Good day and welcome to the Applied Optoelectronics Second Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the call over to Monica Gould, Investor Relations for Applied Optoelectronics. Please go ahead, ma'am.

Thank you. I'm Monica Gould, Investor Relations for Applied Optoelectronics, and I'm pleased to welcome you to AOI's Second Quarter 2020 Financial Results Conference Call. After the market closed today, AOI issued a press release announcing its second quarter 2020 financial results and provided its outlook for the third quarter of 2020. 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 section 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 Q2 results and Stefan will provide financial details and the outlook for the third quarter of 2020. 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. In some cases, you can identify forward-looking statements by terminology such as believes, anticipates, estimates, intends, predicts, expects, plans, may, should, could, would, will or thinks and by other similar expressions that convey uncertainty of future events or outcomes. Forward-looking statements also include statements regarding management's beliefs and expectations related to the expansion of the reach of our products into new markets and customer responses to our innovations as well as statements regarding the company's outlook for the second quarter of 2020. Except as required by law, we assume no obligation to update…

Thank you, Monica. And thank you, everyone, for joining us today. I would like to once again to thank our entire AOI team that's continued to support one another and our customers during the COVID-19 pandemic. Our condolences go out to all those around the world who have been impacted by the virus and we send our thanks to the first responders and essential workers who continue to protect and support our communities. Turning to the quarter, AOI delivered Q2 revenue of $65.2 million, which was above our guidance of $55 million to $60 million. Q2 revenue grew 50% compared to the second quarter last year and 65% sequentially, marking the fourth quarter of year-over-year growth that AOI has recorded since the third quarter of 2017. Outperformance was driven by improved demand from our data center customers, increased customer diversifications and record revenue in our telecom segment led by 5G deployments in China. Non-GAAP gross margin of 23.1% was on the low end of our expected guidance range due to product mix as well as some COVID-19 related expenses that continue into the quarter, while non-GAAP net loss of $0.24 per share was in line with our expectations. We expect that continued improvement through our cost reduction efforts and more favorable product mix will lead to improving gross margin over the next several quarters. And we anticipate revenue to be up more than 20% sequentially at the midpoint of our guidance range. We are encouraged by the increased data center demand for a diverse set of customers and improving 5G-related activity that began earlier this year and will continue into Q3. During the quarter, we had eight design wins, including four with telecom customers, which are related to 5G network deployments, mainly in China. The other four design wins were…

Thank you, Thompson. As you may recall, we had disruptions in operations in our China factory during Q1. However, as Thompson mentioned, due to the hard work and dedication of our employees and supply chain partners, we are back to normal operations and have increased capacity in both our wafer fab in Sugar Land, as well as our factories in China and Taiwan compared to our capacity pre-COVID. We continue to see high demand from our data center customers who remain focused on improving network performance in light of the increased traffic related to the shift towards working from home. We also received our first orders from CATV customers that we believe are related to network upgrades by MSOs also responding to stresses on their networks. Looking ahead to Q3, we are expecting over 20% sequential growth at the midpoint of our guidance range and a continued improvement in our gross margin. Turning to our quarterly performance. Total revenue for the second quarter was $65.2 million, which was above our guidance range. Our data center revenue rose 58% sequentially and 65% year-over-year to $52.6 million and accounted for 81% of our total revenue. This was our highest data center revenue quarter in two years. In the second quarter, 33% of our data center revenue was from our 40G transceiver products and 64% was from our 100G products. As Thompson noted, this marks the second quarter in a row of year-over-year in our 100G transceivers. Importantly, we continued to see increased data center demand during Q2 from a diverse set of customers. Overall, for the quarter, our top 10 customers represented 86.9% of revenue, which is down from 90.9% in Q2 of last year. We had three 10% or greater customers in the quarter, all of which were in the data…

[Operator Instructions]. And the first question will come from Alex Henderson with Needham & Company.

