Good afternoon. My name is Jaime, and I will be your conference operator today. At this time, I would like to welcome everyone to Applied Optoelectronics first quarter 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, you may press star and then one using your telephone keypad. To withdraw your question, you may press star and two. Please also note that today's event is being recorded. At this time, I'd like to turn the conference 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 first quarter 2018 financial results conference call. After the market closed today, AOI issued a press release announcing its first quarter 2018 results and provided its outlook for the second 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, and Dr. Stefan Murry, AOI's Chief Financial Officer and Chief Strategy Officer. Thompson will give an overview of AOI's Q1 results, and Stefan will provide financial details and the outlook for the second 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, 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 business are 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 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 AOI management will attend the Cowen Technology, Media & Telecom Conference in New York on May 30th. We hope to have the opportunity to see many of you there.
I'd like to note the date of our second quarter 2018 earnings call is currently scheduled for Tuesday, August 7th, 2018. 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. I'm reviewing our first quarter result. AOI delivered revenue of $65.2 million and gross margin of 40%, which led to net income of $5.6 million, or $0.28 per diluted share. Our revenue came slightly below our guidance as the delivery of certain orders slipped into Q2 due to higher than expected employee turnover in our China factory as a result of the Chinese New Year. This order has been shipped in Q2. On a more positive note, market trends were in line with our expectations. We currently believe the fourth quarter represents the bottom of the declining data center demand we have seen over the past few quarters. Data center inventory condition has begun to normalize, with our expectation being that inventory level will return to more normal level later this year.
We also currently expect 100G volumes to more than double in the second half of the year over the first half as we deliver on the committed orders we announced last quarter. We also made good progress in diversifying our customer base with nine design wins, including five for our 100G products, and some of these design wins were with new customers. In order to meet our customers' needs, AOI has continued to innovate both in new product development as well as in advanced automation and manufacturing process. Our recently announced 200G PAM4 PIN photodiode array is a great example. With this new technology, AOI now controls production of both the laser and the photodiode array, which were the most critical and expensive components required in the production of 200G and 400G transceiver.
We believe our continued innovation, vertical integration, and our proprietary manufacturing process together set AOI apart from our competitor as a cost and quality leader in this highly competitive industry. With that, I will turn the call over to Stefan to review the details of our Q1 performance and outlook for Q2. Stefan?
Thank you, Thompson. Total revenue for the first quarter was $65.2 million, compared with $96.2 million reported in Q1 last year. As Thompson mentioned, our revenue came in below our expectations due to slight delays in the completion of some orders as we worked through higher-than-expected employee turnover in our China factory. As you may know, many of our products are manufactured in our Ningbo, China factory, which experiences a shutdown during the Lunar New Year. After the holiday, it is typical for some employees to fail to return to the factory on time or at all. This can affect our ability to produce sufficient products to meet our demand, which was the case this quarter.
Because we needed to recruit and train a larger number of employees than usual, the process of bringing these new employees to full productivity took longer than expected, and some orders were delayed as a result. We worked closely with our customers to avoid any impact on them from these delays, which were only a few days in duration. Looking ahead, as Thompson mentioned, we believe that unit sales of our 100G products will more than double in the second half of 2018 compared with the first half. This estimate is based largely on the committed orders we announced last quarter. While there will be some price reduction as volume increases this year, we believe that the percentage reduction in price over this time period will be less than we saw last year.
In Q1, our data center revenue came in at $50.6 million, compared with $79.6 million in Q1 of last year. In the quarter, 41% of our data center revenue was derived from our 100G transceiver products, compared with 35% last quarter. 53% was from our 40G products. We continue to maintain focus on diversifying our customer base. In the quarter had nine design wins, including five for our 100G products. We believe our cost leadership, scalable production capacity, in-house component supply, and track record of innovation will allow us to be successful in these customer engagements. As Thompson mentioned, AOI continues to innovate and expand our product portfolio. We recently announced the development of a 200G PAM4 PIN photodiode array that can be leveraged to produce 200G and 400G transceivers based on 50G per lambda technology.
