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Opnext Inc. (NASDAQ:OPXT)

F3Q09 (Qtr End 12/31/08) Earnings Call

February 05, 2009; 09:00 am ET

Executives

Harry Bosco - President & Chief Executive Officer

Robert Nobile - Chief Financial Officer

Gilles Bouchard - Chief Operating Officer

Analysts

John Harmon - Needham & Co.

Dan Morris - Oppenheimer

Ehud Gelblum - JP Morgan

Paul Bonenfant - Morgan Keegan

Rahul Kanmulkar [Ph] - Jefferies & Co.

Ian Wenzinger [Ph] - SNP

Operator

Good morning. My name is Rachel and I will be your conference operator today. At this time, I would like to welcome everyone to the Opnext third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions)

Mr. Dean, you may begin your conference.

Doug Dean

Good morning and thank you for joining us today. My name is Doug Dean, and I’m the Vice President of Investor Relations for Opnext. Today we will discuss our financial results for the third quarter, ended December 31, 2008, and provide some commentary regarding our market conditions and business outlook.

We’ll begin with remarks from Harry Bosco, President and Chief Executive Officer of Opnext, along with Robert Nobile, our Chief Financial Officer and Gilles Bouchard, our Chief Operating Officer and then we’ll take your questions.

As always in our prepared remarks and our responses to your questions, we will rely on the Safe Harbor exemptions, under the rules and regulations of the securities act and our Safe Harbor statements and the company’s filings with the SEC.

Now, let me introduce Harry Bosco.

Harry Bosco

Thank you Doug and good morning everyone. I’d like to start by saying the market weakness that we saw at the end of last quarter, continues to impact our performance throughout the December quarter and we expect it will carry forward into 2009.

We are experiencing softness in vendor managed inventory pools and some of our customers are pushing out existing orders as they manage their inventory levels to reflect their customer demands. However, we believe the softness is being felt across our industry and that our revenue decrease does not reflect any overall share loss.

Furthermore, we believe the deployment of broadband applications will continue to drive higher bandwidth requirements for networks in the long term and that Opnext is well positioned with the key equipment suppliers to support their needs.

Revenues for the December quarter were $70.5 million, a decrease of 12% from the September quarter and an increase of 6% from the December 2007 quarter. The revenue decrease from last quarter was felt across all of our major product lines, with the exception of XFP products, which continue to benefit from the transition of communication equipment to pluggable modules.

Earnings on a GAAP basis were negative $0.23 per diluted share, reflecting several infrequent and nonrecurring charges and expenses. On a non-GAAP basis, earnings were a negative $0.10, includes an aggregate, a negative impact of $0.10 resulting from inventory and bad debt charges. Additionally, operating cash flow for the December quarter was essentially breakeven.

Before I turn it over to Bob to review our third quarter financial results, I’d like to comment on my recently announced retirement as CEO and President that will be effective on April 1. During the past eight years the company has been through many changes and faced many challenges. We endured a significant business downturn in 2002 to 2004, but emerged as a market leader in 10G products.

On the strength of our performance and a favorable market, Opnext went public in early 2007. Since then we paved the way in 40G module development and the recent acquisition of StrataLight, positions Opnext as a leader in 40G solutions and now we look forward to addressing the 100G frontier and maintaining our leadership positions at even higher network speeds.

Gilles Bouchard, currently our Chief Operating Officer, will take the reins of the company on April 1. Gilles has done an outstanding job running our business operations since he joined Opnext in November 2007. He has led the StrataLight integration and planning efforts over the past few months, paving the way for a seamless transition. As Chairman, I’m looking forward to working with Gilles and the Opnext Board to grow the company and increase shareholder volumes.

Let me now turn it over to Bob to review our third quarter performance.

Robert Nobile

Thanks Harry and good morning everyone. As Harry previously mentioned, for the quarter ended December 31, 2008, we generated sales of $70.5 million, representing a decrease of $9.7 million or about 12% as compared to the previous quarter. This decrease was felt across most of our major product lines with the exception of our XFP products.

