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NeoPhotonics Corporation (NYSE:NPTN)

Q4 2012 Earnings Call

February 21, 2013 5:00 PM ET

Executives

Erica Mannion – IR

Tim Jenks – Chairman, President and CEO

JD Fay – SVP and CFO

Analysts

Simon Leopold – Raymond James

Eric Ghernati – Bank of America

Vijay Bhagavath – Deutsche Bank

Operator

Welcome to the NeoPhotonics 2012 Fourth Quarter and Year End Conference Call. This call is being webcast live on the NeoPhotonics event calendar webpage at www.NeoPhotonics.com. This call is property of NeoPhotonics and any recording, reproduction or transmission of this call without the expressed written consent of NeoPhotonics is prohibited. You may listen to a webcast replay of this call by going to the NeoPhotonics event calendar webpage. I would now like to turn the call over to Erica Mannion, Investor Relations for NeoPhotonics.

Erica Mannion

Good afternoon. Thank you for joining us to discuss NeoPhotonics operating results for the fourth quarter and full year of 2012. With me today are Tim Jenks, Chairman, President and CEO and JD Fay, CFO.

The call today contains forward-looking statements that involve risks and uncertainties. These include statements related to NeoPhotonics’ business outlook for the quarter ending March 31, 2013 and full year 2013, future periods, industry trends, and forward-looking statements that management may make in response to questions. Forward-looking statements are generally indicated by words such as would, believe, should, expect, outlook, estimate, anticipate, forecast, and similar expressions that look toward future events or performance.

Actual results may differ materially from forward-looking statements. Factors that could cause results to differ materially from statements include those described in today’s press release as well as those detailed in the section entitled Risk Factors of the company’s quarterly report on Form 10-Q most recently filed with the SEC. NeoPhotonics cautions you not to place undue reliance on forward-looking statements, and that these statements speak only as of the date they are made.

Non-GAAP financial measures will be discussed today. Please visit NeoPhotonics Investor Relations webpage for the company’s press release, which contains an explanation of these non-GAAP financial measures and a reconciliation to the comparable GAAP measures.

Now, I will turn the call over to Tim Jenks.

Tim Jenks

Thank you for joining us today.

We made solid progress in 2012. We accelerated our growth rate, growing 22% year-over year and reaching record annual revenue of $245.4 million.

In the fourth quarter our revenue was $62 million, which was at the high end of our projected range of $58 million to $62 million. This is down $4.1 million, or 6%, from the prior quarter and up $4.8 million, or 8%, from the fourth quarter of 2011.

Returning to our revenue in the fourth quarter of 2012, we experienced 8% growth over the same period last year, with the strongest growth of products used in coherent and other high speed networks and Agility products.

Gross margin for 2012 was 25.0%, up from 24.9% in 2011; non-GAAP gross margin for 2012 was 27.0%, up 130 basis points from 25.7% in 2011. And Adjusted EBITDA for 2012 was $9.3 million, up from $2.7 million in 2011. Each of these measures shows our progress in scaling our business and achieving favorable benefits from key growth products over the past year.

Our net loss per share from continuing operations in the fourth quarter of 2012 was $0.10. On a non-GAAP basis, we were approximately breakeven in the fourth quarter after having achieved profitability in the third quarter of 2012. Our non-GAAP net loss per share from continuing operations was $0.00 for the fourth quarter, a significant improvement from a loss per share of $0.26 in the fourth quarter of 2011. Our net loss per share from continuing operations for the full year 2012 was $0.62. For the year our non-GAAP net loss per share from continuing operations was $0.16 for 2012, a significant improvement from a loss per share of $0.40 in 2011.

We are particularly pleased with the increase in revenue from our 40 Gigabit and 100 Gigabit products. Not only did these products grow rapidly but also they can have higher margins on average compared to other products in our business.  The majority of this business is for 100 Gig applications and revenue for 100 Gig products in 2012 grew more than 300% compared to 2011.  We believe that our percent of revenue in 40 Gig and 100 Gig business is the highest of companies in the optical components market.  

In the fourth quarter of 2012, revenue from Speed and Agility products was approximately 60% of our total revenue, up from approximately 59% in the prior quarter, and in dollar terms, down approximately 5% sequentially. Within this group, revenue from our 40 Gig and 100 Gig products was approximately 30% of total revenue, which was sequentially down from 33% of total revenue in the prior quarter, and up from approximately 25% in the second quarter and approximately 17% in the first quarter. Again, this part of our revenue is largely derived from 100 Gig applications.

Networks are rapidly moving to 100 Gig and we believe this trend will continue in the future to 400 Gig and 1 terabit per second data rates. We also believe the basic architectures of 100 Gig Coherent transmission will continue to be used as data rates go up. Therefore, we believe that this product group can continue to grow over the next several quarters and in the medium term, despite fluctuations that are typical with seasonality and carrier deployments. We entered the 100 Gig business in 2010, therefore all of these products are less than two years old and are derived from our advanced PIC integration technologies.

In the fourth quarter, revenue attributable to our Access product group was approximately 29% of our total revenue, which was unchanged from the prior quarter, though lower sequentially in dollar terms by approximately $1.1 million.