I actually have two questions. So, the first one, the new hyperscale customer, there was another supplier into that customer if I believe – which was InnoLight. And I had heard that had some supply chain disruptions. Do you think that that's a part of the reason that you got in? Or do you think that you would have been in regardless of what the competitor supply availability looks like? And does that have any impact on the way you're thinking about the outlook?

I can't say that there's anything specific about any of our competitors that would have impacted this customer's decision. It's a customer that we've been working with for some time to gain some traction there, and I think they've appreciated our ability to supply and, obviously, the complete profile that we bring to the table with cost and quality and delivery advantages. So, I think it was much more about us than about some competitors losing the attraction there.

Glad to hear that. The second question, I wanted to delve into the telco piece. It seems pretty clear that what's driving this is the chipsets going into CPRI and fronthaul for 5G that is a huge potential build over time, not just in China, but globally. And I'm assuming that these are chipsets that are selling in there. Can you give us some sense of what the rate of chips that are going into that market looks like? How many are diodes? How many are EMLs? And to what extent you see that ramping from here? And any sense of what the TAM is for that market over the next three, four, five years as that 5G footprint gets built out?

So, there's a few questions embedded in there. As far as the ratio or the precise types of lasers, I don't have a breakdown on that. It's a combination of DFB lasers that we're selling, some EMLs, but very small, and some transceivers. The precise breakdown, I don't have available now. As far as the TAM there, it really remains to be seen. I think in China alone, which is where we're seeing the most activity right now, they're talking about tens of millions of towers, which would be several many tens of millions of radios, each of which would require a fronthaul transceiver. So, you can kind of get an appreciation at the size of the market is really large. Our anticipation is not that AOI is going to be a majority player or anything like that in that market. But I think that it's very reasonable for us to expect to get 10%, 20% of that market and hopefully expand over time. And as the opportunities in the rest of the world outside of China begin to materialize to, to continue to grow that market share.

If I could just finish one last question on that same subject, the impact of this on the utilization rate in your fab, I think, is going to be pretty significant. Do you expect to see a couple of points of margin expansion as these volumes ramp relative to the other transceiver business because of the overhead allocation associated with that?

I won't comment on the exact magnitude that we expect to see. We have given guidance, of course, that indicates continued improve on a gross margin. We mentioned that in our prepared remarks as well. You saw the improvement from Q1 to Q2 already. And that's due to a number of factors, but certainly cost reduction overall, coming from higher fab utilization is a big part of that. And we would expect that to continue as long as you know the growth in that chip market continues.

The next question will come from Simon Leopold with Raymond James.

First, just a very quick, easy clarification. The percent of data com that was 100 gig, did you say 54% or 64%?

I'm sorry. You cut out there just a little bit. I think you're asking about the data center revenue that was 100 gig. And if so, that's 64%.

Sorry about that. I'm a little bit Internet and power disadvantaged, thanks to the tropical storm. I'm trying to speak up and be quick. I wonder if you could maybe bridge the gross margin. It was a little light this quarter on very good revenue and similarly light in the guidance. I'm just wondering if you could explain how much of the pressure is COVID expenses? How much maybe is mix, if the telecom products are dilutive to the gross margin. Just help us understand those factors.

Some of it is COVID. Not a lot. I think the main factor is – well, really two things. It's product mix related and it's cost reduction related. In other words, those are the two things that we have two levers that we can pull from here on to try to continue to see improved gross margin. As I mentioned in the previous question or answer to the previous question, the fab utilization helps in terms of improving our cost structure. But just like other ways of reducing the cost over time, it does take time for those to flow through because we have a significant amount of inventory and their cycle time associated with it. So, the improvements that we expect to see, we believe, are real and they're coming, but it takes some time for them to actually materialize in the financial statements.

And then just one last one, if I might. The new data center 10% customer, which is really good news, is this something you see as sustainable or basically as far as you can forecast, or was there something one times about this quarter?

No. This customer has actually been growing with us for some time slowly, and they just made it into that 10% category this quarter. But I would not expect that to be a flash in the pan type of thing. I think we've done a good job with this customer. They, by all accounts, seem to like us as a supplier. And barring any unforeseen circumstances, I don't see any reason why they wouldn't continue to purchase from us.