Sales of our 10G and above products decreased almost 14% to $56.7 million and accounted for just over 80% of our total revenue. Sales of our less than 10G product line decreased about 7% to $8.4 million, while industrial and commercial product sales decreased by approximately $200,000 or 4% to $5.4 million.

Compared to the quarter ended December 2007, our sales increased $4.1 million or roughly 6% from $66.4 million. The increase was driven primarily by higher demand for our XFP, X2 and SFP products, partially offset by lower demands for our 40G and XENPAC modules.

For the quarter ended December 2008, Cisco and Alcatel-Lucent represented approximately 35% and 16% of total sales, as compared to about 39% and 15% in the previous quarter. Sales to the balance of the top 10 customers during the quarter demonstrated the benefits of our board customer base, as they increased about 4% sequentially in a down market and represented nearly 32% of total revenues.

Geographically, revenues in North America represented 52% of total sales, while Europe represented 22%, Japan, 15% and the rest of Asia was approximately 11%, marking the first time our Asia sales outside of Japan exceeded 10% of total revenues.

Gross margins for the quarter ending December 2008 was 22.1%, including a $5.7 million non-cash charge for excess and obsolete inventory in response to the weakening market condition. This charge accounted for most of the gross margin decline from the September quarter.

As compared to the September quarter, R&D expenses decreased approximately $600,000 to $10.6 million, an increased as a percentage of revenue to 15% from 14%. The expense decrease primarily reflects lower levels of R&D materials related to prototype builds, offset by the negative effects of foreign currency exchange fluctuations.

SG&A expenses increased $1.6 million from the September quarter to $14.8 million, an increased as a percentage of sales to 21% from 16.5%. The increase primarily resulted from an approximate charge of $900,000 associated with Nortel’s bankruptcy filing, as well as the negative effects of foreign currency exchange fluctuations.

As a result of the weakening market conditions during the quarter ended December 2008, including the impact on our market capitalization, we recorded a $5.7 million non-cash charge to write off the entire amount of our goodwill that was associated with the acquisition of Pine Photonics in June 2003.

Our operating loss was $15.5 million as compared to operating profit of approximately $100,000 last quarter. After adjusting for the goodwill impairment charge, stock based compensation expense, plus action related litigation expenses and cost associated with the acquisition of StrataLight, non-GAAP operating loss was $7.7 million as compared to non-GAAP operating profit of $1.9 million last quarter. This change primarily resulted from a $5.3 million increase in excess and obsolete inventory charges, approximately $900,000 of Nortel related bad debt expense and the negative effects of lower sales volumes, all of which was partially offset by lower R&D spending.

During the quarter ended December 2008, the sequential negative effects from foreign currency exchange fluctuations were substantially offset by the benefits from our hedging programs. As a result of the Q3 hedging programs, we experienced an approximate Yen exchange rate of 107 Yen to the dollar. About 20% of our revenues in the December ‘08 quarter were exposed to the Yen and we were successful in reducing our Yen cogs exposure from 80% to less than our original 60% target. In addition, about half of our operating expenses were Yen denominated.

After accounting for interest and other income, net loss is $14.5 million or negative $0.23 per diluted share. Non-GAAP net loss was $6.8 million or negative $0.10 per diluted share, including in aggregate negative impact of $0.10 per diluted share resulting from excess and obsolete inventory charges and Nortel related bad debt expense.

Operating cash for the December quarter was essentially breakeven. Cash generated from operations for the 9 month period ended December 2008, was $2.7 million. During this period, cash and cash equivalents decreased by $15.7 million to $206 million, primarily as a result of $6.6 million of short term loan payments, $6.5 million of payments on capital lease obligations, $2.2 million of cross incurred in connection with the StrataLight acquisition and $2.5 million of capital investments.

