Hello, welcome to the Applied Optoelectronics 3Q18 Financial Results Conference Call. All participants will be in listen-only mode. Should you need operator assistance, please signal a specialist by pressing star then zero on your touch-tone phone. After today's presentation, there will be an opportunity to ask questions. To ask a question, you will press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note, this event is being recorded. I'd now like to turn the conference over to Maria Riley, investor relations for AOI. Please go ahead, ma'am.
Thank you. I am Maria Riley, Applied Optoelectronics investor relations, I am pleased to welcome you to AOI's third quarter 2018 financial results conference call. After the market closed today, AOI issued a press release announcing its third quarter 2018 financial results and provided its outlook for the fourth 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 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, Dr. Stefan Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give an overview of AOI's Q3 results, Stefan will provide financial details and the outlook for the fourth 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 terminology such as may, will, should, expects, plans, anticipate, 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 confirm these statements to actual results or to changes in the company's expectations.
More information about other risks that may impact the company's business are set forth in the risk factors section of the company's reports on file with the SEC. 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 non-GAAP measures, as well as our discussion of why we present non-GAAP financial measures, are included in our earnings press release that is available on our website. Before moving to the financial results, I'd like to announce that AOI management will attend the Needham Network and Security Conference on November 13th and the Raymond James Technology Conference in New York on December 4th.
We hope to have the opportunity to see many of you there. Additionally, I'd like to note the date of our fourth quarter 2018 earnings conference call is currently scheduled for Thursday, February 21st, 2019. 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, everyone, for joining us today. In reviewing our third quarter results, AOI delivered revenue of $56.4 million and gross margin of 34%, which brought our net income to $2.7 million, or $0.14 per diluted shares. As we announced in September, our revenue was below our expectations due to an issue we identified with a small percentage of 25G lasers, which led to a temporary delay in 100G transceiver shipments to a data center customer. As we worked to troubleshoot the issues, we enact a solution quickly, and with agreement of this customer, resumed shipments. The delay, however, resulted in softer-than-expected data center revenue of $39 million. We continue to have active engagement with this customer and believe we have a strong relationship. Here at AOI, we are committed to a high standard of product quality and customer support.
We believe our customer appreciate the measure we take to thoroughly resolve any issues and our willingness to go above and beyond. While we are disappointed with our third quarter performance, we remain encouraged by the demand we are experiencing with our other data center customers. In CATV, we are also pleased with increased activity and interest we are seeing in this market, especially for our Remote PHY products. We have continued to focus on expanding the reach of our products to a broad group of customers and diversifying our customer base. We are pleased with the progress we continue to make on this front. Building on the large design wins with the data center operator in China that we announced last quarter, in Q3, we secured seven new design wins.
This brings our total number of design wins to 46 for the year. Which includes design wins for data center and other segments. We also continue to make progress on innovating across our optical platform, expanding our vertical integration. We believe our platform, proprietary manufacturing process, and vertical integration are keys to our success in the market. We remain focused on building on these strong foundations. With that, I will turn the 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 was $56.4 million, compared with $88.9 million in the prior year period. Our data center revenue was $39 million, compared with $65.8 million in Q3 of last year. As Thompson mentioned, our revenue in the quarter was impacted by a temporary delay in 100G transceiver shipments to a data center customer as we worked to troubleshoot an issue we identified with a small percentage of 25G lasers. We hold ourselves to a high standard and acted to resolve the quality issue. We determined less than 1% of the lasers were impacted, implemented a solution, and continued shipments using our internally sourced 25G lasers to the customer. We believe the measures we took to resolve this issue reflect our strong commitment to our customers. Shipments have resumed to this customer, and we continue to have ongoing discussions and active engagement.
Our production capacity in Q4 is expected to continue to lag demand, and this is reflected in our Q4 guidance. The production capacity in Q4 will be negatively impacted primarily by additional product testing steps that we have implemented in order to further reassure our customer base that we have eliminated any potentially troublesome laser devices from our inventory, including work in process. Most of these additional testing steps are temporary measures to screen existing inventory. In addition to the reduced production capacity, these costs will also temporarily increase our cost of goods sold and thus negatively impact our gross margin in Q4. We continue to experience good demand with our other top data center customers and began shipping volume orders to a large Chinese data center operator.
