading 40G and 100G datacenter products with another hyper scale datacenter customer.

With this new customer, we now serve three of the top four web scale datacenter operators. And we are encouraged by the volume of award we've received from this customer to date.

Turning to our cable television market, revenue from our CATV products in the third quarter was $12.9 million compared with $14.2 million in Q3 of last year. On a sequential basis, CATV revenue grew 35%, which reflects an improving demand environment due to the DOCSIS3.1 upgrade.

With DOCSIS3.1 enabling the gigabit H CATV network. Cable operators are in a race for internet speed.

Earlier this year, Comcast announced plan to offer gigabit internet service using DOCSIS3.1 technology. And is the first cable operator to aggressively deploy this service to optimize the capacity of their existing network.

This is driving a lot of excitement in the market and we continue to believe we are well positioned to capitalize on the industry move to DOCSIS3.1. Additionally, as cable operators upgrade to more fiber deep architecture with DOCSIS3.1, they anticipate a need to reduce congestion in the HFC head end and Remote PHY is leading technological approach to solving this problem.

We recently showcased our newly launched Remote PHY product at the SCTE Cable-Tec Expo and the initial customer response was very positive. With our technical expertise in both advanced optics and radio frequency design, we believe we are well positioned to capture leading market share as this network architecture evolve.

Our telecom segment delivered revenue of $3.4 million, up 12% year-over-year, driven by continued demand from our telecom customers and new design wins. For the quarter, 75% of our revenue was from datacenter products; 18% from CATV products; with the remaining 7% from FTTH, telecom and other.

In the third quarter, we had two 10% or greater customers in the datacenter business that contributed 56% and 19% of total revenue respectively. Moving down the income statement, our Q3 non-GAAP gross margin was 33.1%, ahead of our guidance, and within our target model.

Our non-GAAP gross margin increased 170 basis points when compared with the 31.4% reported in Q2 of 2016, and increased 140 basis points from the 31.7% reported in Q3 of last year. The sequential improvement in our Q3 gross margin was driven by our improved execution and the benefit of our cost reduced 100G transceivers.

In total, R&D expense was $8.2 million or 11.7% of revenue, compared with $7.7 million or 13.9% of revenue in the prior quarter. The increase in R&D expenses primarily due to additional spending on 200G and 400G datacenter product development, in addition to increase spending in Remote PHY as we adoption schedules for this product being earlier than originally planned.

Sales and marketing expense was $1.5 million or 2.1% of revenue, compared with $1.5 million or 2.7% of revenue in the prior quarter. G&A expense was $5.5 million or 7.8% of total revenue, compared with $4.7 million or 8.5% of total revenue in the prior quarter.

The sequential increase includes additional expenses associated with the new facility that we brought online in the quarter. This brings total operating expenses in the third quarter to $15.2 million or 21.6% of revenue, up approximately $1.3 million when compared with $13.9 million or 25.1% of revenue in the prior quarter.

Non-GAAP operating income in Q3 was $8.1 million, compared with operating loss of $3.5 million in the prior quarter and operating income of $6.9 million in Q3 of last year. Our non-GAAP operating margin in the quarter was 11.5%, up 520 basis points from the prior quarter and down 60 basis points from Q3 of last year.

Non-GAAP net income after tax for the third quarter was $7 million compared with net income of $2.8 million in the prior quarter and net income of $6.7 million in Q3 of last year. We reported non-GAAP net income of $0.38 per diluted share compared with the non-GAAP net income of $0.16 per diluted share in the prior quarter.

And non-GAAP net income of $0.40 per diluted share in Q3 of last year. GAAP net income for Q3 was $17.7 million or $0.97 per diluted share, compared with GAAP net income of $0.6 million or $0.03 per diluted share in prior quarter.

And GAAP net income of $2.7 million, or $0.16 per diluted share in Q3of last year. The Q3 weighted average fully diluted share count was approximately 18.4 million shares.

After considering all available evidence, we've concluded that a full evaluation allowance against our deferred tax asset is no longer appropriate. As a result, AOI has reversed this evaluation allowance against its US deferred tax asset, which resulted in a non-recurring tax benefit of $11.9 million.