Now, let me turn it over to Gilles to provide future thoughts on the combined company and our view of market conditions and guidance.

Gilles Bouchard

Thank you Bob and good morning everyone. Let me start by thanking Harry for his unrelenting support, mentoring and confidence in the past 15 month. As I step into my new role, I am excited about the possibilities that the combination of Opnext and StrataLight brings to the market and also very conscious of the many challenges and opportunities presented by the current market conditions.

The merger of optical device and module technology, together with subsystem expertise will help our customers optimize their future network designs with superior performance and costs. They have reacted very positively to the unique combination of R&D skill in 40G and 100G, vertical integration and a long tradition of quality that the new Opnext offers.

With extensive planning behind us, we now look forward to a smooth and swift integration of StrataLight, now called Opnext Subsystems or OPS. At the same time, even as we ship Opnext to be the leader at higher network speeds, we are also very aware of the difficult market conditions we are facing today and the need to focus relentlessly on cash flow performance while investing in our future.

We continue to experience an unfavorable product mix, the adverse effect of foreign currency exchange and a slowing demand, which in turn drives increased pricing pressure. Based on the Yen exposure that Bob described and a current Yen exchange rate of 90 Yen to the dollar, we expect that gross margin will be negatively impacted by the Yen in Q4. Independent of the Yen impact, we expect continued deterioration of the gross margin percentage due to pricing pressure and product mix.

As Harry noted, while operating in this difficult demand environment, our focus now is to continue to serve our customer base, complete the integration of StrataLight and reduce our cost structure while continuing to invest in R&D programs for our future. We expect R&D as a percent of revenue to increase in Q4, reflecting major investments in 100G and other critical programs.

Across the business, we are taking broad actions to reduce our cost structure and we are also realizing synergies from the StrataLight acquisition. Our goal remains to accelerate our industry leadership at the higher network speeds and expand our customer relationships as we address the continuing needs for greater bandwidth and emerge from the market downturn as a stronger company.

However, we continue to take a cautious short-term view based on a tough market environment and tempered customer views. With that in mind, we expect revenues to be in the range of the $80 million to $90 million for the fourth fiscal quarter ending March 31, 2009, inclusive of the StrataLight business.

With that, I will now turn it back to Doug to begin the Q-and-A portion of the call.

Doug Dean

Thanks Gilles. That completes our prepared remarks and I will be glad to take your questions. So we may get to as many of you as possible, please limit your questions to no more than two at a time. The operator will now provide instructions on how to submit your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Harmon with Needham & Co.

John Harmon - Needham & Co.

Hi, good morning.

Harry Bosco

Good morning, John.

John Harmon - Needham & Co.

So, I’m sure everyone’s wondering how StrataLight performed in the quarter? What was StrataLight’s revenues or was it inline with the other 40G businesses and looking at your revenue guidance, what are your expectations for StrataLight versus core Opnext?

Robert Nobile

The revenues for StrataLight for the quarter ended December were approximately $24 million John, and the guidance that we’ve discussed encompasses both the Opnext and the StrataLight business.

John Harmon - Needham & Co.

Okay. Well, second question then. Maybe you could just contrast the performance of your telecom businesses and the outlook as well as versus of your datacom businesses.

Harry Bosco

Yes John, we saw an impact in our datacom business and it continues while the telecom business took a downturn and has kind of leveled off, but that’s a near time impact. In the future we expect the telecom business could slow down based on some of the Cap Ex discussions out there today and datacom business should start to level off and hopefully as the IT infrastructure starts to come back up again, we’ll see that grow again.

John Harmon - Needham & Co.

Okay. Thank you.

Operator

Your next question comes from the line of Dan Morris with Oppenheimer.

Dan Morris – Oppenheimer

Good morning. Just wondering if you could stand a little bit on the pricing environment and was the pressure pretty much across the board or are there product areas you can highlight as especially hard hit?