With the development of this new technology, AOI now manufactures the two most expensive components required to produce 200G and 400G transceivers in-house, enabling us to maintain low cost and reduce our time to market for these products. Regarding cost reduction on our current 100G products, during the first quarter, AOI successfully transitioned a majority of the optical multiplexers used in our CWDM data center transceivers to in-house produced parts. By the end of Q3, we expect the majority of the demultiplexers to be sourced internally as well. Together, the multiplexer and demultiplexer pair represents the second highest cost material in our CWDM modules, just behind the active optical components. By transitioning these to in-house produced parts, we are realizing significant cost reduction on these high-value components.
This continues our strategy of vertical integration, as we have now brought the lasers, the photodiodes, and the mux in-house, with the demux to follow in Q3. The cost advantage, time to market, and flexibility afforded us by bringing these components in-house is a significant factor in our success, and one that is a source of competitive advantage with our customers. At OFC, we showcased our full suite of next generation technology, including our 200G and 400G transceiver products and 100G EML and DML lasers, and we are very encouraged by the customer response. We also discussed during our OFC investor session our new 400G high-density light engine assembly, which extends our 40G and 100G platform to 400G. We expect to leverage this mature, high quality, and low-cost platform for years to come.
Turning to our cable television market, we generated revenue of $10.6 million compared with the unusually strong $13.1 million that we generated in Q1 of last year. Looking ahead, we continue to anticipate growth in this market, especially as demand for Remote PHY picks up later this year. Our telecom products delivered revenue of $3.6 million, compared with $3.2 million in Q1 of last year. For the quarter, 78% of our revenue was from data center products, 16% from CATV products, with the remaining 6% from FTTH, telecom, and other. In the first quarter, we had three 10% or greater customers in the data center business that contributed 36%, 26%, and 14% of total revenue respectively. Moving beyond revenue, we generated a gross margin of 40%, which represents a decrease of 100 basis points, compared with the 41% reported last quarter.
Our gross margin came in slightly below our expectations due to capacity underutilization during the Chinese New Year and higher than anticipated costs for training new employees in Ningbo. Total operating expenses in the quarter were $20.1 million, or 30.8% of revenue, compared with $18.9 million, or 23.7% of revenue in the prior quarter. The sequential increase was mostly due to higher R&D expense as we invested in new production technologies that will enable further cost reduction on our transceiver products, as well as 200G, 400G, and Remote PHY products. As a reminder, we expect R&D to remain at this level over the next few quarters while we focus our efforts on these initiatives. Operating income in Q1 was $6 million, compared with operating income of $13.8 million in Q4 of 2017. Our operating margin in the quarter was 9.2%, compared with the 17.3% reported in Q4 of 2017.
During the quarter, we had a larger-than-expected foreign exchange loss associated with the settlement of intercompany accounts receivable balances. This negatively impacted our non-GAAP income by approximately $1.2 million. Non-GAAP net income after tax for the first quarter was $5.6 million, or $0.28 per diluted share, compared with $21.8 million, or $1.10 per diluted share in Q1 of 2017. GAAP net income for Q1 was $2.1 million, or $0.11 per diluted share, compared with GAAP net income of $19.8 million, or $1 per diluted share in Q1 of last year. The Q1 weighted average fully diluted share count was approximately 20 million shares. We recognized approximately $0.3 million in tax benefit from employee options that were exercised during the quarter. Turning now to the balance sheet.
We ended Q1 with $83.3 million in total cash equivalents, short-term investments, and restricted cash, compared with $84 million at the end of the previous quarter. As of March 31, we had $92.6 million in inventory, an increase of $16.9 million from Q4. The increase in inventory is primarily attributed to higher work in process as we prepare for expected demand in Q2 and the second half of the year. We made a total of $9.7 million in capital investments in the quarter, including $7.5 million in production equipment and machinery and $2.1 million on construction and building improvements. We continue to expect our capital expenditures in 2018 to approach $109 million, with the construction of our new factory in China accounting for most of the increased spend compared to last year. Moving now to our Q2 outlook.
We expect Q2 revenue to be between $75 million and $81 million, and non-GAAP gross margin to be in the range of 39.5%-41%. non-GAAP net income is expected to be in the range of $7.8 million-$10.4 million, and non-GAAP EPS between $0.39 per share and $0.52 per share, using a weighted average fully diluted share count of approximately 20 million shares. We expect our Q2 effective tax rate on our non-GAAP net income to be between 7%-12%. With that, I will turn it back over to the operator for the Q&A session. Operator?