In the fourth quarter, our largest three customers together comprised approximately two thirds of our total revenue, which is approximately the same percentage as in the fourth quarter 2011. Revenue from Alcatel-Lucent, Ciena and Huawei Technologies each comprised more than 10% of our total revenue in the fourth quarter, with Huawei comprising approximately 38% of our quarterly revenue. Our top 10 customers comprised approximately 90% of our total revenue in the fourth quarter.

Our products are designed to enable cost-effective, high-speed data transmission and efficient allocation of bandwidth over these networks. We sell our products to the leading network equipment vendors globally.

Our technology differentiation is the result of several elements, including our ability to: develop and produce both monolithic and hybrid photonic integrated circuits in high volumes with high yield and superior performance. To deliver integrated photonic solutions with low optical loss in channelized devices, with high sensitivity for receivers, and in small sized photonic chips with reliable and repeatable product performance, in customized PIC-based innovations to help match the needs to the industry’s, leading manufacturers’ systems, and integrate sophisticated electronics to provide more complete opto-electronic solutions.

Each of these elements is intended to enable NeoPhotonics to deliver high performance and low cost by design.

Last month we announced our agreement to acquire Lapis Semiconductor Optical Components Unit or OCU, which is a leading provider of lasers, drivers, and detectors for high speed 100 Gig applications. We believe that our pending acquisition of OCU will further accelerate advanced PIC-based solutions for 100 Gig, 400 Gig and 1 terabit per second networks in the future.

We believe in the strategic fit of this acquisition given our strong competitive position in 100 Gig products. Lapis Semiconductor Co., Ltd. is a wholly-owned subsidiary of ROHM Co., Ltd. of Japan, and OCU has been a supplier to NeoPhotonics for several years. Reactions from our leading customers has been favorable and we project this transaction will add approximately $40 million to $50 million in annual revenue to our business, and that it can be accretive on an Adjusted EBITDA basis within the first year of closing the transaction. Further, we believe that the acquisition can enhance our competitive position by providing us with additional scale, semiconductor and optical technologies for high speed 100 Gig and above applications, experienced engineering talent, and a deeper geographic reach.

Notably, the transaction will bring to us key technologies and over 150 patents and patent applications in semiconductor devices and photonic integrated circuits for high speed 100 Gig applications with two critical material systems, indium phosphide and gallium arsenide. This transaction will help us to leverage our success in PIC-based solutions by adding OCU’s laser and array products, plus high speed modulators, as well as a suite of drivers and trans-impedance amplifiers, or TIAs − these are control devices that are used together with semiconductor lasers and photodiodes. Their range of laser and photodiodes and device control ICs are designed for use in high speed optical communication networks, fiber to the home, optical and electrical test equipment applications and RF networks. Much of the device technology of OCU is focused on devices designed to achieve speed in networks. An example of this is that OCU was an early developer of an integrated laser and modulator capability for 40 Gig transmission, as well as of lasers and drivers for 100 Gig applications. Additionally, OCU products can be deployed at the core of systems that are delivering high bandwidth. This business was originally built as a part of OKI Semiconductor and OKI Electric, and it has been a technology innovator throughout its 30+ year history. Moreover, we believe OCU is generally viewed in the industry as a high performance and high quality leader in this segment.

We plan to continue the operation of this business as a worldwide supplier of advanced lasers, photodiodes and high speed ICs, and to continue to serve all of OCU’s current customers globally. As we have done successfully with our prior acquisitions, we plan to leverage our existing sales channels as the two businesses serve many common customers. We expect internal use of OCU products to expand, so as a result, we believe that this acquisition will also help us to realize additional cost savings over time.

We also have several common customers with OCU, so we believe we can realize customer synergies. OCU also brings additional customers to NeoPhotonics on a combined basis, including in the domestic Japan market, which we believe is a key market for our industry.

We are pleased with our progress and we remain focused on serving our customers as a strategic supplier. Our customers have actively embraced our new, Coherent and other high speed products, including certain new product developments which I will talk about later. Our customers are also excited about our planned acquisition of Lapis Semiconductor OCU and our enhanced technologies for their next generation of systems. We believe that our multi-quarter trends of growing revenue from our leading customers, and from high speed 100 Gig products are important, particularly as the momentum for deploying high-speed line-side and client-side networks leveraging Coherent and PIC technologies continues to gain momentum.

At this point I’ll turn the call over to JD to review our financial performance and projections.

JD Fay

Thank you, Tim, and good afternoon.

I will review the financial results for the fourth quarter ended December 31, 2012, the full year of 2012, and conclude with our outlook for the first quarter of 2013, with additional notes on expectations for the full year.

For the fourth quarter of 2012, revenue was $62 million, a decrease of approximately 6% from the third quarter of 2012. While the sequential decline is consistent with seasonality that we typically expect in the fourth quarter, our fourth quarter was nevertheless at the high end of our projections and the highest fourth quarter of revenue in our history.

GAAP gross margin for the fourth quarter of 2012 was 22%. Non-GAAP gross margin for the fourth quarter was 23.9%, and compares to the previous quarter’s Non-GAAP gross margin of 32.9%. Non-GAAP gross margin for the fourth quarter of 2012 excludes stock based compensation expense, and amortization of purchased intangibles and other assets and costs relating to the 2011 acquisition of Santur, of approximately $1.2 million.