Robert Nobile

Pricing pressure Dan is really across the board. I think you’ll see it a little bit higher in products like tuneables and some of the ex-10G products.

Harry Bosco

Yes, a lot of this pricing impact we expect it just in normal course of business. We have seen some areas where it’s taking a little more aggressive positions.

Dan Morris – Oppenheimer

Okay, and as you look out through 2009, do you have any assumptions or expectations for ASP declines that you could quantify?

Harry Bosco

We said in the past it’s on an average of about...

Robert Nobile

Yes, they’ve been about 15% year-over-year declines, say over the last two years or so. I think we’re seeing that slightly increasing at this point in time and it’s not a straight linear change quarter-over-quarter. There is always a higher percentage that takes place going from the December quarter to the March quarter due to year-end price contract negotiations.

Dan Morris – Oppenheimer

Okay, great. Thank you.

Operator

Your next question comes from the line of Ehud Gelblum with JP Morgan.

Ehud Gelblum - JP Morgan

Hi, thank you. Good morning.

Harry Bosco

Good morning, Ehud.

Ehud Gelblum - JP Morgan

A couple of questions; can you tell, I missed this, how big the 40 gig business was this quarter and how much you expect it to be in the guidance of 80 and 90?

Robert Nobile

This quarter 40 was about $5 million.

Ehud Gelblum - JP Morgan

So that’s down with everything else, seems like it’s down a little bit more.

Harry Bosco

That’s down by 7 to 5, right?

Robert Nobile

Yes.

Ehud Gelblum - JP Morgan

Do you expect it to stay flat as you move into the next quarter in the 80s and 90?

Harry Bosco

Well, as you know for next quarter we’ll include the trial business, as obviously the 40G business is going to be bigger because of that.

Ehud Gelblum - JP Morgan

But, if you could isolate your own business, somehow give it some comparable.

Harry Bosco

We’re qualified in 12 different customers. So we see that some of our customers have pushed out their demand for 40G, so we expect to materialize some of that, probably in the first quarter actually.

Ehud Gelblum - JP Morgan

And have they express any kind of interest at this point waiting for 100G given the environment or are they still going to handle their 40G plans; they are just delaying them by a quarter or two?

Harry Bosco

No, the 40G plans are still getting deployed. I mean you have many of our customers that bought this, again getting ready to go out with their commercial products and so you get that little punch and then you get initial deployments and eventually you start to get the real mass deployments.

Gilles Bouchard

All we can see here, now that we have the visibility in the tri businesses, the transport side of 40G, the deployments are pretty healthy, so we should see a very natural pool in the client side as a consequence.

Ehud Gelblum - JP Morgan

Okay, and if you so look at that $24 million to StrataLight, I know you’re starting to mix the businesses together obviously, but does that $24 million go down equally along with the same amount as the rest of the Opnext business or is that…?

Harry Bosco

No, I think you got to look at it this way. Again, you never can tell, right? I mean from day-to-day, but if you think about it, StrataLight made a transition from the PSBT into DPSK, so the DPSK is now getting deployed and it’s just a ramp-up on that. It’s just starting to come up.

Ehud Gelblum - JP Morgan

So that’s actually growth in the $24 million?

Harry Bosco

We may see it grow. I mean I just don’t want to say it right now, but certainly we expect it to grow.

Ehud Gelblum - JP Morgan

So the ponderous of the Opnext is the rest of the piece.

Harry Bosco

Yes, because you have datacom and other kinds of businesses that are softening up.

Ehud Gelblum - JP Morgan

Right, that makes sense. One quick question on the gross margin; as we use a comparable going into next quarter down from this quarter is the base line the 22% you showed or should we be adding back as the obsolete inventory charge and looking at it closer to 29% as the base line gross margin to grow from in the next quarter.

Robert Nobile

The 22% base line is a good way to think about it going forward, but understand that there is a lot of things that are offsetting each other in that. We do not expect our inventory obsolete and XFP charges to continue with the rate we saw in this third quarter. On the other hand, we expect a fairly significant impact from the Yen.

