I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics fourth quarter and year 2018 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. To ask a question, please press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note, this call is being recorded. I would now like to turn the call over to Maria Riley, Investor Relations for AOI. Ms. Riley, you may begin.
Thank you. I'm Maria Riley, Applied Optoelectronics investor relations, and I'm pleased to welcome you to AOI's fourth quarter and year 2018 financial results conference call. After the market closed today, AOI issued a press release announcing its fourth quarter and year 2018 results, provided its outlook for the first quarter of 2019. 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 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 Q4 results. Stefan will provide financial details and the outlook for the first quarter 2019.
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, will, should, expects, plans, anticipates, believes, or estimates, 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 other risks that may impact the company's businesses are set forth in the Risk Factors section of the company's reports on file with the SEC. All financial numbers discussed today are on a non-GAAP basis, unless specially noted otherwise. Non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation between our GAAP and non-GAAP measures, as well as a discussion of why we present non-GAAP financial measures, are included in our earnings press release that is available on our website. Before moving to the financial results, I'd like to announce that we will host an investor session at OFC on March fifth at the San Diego Convention Center. This discussion will be webcast live. 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 2019 earnings call is currently scheduled for Wednesday, May 8, 2019. I would like to turn the call over to Dr. Thompson Lin, Applied Optoelectronics Founder, Chairman, and CEO. Thompson?
Thank you, Maria. Good afternoon, everyone, and thank you for joining us today. In summarizing our performance in the quarter, we delivered non-GAAP revenue of $58.9 million and non-GAAP EPS of a loss of $0.02, which was in line with our guidance. Our gross margin was below our expectations as we incurred higher than anticipated costs to resolve the inventory issues we experienced last quarter. Looking ahead, we expect gross margin to begin to gradually improve starting this quarter. For the year, AOI delivered revenue of $268.4 million, generated a gross margin of 35.5%, and non-GAAP earnings of $1.04 per diluted share. While 2018 had its challenges for the overall optics market and for AOI, I would like to note a few of our accomplishments that we believe have strengthened our position in the long term.
First, while our customer base continue to be concentrated, we have made progress in our initiatives to broaden this base. This started with a large purchase commitment early in the year from a new hyperscale data center customer based in the U.S., and during the summer, we gained a design win with a large data center operator in China. Diversifying our customer base is a top priority for AOI, and we are pleased with the progress we made on this front in 2018. All in for the year, we secured a total of 26 new design wins, of which 12 were with new customers, including a large U.S.-based data center customer that we secured this quarter. This compares favorably with 2017, where we had 19 design wins in total and 10 with new customers.
We believe that the emphasis we have placed on diversifying our customer base has continued to bear fruit. Second, we continue to demonstrate our strong commitment to our customers. While at times this requires us to make difficult choices with near-term trade-off, we believe that our focus on our customers build enduring relationships that can continue to develop in 2019 and beyond. I'm proud to say that we have maintained all of our top customers. Third, we continue to innovate and expand our technology leadership in advanced optics. This included advance in 200G and 400G in the data center and with mobile for our CATV customers. Just last month, we released a silicon photonic-based 400G optical module that is now currently available for customer sampling. This technology platform will enable our data center customers to scale the infrastructure beyond 400G to ultimately 1.6 Tb per second.
The customer response has been very positive for our leading-edge suite of products, we remain confident in our ability to monetize our innovation as the market evolves and adopts next-generation technologies. Fourth, we'll continue our market diversification efforts by shipping product to several telecom customers to be tested for use in next-generation 5G mobile networks. Many of these 5G optical products will need to perform well under demanding outdoor temperature conditions, we believe that our experience in manufacturing optical devices used in similar conditions for CATV applications will help us secure a foothold in this market. While we are still early in the 5G cycle, we believe 5G will be a significant driver of the high-speed optical component market, likely starting later this year.
Overall, we are pleased with the technical achievement we have made this year, the progress we made in expanding our customer base, and our continued support of our existing customers. I want to thank the AOI team for their hard work and dedication this year. Before I turn the call over to Stefan to discuss our results in more detail, I'd like to make a few comments on the market dynamics we currently see in the data center market. Several other industry players have commented in recent weeks about the poor visibility in China and the excess inventory situation in the data center market. We are not immune to these dynamics. It is clear from our conversation with our hyperscale data center customers that inventory in the supply chain has gotten ahead of deployment, due in part to the transition to 100G.