The next question will come from Paul Silverstein with Cowen.

Hopefully, this is different than what Alex and Simon asked you, but on the gross margin front, Stefan, do you have visibility to getting back to 30-plus-percent? And if you do, can you give us a sense for when that is? I appreciate that it takes time to flow through, from your previous responses, but any visibility right now?

I think our goal is still to get back to the 30-plus-percent range. I could see us getting into the upper 20% range by the end of the year. Whether we could hit 30% in that timeframe, I suppose there's some scenarios where that could happen. But that's probably not as likely. But I think we're talking about a matter of quarters, not years for us to get back to that 30% level.

And I trust the competitive dynamics are not meaningfully different today than they were previously, either better or worse.

No. We haven't seen any real changes in the competitive dynamic.

In one of the questions on margins, from a pricing perspective, I know it resets once to twice per year, depending on the customer. I assume that's still true. But in terms of those resets, any insight you could provide in terms of what it's looking like?

Nothing specific. Obviously, we don't give that type of guidance typically. I can't say that – we are seeing pretty strong demand right now. And in past situations where we've seen that kind of strong demand, typically, that provides a little more pricing leverage on the suppliers as opposed to the customers. But, again, that's just an observation from prior periods. I can't really speculate about the pricing resets that we might see in the future.

Understood. One last quick question. I assume, by definition, when we're talking about the China 5G opportunity, we're talking about three, maybe four systems customers that you do or can sell into to access that opportunity in terms of Huawei, ZTE. Fiberhome and perhaps, what was it, Alcatel Shanghai Bell Nokia. Does that go without saying?

Yeah. I think that's correct in terms of the end customers. Just to be clear, many of our customers – we do sell directly into some of those customers, but many of the customers are Chinese-based transceiver manufacturers that then supply those transceivers. So, we would supply laser diodes, for example, into those transceiver manufacturers. They would manufacture the transceivers and then sell them to the end customer. So, much of our business is likely not to be directly with those big guys. But I would assume, based on my knowledge of the market there, that your list of WAN customers is accurate.

And did you say how many of those transceiver customers you're selling in? So, can you share that with us?

There's a lot of them. There's probably more than a dozen.

Our next question will come from Samik Chatterjee with J.P. Morgan.

This is Bharat on for Samik. So, if I could just start with the data center segment. And I think it was just, I think, a couple of quarters ago, you highlighted [Technical Difficulty]. So, just wanted to understand what we're seeing there. Have you started getting to that customer already [Technical Difficulty] and any update on probably when revenue [Technical Difficulty] come from that? So, can you [Technical Difficulty] think about [Technical Difficulty]?

Samik, I'm sorry to say that your line is very difficult to understand. So, I missed that question. Can you try to repeat it?

This is Bharat for Samik. So, if I could just start on the data center segment and 400 gig specifically, so I think it was a couple of quarters ago that you highlighted a design win there with a NEM customer. So, I just wanted to get a sense, have you started to ship to that customer already and any update on when new recognition can come from that? So, what are some of the milestones there that we can track?

So, the question was regarding 400G. We haven't shipped significant quantities to that customer or any other customer of 400G yet. My sense is that the 400G, because of COVID, I think some of the 400G qualification efforts are taking longer than expected. And I don't think that's anything unique to AOI. I think the information that we have is that a lot of – particularly the hyperscale customers, many of them are working from home, just like many of us, and that complicates qualification efforts because you've got engineers that can't come to the lab or they're otherwise constrained in their ability to complete those qualification efforts. So, my sense is that that 400G revenue was probably pushed out a little bit. But that's not necessarily a bad thing for us, either. If you look at our results this quarter, we're seeing very strong uptick in 100G revenue. And I would expect that to continue to be there until such time as 400G is ready.