Loss from continuing operations for the fourth quarter of 2012 was $3 million, as compared to income from continuing operations of $0.7 million in the third quarter and a loss from continuing operations of $22.8 million in the fourth quarter of 2011. Diluted loss per share from continuing operations for the fourth quarter of 2012 was $0.10.

Non-GAAP loss from continuing operations for the fourth quarter of 2012 was $0.1 million, as compared to Non-GAAP income from continuing operations of $2.7 million in the third quarter and Non-GAAP loss from continuing operations of $6.4 million in the fourth quarter of 2011. Non-GAAP diluted loss per share from continuing operations for the fourth quarter of 2012 was zero cents, and compares to Non-GAAP diluted income per share from continuing operations of $0.08 in the prior quarter, and Non-GAAP diluted loss per share from continuing operations of $0.26 in the fourth quarter of 2011.

Non-GAAP income from continuing operations and Non-GAAP diluted income per share from continuing operations for the fourth quarter of 2012 exclude stock-based compensation expense, amortization of purchased intangibles and other assets, acquisition-related costs, and associated adjustments to contingent consideration relating to the Santur acquisition and the income tax effects of these adjustments. These items totaled approximately $2.8 million.

Adjusted EBITDA in the fourth quarter of 2012 was $3.5 million, as compared to Adjusted EBITDA of $6.4 million in the third quarter and an Adjusted EBITDA loss of $3 million in the fourth quarter of 2011. The quarterly decline in Adjusted EBITDA was primarily due to lower revenue and gross margin, thus lower gross profit, partially mitigated by good cost control as we exited the year.

Next, I will discuss the fourth quarter in further detail.

Our quarterly revenue decline was primarily the result of seasonal effects that we have seen in prior years, including global holidays that tend to slow purchasing and deployments and result in fewer production days, plus lower prices for some of our products that were implemented following annual negotiations done during the quarter.

Gross margin was sequentially lower compared to the third quarter primarily due to both seasonal factors and certain special causes. Typical seasonal factors previously mentioned include lower business activity which results in lower overhead recoveries, and thus lower gross margins. Further, in the fourth quarter, we experienced higher manufacturing costs with one of our high speed products that has been growing rapidly. This product group has been additive to our 100G penetration and it typically is accretive to gross margin.

In the fourth quarter, however, in response to growing demand, our production activity accelerated, but we experienced higher yield loss and unfavorable inventory variances. Additionally, our wafer fab utilization declined in the fourth quarter more than expected, although in connection with the seasonal declines in our business. The combined impact to cost of goods sold for these items was approximately $4.3 million, or 700 bps, which is reflected in our fourth quarter results.

We are working diligently to eliminate these added costs of manufacture from our production and to balance our fab utilization, particularly as we anticipate growth in our business later this year, and as of today we believe that we will be able to substantially do so by the end of the second quarter of 2013. Such costs are expected to adversely impact our first and second quarter 2013 gross margins as well. The magnitude of this impact in the first quarter is expected to be in the range of $2.5 million to $3.5 million, and declining somewhat in the second quarter.

Total operating expense in the fourth quarter of 2012 was $17.3 million, as compared to $19.5 million in the third quarter, and compared to $35.1 million in the fourth quarter of 2011.

Within operating expenses, research and development was $8.5 million, down from $9.9 million in the prior quarter primarily due to the timing of materials purchases and lower personnel costs; sales and marketing was $3.5 million, approximately flat with the third quarter; while general and administrative was $5.4 million, down from $6.8 million in the third quarter on cost containment as we finished the year and lower personnel costs.

Now, I will provide an overview of our financial results for the full year of 2012.

NeoPhotonics delivered record annual revenue for fiscal year 2012. Total revenue was $245.4 million, an increase of $44.4 million, or 22%, over 2011. On a year-over-year basis, our revenue growth was primarily attributable to growth in our high speed 100G products. In 2012, revenue from our 40/100G products grew over 300% from 2011.

We believe we made substantial progress in 2012 to reduce customer concentration that can persist in to 2013, perhaps even continue to improve. For example, for the full year 2012 Huawei comprised approximately 36% of our total revenue, down from approximately 51% in 2011; Alcatel-Lucent comprised approximately 16% of our total revenue, up from less than 10% in the prior year; and Ciena comprised approximately 15% of our total revenue, up from less than 10% in the prior year.

Further, in 2012, revenue attributable to our customers in North America was approximately 27% of our total revenue, while revenue attributable to our customers in China was approximately 50% of our total revenue, and the rest of world comprised the remainder.

Gross margin for 2012 was 25%, up from 24.9% in 2011. Loss from continuing operations for 2012 was $17.7 million, which was up from a loss of $15.4 million in 2011.

Non-GAAP gross margin for 2012 was 27%, up from 25.7% in 2011. Non-GAAP gross margin for 2012 excludes the same items mentioned in the quarterly discussion and in 2012 totaled approximately $4.9 million.