While it is still early in the year and visibility is limited, we believe that the second half of 2019 will be stronger than the first as inventory is worked out over the next couple of quarters. Also, we have seen some of our data center customers in China taking a more conservative approach in their CapEx deployment due to concern of slowing economic growth in their country. While both of these factors will affect our short-term outlook, an underlying trend driving demands for our product has not changed, nor has our status with our customers. We serve some of the most dynamic and rapidly evolving companies in the world, and believe their need for high-speed computing power remains fundamental for their business.
With the technology we have developed and plan to bring to market, we believe we are in a strong competitive position to address our customer needs as demand improves. We remain focused on building on our strong foundation as a leader in advanced optical technology and expanding 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?
Thank you, Thompson. Non-GAAP revenue for the fourth quarter was $58.9 million, which was in line with our guidance range of $56 million to $63 million. Our data center revenue came in at $42.6 million, compared with $62 million in Q4 of last year. In the quarter, 60% of our data center revenue was derived from our 100G data center products, and 38% was from our 40G products. Our production capacity remained constrained in the quarter due to the additional product testing steps we implemented last quarter to screen for any potentially troublesome laser devices from our inventory, including work in process. As discussed last quarter, we identified and remedied the root cause of the problem that affected a small number of our lasers, and we added additional testing steps, including temporary steps to screen existing inventory.
We remain on track to return to normal lead times by the end of this quarter. This quarter, we also issued a $900,000 credit to a customer. We expect this credit to be non-recurring and have therefore adjusted it out of our GAAP revenue. As Thompson mentioned, based on conversations with our hyperscale data center customers, we believe there was some inventory buildup in the supply chain as customers transitioned to 100G. We believe this will obfuscate demand and visibility in 2019. We currently expect demand in the first two quarters of the year will be sequentially down from our most recent quarters. We currently expect the second half of the year to improve over the first. We are still early in the year and visibility is limited.
We continue to ship to and have good relationships with all of our hyperscale customers, and believe we are in a solid position to expand our business with them when market conditions improve. We continue to have strong technical engagement with our customers and are making good progress on developing our next generation of data center products. Last month, we announced the release of a silicon photonics-based 400G optical module that is now currently available for customer sampling. These modules adhere to the requirements of on-board optics and incorporate several new technologies, including an advanced silicon photonics-based Optical Sub-Assembly that is the result of years of R&D effort by AOI and our technology partners. This next-generation module is significant because the suite of technologies it incorporates will enable future similar modules to scale beyond 400G, ultimately to 1.6 Tb per second, thereby enabling continued scaling of our customers' infrastructure.
We gathered very positive feedback while demonstrating early prototypes at the European Conference on Optical Communication last year, and look forward to seeing the customer response after showcasing this technology at OFC next month. We believe the new and innovative technologies that we have developed and cost reduction efforts position us well to continue to expand the reach of our products to a broad group of data center customers and diversify our customer base. While we will always rely on a relatively concentrated number of customers, diversifying our customer base remains a top priority. In the quarter, we had three design wins, including one with a large U.S.-based data center customer, which is a new customer to AOI. This brings our total number of design wins to 26 for the year, including 12 with new customers to AOI.
This exceeds our 2017 totals in both number of design wins and new customer wins, demonstrating the effectiveness of our continuing efforts to diversify our customer base. In our CATV business, we remain encouraged by the customer activity in this market. We generated revenue of $12.7 million, compared with $14.3 million reported in Q4 of last year. This was a result of some weakness in demand, mainly in Europe and Asia, partially offset by demand from North American MSO. In the quarter, we started to ship volume orders for our Remote PHY product, and we remain in active qualification trials with four additional customers for this technology. Our telecom products delivered revenue of $2.8 million, compared with $3.2 million in Q4 of last year. For the quarter, 72% of our revenue was from data center products, 21% from CATV products, with the remaining 7% from FTTH, telecom, and other.
In the quarter, we had four 10% or greater customers, three in the data center business that contributed 38%, 18% and 11% of total revenue respectively, and one in the CATV business that contributed 11% of total revenue. For the year 2018, these same four customers represented 39%, 22%, 12% and 10%, respectively, of total revenue. Moving beyond revenue, in the quarter, we generated gross margin of 24.7%, compared with the 34% recorded last quarter. Our gross margin came in below our expectations due to higher-than-anticipated costs incurred while we worked to resolve the inventory issue we experienced last quarter. Looking ahead, we expect gross margin to improve gradually starting this quarter. Total operating expenses in the quarter were $18.7 million, or 31.8% of revenue, compared with $22.8 million or 40.4% of revenue in the prior quarter.