Ladies and gentlemen, at this time, we'll begin the question and answer session. To ask a question, you may press star and then one using a touch-tone telephone. To withdraw your questions, you may press star and then two. If you are using a speakerphone, we do ask you to please pick up your handset before pressing the keys to ensure the best sound quality. Once again, that is star and then one to ask a question. We will pause momentarily to assemble the roster. Our first question comes from Simon Leopold from Raymond James. Please go ahead with your question.
Great. Thanks for taking the question. A couple things I wanted to check on. One was from a longer-term perspective, I think you've given guidance for gross margin in a range of 41%-45%. You're guiding a little bit below that for the June quarter. I know this is one of the questions we get a lot, given the Facebook commitment, worry about gross margin. Could you talk about the longer-term gross margin trend?
Yeah, Simon, I think we still believe that we can, in the longer term, maintain that 41-plus% gross margin. Part of what's affecting us right now is we have some inventory that we had to buy towards the end of the year and into the first quarter that was at a little bit higher cost than what we expect that inventory to be at in the longer term. That's pulling down the gross margin a little bit in this quarter and in Q2. The other thing, as we mentioned in the call, is we have a number of components that we're going to be bringing in-house. For example, we talked about the multiplexer and demultiplexer pair, as well as the photodiode, and those components will also help us to reduce costs.
We do think we can get back up to that 41% range, but we have a little bit of work to do to get there.
Okay. Did you quantify how much, or can you quantify how much revenue has slid from the March quarter into June? I'm just wondering why, given the timing issues with what happened in March, why the June outlook wasn't a little bit better.
Well, as we noted in the remarks, it's just a couple of days' worth of production. Basically, you could take our sort of average daily production and tack on two or three days to that, and that was the size of the slip. It was not that much. We had significant orders in the quarter, but we just couldn't ship all of them due to the personnel issues that we talked about around Chinese New Year.
Okay. One last one. Arista on its earnings call last week and yesterday at its analyst meeting indicated that it viewed the 100G optical transceiver market as having adequate supply now, and it wasn't clear what exactly they were alluding to. Given your 100G shipments, it doesn't seem as if you've opened up the floodgates. I'm just wondering what you're seeing in terms of the marketplace of new capacity, competitive landscape. Thank you.
Yeah. We continue to adjust our capacity as needed to make sure that we can meet the current demand and the demand that we expect to see in the future. I think we mentioned earlier that we expect the second half to be a pretty strong second half to the year. We're certainly preparing to meet that demand. I don't know if that answered your entire question there, Simon, but
Well, any commentary on competitive landscape, because listening to the supply chains, for example, Fabrinet, it's not clear to us where a significant volume of new supply could be coming from. I'm not seeing it. I'm just wondering what you're seeing in terms of supply from your competitors.
I think there's pretty good evidence that a couple of our competitors have either exited the market or are changing their focus in terms of the way that they attack the market. From that perspective, I think the biggest change that we've seen is those competitors, most of whom weren't really big producers in the first place, but they're basically changing their strategy or getting out altogether. Whereas AOI has been the cost leader in this market. I think we continue to believe that we are the cost leader, and I think in the long term, that's what it takes for us to continue to win these customer engagements, as we mentioned in our remarks.
Great. Thanks for taking my questions.
Thanks.
Our next question comes from Mark Kelleher from D.A. Davidson. Please go ahead with your question.
Great. Thanks for taking the questions. Just to follow up on that last thought there. Let me ask it a different way. Are you seeing any change? A couple have exited, but there are a couple that are still in the market, very aggressively pricing. Have you seen any change in that pricing dynamic?
No, I don't think so. Look, our prices are generally negotiated well in advance, so we think we have a pretty good handle on what the prices are going to be in the future, and we haven't seen anything in the pricing dynamic that's meaningfully changed from what it was before.
Okay. On those personnel issues that you encountered on the Chinese New Year, is that something that caught you by surprise? Is that something unusual? Is that something we should anticipate each March quarter? How odd was that you had that problem?
Well, I think anybody that produces product in China has issues surrounding the Chinese New Year. That is, there's typically factory shutdowns and there's personnel turnover around that time. That's definitely not unique to us, and it's something that we experience every first quarter. What we have to do is take a sort of an estimate on how many employees are going to come back and which employees, how many do we need to hire, and that sort of thing. Obviously, this year we were off by a little more than we expected. I think it's worth mentioning that we've made so much progress over the last couple of years in terms of adding automation and things. If you go back a few years, we had a much larger problem in the first quarter, again, related to Chinese New Year.
