Good afternoon. My name is Chris and I will be your conference operator. At this time, I would like to welcome everyone to Applied Optoelectronics Second Quarter 2021 Earnings Conference Call. Today, all participants have been placed on mute to prevent any background noise. [Operator Instructions] Please note that this call is being recorded. I would now like to turn the call over to Lindsay Savarese, Investor Relations for AOI. Ms. Savarese, you may begin.

Thank you. I'm Lindsay Savarese, Investor Relations for Applied Optoelectronics, and I'm pleased to welcome you to AOI's second quarter 2021 financial results conference call. After the market closed today, AOI issued a press release announcing its second quarter 2021 financial results and provided its outlook for the third quarter of 2021. 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 2021. 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 statements. 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 third quarter of 2021. Except as required by law, we assume no obligation to update…

Thank you, Lindsay. Thank you for joining us today. We delivered revenue and non-GAAP EPS in line with our expectations. However, our gross margin came in slightly below our expectations mostly due to our unfavorable product mix in our CATV segment at increased cost from the component shortage we experienced in the quarter. Total revenue for the second quarter of $54.2 million decreased 16.9%, compared to a strong second quarter in the prior year, but was up 9% sequentially. The strong sequential growth was led by our CATV segment, which this quarter decreased our data center business, accounting for 51% of total revenue [to our CATV] demand environment remained strong as MSO particularly in North America continued to upgrade their network. Total revenue for our CATV products increased more than four-fold year-over-year in Q2, an increase 48.1% sequentially of a strong fourth quarter to a record $27.6 million. As we expected, we experienced generally soft Q2 conditions in the data center segments. As a result, total revenue for our data center products of $22.4 million decreased 57.4% year-over-year and 13.7% sequentially. We are pleased to report that with [Q2 new design] wins with two customers for our 400G products during Q2. In addition to the design wins, we had five technical qualification of our 400G products, which Stefan will discuss in more detail. We are encouraged by the [traction] we are seeing with our 400G products as our customers start to degrade. We expect the order will continue as our customers start to realize the benefit or performance of our [400G solution]. Based on this, we continue to expect our data center business to begin to increase in the second half of the year as our customer begin 400G upgrades and inventory issue around 100G normalize. Turning to our telecom segment, while we do see early sign of a recovery in Q1 we saw mixed condition in Q2, with some customer present new order, while others continue to use existing inventory. Overall, with the market condition in the China Telecom markets is continuing [to repeat] as the timing and cadence of the 5G rollout there remain [somewhat opaque]. As a result, revenue from our telecom products of $3.3 million was down 46% year-over-year and 25.6% sequentially. Looking ahead, we believe China will continue to make investment in both their 5G and fiber-to-the-home infrastructure and we expect higher revenue in the segment in the second half of this year, compared to first half. With that, I will turn the call over to Stefan to review the details of our Q2 performance and outlook for Q3. Stefan?

Thank you, Thompson. As Thompson mentioned, we delivered revenue and non-GAAP EPS in-line with our expectations. However, our gross margin came in below our expectations, mostly due to unfavorable product mix in our CATV segment, and increased costs associated with the component shortages we saw during the quarter. While we continued to see softness in the data center market, and conditions in the China 5G market remained somewhat soft, we are pleased with the continued strength and record results we are seeing in the CATV market. And looking ahead, we are encouraged by the traction we are seeing with our 400G products, which we believe will drive growth in our data center business as order volumes ramp later in the year. Notably, we are pleased to report that we secured two design wins for our 400G products during Q2. In total for the second quarter, we secured three new design wins among three customers, all of which are existing AOI customers. All three of the design winds were in our data center business, and two of the three were for 400G, which I'll discuss in more detail shortly. Total revenue of $54.2 million decreased 16.9%, compared to a strong second quarter in the prior year, and was up 9% sequentially. Our Q2 revenue was in-line with our guidance range of $51 million to $56 million. As we expected, the headwinds we saw in Q1 continued into the second quarter in the data center market related to the inventory normalization that followed the shift to working from home early last year. We believe these headwinds will begin to subside in the second half of the year, driven by several of our customers who will begin to ramp 400G deployments. Additionally, we believe that inventory conditions in our 100G business will begin…

[Operator Instructions] Today's first question comes from Simon Leopold with Raymond James. Please proceed.