As I indicated, we had an effective Yen rate of 107 during the third quarter and at today’s rates which are approximately 90, there is a significant impact going forward. As you know, we have approximately 20% of our revenues exposed to the Yen, now about 60% of our cost of goods, as well as about 50% of our operating goods. With that you can see that the benefit from the non-recurring inventory charge is kind of offset by the currency effect.

Ehud Gelblum - JP Morgan

Right, so the last question; the hedges roll off when? Has it rolled off already? So, we’re going to see the full effect of the 90 in this quarter?

Robert Nobile

That’s correct. I mean we have hedges in place for this quarter; however, by the time we entered into them, the Yen had already significantly strengthened against the dollar. So the benefit, we won’t have any upside benefit coming from them, but we do have some downside protection.

Ehud Gelblum - JP Morgan

Okay, appreciate it. Thank you.

Operator

Our next question comes from the line of Paul Bonenfant with Morgan Keegan.

Paul Bonenfant - Morgan Keegan

Hi, thank you. First question, on the gross margin again, with 22.33% as a base line, is it fair to assume that StrataLight contribution to gross line is favorable and what sort of magnitude should we be thinking about next quarter. Could we be looking at a several hundred basis point decline?

Robert Nobile

As I indicated to Ehud, I think you should think about our actual GAAP rate of about 22% continuing into next quarter. That rate again includes the benefits of lower inventory charges, offset by the negative effects of currency and also includes the negative effects of continued price pressures as well as lower volumes and offset by the benefit of bringing StrataLight into the organization.

Paul Bonenfant - Morgan Keegan

And assuming that the StrataLight revenues don’t decrease materially sequentially, then I guess it would imply somewhere on the order of a 5% to 20% sequential decline for your organic revenues?

Robert Nobile

Again Paul, we’ve given out our guidance on a combined basis; it’s $80 million to $90 million for next quarter.

Paul Bonenfant - Morgan Keegan

All right fair enough, I will do the math and final question if I may; you talk about cost cutting measures but in the context of your comments you also talked about continuing your investment in 100G. If the slowdown and the downturn continue, would you consider pushing that development out or how else do you think you can reduce the expense structure to more closely align with a lower revenue base.

Gilles Bouchard

Hey Paul, let me talk about costs a little bit. I mean slowing down programs like 100G would be one of the last things we would consider. We’re at the peak investment right now and you’re looking at some very key milestones for those programs which we think will position us very well for the future.

We look at cost cuttings in really two phases. We’ve gone through the first phase with the Strata acquisition, looking at basically four major things with some discretionary spend, actions, our acquisitions of programs across the combined companies, some leverage in SG&A and some procurement leverage, so those are built in our numbers.

As you know, our fiscal year starts in April 1 and we’re right in the middle of planning for this fiscal year as part of our Phase II cost planning which we’re looking at dozens of other items, which will be in from next year to bring the cost structure inline with the current market conditions.

Paul Bonenfant - Morgan Keegan

Thank you for taking my questions.

Operator

(Operator Instructions) Your next question comes from the line of Bill Choi with Jefferies & Co.

Rahul Kanmulkar - Jefferies & Co.

Hello, this is Rahul Kanmulkar [Ph] Calling in for Bill Choi. My first question is about your general products line. I mean you have made a comment that you saw the decline across the board, maybe except in pluggable modules. So did you see any different dynamic in datacom and telecom markets?

Harry Bosco

Yes, I think you will see XFP’s changing, keep going, because it’s replacing two types of things; replacing 300-pin and also discrete designs. So, new designs coming out of the telecom equipment manufacturers are all involved pluggable modules, so they can partially equip these systems when they give them to their customers. So I think you will see XFP continue to go up and plus it’s more economical for them. So they’re partially equipped, is more economical, replacing our legacy and also new growth and XFP is being used in datacom areas. So we’ll see that to continue.