This year, while there was some slip, it was relatively minor compared to what we've seen in years past. The way that we're doing that is by improving the automation so that we can retrain and rehire more workers and get them up to full productivity faster. It's also worth noting that this year, the Chinese New Year was a little later in the year than it sometimes is. That also makes it a little bit harder for us to get the employees in the door and sort of get them up to full speed and then still be able to ship by the end of the quarter.
Okay, great. Thanks.
You're welcome.
Our next question comes from James Kisner from Loop Capital. Please go ahead with your question.
Yeah, thank you. I really appreciate the comments about the second half and sort of returning to a normal level, and much more growth, doubling of 100G. Maybe you'd help us, just the overall revenue level for the year. At this point, is it clear to you have visibility that you could actually grow your top line year-over-year versus 2017?
Yeah. We don't really give guidance that far out. It's still relatively early in the year. As we mentioned, I think we're looking at a pretty good second half. A lot of that is based on orders that we have committed, which is unusual for us to have that many committed orders this early in the year. There's still a lot of work to do before we can confidently project what we're going to be for the whole year.
Okay. That's helpful. I guess on inventory, again, appreciate the comments on that. You previously thought that you'd hoped to get kind of to a normal level in the first half, and some things have changed, obviously. Any thoughts on the trajectory of inventory and what that might look at 2 quarters from now, either from a day standpoint or just an absolute kind of rough level of inventory?
Well, I think the inventory will come down on a $ basis. As I mentioned, we had some inventory both in our vendor-managed inventory warehouse as well as some inventory in work in process and inventory in transit, meaning stuff that we had shipped prior to the end of the quarter, but it wasn't received at the customer by the end of the quarter. Those things were the biggest source of the inventory increase over last quarter, and clearly those things will burn down over the next quarter or 2.
Okay, thanks. Just kind of last one here on cable. In numbers, I guess it looks like maybe there was a bit of a inventory correction at your customer, a minor one. One of your biggest customers reported and talked about strength and access, and you obviously didn't see that in Q1. Recognizing Q1 is usually kind of seasonally weak for access, that was unusual. Is your guidance contemplating that business would grow sequentially? I got the sense when you said that later this year, in September, December, you just have to grow year-over-year kind of confirm that as well. Thanks.
The commentary that we had for later this year relative to cable was specifically about the Remote PHY product that'll start ramping later this year. We do expect sequential growth in cable. It's worth mentioning too, that part of the reason why our cable results were a little bit lower than they would've otherwise been, is that we did divert some of the personnel in China that were working on cable TV products and put them on producing some of the data center products, again, to try to make sure that we had minimal slippage on our data center delivery. There were some cable TV orders also that we couldn't deliver in the quarter due to the manpower issues that we discussed earlier.
Okay. I'm sorry, I lied. One last one. Can you give any kind of qualitative sense for the mix of PSM4 versus CWDM4 sequentially? I know you don't explicitly disclose it. I'm just curious about the overall mix. Thanks.
Yeah, we continue to see a trend towards more CWDM and less PSM. I think that's been a pretty consistent theme of ours for a number of quarters. I think there's others in the industry that have said similar things, so this isn't unique to AOI. As far as the exact percentages, as you know, we don't disclose that.
All right. Thank you very much.
Welcome.
Our next question comes from Fahad Najam from Cowen and Company. Please go ahead with your question.
Glad you could squeeze me in. Previous questioner asked all the questions I had. Just one question on, in terms of if we delve into 100G CWDM4 versus PSM4, can you just help us in terms of understanding, is CWDM4 a bigger portion of the mix?
Well, again, we don't really break out that. What we have said is that over time, we expect CWDM to continue to grow, and the PSM will gradually decline.
Okay. Appreciate that. Circling back to a comment that Thompson, you had made earlier, where you said that you expected Q1 2018 to be the bottom in terms of the demand from data centers. Can you help us understand in terms of the second half outlook, are you expecting growth from all your major cloud customers? And in particular, with this one customer that's been, what, 14% of your revenue, they seem to have been declining down. Do you expect that particular cloud titan customer to start to ramp in the second half?