Thanks for taking the question. I want to start out first just, if you could clarify the CATV headwind, you quantified it as $3 million headwind due to supply constraints, I guess there are a couple ways one could interpret that, but I think what I'm imagining you're suggesting is, looking at this quarter sales of roughly 27.5 million and subtracting 3 million from that. But alternatively, I could sort of think of hey, I was imagining it would be 30, but with 3 million of headwinds, it'll be 27. So, I guess I'm trying to understand the baseline or maybe a little bit finer details, the impact of that headwind, you highlighted.

Yeah, Simon, thanks for bringing that up. So, I think the answer is, it's more like the ladder scenario that you had, not necessarily that those numbers are what we had in mind, but what we were saying is that, relative to what we could otherwise deliver that is based on orders and requested delivery schedules, and you know, shipping schedules and all that, we could have delivered $3 million more in our cable TV segment, but for the fact that those raw materials are constrained at this point.

And let me just clarify that, is that 3 million hit in the June quarter or is that 3 million headwind your forecast for September?

It’s forecast for the September quarter. So, we're saying in the next quarter, in the third quarter, the one that we're in currently, we would have been able to deliver based on our current forecast, approximately $3 million more revenue than we now believe that we can do to component shortages.

Right. And I want to see if maybe you could help us understand how to think about your opportunities in the 400 gig market, and where you see, essentially, competing with [ZR products], because I imagine there's, you know your products are probably cheaper than the ZRs, but have shorter reach. And so just trying to get a better idea of how you're thinking about sizing that market opportunity in, let's say, 2022?

Sure. So, first of all, I mean, we're pretty excited about the progress that we made in the 400 gig market, we highlighted the – not only the two design wins that we had in the quarter, but also the fact that we have five technical qualifications, which, as we noted is – as a significant milestone, I would say the technical qualification is typically the biggest hurdle to get over, in logging a design win. The remaining hurdle would be really just receiving an order, which typically involves, you know, getting set up with proper purchasing codes and negotiating some pricing and things like that. So, those hurdles are relatively low. The technical qualification is really the key piece that I think typically takes the longest. So, we're pretty excited about the progress that we had with those two design wins and the five technical qualifications. With respect to your question about, you know, kind of where we fit in, in the ecosystem, I think, as you mentioned, our products are positioned to be a lower cost version of 400 gig that can be used primarily in intra data center applications. So, you know, it distances up to a couple of kilometers, as opposed to longer distances in that, which is where ZR is typically targeted. Now, ZR, of course, will work at shorter distances, but at a higher price, as you noted. And as far as you know, the market sizing for next year, you know, I can point you to some third party estimates and things like that, for the overall market size, I think what we're hearing from our particular customer base is that they're going to, you know, begin implementing 400 gig later in the third quarter and into the fourth quarter. My anticipation is that that'll be a relatively slow, incremental ramp throughout that time, because that's typically how it goes with these customers, when they try to implement a new technology like 400 gig. They don't instantly, you know, start to implement that technology, they put it in incrementally, test it, make sure everything's working as expected, and then begin to ramp up after that. So, this kind of two phase ramp is what I would expect there. And the second phase, which would probably be a stronger ramp is probably sometime in the middle part of next year.

Right. And then just maybe a quick one, if I might is, we’ve seen awards coming out of China for 5G technology, there was the 700 megahertz award a few weeks ago, and then more recently, China Unicom and Telecom made tenders for RAN, just wondering how we can maybe look at those events in terms of helping, give us some sense of when your China business related to the 5G backhaul, front haul should improve?

Yeah, that's a great question, Simon. I mean, the 5G market is a little bit hard to make out right now. As we noted in our earlier remarks, some of our customers in China have begun ordering more products from us, which implies that their inventory levels are down to, you know, whatever level they think is comfortable, and they're placing new orders. Other customers haven't yet started to place those new orders yet. So, I think we're, I – my, the way I'm interpreting that is that we're in a period where new orders are starting to flow from or either new orders are starting to flow from the carriers like China Telecom and China Unicom or that there's line of sight to those new orders and some of our vendors are getting ready while other vendors probably still have some buffer inventory that they want to draw down before they start to place new orders. So, it feels like that should start to turn with more of our customers in this quarter or certainly by the fourth quarter, and the data points that you gave around the new bandwidth awards and new product orders coming out of China Telecom and China Unicom, I think those are significant data points that point also in that direction of a gradual recovery in the next quarter or two.