In the quarter, our operating expenses decreased sequentially due to lower bonus accruals as a result of our performance in the year. Operating loss in Q4 was $4.2 million, compared with an operating loss of $3.6 million in the prior quarter. non-GAAP net loss after tax for the fourth quarter was $0.5 million, or a loss of $0.02 per basic share, compared with a net income of $17.9 million or $0.89 per diluted share in Q4 of 2017. GAAP net loss for Q4 was $8.6 million, or a loss of $0.43 per basic share, compared with a GAAP net income of $5.7 million, or $0.28 per diluted share in Q4 of last year. The basic shares outstanding used for computing the net loss in Q4 were 19.8 million shares. Turning now to the balance sheet.
We ended Q4 with $58 million in total cash equivalents, short-term investments, and restricted cash, compared with $64.1 million at the end of the previous quarter. As of December 31, we had $93.3 million in inventory, a decrease from $107.9 million in Q3. Our cash balance reflects the use of approximately $11.6 million in cash to fund operations during the quarter. We made a total of $19.6 million in capital investments in the quarter, including $17.2 million in production equipment and machinery and $1.6 million on construction and building improvements. This brings our total capital investments for the year to approximately $77.4 million, which was below our most recent $90 million CapEx forecast as we reduced purchases of certain equipment to maintain production volume in line with demand, while at the same time, investing in the additional testing equipment needed to meet the new testing requirements implemented last quarter.
Looking ahead, we expect capital expenditures in 2019 to be approximately $56 million, which factors in a continuation of the construction of our new factory in China. We continue to monitor end market conditions and may adjust our spending plans as necessary. Our total debt at year-end was $84 million, up from approximately $50 million at the end of 2017. Much of this debt is associated with our capital expansion activities, with maturities extending out several years. Just as we continuously monitor our spending plans to match market conditions, we regularly assess our capital structure to ensure we have the right mix of funding for current operations and future expansion. Moving now to our Q1 outlook. We expect Q1 revenue to be between $50 million and $55 million. We expect Q1 non-GAAP gross margin to be in the range of 26.5%-28.5%.
Net loss is expected to be in the range of $3.7 million to $5.8 million, and non-GAAP loss per share between $0.18 per share and $0.29 per share, using a weighted average basic share count of approximately 19.9 million shares. We expect our Q1 effective tax rate on our non-GAAP net income to be between 32% and 40%. With that, I will turn it back over to the operator for the Q&A session. Operator?
We will now begin the question and answer session. To ask a question, you may press star then one on your touch tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Our first question is from Simon Leopold at Raymond James.
Thank you for taking the question here. I think that you made this in the prepared remarks, but I just want to make sure that I clarify. I believe you stated that your relationships with your key web scale customers remain sound. I know there's been a lot of speculation that the Facebook deal that you talked about a year ago has either been revised or changed or canceled. Could you just clarify your standing with Facebook, please?
Yeah, Simon. I can't obviously comment, due to non-disclosure agreements on specific individual customers. However, as we pointed out in our prepared remarks, and I'll say again, we believe all of our major hyperscale data center customer relationships remain intact.
Great. Just to follow on, when you talked about the inventory that's in the channel, is this concentrated with one customer, two customers, three customers? How should we think about the concentration of the inventory buildup you referred to?
Well, I think first of all, we're not the only company that's reported that's talked about this a little bit. I think what we're seeing is kind of consistent across the industry. We see some buildup of inventory across multiple customers, obviously to a greater or lesser extent, depending on which customer you're talking about.
Thanks. One last one, if I might. You recently filed an 8-K regarding modifying some loan agreements, a credit line, credit agreement, and one sentence in there caught my attention that the bank is asking for monthly financial reports rather than quarterly reports. That kind of surprised me. That's sort of a classic yellow flag that somebody's concerned about cash flow. Could you help us understand what was behind that?
Actually, the bank has been requesting that for some time, and I had previously agreed to it at some point when we did another loan agreement. I didn't want to amend just for that one item. I don't think there's really much more to it than that.
Okay. Thank you for taking the questions.
Next question is from Fahad Najam at Cowen.
Thanks for taking my question. Stefan, if you could help us understand in terms of the broader picture, the dynamics in 100G PSM4, the pricing environment, and then also the pricing environment by CWDM4. Do you see the same level of heightened price declines as you saw last year? Is it beginning to normalize? Maybe if you can be a little bit more granular by product markets, that might help us understand what's happening beyond the inventory issues.
Well, Fahad, as you know, we don't guide more than one quarter out and generally not on a product-by-product basis. I think overall, in terms of pricing, what we expect to see this year is for pricing declines to be similar to what they were last year. Perhaps a little bit less, but about the same number. As far as how that's going to break out between CWDM and PSM, again, we're not going to give that sort of guidance on that sort of a granular basis.