Non-GAAP loss from continuing operations for 2012 was $4.7 million, an improvement from a non-GAAP loss from continuing operations of $9.6 million in 2011. Non-GAAP loss from continuing operations for 2012 excludes the items previously noted in the quarterly discussion, which totaled approximately $13 million in 2012, and are detailed in today’s news release available on our website.

Non-GAAP diluted loss per share from continuing operations for 2012 was $0.16, on 28.5 million diluted shares, and an improvement from Non-GAAP diluted loss per share from continuing operations of $0.40 in 2011.

Adjusted EBITDA for 2012 was $9.3 million, an increase of nearly 250% over 2011 Adjusted EBITDA of $2.7 million. We view growth in annual Adjusted EBITDA as a potential leading indicator to annual profitability on a non-GAAP basis, and thus we are pleased that we are making progress on this basis.

On the balance sheet, we ended the fourth quarter with cash, cash equivalents and short-term investments of $101.2 million, down $4.7 million from $105.9 million at the end of the third quarter of 2012 and up from $86.4 million as of the end of 2011. The sequential quarterly decrease in cash was primarily due to capital expenditures, scheduled debt repayment, and acquisition expenses, partially offset by customer collections.

Total bank debt at December 31, 2012 was $22.2 million, down from $23.4 million at September 30, 2012.

Accounts receivable, net, at December 31, 2012 were $70.4 million, approximately flat with the prior quarter, as was the change in days sales outstanding, which was approximately 101 days.

Now, I will provide our outlook for the first quarter of 2013 and beyond.

Our outlook excludes the impact of the acquisition of Lapis OCU, as it has not yet closed and related-transaction expenses. Currently, it is expected to close in the second quarter of 2013, but may close in the first quarter if the conditions to closing are satisfied earlier.

Also, as a reminder, the first calendar quarter is typically our seasonally lowest quarter as it is impacted by the confluence of the full impact of new pricing that was negotiated in the middle of the fourth quarter, which generally causes a sequential decline in revenue; as well as shorter production time at our facilities and at our customers due to holidays in China, which means fewer working days and an associated impact to demand, overhead recoveries and margin compression, and the determination of carrier CapEx spending levels, particularly in Asia. In addition, as we present these data, China has just completed its Lunar New Year holidays. Typically, capital expenditures and deployment plans in China are finalized after these holidays and may be announced late in the first quarter. Until these activities are completed, this means our visibility of demand for our products in the very short term, particularly in the first quarter, is low.

Finally, as discussed earlier, the first quarter’s gross margin will be adversely impacted by higher manufacturing expense and lower fab utilization continuing from the fourth quarter of 2012, as well as the start-up of our new manufacturing center in Dongguan, China, which will be discussed further.

Accordingly, our expectations for the first quarter are as follows: We anticipate revenue for the first quarter ending March 31, 2013 to be in the range of $50 million to $55 million. Non-GAAP gross margin is anticipated to be in the range of 22% to 24%. Non-GAAP loss per share is anticipated to be in the range of $0.15 – $0.25

The Non-GAAP outlook excludes the expected amortization of purchased intangibles and other assets of approximately $1.3 million, the expected impact of stock based compensation of approximately $1.2 million, and expenses related to the acquisition of Lapis OCU of approximately $1.2 million, which is expected to be approximately one-third of total transaction costs. Of these amounts, approximately $1.0 million is estimated to relate to cost of goods sold.

The share count assumption used to estimate the first quarter is approximately 30.5 million. This estimate can change based on stock and option activity in the period.

Looking at the full year 2013, we continue to believe demand is favorable for NeoPhotonics products, with continued potential in high speed and Coherent products in 100G and fiber-to-the-home and LTE wireless backhaul deployments around the world. We believe we can grow our revenue 8% to 10% on a year-over-year organic basis. With that level of growth, we would expect to be profitable on a non-GAAP basis for the full year. This means that for us to achieve our objective of profitability on a non-GAAP full year basis, we expect to achieve a level of profitability in the second half of 2013 that would offset our expected loss in the first half of the calendar year.

As a reminder relating to the pending acquisition of Lapis OCU, based on preliminary unaudited pro forma financial information provided by management of Lapis Semiconductor, the OCU business unit had revenue of approximately $45 million for the nine months ended September 30, 2012 and gross margin was approximately 30% for this period. Accordingly, we believe that the business will favorably impact our annualized gross margin on a non-GAAP basis after the closing of the acquisition and excluding integration costs.

Now I will turn the call back to Tim.

Tim Jenks

Thank you, JD.

NeoPhotonics is a technology company that designs and produces photonic integrated circuit, or PIC, based optoelectronic modules and subsystems for bandwidth-intensive and high-speed communications networks including Coherent 100 Gig data rates, plus fiber-to-the-home networks and 3G and 4G LTE wireless backhauling.

Our current product development actions focus on deploying PIC-enabled capabilities into fast growing segments of optical communications, and can have a positive impact on our potential for future growth.