In the quarter, 63% of our data center revenue was derived from our 40G transceiver products, and 34% was from our 100G products. We continue to work diligently to diversify our customer base and remain in active qualification for our 100G and 200G products with customers outside of our core hyperscale customer base. In the quarter, we secured seven design wins, including four design wins with two large U.S.-based equipment manufacturers. This brings our total number of design wins to 46 for the year, which includes design wins for data center and other segments. As a reminder, our transceiver customer base has historically been focused on direct sales to data center customers. These design wins with equipment OEMs are an important step as we continue our push to diversify our customer base. In our HFC business, we continued our momentum in the quarter due to ongoing upgrade projects.
We generated revenue of $14.3 million, up slightly sequentially and below the record $18.9 million reported in Q3 of last year. We are very encouraged by the customer activity we see in this market, especially with our Remote PHY product. We are currently in trials with five customers for our Remote PHY product, and these trials appear to be going well. At the recent SCTE-ISBE Cable-Tec Expo in Atlanta, AOI was the first company to demonstrate Remote PHY capability to 1.7 gigahertz, which is a significant technical achievement that will allow MSOs to unlock additional revenue-generating spectrum already installed in their plants. This technology was well received by many attendees at the conference. Our telecom products delivered $2.7 million in revenue compared with $3.5 million generated in Q3 of last year.
For the quarter, 69% of our revenue was from data center products, 25% from CATV products, with the remaining 6% from FTTH, telecom, and other. In the third quarter, we had four 10% or greater customers. Three in the data center business that contributed 31%, 22% and 15% of total revenue, respectively, and one in the CATV business that contributed 15% of total revenue. Moving beyond revenue, we generated a gross margin of 34%, a decrease from the 40.4% reported last quarter. Our gross margin came in below our expectations due primarily to capacity underutilization while we worked to resolve the inventory issue we experienced this quarter. Additionally, we incurred approximately $1.5 million in inventory write-downs related to the quality issue. Looking ahead, we expect our gross margin to decline in Q4 due to the temporary increases in testing costs I mentioned earlier.
We expect these additional costs to largely be eliminated by the end of the year, and margins are expected to improve starting in Q1. Longer term, we remain committed to our 40% gross margin target. Total operating expenses in the quarter were $22.8 million or 40.4% of revenue, compared with $20.8 million or 23.7% of revenue in the prior quarter. The sequential increase was mostly due to higher R&D expense incurred to troubleshoot and resolve the issue we experienced in the quarter. We expect R&D to remain at an elevated level for a few quarters as we continue to invest in new technologies and improve our execution.
Our operating loss in Q3 was $3.6 million compared with operating income of $14.7 million in Q2 of 2018. Non-GAAP net income after tax for the third quarter was $2.7 million, or $0.14 per diluted share, compared with income of $12.9 million or $0.64 per diluted share in Q2 of 2018. GAAP net loss for Q3 was $3.7 million, or a loss of $0.19 per diluted share, compared with GAAP net income of $8 million or $0.40 per diluted share last quarter. The Q3 weighted average fully diluted share count was approximately 20.2 million shares. We recognized approximately $0.6 million in tax benefit from employee options that were exercised and restricted stock that vested during the quarter. Turning now to the balance sheet.
We ended Q3 with $64.1 million in total cash equivalents, short-term investments and restricted cash, compared with $77.9 million at the end of the previous quarter. As of September 30, we had $107.9 million in inventory, an increase from $93.3 million in Q2. The increase is largely due to products in production that could not be completed during the quarter due to additional reliability testing time required. Operating cash flow in the quarter totaled $7.5 million, compared with $8.1 million in Q3 of last year. We made a total of $21.4 million in capital investments in the quarter, including $14 million in production equipment and machinery, and $6.7 million on construction and building improvements. This brings our total capital investments year-to-date to $57.9 million. Before turning to our outlook, I would like to make a few comments on the tariff situation with China.
AOI uses a variety of raw materials and manufactures a diverse set of products. While a small number of these are on the tariff list, we believe there will be minimal impact overall from tariffs on AOI's business. If the tariff situation changes, we continue to believe that we are well-positioned to adapt and plan for such contingencies. As you know, all three of our locations are capable of manufacturing transceivers, with Taiwan and China both capable of manufacturing these products in high volume. Moving now to our Q4 outlook. We expect Q4 revenue to be between $56 million and $63 million. Non-GAAP gross margin is expected to be in the range of 30%-31%.