If I may ask you, sticking with the broader picture, there's been a certain degree of consolidation in this space. Luxtera got acquired by Cisco. Which is a customer of yours for CATV products. You've got Oclaro that got acquired by Lumentum, ColorChip, which was in the process of being sold to some Chinese buyers, apparently now in financial distress. To that extent, any change in the market and competitive dynamics? Are you seeing a noticeable development in that front? Also, can you comment on any prospective risk of share losses at your customers? Do you think you are maintaining your share, or is this still going to function off quarterly ebbs and flows?
Okay. There's a couple questions embedded in there. I'll try to address them one at a time. First of all, regarding the broader topic of consolidation. I think it's fair to say that customers generally want to have a variety of suppliers to choose from. When that group shrinks, they have less choice and perhaps that could bode well for AOI. I think ultimately their decision is really based on the same kind of decision-making metrics that they've always used in the past and that we've always talked about. Things like the technology roadmap, how well your roadmap aligns with their future needs, and price and quality, things like that. On balance, I think the consolidation is probably neutral, but it doesn't hurt AOI, I would say. You asked specifically about Luxtera or Cisco's acquisition of Luxtera.
I think I can just say, on that front that AOI hasn't supplied any products to Cisco that would compete with Luxtera's products. As you mentioned in your question, we're a supplier mainly of cable TV products, and to my knowledge, Luxtera didn't have any of those products. I don't think there's really any risk to AOI's business there. There was one more question in there. I forgot what it was, Fahad. I'm sorry. Could you back up?
If you can comment on the share, your respective share at your hyperscale customers. Do you think you're maintaining share at each of those customers?
Again, we obviously can't comment on specific customers. What I can say is we have very good relationships with all of our large hyperscale customers, as we mentioned in our prepared remarks. I think what we're really excited about now is as those customers start to look ahead to 200G and particularly 400G, the level of discussion that we're having, very detailed discussion and the tenor of that discussion, I think is very promising for us. We're excited about that transition, and I think there's no indication that we're not going to be a major part of our customers' plans, both in the nearer term and in the longer term.
Appreciate the answers. I'll cede the floor.
Once again, to ask a question, you may press star, then one on your touch-tone phone. Our next question comes from Dave Kang at B. Riley.
Hey, guys. This is actually Lee Krowl filling in for Dave Kang. Thanks for taking my questions. First off, I just wanted to ask, maybe it's a little more trivial, but with this tepid near-term demand trend, is it your expectation that you'll still be able to double 100G volume in 2019 versus relative to your prior comments?
When we say that the demand picture in the second half of the year particularly is uncertain, that's exactly what we mean. I wouldn't want to put a mark on the map, so to speak, in terms of where we think we can go. I think the near-term demand is looking muted, that's for sure. There are some very positive developments that could happen in the second half of the year that we're working through with some of our customers to try to see how that goes. We've talked in the last few earnings calls, and actually if you go back for a year or so, about an increasing cadence of new design wins. To the extent that some of those design wins could start to contribute, particularly later in the year, that could be very exciting.
Again, the visibility is limited, as we said, I wouldn't want to give you an indication based on that limited visibility.
Got it. Then I guess you sort of answered it, you kind of indicated Q1 ticks down leading into Q2, kind of indicating the trough in terms of revenue. Are there any specific demand drivers in the second half you could point to that would give you the confidence that revenue can grow sequentially in Q3?
Yeah. We're hearing indications of early adoption of 400G technology by certain customers, for example. We're also very excited about the progress that we're making in terms of 5G technology. That's probably more of a 2020 thing, but that telecom market is one where we haven't been a major player previously. I think it doesn't take a lot of design wins and sales into that market to really improve our dynamic there. We talked also about Remote PHY. I think there's every indication in the CATV market that Remote PHY technology is going to be a bigger part of the second half of the year, certainly than it is in the first. There's a number of positive demand trends there. I think counterbalancing that obviously is the uncertainty surrounding particularly China.
Again, we're certainly not the only company that's talked about an uncertain demand environment in China. I think many of our customers there are looking at the potential of a slowing economy over there and sort of reevaluating their plans around what they think that means for their business. They're all in a process of trying to make that determination. I suppose the upside of the number of design wins and things that we have, the downside risk is we're not quite sure how things in China are going to go. I will point out in terms of China, historically a large percentage of our revenue has not derived from China.