Rahul Kanmulkar - Jefferies & Co.

So in terms of the end market condition, did you see any different dynamic playing at datacom versus telecom or do you see the slowdown literally across the board?

Harry Bosco

I think datacom; certainly you’ve heard some of the other customers talk about their marketplaces. Clearly the I.T. spending affects all the enterprise businesses right, so we get impacted by that. In the telecom area, programs are underway, but some of the service providers continuing on. At any point in time with Cap Ex being controlled, we could see a slowdown in that, but it will be more fluctuating as opposed to just a consistent thing.

Rahul Kanmulkar - Jefferies & Co.

Okay and finally could you elaborate a little bit more on your 100G investments? I mean right now what is the status of your customer relationship there? In which part of the network will these technologies be implemented and what is the gestation right now.

Harry Bosco

If you take a look at 100G right now, it’s kind of where 40G was, let’s say, three to four years ago. We’re now getting trial systems put together; we’ve the basic technology under development. There is some core technologies that you need to make this feasible, beyond just getting the prices down in this stuff, the cost down.

We have fundamental devices under development now that will be used in these, as well as partners we have tied into to get this down. We’re trying over the next year, year and a half to get models out there, systems out there running in customer bases and it’s really up to them on how fast they deploy it, but again this is a long process. As Gilles said, getting in there early is very critical to us and it’s going to be both on a datacom area as well as the telecom area.

Gilles Bouchard

Maybe another comment is I think we’ve seen very, very strong interest from customers in both our client side and live science energy programs which established some very key partnerships there, so the demand is there. Obviously one of the interesting factors about 100G is that it requires major, large R&D investment, so only few companies can do this and Opnext I think is one of the few companies that can provide the skill and R&D to do this and therefore having a few key partnerships with customers.

Rahul Kanmulkar - Jefferies & Co.

Okay. Thank you for taking my questions.

Operator

Your next question comes from the line of Ian Wenzinger [Ph] - SNP.

Ian Wenzinger – SNP

Yes, thank you. You gave some guidance on gross margin. I’m wondering, the effect on the operating expense lines, I think their operating expense as a percentage of sales ran pretty close to where you guys were before the downturn and I’m wondering, going forward how that operating expense project is going to work. I know a lot of it’s focused on R&D.

Robert Nobile

Depending upon the range of our revenue guidance and after factoring in the negative impacts of foreign currency, exchange rates, again if you assume a today rate of 90 Yen; we’re looking at expectations of R&D spending next quarter, somewhere in the low to mid 20% range and on the SG&A side, fairly consistent with where we were this quarter at about low 20s, maybe event a bit below 20%.

Ian Wenzinger – SNP

So I mean just going forward, assuming that this downturn lasts through the next several quarters or so, is there any plan in place to sort of get your operating model at least close to profitability? I mean it looks like you’re operating margins are running negative 25% or so, what’s your plan looking forward to try to lower that cost base?

Robert Nobile

As Gilles mentioned, we’re in a two phase cost reduction mode at this point. We’ve already implemented various programs in connection with the integration with StrataLight and as we put our plans together for our next fiscal year, we will also have a second phase of actions that we’ll undertake.

Ian Wenzinger – SNP

Thank you.

Operator

Your next question is a follow-up from the line of John Harmon with Needham & Co.

John Harmon - Needham & Co

Sorry, someone asked my question. Thank you.

Operator

There are no further questions. Do you have any closing remarks?

Doug Dean

Thank you, operator. With no more questions, that concludes our investor call for today. Thank you for joining us this morning and operator please provide the replay instructions.

Operator

Thank you for joining today’s conference call. This call will be available for replay beginning at 12:30 pm Eastern Time today, through 11:59 pm Eastern Time on February 12, 2009. The conference ID number for the replay is 82515809. The phone number to access the replay is 1800-642-1687 or 706-645-9291. This concludes the conference call. You may now disconnect.

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