We have excluded the net non-cash income tax benefit in the quarter from our non-GAAP net income. As a reminder, please refer to our earnings release for details about our use of non-GAAP performance measures.

Turning now to the balance sheet, we ended Q3 with $60.2 million in cash, cash equivalents, short-term investments and restricted cash compared with $47.3 million at the end of the previous quarter. Accounts receivable increased to $44.2 million compared with $41.5 million last quarter, and accounts payable decreased approximately $0.7 million over Q2.

Our free cash flow in the quarter was approximately $0.8 million which represents the first quarter that we were free cash flow positive since 2012. Our capital investments in the quarter decreased to $6.6 million which includes $3.3 million in production equipment and machinery and $2.8 million on construction and building improvement.

As of September 30, we had $54.9 million in inventory, a decrease from $59.8 million in Q2. Moving to our outlook, we expect Q5 revenue to be between $75 million and $79 million, which reflect an increase in CATV demand as well as a continuation of the accelerated expense from our datacenter customers.

We expect Q4 non-GAAP gross margin to be in the range of 34% to 35.5%. Non-GAAP net income is expected to be in the range of $8.5 million to $9.5 million, and non-GAAP earning per share between $0.46 and $0.51 per share using a weighted average fully diluted share count of approximately 18.5 million shares.

Before I open up the call for questions, I'd like to make a few comments for modeling purposes. While we have not historically experience Q1 seasonality in the datacenter business, please note that we are now producing some of our datacenter products in our China facility.

And in the first quarter, we will have fewer production days for these products in comparison to the fourth quarter due to the Chinese New Year holiday. And lastly on a GAAP basis with the release of the tax allowance, we expect our midterm annual effective tax rate starting in 2017 to be approximately 20%.

We expect to be able to utilize our net deferred tax assets to offset cash taxes as we discussed above concerning our release. With that I'll turn it back over to the operator for the Q&A session.

Operator?

Thank you for taking my question. This is Mauricio in for Simon.

Stefan just wanted to ask you a couple of questions. First one could you please give us an update on your view of the current pricing environment and your expectations on the upcoming annual price negotiations going into fiscal year 2017?

Yes, Mauricio, I think the pricing that we saw this quarter was in line with our expectations. And we think we have a pretty good rerun where the pricing is going to be into the year.

I would point that this concept of annual price negotiations is really more -- it is a concept that applies more to telecom than the datacom market or the datacenter market specifically that we are in. The datacenter market tends to be characterized by -- it is not characterized by all customers doing a price negotiation annually at the same which just kind of typical of the telecom market.

So but as far as the quarter win and the successive quarters it is in line with our expectations.

That's really helpful. Thank you.

And then on 100Gig, I think you mentioned that the mix from 100 gig product was approximately 14% in the quarter. But then looks like your gross margin came in quite strong.

So I just wanted to ask you on if this increase in gross margin due to your ability to ship higher than activated gen2 100Gig product this quarter?

Yes. The percentage that we talked about just to make sure we are all in the same page it was 14% of our datacenter product.

On our fully revenue with 14% of datacenter revenue. And, yes, the growth in 100Gig was one of the things that affected that gross margin positively.

As we mentioned, we do have this cost reduced platform. I think as we mentioned in our prepared remarks, I mean I really can't say enough how proud I am of the entire AOI team for being able to execute better than expected in the quarter.

And I think the better execution includes delivery of the cost reduced, 100Gig product as well as some of the 40Gig product which also contributed.

Yes. 40Gig seems to have been -- to have also accelerated this quarter.

And we heard comments from some of your competitors suggesting a potential delay in volume chips of 100Gig due to a delay at the chip sale level? I know you don't provide comments on the availability of third party equipment but I was just wondering if you've seen any sort of bottleneck at the chipset and switching level that could potentially affect short term demand for 100Gig.

Well, I mean this was our record quarter for us in terms of 100Gig. So I guess I have to say that we certainly didn't see any evidence of slowdown in demand quite the opposite, I mean it picked up quite a bit from last quarter.

So, no, as far as the availability of the chipset, like I said I can't really comment on because we don't buy those chipsets but the customers are taking product at a rate that they had let us to expect based on the forecast. So it doesn't seem like there was anything unusual that happened among our customer base in the quarter.