A number of our newer design wins have been, however, in China, so it's not so much that we're going to be losing the existing business there, but that some of the design wins that we expected to kick in earlier in the year now look like they may be a little later in the year, and the extent to which they occur is a little difficult to calibrate at this point.
Got it. Just the last one from me. Could you maybe talk about the inventory situation and maybe delineate the inventory backup in the channel, 40G relative to 100G?
I think the inventory backup is probably more about 100G than it is about 40G. I can't really quantify that exact backup for you.
Got it. Thank you for taking my questions.
No problem.
The next question is from Richard Shannon at Craig-Hallum.
Thanks, Tom, Thompson, Stefan, for taking my questions. I apologize, I jumped on the call a little late, so I may have missed some things. First of all, Stefan, did I hear you say that 100 Gb was 72% of data center?
I believe that's right. Let me just check the number here. Data center was 72% of our revenue. You were asking about 100 Gb versus 40 Gb?
Yes, please.
Let me find that number for you. 60% of our data center revenue is from 100 Gb and 38% from 40 Gb.
Okay, 60% is up quite a bit from 34% the prior quarter then, right?
That's correct. Yep.
Okay, excellent. Let's see. You talked about a design win with a large U.S. data center customer. Can you describe that in any detail, like specifically on speed and how you expect that to progress to eventually generating volume revenues there?
I can't give too many details. As you can imagine, we're under nondisclosure agreement with this customer. I would classify this customer as a recognizable name, it's not one that is as big in terms of scale as some of our other larger hyperscale data center customers. This is a smaller customer. It's likely to not be contributing as meaningfully, certainly, as some of our other larger data center customers. However, I think it's worth pointing out that what we're really trying to demonstrate here is that our efforts towards broadening our customer base are being successful. We're adding new customers, we're getting design wins and new business coming from these customers. Yes, it's fair to say that many of those customers aren't going to be as big as some of our previously announced large hyperscale customers.
There just aren't that many of those types of customers out there. Over time, incrementally, with a lot of hard work and attention to these customers' needs, we're managing to gain a strong foothold in a wider swath of customers, which I think long-term is really what's very healthy for AOI.
Okay. That's helpful. Thanks for that. A couple more from me. Stefan, can you help us understand the exposure, I don't know if you want to talk about it in terms of when you'll see it or mix at the end of the year, whatever, but your contributions you could see from 200 Gb and 400 Gb.
Yeah. 200 Gb, I think we've been pretty consistent in saying that 200 Gb is going to be a relatively small market. There are a few customers who are certainly interested in it, some who have purchased from us or are purchasing from us. I think it's likely to remain a relatively small part of the market. I think 400 Gb is a much bigger potential market. I think that's the next stepping stone for a lot of our customers. As I said earlier, I think we see a lot of interest in 400 Gb from some customers. Some customers are indicating that they would like to see that 400 Gb in production later in the year. We'll see. We're certainly working very hard to achieve that timeframe, and I'm sure our competitors are as well, so that hopefully that ecosystem will be there.
Hopefully the customer decides to take that leap because I think it's an important stepping stone for AOI and the industry.
Okay. Helpful. My last question, probably for you, Stefan, on gross margins. I don't have all the details, given I was just traveling to get to my office here. How should we think about gross margins trending from the levels of first quarter guide? I think you said it's going to grow in the second quarter. Then think about the context of where you have been the last couple of quarters and your previously communicated goals of, I think it was in the high 30s or low 40s, honestly, I can't remember. If you can help us think about the context of gross margins with that'd be great, please.
We do expect gross margins to gradually improve starting this quarter. I think a lot of the uncertainty that we have regarding sort of revenue and general market conditions also extends a little bit to gross margin. I think generally speaking, what we'd expect to see is improvement in gross margins throughout the year. In order to get to those higher gross margins, we need to work our way through all the additional testing measures that we've talked about. As we said in our prepared remarks, that should be largely finished by the end of this quarter. We're going to continue insourcing more of the bill of materials that we've been building in line with our previous goals.
I think some of those insourcing efforts took a back seat towards the additional testing and implementing some of the changes to our processes that needed to be implemented. As we resume that, I think we'll be able to see some of the benefits of that falling to the gross margin line as well. As far as where we see gross margins going in the future, again, I think the range of high 30s to low 40s is an achievable range for us. I don't want to put a timeframe on when we can get there, but I think it's achievable.
Okay. Thank you for that. That's all the questions from me. I'll jump out of line.
At this time, we show no further questions. I will turn the call over to Dr. Thompson Lin for closing remarks.
Okay. Thank you for joining us today. As always, we thank our investors, customers, and employees for your continuous support.