We have previously stated that design wins, wherein customers qualify NeoPhotonics products for use in their systems plus we have received a purchase order for the products, can be leading indicators of future revenues. For 2012, we secured 17 total design wins with our tier 1 customers, and our cumulative design wins increased to 141 as of the end of 2012, up from 124 at the end of 2011. Our design wins in 2012 spanned our range of product families and included multiple design wins for our 100 Gig products including our integrated coherent receiver, and 100 Gig CFP module. For clarity, for a customer, a single design win can have multiple individual product numbers over time. And given the long life cycles of our customers’ systems, a single design win for NeoPhotonics can provide us revenue for several years, in many cases 7 to 10 years.

Our tunable laser product line has grown handsomely during the past year, as our narrow line width ITLA product gained market share in the market for Coherent 100 Gig and 40 Gig systems. We supplied narrow line width ITLAs to approximately 15 customers in 2012.

We plan on introducing a new micro-ITLA narrow line width tunable laser which leverages our core PIC array laser technology. The product would be designed to provide enhanced performance in a smaller size and add key functionalities required in the most advanced 100 Gig coherent transmission systems. We expect to be sampling this product to lead customers in the second half of the year.

It is important to note that our tunable laser is one product in a suite of solutions for coherent networks.

In addition, later this year we expect to introduce a new variable power integrated coherent receiver that is focused on the most demanding 100G coherent transmission systems. Our suite of coherent transmission products now includes narrow line width lasers, coherent mixers, integrated coherent receivers and we expect to add the micro-ITLA and variable power receiver. We believe that these coherent products represent not only high performance devices but also are a broad range of coherent solutions. Moreover, the addition of Lapis Semiconductor OCU is intended to expand the coherent product suite still further.

As mentioned on prior conference calls, we have sampled our Multicast Switch and we are pursuing qualifications with initial customers. Our Multicast Switch, or MCS, product is designed to be most efficient in Coherent optical networks. Our MCS product can expand the flexibility of a node to enable any port to drop any wavelength, from any direction, and to allow two identical wavelengths from different directions to be dropped through the same switch – that is, colorless, directionless and contentionless. We believe that the MCS represents a critical enabling technology for CDC ROADM systems.

In 2012, we introduced a GPON Optical Line Terminal, or OLT, that incorporates embedded Optical Time Domain Reflectometry, or eOTDR, which is designed to provide carriers a cost effective path to monitor their fiber infrastructure during network operation. We also have introduced a mode-coupled receiver into a GPON OLT, which is a central office device that incorporates key PIC elements, and which is designed to enable broader deployment of GPON networks by carriers at significantly reduced deployment costs.

Finally, adding to our progress with 100 Gig client side modules in the CFP form factor, in 2013 we plan to introduce a small form factor 100 Gig module in the CFP2 size that incorporates 10 lanes of 10 Gigabit data rates, that is 10x10, based on our proprietary indium phosphide PIC array laser technology. We believe that our 100 Gig CFP2 module can add to the success of our current 10x10 CFP platform as well as providing us with an ability to enter new markets. Fueled by server virtualization and cloud computing, we believe that server data transfer rates are rapidly expanding and that the adoption of 10 Gig Ethernet on server infrastructure is accelerating the demand for multi-channel solutions. We believe the 100G CFP2 is an attractive form factor for fast growing datacenters and Metro Ethernet applications. We expect to be sampling this product to lead customers in the second half of this year.

We are vertically integrated in our approach to manufacturing and we view our operational expertise as a core capability. We produce our PIC chips in owned fabs in Silicon Valley and we do the vast majority of our assembly and module testing in owned factories. During the first quarter, we plan to open a new 80,000 sq. ft. manufacturing facility in Dongguan, China, which would increase our in-house manufacturing space by approximately 50%. This facility is designed to add to our capacity and manufacturing footprint, while furthering our pursuit of sustainable cost advantages. We have seen various reports of higher CapEx both in the west and potentially in China later in 2013. With this manufacturing expansion, we believe we will be well prepared for potential growth in industry volumes, and specifically for the exciting new products that have been introduced in 2012 and we plan to introduce in 2013 that I previously described.

In addition, we are aggressively pursuing advanced developments in both 100 Gig line side coherent transmitters and in lower power and lower cost 100 Gig client modules for both carrier telecom and for enterprise applications. Each of these products are intended to contribute to our 100G product suite and to our Access network portfolio. These development efforts lead with compelling PIC-based technology solutions for coherent and other high speed applications.

We believe the combined growth of the market for Coherent networks and the use of high speed modules on the client side can help to fuel NeoPhotonics growth in the quarters and years ahead. We believe these markets are in their early stages of development and offer opportunities for NeoPhotonics to see future increases in demand. We have increased production capacity of our new 100 Gig products including narrow line width tunable lasers, integrated coherent receivers and 100 Gig client side modules, to help support growing demand. We believe that our key investments in next gen products are aligned with key industry trends that include moving to 100 Gig data rates and beyond; expanding coherent applications to metro deployments; connecting datacenters to Telco networks with 100 Gig links; enabling coherent switching; providing new Access network innovations that enhance network reliability, cost and efficiency, and, increasing Access network speeds to 10 Gigabit data rates and above

We see the potential for more growth ahead. As industry CapEx forecasts move up, we believe we are well positioned. At the same time, the things we are doing in communications technology are complex as well as competitive. These factors, as well as our vertical integration, have significant bearing on our business model.