Thanks for taking my questions.

My pleasure.

The next question comes from Alex Henderson with Needham.

Thanks. Stefan, can you give us a little bit of a granularity around, you know, what’s your thoughts are between the data center and CATV and the guide for 3Q? What are we assuming there? Is the spike up in 2Q an abnormal spike, and it's going to stabilize or decline sequentially back to a more normalized growth or revenue level or is that a new base that will be growing the CATV? And, you know, clearly, it's nice getting 400 gig wins, but the data center business declining sequentially into what is normally a seasonally strong quarter, is that now a trend line where it's – you should expect the 40 gig to roll over a little bit faster, going forward as people don't want, you know, 40 good products in their – you know, to put new into their networks or a little out there?

Sure. So, I'll take your first question first, which is, you know, what's the trajectory for cable TV? As I noted in our prepared remarks, our cable TV revenue is limited over the next quarter or perhaps beyond by component availability. And we talked about the magnitude of that in the third quarter being about $3 million. So, you can get a pretty good picture that, you know, at least in Q3, and I would say that, you know, after that, in subsequent quarters after that, depending on component availability, we should be at about that level as well. So, I think we're kind of at a new, a new level in cable TV, and there's opportunities to grow from there, particularly as we overcome some of these supply constraints, which is currently the limiting factor to deliver revenue there. At the same time, then your second question is about, you know, the trajectory in datacom, and I do think Q2 probably represents the low point in datacom revenue for us, at least the local minimum. That is, I think we'll see some incremental improvement in data calm. And as we noted in our prepared remarks, that's going to be driven by two factors. One is the 400G design wins and our beginning that first phase ramp that I spoke with Simon about earlier in the 400G business. And at the same time, I also expect to see some recovery in our 100G business, as some of the customers that had previously purchased inventory are finally getting that inventory back down to a level that they think is appropriate to begin placing new orders. So, those two factors, I think, can drive some incremental growth in the data center business.

So, it sounds like data center up modestly a couple of million dollars, you're talking about the other ones probably Telecom, that sounds like it’s up a little bit sequentially off of a fairly low base. So, that would suggest that you do expect a little bit of a retrenchment in the CATV to get to your guide, I would assume?

Yes, that's correct. And we highlighted that that's largely due to component shortages.

Okay. I get it. That's perfect. I wanted to go back to the inventory, your inventory carry rate is very high relative to, you know, to your revenue base, and relative to industry standards. And I get it that in this environment, that's probably not a bad thing, but do we have any concerns about having potentially any issues of having too much of, say, older product, or lower speed products that might not be applicable to the future demand picture? Do you have the right inventory in that mix?

I think we do. You know, if you remember, in some prior quarters, we've talked a lot about the fact that our 400G platform and our 100G platform and our 40G platform share a lot of commonality in terms of the design and the parts. And so, you know, to that extent, there's inventory of raw materials and things that may have been applicable to even 40G products that we could still continue to use in 100G and certainly, you know, cable TV, well, some of the older generation products, maybe slower selling than the current stuff. There's still a lot of demand even for older generation products. So, we feel pretty good about the inventory that we have. I should say, we feel good about the quality of the inventory that we have. Now, your point about inventory level being high is well taken. We did bulk-up on inventory quite a bit in the, actually even prior to COVID in the Chinese New Year period going back last spring. And, you know, I think that that probably, you know, we probably got a little bit out of – ahead of our [SKUs] in terms of the amount of inventory that we have. To your point, it's comforting to have that inventory around with all the uncertainties that we've endured in the last year. But we do want to continue to draw that inventory level down. We've made some significant progress in that regard. I mean, we've pulled our inventory, I think it maxed out at around $113 million, and we're down to just about $100 million at the end of the quarter. So, I mean, that's good progress. I want to continue to make progress on that regard. And bring that inventory level down to a number that I think would be, you know, more appropriate for the business, which is probably in the $80 million vicinity.

One technical question, you said the 0.9 million of mark to market at the market issued, was that shares or was that revenue? You know the cash in.

