Applied Optoelectronics, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Unaudited consolidated results; financial amounts below are in U.S. dollars unless noted.
Business context
AOI designs and manufactures fiber-optic networking products for data center, cable television (CATV), telecom and fiber-to-the-home markets. It operates manufacturing and R&D facilities in the U.S., Taiwan and China. Data center products remained the largest business, contributing 69.1% of Q3 revenue.
Financial performance and liquidity
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $56.4m | $88.9m | $209.4m | $302.5m |
| Gross profit / margin | $17.5m / 31.1% | $39.4m / 44.3% | $77.2m / 36.9% | $134.1m / 44.3% |
| Operating income (loss) | ($9.6m) | $18.1m | $1.5m | $76.6m |
| Net income (loss) | ($3.7m) | $19.4m | $6.4m | $68.2m |
| Diluted EPS | ($0.19) | $0.95 | $0.32 | $3.39 |
- Cash flow: For the first nine months, operating cash flow was $25.6m, down from $57.5m. Investing activities used $71.0m, including $52.3m for property and equipment and $5.6m for land-use rights. Financing provided $17.9m. Cash, cash equivalents and restricted cash declined $25.9m to $58.1m.
- Balance sheet at September 30: Cash and cash equivalents were $56.4m; short-term investments $6.0m; restricted cash $1.7m. Current assets were $215.2m and current liabilities $82.7m. Inventory was $107.9m, up from $75.8m at year-end 2017.
- Debt: Notes payable and long-term debt totaled $71.2m ($8.3m current; $62.9m non-current), versus $49.6m at year-end 2017. Unused borrowing capacity was $63.6m. AOI reported compliance with credit-facility covenants.
Material changes and management commentary
- Q3 revenue fell 36.6% year over year; nine-month revenue fell 30.8%. Data center revenue declined 40.8% in Q3 and 35.2% year to date. CATV and telecom revenue also declined in Q3; nine-month telecom revenue increased 7.0%.
- Management attributed Q3 data center weakness in part to reduced shipments of certain 100G transceivers to a customer after concerns about failures in similar previously shipped products. AOI said it performed extensive testing, redirected production resources to investigate, and resumed shipments with customer agreement before quarter-end.
- Management also said a major customer’s data-center architecture changes may reduce anticipated demand for 100G transceivers. The company cited new-customer wins as a potential offset, but said there was no assurance of a full offset. It revised its expected 2018 Facebook contract value to approximately $90m from a previously indicated approximately $125m, citing shipment delays.
- Gross margin weakened, which management linked primarily to lower capacity utilization and fixed-cost absorption during the product investigation. Q3 inventory expense included a $3.2m lower-of-cost-or-market adjustment; the nine-month charge was $5.5m, versus $1.4m in the prior-year period.
- Operating expenses increased 27.3% in Q3 and 31.7% year to date. R&D expense rose 54.3% in Q3 and 56.1% year to date, principally due to personnel, depreciation, materials and project costs.
- The nine-month income tax benefit was $4.0m, compared with $6.9m of tax expense in 2017. Tax results included a $1.8m favorable Tax Act measurement-period adjustment to the transition-tax obligation; the company reported the transition-tax assessment complete at $3.2m total.
Outlook, risks and unusual items
- AOI stated that existing cash, operating cash flows and borrowing availability should be sufficient for anticipated cash needs over the next 12 months. It gave no clear numeric forward revenue or earnings guidance in the supplied filing text.
- Key risks include heavy customer concentration (top ten customers represented 92.9% of Q3 and 94.0% of nine-month revenue), demand and order volatility, product qualification or reliability issues, inventory obsolescence, fixed manufacturing costs, competition, and exposure to China/Taiwan operations, currencies and trade policy.
- Two securities class actions concerning the 2017 demand outlook were pending, as was a related derivative action stayed pending a ruling on the motion to dismiss. Two additional related class-action complaints were filed in October 2018 following the September 28 revision to Q3 revenue guidance, which the company attributed to an issue with a small percentage of 25G lasers in a specific customer environment. AOI disputes the allegations and intends to contest them. The filing does not provide a clear estimate of possible loss.
- AOI expected the new lease standard, effective for it in 2019, to add approximately $9.5m–$11.5m in operating lease liabilities and corresponding right-of-use assets, primarily for its Taiwan branch.
- Management concluded disclosure controls were effective as of September 30, 2018, and reported no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether the 25G laser issue and prior 100G product concerns are resolved, and whether customer shipments and acceptance remain on track.
- Actual demand from major data-center customers as their network architectures change, and progress diversifying the highly concentrated customer base.
- Inventory composition, utilization, reserve adequacy and the potential for further write-downs or margin pressure.
- Capital spending, operating cash generation, borrowing availability and repayment obligations as debt and working-capital needs evolve.
- Developments in the pending litigation and any subsequent disclosure of a reasonably estimable loss or exposure.