We operate a business that has fixed costs, such as a sophisticated and highly trained engineering staff, device fabrication facilities and the infrastructure to support it. As such, decreases in business levels, as we see in our seasonally lower periods (generally our fourth and first calendar quarters) or when there are demand declines, can result in under-recovering fixed costs. And this may result in our earnings being lumpy, both within a year and year-to-year with industry growth ebbing or flowing.

By the same token, in times of accelerating business growth our business model can show leverage. We are planning to launch a number of new and exciting products in 2013, and we believe that several of these products can have higher than average gross margins as compared to our existing and legacy products. We do operate our own plants for manufacturing, which include certain fixed costs. With higher volumes in our owned facilities, and given that a small percentage of our total business is produced by subcontractors, additional revenue growth and higher product gross margins have the potential to add handsomely to operating leverage. It is for these reasons that we believe a target non-GAAP business model of 35% gross margin, with operating expenses of 25% of revenue, and an operating income margin of 10% on a non-GAAP basis is ultimately achievable.

We believe that our investments in technology, new products and factory capacity are timely given the industry trends, and that incremental volumes of our products can be produced at marginal costs that can be appreciably lower, contributing to operating leverage and to accelerate gross margin growth and the path to increasing profitability.

We believe the current trends – including higher forecasted OpEx, faster ramping of 100 Gig networks, rapid growth in datacenters supporting cloud computing – bodes well for our being able to accelerate our growth and expand the leverage in our business.

As networks move in the future from 100 Gig to 400 Gig and 1 terabit, the basic architectures being used in 100 Gig Coherent transmission are expected to continue. We believe that these trends of optical transmission give our technology – and, our business – long legs for the future.

This concludes our formal comments and now I will ask the operator to open up the line for questions.

Question-and-Answer Session

Operator

Thank you. The question and answer session will be conducted electronically. (Operator Instructions). And our first question will come from Simon Leopold with Raymond James.

Simon Leopold – Raymond James

Great, thank you. Just a couple of things. First, if you could just clarify, you went through the segment contributions and I caught the Access at 29%. I missed what you said the Agility was.

Tim Jenks

Speed and Agility was 60%, Simon. Access was 29% and so the remainder is what we would call other telecom.

Simon Leopold – Raymond James

Great. And, then you talked about the effects on gross margins and Speed and Agility this quarter. I think JD said special causes. I wanted to make sure, I understood what that really meant, it sounded like you were suggesting maybe some of the issues were yield problems, but were you also talking about having to raise compensation for the staff, something that would be more sustainable as a headwind.

JD Fay

No, I wasn’t talking about competition or things like that. I was talking predominantly about two specific items, one is higher production costs, meaning yield loss and scrap, for one of our high-speed 100 Gig products. The product’s growing very rapidly. We’re excited about actually its trajectory, but in the manufacturing process as we ramped it we did experienced higher than forecast yield and scrap. So we’re working to mitigate that.

The second is wafer fab utilization. Compared to our forecast entering the quarter a couple of our products that are produced in one of our fabs experienced lower than planned demand. As a result, we ended up selling more through inventory versus as a result of production in the quarter, and thus the cost of that fab was under absorbed and then hit the income statement.

Simon Leopold – Raymond James

And where are you today in regards to remedying the problems you experienced in the fourth quarter that affected the gross margin?

JD Fay

We are in the middle of remedying these problems, but we still have a ways to go. I do expect there to be an impact to gross margin in the order of $2.5 million to $3.5 million in the first quarter as we make incremental progress compared to the $4.3 million, I estimated for the fourth quarter.

And then finally in the second quarter I believe based on our road maps and our work that we’ve done that we will fully remediate the problem, but the expense in the second quarter should be somewhat mitigated but close to that $2.5 million to $3.5 million, I forecast for the first quarter.

Simon Leopold – Raymond James

Thanks, that’s helpful. And you mentioned opening up a new factory, which I guess it should be a good sign about growth prospects. Could you talk a little bit about what that does in terms of cash flow on CapEx?

JD Fay

Sure, the CapEx related to the new factory is relatively modest. Just as a reminder, our CapEx budgets for our business are approximately 6% of total revenue and for 2013, our goal and objective is to be in line with that historic trend. And so, it’s on the order of single-digit million dollars. But it’s within the larger context of maintaining our budget target of 6% of revenue.

Simon Leopold – Raymond James

Great. And then, I just wanted to end with more of a thematic question. There’s obviously been a lot of talk within that component market about silicon photonics and the integration of semiconductor manufacturing techniques and optical components. I generally thought about this as kind of your secret sauce in speed and agility. I wonder if you could maybe help put that discussion in context of what this trend means to NeoPhotonics.

Tim Jenks

Sure, Simon, this is Tim. The silicon photonics has certainly gathered a lot of attention. We would describe it as a type of a PIC platform; we do tend to refer to monolithic or hybrid PICs which we design, develop and produce in our - use that as a core technology. I would point out though that the PIC products that we make often incorporate essentially active elements as well as passive elements, so they can integrate for example indium phosphide based lasers and photo diodes into the device. Silicon on the other hand doesn’t [lays][ph], so it has a certain functionalities that it is – it is amenable to and some that it is not.