Non-GAAP net income is expected to be in the range of a loss of $1.5 million to income of $0.7 million, and non-GAAP EPS between a loss of $0.07 per share and earnings of $0.04 per share using a weighted average fully diluted share count of approximately 20.1 million shares. We expect a Q4 income tax benefit of between $1.4 million and $2 million. With that, I will turn it back over to the operator for the Q&A session. Operator?
Yes. Thank you. We will now begin the question-and-answer session. To ask a question, you may press star, then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press stars and two. At this time, we will pause momentarily to assemble the roster. The first question comes from Simon Leopold with Raymond James.
Great. Thanks for taking the question. As I understand it, the fourth quarter is affected by the capacity limitation. Basically, the bottleneck is around the new quality control and testing that you have to do in order to assure that you've resolved all the problems. Is that the correct way to think about it?
Yes, Simon, that's correct. Just to put a little more color on it, as we mentioned, a lot of the additional testing steps that we're implementing in the quarter are temporary steps. That is, we're having to screen existing inventory work in process, and that's what's temporarily affecting us in Q4. There will be some ongoing additional testing steps, but those are expected to be much less than what we're seeing in the fourth quarter.
Presumably, this prevents you from achieving the $125 million commitment that you disclosed in the 8-K at the beginning of the year. I guess what I'd like to try to understand is how does that dovetail into the contractual agreements? Is there some catch-up that then shows up at some point in 2019? Is the contract voided because of the issues? Could you help us understand the relationship between these two events?
What I could say is that we think we'll probably deliver around $90 million of that $125 million this year. We continue to have a very strong relationship with this customer as well as our other data center customers. We're working through this issue with them.
I guess what I don't understand is, based on the way the contract's structured, is there sort of a make good where basically the gap between 90 and 125, that $35 million, does that get added to 2019? Should we think of it that way, or should we think of it as that business is gone? How should we treat that?
Simon, I can't give you too many specifics on it other than to point out that the contract was filed along with the 8-K, so you can read most of those provisions in there. There isn't a specific provision in there, to my knowledge, that would be consistent with sort of catch up in the way that you're describing it. As I mentioned, this customer continues to work very closely with us and they've agreed to take the commitment that they had given us in the fourth quarter, and we're still working with them on time periods beyond that.
Great. You did address this in your prepared remarks, but I want to make crystal clear that I understand. In terms of the gross margin in the fourth quarter, it's really the effect of the extra testing. When you talked about the 40% gross margin as your long-term target, I presume, essentially, the pricing environment, your pricing agreements and commitments are unchanged from your prior assumptions. Therefore, once you get past this extra testing and these certifications that you're doing for quality control, that the ultimate pricing environment and that 40% kind of gross margin is what we should think about beyond the fourth quarter?
Yes, that's correct. The additional testing steps are what's negatively impacting us in the fourth quarter. The pricing environment was consistent with what we had expected. We think that we can get back to that 40% gross margin target sometime in the future.
Just one last one, if I might. In terms of the shortfall in your revenue versus what we all once expected, is it your sense that essentially that demand was unmet, or do you suspect or have reason to believe that a competitor took that business? Thank you.
I think it's reasonable to believe that some of the business went to a competitor in the quarter. Obviously, all of our customers have needs in terms of their data center requirements, and if one of their suppliers can't deliver it, then I think it wouldn't be surprising to see that a competitor picked up that share, at least temporarily.
Great. Thanks for taking my questions.
Thank you.
Thank you. The next question comes from Paul Silverstein with Cowen and Company.
Stefan, I'm sorry to revisit the issue, I suspect we're all going to be revisiting the issue on this call. In terms of the specific problem, I think what you referenced 25 gig lasers. Can you give us any more insight, and why was this isolated to that particular customer? I assume there's one or more lines that are dedicated to that customer as opposed to other customers. What is the nature of the issue? With respect to your other customers, I assume there's concern if you had an issue with one customer, even if it was a small number of lasers, why aren't other customers concerned? Why should they believe this is isolated and therefore is not a larger issue? Why shouldn't that in turn impact your revenue with those customers now and in the future? What insight can you share with us?
Yeah, I think, Paul, that basically, obviously, I can't go into too many customer-specific details about this because we're covered by non-disclosure agreements with virtually all of our customers. In very broad terms, every customer that we have has different sort of requirements. They operate in different environments, and they have different expectations in terms of the performance of these devices. Again, that's a very general statement. I recognize that, I can't be more specific given the non-disclosure agreements that we have in place. Within that context, every customer has different requirements, environments, and expectations. We haven't seen this problem cropping up with other customers. We've been proactive in going out to all of our major customers and discussing with them what we found.