That's dollars. That's the amount of net proceeds for ….

For the dollar? Okay. Thanks.

All right, Alex. Thank you.

The next question comes from Sam Peterman with Craig-Hallum.

Hi, guys. Sam on for Richard here. Couple questions. I think I'll start with data center. I know you guys have talked about, you know, inventory burns ending in the second quarter and starting to recover from there, which looks like it's going to happen, but, you know, even given that data centers down looks like a little bit more than expected. I mean, was there, kind of worse inventory burns than expected, or something else in data center that can kind of explain the weakness there this quarter?

Well, I don't think that the weaknesses is, kind of a long-term thing. It has to do with just the confluence of order patterns across a couple of different customers. And, you know, as we, as we discussed, I think that probably represents a local minimum in terms of, you know, data center revenue. And I think, you know, the catalyst going forward is again, you know, inventory normalization with our 100G customers, especially one of our large 100G customers, as well as some headwinds, or excuse me, some tailwinds from the 400 gig, as that starts to ramp.

Okay, fair enough. Second question on 400 gig, I'm curious what those five technical qualifications that you talked about, are those with new customers or existing customers, or can you break that down?

All of the 400 gig technical qualifications are with existing customers.

Okay, great. Thank you. And then last one for me on cable TV. I know, I think last call you talked about having, you know, visibility in the order book out through the end of the year. I know, you know, supply constraints are going to cap that a bit, but can you talk about where you sit in terms of visibility today? And if that order books is extending out in the next year at all, and yeah any color there would be helpful?

Yes, the order book is extending out in the next year. The component availability situation, I mean, I was listening in on CommScope’s call, and they're saying similar things about component availability. So, I think it's, kind of an industry wide trend. So, we're not seeing customers, sort of pulling back on orders and shifting order patterns. I think it's quite the contrary, what we're experiencing is that customers are, you know, working with us to try to pull in inventory as quickly as they can, rather than, you know, trying to move orders to somebody else or something.

Okay, great. Thanks. That's all for me.

[Operator Instructions] Our next question comes from Dave Kang with B. Riley.

Thank you. Good afternoon. My first question is on gross margin. Revenue is going to be, kind of flattish sequentially in third quarter and yet you're expecting gross margin to decline by five points sequentially, can you just go over some of the factors?

Sure, there's two factors. One is, some product mix within our cable TV segment, just you know, different customers, sort of waxing and waning in terms of what they're buying. And then the other factor is, is related to the component shortages that we're experiencing. And so we are experiencing increased costs as we try to pull in those components. So, we're paying, for example, expedite fees to suppliers, we're in some cases, qualifying new suppliers that may even be higher cost suppliers just because they have availability, things like that, that are also negatively impacting our gross margin in the quarter. So, we discussed that we think that the cable TV mix is probably a one quarter thing. I think it'll shift more back towards, you know, more favorable product mix in the fourth quarter. The component availability is a little bit unclear how long that is going to last. I think it'll certainly last through the third quarter. It may last into the fourth quarter, but it's not totally clear exactly how fast we're going to be able to recover from that. It's a very fluid situation. Some of those component availability situations are caused by for example, COVID shutdowns in certain parts of the world where suppliers have factories and things, and those – how those things play out, in terms of timing is a little bit difficult to project at this point. But I think it's fair to say it, it should persist through the third quarter and hopefully, we'll find ways around it in the fourth quarter, but it's not totally clear at this point.

Regarding component shortages, is it just mainly in cable TV, I mean, you're not experiencing a similar situation in the data center market?

Yeah, and I think a lot of that has to do with the inventory that we talked about earlier. I mean, Alex had a very good point that our inventory levels are rather elevated. And that's the point that we've made also on our last few calls. You know that's a double-edged sword, of course, we're tying up cash. And there's always some risk of obsolescence, although, as I mentioned, in response to Alex's question, I don't think that's a major concern for us at this point. But, the bright side to that is that, you know, if you do have inventory, then you're not as likely to suffer from supply shortages. So, in the data center business where we have, you know, a longer history and a more, you know, a better track record in terms of order patterns, we were able to bulk up on those products ahead of Chinese New Year last year, and that inventory is continuing to help us out when it comes to component shortages in the present time. The cable TV, part of our business, as you can appreciate, was significantly smaller a year ago, and we didn't have the same bulk of inventory going into, you know, going from pre-COVID times into, you know, the first or second quarter of last year. And therefore, you know, we don't have that same cushion of inventory there. And that's where we're, sort of scrambling to try to find the inventory that we need to continue to grow the revenue in that segment.