It also is – it tends to be used in a very short distances due to optical loss. As a company, I think we produce a lot of our Waveguide-based devices on silicon substrates and ultimately have a broad capability that could complement this as an industry direction however today it’s really not the mainstay of where our product technologies are in – are growing, we do see a lot of interest on a technical level particularly in backplane, and short reach applications. Again, that’s not where most of our business is, but it is an area of long-term potential technical interest.

Simon Leopold – Raymond James

Thank you.

Operator

(Operator Instruction) Next we’ll move to Tal Liani with Bank of America.

Eric Ghernati – Bank of America

Hi, gentlemen. This is Eric Ghernati for Tal. A few clarifications. So did I hear you say correctly that you expect 8% to 10% organic growth in 2013?

Tim Jenks

That’s correct, 8% to 10% organic growth and that did not include the potential adders that would be the result of Lapis Semiconductor OCU as an acquisition.

Eric Ghernati – Bank of America

Got it. And, JD your comments on the profitability, I guess lack thereof for the first half is that on an organic basis or on a combined basis?

JD Fay

That’s on an organic basis, just to try comparing with apples to apples, we’ll come out with combined data once we’re at that closing stage with OCU.

Eric Ghernati – Bank of America

Got it. And just – similarly once again like when you talked about CapEx is 6% for 2013, was it on organic or combined basis?

JD Fay

That is on an organic basis, as well.

Eric Ghernati – Bank of America

Got it, okay. So I guess my question is first of all on the pricing impacts, so first of all I thought I heard you say the impact on all the – the manufacturing issues was $4.7 million on COGS, but then again, you said $4.3 million, what’s the delta?

JD Fay

It’s not the pricing impact that’s for…

Eric Ghernati – Bank of America

No, no, no. I know it’s – It’s the manufacturing issues.

JD Fay

Yes.

Eric Ghernati – Bank of America

You said earlier it was $4.7 million impact on COGS of 700 bps, but then again, you said $4.3 million. But your answer prior question?

JD Fay

Sorry, no, it’s intended to be the same number.

Eric Ghernati – Bank of America

Okay. $4.7 million. Okay. And so I guess if I look at, I’m trying because it does seem, if you strip out the $4.7 million from the gross margin line and then you look at your gross margin guidance for Q1 it does seem like the pricing does have sort of a negligible impact versus what’s at least, I was led to believe, can just explain like the effect on that pricing has on your Q1 guidance?

JD Fay

Sure. Well, as Tim talked a lot about, yeah, first, let me clarify, at least my comments, prepared remarks, do have $4.3 million and for the manufacturing costs, Eric. So I think that’s correct unless I misspoke orally but that’s $4.3 million.

Eric Ghernati – Bank of America

Okay.

JD Fay

But in the context of pricing, we did say in our last call that ASP declines was on the greater end of our historic 10% to 15% per year range. And that – and that’s still true. Of course, we had the manufacturing costs which we just discussed that makes the whole process or the numbers more complicated, but when you exclude that, what you find is that we actually had a fairly favorable product mix in the quarter.

And as Tim talked a lot about, we had a good continued growth even ex seasonality in 100 Gig products, in particular 40/100 Gig as a combined group grew nearly 300 or over 300% year-over-year. Our access business was also steady, and of course that has typically lower than average gross margins. And so with greater higher gross margin products relatively to the access business, it tends to also provide an uplift. So underneath all of the manufacturing costs, what you find is, I think some fairly healthy positive trends in high speed and higher gross margin products. So that I think actually explains the reason why you don’t see the full impact of the ASP declines in the fourth quarter. Finally, of course the ASP declines tend to go into effect at the end of the quarter. So that impact is not the full 15% of course or 10% to 15%. It’s only approximately one-third of that.

Eric Ghernati – Bank of America

But even if I look at the Q1 guidance, and I add back the $3 million. It does seem like in on-apples-to-apples basis, you’re basically looking at a pricing impact shall we call it in the neighborhood of like 200 bps. And so, it doesn’t seem like it’s similar to the 10, the high end of the 10% to 15% range as you guys discussed. Is this all like just more favorable product mix that’s what the reason is?

JD Fay

It is a lot to do with the mix. Of course, we don’t negotiate every product in this period and not every product has the same pricing change, but we continue to believe that our high-speed and higher gross margin products will continue to grow over time. We also believe that they’ll become a larger percentage of the total. And so I think you will see a more muted effect in the first quarter compared to doing the straight math.

Eric Ghernati – Bank of America

Okay. And how should we think about the catch-up for these costs in the second half. Like, are you going to recover like the whole $4.7 million plus $3 million plus $2 million or like how should we think about it?

JD Fay

Well, it’s our expectation that the manufacturing costs topic that we’ve been talking about will be eliminated by the end of the second quarter. So, we do not expect that to continue into the back half of the calendar year. Further, we have a whole host of cost reduction activities, as we do each year that are planned for the year. And that’s one of our main strategies to mitigate the ASP declines that occur in a more step function way at the beginning of the year.