I think the one thing that I can say is I'm very proud of the team that we have here in terms of addressing this issue very quickly. I think our customers appreciated not only the speed at which we were able to address the problem, but our proactiveness, if you will, in going out and talking to the other customers and giving them the data, being very transparent about what we found.
Stefan, the direct follow-up question would be, I trust you don't believe that the issues impacted your business with other customers or has it?
That's correct. I don't believe that it's affected our business with other customers.
If we look at your other-- Well, you know what? I'll pass it on to others, and I'll come back. Thank you.
Thank you. The next question comes from Mark Kelleher with D.A. Davidson.
Great. Thanks for taking the questions. Maybe we could talk more generally about the competitive environment. You mentioned that you thought maybe some competitor had taken some of that market share there. What are the pricing trends you're seeing? Are they consistent with what you've been expecting? Are you seeing any new competitors come into the market?
No. Pricing trends are consistent with what we'd expected. No, I don't really see any new competitors coming into the market.
All right. The new Chinese data center customer, you said that did begin ramping in the quarter?
That's correct. Yes.
Do you expect that data center customer to be similar in opportunity to the U.S. data center customers?
Yeah. It's a customer that definitely has the potential to be as big as any of the other data center customers that we have in the U.S. It's one of the very largest data center operators in the world.
Okay. Maybe just a few thoughts on the CATV. Talk about what your expectations are there. I know you kind of highlighted that a little bit.
Yeah, I think we just recently finished the SCTE, the Society of Cable Telecommunications Engineers Expo, which is sort of a technology conference for the cable TV business. It was earlier in October. We had very good commentary, very good receptivity, I guess you could say, to our Remote PHY product. In particular, we were showcasing a 1.7 gigahertz Remote PHY product at the show. To my knowledge, we were the only supplier that had such a product. I think we're seeing very positive trends in the cable business. A number of the MSOs are either undergoing upgrade projects currently or are about to embark on upgrade projects. That's true for North American MSOs as well as MSOs in Europe and Latin America as well.
We're seeing very positive signs in terms of both our existing products, our DOCSIS 3.1 products, and this emerging new Remote PHY product.
Okay, great. That's it for me.
Thank you.
Thank you. The next question comes from Alex Henderson with Needham & Company.
Thanks. I was hoping you could talk conceptually about how we should be thinking about the CY 2019 timeframe relative to the resolution of this issue and what the snap back might look like. Is it reasonable to think that as we get fully through the testing process, and start to move into 2019, that ultimately you would get back to the type of numbers that had been out on the street beforehand and the expectations that you had kind of implied for next year, where you would be seeing a doubling of demand in the 100G from 2018 to 2019?
Alternatively, are we so constrained by the current situation that we haven't been able to add capacity at a rate that would have got us to that 2019 level, that means that we'll be operating at a much lower level because we haven't been able to take our resources and ramp them in the third quarter and fourth quarter because of the troubleshooting problems?
No, as I mentioned earlier, the additional testing that we've implemented is primarily confined to part of the third quarter and the fourth quarter. Beyond that, there won't be a lot of additional testing that we'll be doing, and certainly it's consistent with our ability to continue to ramp our production capacity. If you look at our overall, we don't give specific guidance more than one quarter out, as you're aware. In general, we still think that the volumes can double next year compared to this year. Admittedly, that's on a little bit lower base now because we missed some of the volume shipments that we expected to have in the third and fourth quarter, but we still expect it to be able to double into next year.
Is it reasonable to say that you think you could double relative to your prior expectations before you ran into this issue? In other words, that your capacity would be there to supply the original expectations once this totally is resolved, assuming it's resolved by year-end, therefore would be back to prior thought process, to double your volume from your original expectations as opposed to from the lowered base.
The capacity will be put in place as needed to be able to achieve the demand that we see at the time. We don't have to add capacity now to have it ready by the end of next year, for example. We're continuing to evaluate the needed capacity and add it as we need to. With respect to doubling, it's really too early to have a crystal ball for the entire next year. I think there's certainly scenarios where we could double based on our prior expectations. We feel comfortable saying we think we can double, given where we actually came out in 2018 or where we expect to come out in 2018.