Okay. And my last question is on 400 gig. I'm trying to, kind of gauge what kind of trajectory we should be expecting. First of all, just wanted to clarify, do you say – did you say 400 gig will ramp end of third quarter or fourth quarter? And then, you know, like, can you just talk about your expectations? Maybe when does it become [indiscernible] 20% of revenues?

So, I think – I said that the 400 gig will start to ramp at the end of the third quarter, which means it's probably not going to be a big amount of revenue in the third quarter, but it should start to, you know, start to become, you know, more meaningful in the fourth quarter. I did also highlight in answer to, I believe it was Simon's question earlier that we typically see in these scenarios, a sort of two phase ramp, right. So, there's an initial phase of ramp, where we go from zero to some relatively small number that's associated with initial orders from customers who are trying out, you know, putting these products into their actual live networks and making sure that they perform as well in that environment as they did in all the lab testing that they've been doing in the qualification phase. They tend to be, you know, appropriately circumspect when it comes to ordering in that first phase. And then once they become more comfortable that everything's working correctly, then there's the second phase where the ramp becomes more substantial and we expect that phase will probably be sometime in the middle part of next year.

And if I can just squeeze in one more regarding 400 gig, how should we think about margins between 100 gig versus 400 gig?

Broadly similar, there can be variations in gross margin among that product family either the 100 gig or 400 gig based on the particular, you know, the particular customers and the particular types of transceivers that are being ordered. But overall, I would expect the margins to be, you know, broadly similar between 100 gig and 400 gig.

Got it. Thank you.

The next question comes from Tim Savageaux with Northland Capital Markets.

Good afternoon. Not a lot left here, but maybe I’ll follow up on 400 gig timing and maybe, kind of the magnitude of the opportunity, it seems that the one area where discussion of 400 ZR would be relevant for you guys would be at Microsoft, where they've stated pretty plainly that they need to get that DCI rollout going before they can upgrade inside the data center. And I'm not saying that's one of your design wins, [but if you could] add some color on that. But with a scenario like that, you know, explain a, why design wins are coming, you know, kind of maybe a little late in the game; and b, you know, kind of support the kind of small ramp and then bigger ramp in mid-year type scenario that you're discussing?

Yeah, I mean, I think you're right, in the sense that for all of our customers, and Microsoft certainly has historically been one of if not our largest data center customer. It has been – recently it has been our largest data center customer. And so, you know, anything that would affect the timing and magnitude of the rollout of Microsoft's 400G efforts, you know, would certainly be of interest to us and could be a partial explanation for some of the ramp rates that we have talked about earlier. That's not to say, you know, certainly not all the design plans are technical qualifications that we had or even necessarily any of them with Microsoft, but we have multiple customers that are involved in that, but certainly, we're watching the situation with Microsoft, and in any of the factors that affect their rollout would likely be affecting us as well.

Got it. And, you know, in terms of the magnitude of that opportunity, you know, should things go reasonably well for you in 400 gig? I mean, can you imagine a scenario sometime next year where your 400 gig business is, you know, approaching the size of your current overall data center business on a quarterly basis?

I could imagine that scenario. I think, as you pointed out, a lot of things have to go right. I would expect that 400 gig can approach, you know, say 10% of revenue at some point next year, which would put it at, you know, roughly the level of our current data center business. So, I think that that's, you know, achievable. Clearly, we're a little ways out from seeing that actually happened and having a tremendous amount of confidence in that, but I think it's certainly possible.

Okay, thanks very much, and congrats on the design wins.

Thank you.

This concludes our question-and-answer session. At this time, I would like to turn the conference back over to Dr. Thompson Lin, for any closing remarks.

Okay. Thank you for joining us today. As always, thank you to all investors, customers, and employees for your continued support, and we look forward to see many of you virtually in all upcoming investment conference.

The conference is now concluded. Thank you for attending today's presentation. And you may now disconnect.