Hi, guys. Congratulation on the great results and guidance.

And thanks for taking my questions. Maybe I follow up on a couple of these past questions here, Stefan, maybe I'll ask a little bit more directly.

How do you see the trend between 40Gig and 100Gig for this quarter and to the extent your visibility beyond that? Tell us how you think it's going to go here in 2017?

Well, we don't really give guidance more than a quarter out. And certainly not on individual product basis.

But I can say that we saw obviously good growth in 40Gig and 100Gig in this quarter. We have as we mentioned before, we have a new customer that we brought on board during the quarter we announced it during the quarter.

The revenue contribution in this quarter was not high for that customer. So and they are a customer for 40Gig as well as 100Gig so if you kind of put that altogether it would not be -- not be a stretched thing we could certainly see continue growth in 40 gig even if our existing customers were to decline, which is not necessarily what I am saying will happen.

But I mean my point is for us we might see growth even if that's not necessarily apparent in our existing customer base. As far as the longer term trend, I mean I think clearly 100Gig is -- we are on the 100Gig upgrade cycle now for sure.

It is going to be -- the technology the future which means eventually overtime 40Gig will decline. How fast that happens and the dynamics between our existing customers and the new one is something we'll have to wait and see but we definitely see 100Gig continuing to grow from this point.

Okay. I guess the follow on to that is in the discussion on gross margin here, obviously you had a very good third quarter and your guidance for fourth quarter is up nicely beyond that.

So I guess I am curious --purpose to ask that question was to understand what's driving the gross margin pretty nice and permitting into the fourth quarter. In other words if you are not seeing 100Gig growing meaningfully faster than 40Gig in the fourth quarter, can you help us understand what's driving the moving up versus this utilization or something else, you can help us understand that will be great.

Yes. I mean I guess I could say 100Gig should grow faster than 40Gig okay.

And also it is worth mentioning as I kind of alluded to earlier that the 100Gig cost reduced platform wasn't shipping for the entire quarter. We didn't start shipping that until mid to late in the quarter.

So we didn't have a full quarter worth of impact of that cost reduced 100Gig platform. So by virtue of having a full quarter of that platform shipping I think that should give you an idea that the gross margin even in the 100Gig has some room for improvement.

Yes. That's exactly I was looking for.

Thanks for that. So question on capacity here.

Sounds like you are attributing the gross margins to also your execution of your operations team here. I guess is there any comments suggesting that you have been capacity constraint in one or product excusing any manner and actually let me just stop and ask that specific question first one and move on to other one.

Well, it is -- we like to operate near capacity. By that mean that's most sort of efficient operating point for us.

And we've been adding as you know looking at our CapEx and it came down for the Analyst Day so you've seen the new facility here in Sugar Land, we've got significant capacity additions that we brought on board. So the capacity that we have is not fixed number right.

It is kind of moving target. But as far as that goes we like to add capacity as we see the forecast forming up particularly among our major customer.

So we like to operate at close to full capacity. You noted in my comments there that we talked a little bit about the impact of an extended Chinese New Year holiday in China in comparison to our Taiwan facility where we had previously manufactured most of the datacenter product.

So you get the idea that we don't have a lot of excess capacity but the most important thing is that we are keeping up with customer demand. We are shipping to what customers need and we are adding capacity as we need to be able to maintain both our cost leadership and the ability to deliver to customers which is what customers love about AOI, that's our -- that's what we do well right.

We ship what customers need on time and at a very attractive cost point for us.

Okay. It is helpful.

And just one last quick follow up on the CapEx here. Stefan, I apologize I missed the number you quoted for production equipment CapEx in the quarter and what should we expect going forward as far as I guess into the fourth quarter then?

Yes. So the number in the third quarter was $3.3 million.

So it is the half of our CapEx. We didn't really give guidance on the fourth quarter.

It is one of those things where we had some annual guidance out there I believe it was $50 million to $55 million. We haven't changed that number in the quarter so you can go back and look at other three quarters to see which left.

Okay. And thank you for joining us today.

As always we thank our investors, customers and employees for your continued support.