Yeah. Fahad, this is Stefan. As you know, we have non-disclosure agreements with our customers. We really can't talk about customer specific issues like that. What matters to us, I think, is that in aggregate, we're seeing a strong booking ledger for the second half. As we mentioned, a lot of that is coming on the basis of contracts that we have in place, so we're fairly confident in those numbers. What the other customers are doing, obviously remains to be seen. There's still some work to do to get their numbers anyway, but it certainly is not something that we're going to break out in the call.
One thing I want to add on is, you can notice we have many design win every quarter, and we are still many new customer under qualification. We believe we should have several more good sized customer in this year we can bring in. We believe our market share in the intra-data center will increase compared to last year.
All right. Just so I understood, Stefan, your response and Thompson, your response. In terms of the second half outlook, you're expecting a broad-based improvement from all your cloud customers.
We're expecting a broad-based improvement, yes.
Okay. All right.
Add up all of the broad-based customers together, we're expecting an improvement, yes.
Got it. Appreciate that. Then one more, if I may. In terms of the new design wins, the nine new design wins, can you tell us a little bit more about these design wins? Is it with tier 1 NEM suppliers? Are they additional cloud suppliers? Just any more qualitative insights on those new design wins.
It's a mix, Fahad. There's some that are data center operators, cloud type data center operators, and there's others that are OEMs. It's a good mix, which I think is important to us. One of the things that we're working very hard to do is to continue to diversify our customer base. That means different types of products, different types of customers, different types of end markets. So, making inroads into having design wins in some cloud type customers, but other types of customers as well, is important to us, and I think we're making good progress there.
All right. Appreciate the answers. Thank you.
Once again, if you would like to ask a question, please press star and then one. To withdraw your questions, you may press star and then two. Our next question comes from Richard Shannon from Craig-Hallum Capital Group. Please go ahead with your question.
Thanks, Thompson and Stefan for taking my question. Maybe just one or kind of a two-parter here. You talked about some nine design wins in the quarter five for 100G. I wonder if you could tell us whether any of them are CWDM4 full spec. If so, are there any of those wins helping you with your positive outlook for the second half of the year?
We do have some design wins for CWDM. I actually don't remember off the top of my head if they were full spec or light.
No, most of them are full spec.
Full spec, I think is correct. As far as whether it's contributing to our positive outlook for the year, absolutely. I think it's worth noting that there are some of these design wins that could be really material to revenue, either in the second half or beyond, and there are some that are certainly smaller. I don't want to oversell that all these design wins are huge ones, but there are certainly some that can be material.
Okay, that's helpful. One last question from me. I've got to jump off to another earnings call. Wondering if you can discuss the opportunities you're seeing with the large China cloud operators. It's a customer base that hasn't existed with you, at least in volume today, but it seems like it could be an opportunity. Wonder if you could discuss what you're seeing there.
We think we're making pretty good inroads into the China operators. By and large, those China cloud operators are smaller in scale than certainly many of the cloud titans that are sort of our traditional customer base. We're making good inroads. I think we've had a number of design wins and some design win activity that's still ongoing, but is looking very good. Again, compared to our large cloud titans, most of those Chinese companies are somewhat smaller in scale.
Okay, that's helpful. Thanks for taking my questions, guys.
You're welcome.
Our next question is a follow-up from James Kisner from Loop Capital. Please go with your follow-up.
Thank you. On 40G, can you just give us an updated perspective on how fast that rolls off? Should we be taking revenue out of that 40G bucket as we put it into the 100G, or is there maybe kind of a longer tail on it? Just any kind of in texture on how we should model 40G would be helpful. Thank you.
I can't go too much into more detail than what we've already said. We think it will decline. What's going on is that it's a little bit customer specific. That is, we have some customers that are already transitioned virtually 100% to 100G. We have other customers that are continuing to use 40G. I think it's probably fair to say that if you look back, say, a year ago or so, that 40G is probably hanging in there a little stronger than we would've thought at that time. Again, it's kind of customer specific. It's not across the board. 40G is important to some customers and less important to others.
Thank you.
You're welcome.
Ladies and gentlemen, at this time, this will conclude today's question and answer session. I'd like to turn the conference call back over to Dr. Thompson Lin for any closing remarks.
Okay, thank you for joining us today. As always, we thank our investors, customers, and employees for your continued support, and we look forward to seeing you at our upcoming conference.
Ladies and gentlemen, the conference has now concluded. We thank you for joining today's presentation. You may now disconnect your lines.