Those cost reduction plans require the better part of the year to implement up. So, we should and we do expect to see more of those positive impacts in the back half the year. And then finally, as we go into the middle part of the year, we would expect to be in the growth position relative to where we think the market is going as Tim talked about earlier in terms of its improving. We believe the fundamentals will improve, the CapEx will grow, plus it’s our seasonal high period. So, we would expect more absorption in our factories. Therefore more operating leverage and margin leverage when combined with increased cost reduction, we think will increase the gross margin.

Eric Ghernati – Bank of America

Okay, thank you.

JD Fay

You’re welcome.

Operator

Next, we move to Brian Modoff with Deutsche Bank.

Vijay Bhagavath – Deutsche Bank

Yeah, hi guys. This is Vijay Bhagavath calling on behalf of Brian. You can hear me, okay.

Tim Jenks

Hi, Vijay. Yeah, we can hear you, just fine. Thanks.

Vijay Bhagavath – Deutsche Bank

Yeah, hi. So, yeah two questions. The first one is you obviously talked to a lot of your OEMs and customers in China. What’s your view of China service provider spending, you think it could improve heading into the back half, it could stay flattish. I mean, we’re hearing conflicting views on that?

Tim Jenks

Are you specifically referring to what are the China carrier CapEx plans for the year. Is that you are referring?

Vijay Bhagavath – Deutsche Bank

Yeah, and know kind of any from your own discussions with customers and/or service providers. Do you get the sense service provider Telco CapEx spending in China would improve as we hear it…?

Tim Jenks

Yeah. Okay. Of course, as we’ve seen over multiple years and as JD mentioned briefly the timing of the Lunar New Year, the Chinese Spring Festival, as it were, it just ended. And so it is generally after this period of time that annual plans are announced and rolled out. And so that it is generally subsequent to this period that demand forecast are fully known. Now what we have seen is increasing forecasts from some of our customers and so that the forecast then are expectations that are in line with what they believe the CapEx plans will be of course, this year we also have the overlay of new government and how their new policies will affect in terms of infrastructure investments and growth.

Generally speaking, we would expect to see the June quarter reasonably higher than the March quarter for that reason as plans rollout post Spring Festival, the lead times for products tend to have very limited effect in the first quarter, but a strong effect on the second quarter and then going into the third quarter as long ago as September, October of 2012 we heard discussions of the so-called Broadband China initiative, which we expect to continue to increase demand for access products and then we’ve seen increasing rates of deployment for high speed coherent 100 Gig networks as well.

So both in the high-speed coherent 100 Gig as well as in the fiber to the home we expect the market drivers in the China telcos will be reasonably strong.

Vijay Bhagavath – Deutsche Bank

And the second question is a little more conceptual which is you obviously have to do these down rounds of price negotiation every year. But then you have fixed costs, you’ve manufacturing costs. So any thoughts on rethinking the vertical business model because you obviously have to do price negotiation, but you can’t negotiate down your costs, your cost of running your fabs and whatever else in manufacturing?

Tim Jenks

Well, the reality of our business is that there are strong volume drivers in the business overall. We are seeing substantial increases in volume on a quarter-on-quarter and year-over-year basis. There are very strong increases in forecast for the high-speed and coherent products. And so we are over time actually working on cost reductions not just on a variable level, but also on a fixed level, we do serve the industry’s largest customers and the fact that we do operate many of our own manufacturing facilities we tend to be faster in our ability to ramp than average, more able to ramp quickly for a focused demand and our large OEM customers appreciate that capability. So ultimately, if we do have the internal capability with faster response. We do get the benefits of increases in demand with more business, more volume and then we’re able to spread our fixed cost over that larger volume and the result of that is really, every year for the last seven or eight years, we’ve grown our business in the range of 20% plus per year.

And, we do that recognizing that ASPs will decline in that cost reduction, particularly cost reduction through technology advances and design benefits has to drive our ability to provide lower-cost solutions to customers, but it is a complex and a competitive business. But, that is not a trend that we anticipate is going to rapidly change. So I hope that addresses your question.

Vijay Bhagavath – Deutsche Bank

Yeah, thanks, very helpful. And then final question is on the mix, you have roughly 60% exposed to speed and agility, little over 30% to access, do you see that percentage mix skewing towards speed and agility this year or it roughly remains to 60% - 30% split?

Tim Jenks

Well, we do see that generally continuing, what we did talk about is the fact that particularly, the high-speed products are going to continue to grow. The fact that they are continuing to grow, we’ve seen that quarter-over-quarter. I did mention 40/100 Gig products being 17% in the first quarter, 25% in the second. Now they are in the range of a third of our business for the year. We would expect that to continue to trend up actually. So generally speaking, we might see the trend on the 40/100 Gig continue upward towards 40% of our business and we might see the access business in the range of a quarter of our business. So that, I think the trends will continue.

Vijay Bhagavath – Deutsche Bank

Very thanks, very helpful.

Operator

And there are no further questions at this time. I would like to turn the call back to over Mr. Jenks for additional or closing remarks.

Tim Jenks

Thank you very much to everyone for joining us today. Before we conclude, I would like to thank our shareholders for their time today and their continued interest in our company. I also want to thank our customers for their continued support, and our exceptional employees for their dedicated, diligent, and professional efforts. We look forward to our next update with you. Thank you very much.

Operator

And that will conclude today’s call. We thank you for your participation.

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