Got it. And if I could just ask a follow-up on the telecom end market. Can you help us think about what's the run rate revenue you're expecting from that business as we look into the second half? And the reason I ask that is how should we think about the sustainability of demand for 5G from China because, as some of the equipment peers have called out, there is a high inventory position across OEMs [indiscernible] from purchasing in the region in the second half. So, just wanted to understand what the drivers are there as we look into the second half.

We don't give breakdown by segment on a forward-looking basis. But I imagine this will be just like any other nascent market, right? There will probably be some ups and downs as we go forward. But I think on a quarter-by-quarter basis, you may see some variability there. But I think the overall trend towards increased volumes with this 5G deployment that's happening, I think, is pretty clear.

The next question will come from Dave Kang with B. Riley.

I was wondering if you guys could provide more color around new customer wins. Are there any 400G customers that you guys have in the pipeline? Or is that push out still kind of how you guys are trending?

Well, as I mentioned before, I think a lot of the 400G qualification efforts are getting pushed out. We did not have any 400G wins this quarter. To be clear, we didn't have any notifications that we are no longer under consideration for 400G. In other words, we're kind of at the status quo. I think that the qualification efforts have just gotten pushed out and slowed down a little bit with our customers. And that's true for us as well as for any of our competitors. As I said earlier, I think our businesses, in 100 gig, is growing very nicely. And so, the 400G delay isn't necessarily a bad thing for us. It gives us some time to work on the cost and manufacturability of those devices. And that can only be a good thing for us when the time comes.

[Operator Instructions]. Our next question will come from Fahad Najam with Cowen.

Much of my questions have already been answered, but I'll ask you a question in terms of any trends you're seeing among your largest hyperscale – the US-based hyperscale customers, of a need to push – pull the supply chain out of China into outside of China, maybe in the US, especially given the fact that Microsoft and Amazon, two of your customers have – or have been vying for this significant US government DoD contracts? Are you seeing a request or pull-in from your customers to move some of your supply chain out of China? Can you provide some color there?

Well, sure. As we've noted for the last few quarters, we've been producing more and more of our products in Taiwan as opposed to China. And the customers are certainly aware of and supportive of that. I think, right now, the focus has largely been due to the tariff situation, not because of they necessarily have a mandate to move out of China. As the political situation with China continues to evolve, obviously, that could become more of a factor. But for now, I think it's mainly just the cost reason why they want us to produce more in Taiwan. But it's certainly been a factor of conversation with customers, yes.

Can you share with us today how much of your production is outside of China now versus, say, before the tariff situation?

It's a really difficult question to answer, Fahad, because what we've been doing is we've been moving certain parts of the manufacturing from China to Taiwan, and we've been doing other earlier parts of the manufacturing process in China. So, it's not like we've completely moved production from China to Taiwan. It's been more of a reassignment of manufacturing activities between the two plants.

So, related to previous questions around gross margin, do you think that moving your production or if you settle on to a more [indiscernible] supply chain there out of Taiwan, do you think that that would help your gross margin cost structure going forward? Is that what you were alluding to when you said your cost structure kind of depend on – is that driven by the fact that you're still transitioning a lot of your production out of China into Taiwan, and that's driving up some incremental costs over the near term?

There's some incremental cost in there. But I actually think, look, the labor cost, for example, in Taiwan is more expensive than China. So, on balance, once we once we hit a steady state here, the gross margin, if we can't do significant cost reduction, like we have been doing, then the gross margin would tend to trend down because of that. The reason why we think it's going to go up is, again, product mix and very good attention that we're paying to our cost of production and the ability to continue to improve our manufacturing, improve our supply chain to get that cost to come down. And that's a big part of what we're expecting in order to see the gross margins get back to that upper 20% and then ultimately 30% range.

[Operator Instructions]. This concludes our question-and-answer session. I would like to turn the conference back over to Thompson Lin, Chief Executive Officer, for any closing remarks. Please go ahead.

Okay. Thank you for joining us today. As always, thank you to our investors, customers and employees for your continued support. And we look forward to virtually seeing many of you at our upcoming investor conferences.

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