Do you think that there's any lingering share loss as a result of this with the core customer that you were working with to resolve the issue with? Or is this just a divot in the trajectory and you're back to where you would've been otherwise once it's fully resolved?
It's hard to say right now. We're still working through this, I can't really say for sure at this point. What I can say, what's really important for us is continuing to diversify our customer base, right? We've made great success in that, as Thompson highlighted, I mentioned in my remarks as well. We have seven design wins in the quarter. Three of those were for 200G products. Several of them were with a new class of customers, that is large equipment manufacturers as opposed to data center operators. I feel very good where we are with our efforts in terms of customer diversification, both in terms of new products, new customers, and new classes of customers that is non-data center operators, for example. I think that effort is what's been taking primacy for us.
It's our most important effort right now, besides, of course, getting back on track relative to deliveries to the customers that we have now. I think long term, that's really the most important thing for all of us to keep in mind for our business.
One last question. I know you don't guide out to 2019, but for the tax rate, I think you'd talked about 16% in the past. Is that still kind of the ballpark that you are thinking for 2019?
It sounds about right. Actually, we haven't done our planning process in detail for 2019, so it's a bit early to give you a precise guess on the tax rate, but that sounds not unreasonable.
Great. I'll cede the floor. Thank you.
Thank you.
Thank you. The next question comes from James Kisner with Loop Capital Markets.
Hi, thank you. I just want to talk about the balance sheet a little bit. It looks like you burned some cash here in Q3. I'm just wondering what you're expecting for cash burn in Q4. Obviously inventory built up a little bit with this product issue. Are you anticipating you might have to write some of it off? Are you expecting to be able to fill it all and just kind of relatedly, what are your plans for CapEx? Are they adapted at all here, just given the cash flow pressure in the near term? Thank you.
Yeah. There's two questions embedded in there. First of all, in terms of the cash balance, it was lower at the end of the quarter. A lot of that went into inventory. As we mentioned, we had a lot of inventory that was partway through the manufacturing process, and we weren't able to ship all of that out or complete the manufacturing and ship it all out in the quarter, we expect that will come back down from here. We think Q3 was probably the high water mark in terms of inventory. That'll start turning back into cash, I think, as we move forward. You asked a question about capital expenditures, and as I kind of mentioned in my previous answer, we are evaluating our capital expenditures and the need to add additional equipment and what have you, as we see the demand shaping up.
We don't have to buy equipment a year in advance in most cases, for example. We can do that much quicker as we see the demand shaping up. Really, our CapEx is defined by what we see in terms of demand over the next two of quarters, and we'll continue to adjust that as we need to. I thought there was another question embedded. Oh, you asked about inventory write-downs. We had about a million and a half dollars of inventory write-downs or reserves in the quarter. I suspect most of that should already be. I mean, that's already flushed out in the balance sheet now. I wouldn't expect huge inventory adjustments in the fourth quarter, but a lot of that depends on the testing that we have ongoing at this point.
Okay. That helps. You alluded to this a little bit. I mean, there's been a lot of talk about slowing hyperscale demand in general, and just given you're not shipping recently, maybe you just don't have a good view on that. Just any general thoughts on the hyperscale demand environment as we exit the year and begin kind of Q1. Are you seeing kind of a slowdown that other folks are also seeing? Thank you.
I mean, a lot of people have had slowdowns or talked about slowdowns in particular customers. What matters for us, I think, is that we have a few data center customers, but we don't have all of them yet. In particular, we talked about this Chinese data center operator and a few other operators that we're working very diligently to get. I think what matters to us mostly is continuing to diversify and adding new customers. Whatever happens with our existing customer base, these customers, of course, they're very quick to react. They're very diligent about managing their needs in terms of bandwidth. They change their forecasts up and down all the time.
The best thing that we can do to react to that, I think, is to get a more diversified customer base and make sure that we can average out any fluctuations that we might see over a larger number of customers. Particularly if we can get customers that are in different segments, like for example, the equipment manufacturers that we talked about earlier. They're primarily selling to an enterprise-type data center market. That's a completely different dynamic, and I think one that will help continue to further allow us to minimize our risk associated with any one large customer.
Okay. Thank you.
Thank you. This concludes our question and answer session, I would like to turn the floor back to Thompson Lin for any closing comments.
Again, thank you for joining us today. As always, we thank our investors, customers, and employees for your continued support.
Thank you. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines.