Opnext, Inc. Q3 2009 Earnings Call Transcript

Nov. 9.09 | About: Opnext, Inc. (OPXT)

Opnext, Inc. (NASDAQ:OPXT)

Q3 2009 Earnings Call

November 9, 2009 4:30 pm ET

Executives

Douglas Dean – Vice President Investor Relations

Gilles Bouchard – President, Chief Executive Officer

Robert Nobile – Chief Financial Officer

Analysts

Daniel Morris – Oppenheimer

[John Zorrow – Borjing Capital]

Paul Bonenfant – Morgan, Keegan & Company

[Sven Enma – Thomas Weisel Partners]

Todd Kaufman – Raymond James

[Edward Savisky – ACI Research]

Operator

I would like to welcome everyone to the Opnext Incorporation second quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Douglas Dean, Head of Investor Relations.

Douglas Dean

Good afternoon. Thank you for joining us today. I’m Doug Dean, Vice President of Investor Relations for Opnext. Today we will discuss our financial results for the second quarter ended September 30, 2009 and provide some commentary regarding our market conditions and business outlook. We’ll begin with remarks from Gilles Bouchard, President and Chief Executive Officer of Opnext along with Bob Nobile, our Chief Financial 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 of the rules and regulations of the Securities Act and our Safe Harbor statements in the company’s filings with the SEC. And now let me introduce Gilles.

Gilles Bouchard

Good afternoon everyone. Let me start by saying that our performance was mixed this quarter. Our 10G module sales continue to rebound from the lows of our fiscal fourth quarter and customers tone continues to be positive. We achieved nearly 10% sequential quarterly growth in our 10G telecom business which exhibited more stability throughout the downturn and our 10G datacom business grew more than 10% of the previous quarter. This portion of our business decreased more dramatically during the downturn and has more upside potential.

Results from our 40G sales were disappointing and continue to experience challenging Yen exchange rates. The lower than expected 40G sales resulted from a slowdown in the U.S. market segment due to customer rebuilds and cautious spending tied to the global economic uncertainty.

The net effect of the sequential revenue decline of $4.2 million or 5% to $81 million. During the quarter we continued to control costs and expenses resulting in gross margin operating expense and EBITDA improvements.

Despite lower revenue and unfavorable Yen exchange rates, non-GAAP EPS was unchanged at negative $0.10 per share and adjusted EBITDA grew slightly as compared to the previous quarter. These results were achieved while we continue to invest in new products and technologies resulting in increasing design wins and improving momentum with our customers.

Our efforts at higher network speeds as well as several customer R&D contracts with future revenue are milestones. This is a promising development that dominates our decision to continue to invest during difficult times.

Now let me turn it over to Bob to review the details of our second quarter performance.

Robert Nobile

Good afternoon everyone. Opnext generated total revenue of $81 million, representing a decrease of $4.3 million compared to the previous quarter. Sales of our 10G and below products increased about 4% to $49.9 million and an 8% increase in 10G sales primarily from higher sales of SFP and SFP+ products which was partially offset by reduced sales of less than 10G SFP products as we continue to be selective in this highly price sensitive market.

Sales of our 40G products decreased $7 million to $28 million. And finally, industrial and commercial product sales increased about 35% to $3.1 million.

Compared to the quarter ended in June 2008, our sales increased $800,000 from $80.2 million including $24.3 million from Strata Light. For the quarter just ended in September, sales to Cisco and Nokia Siemens’ networks represented approximately 48% of total revenue. This is consistent with our aggregate percentage in the prior quarter as increased sales to Cisco were offset by decreased sales to NFN.

Geographically, revenues in North America represented 44% of total revenue while Europe represented 34%, Japan 10% and the rest of Asia was approximately 12%.

Gross margin was 21.7% compared to 19.6% for the June quarter. The September quarter included a 250 basis point negative effect from non cash charges and costs associated with the acquisition of StrataLight compared to a 360 basis point negative effect in the June quarter.

Excluding these effects as well as the impact on stock based compensation expense; non-GAAP gross margin was 24.2%, an increase of 100 basis points from the 23.2% in the June quarter.

This improvement primarily resulted from higher 10G and industrial and commercial product volumes, lower material and outsourcing costs and a 170 basis point net benefit from lower inventory charges which in the aggregate more than offset the negative effects from lower average selling prices, lower 40G sales and a 190 basis point negative impact from foreign currency exchange fluctuations and hedging programs.

Research and development expenses decreased approximately $300,000 to $8.7 million from $19.1 million in the June quarter while non-GAAP research and development expenses were $16.5 million as compared to $16.9 million in the prior quarter. This $400,000 decrease primarily resulted from a $700,000 reduction in R&D spending, offset by a $300,000 negative impact from foreign currency exchange fluctuations.

Selling, general and administrative expenses decreased $900,000 to $13.5 million from $14.4 million in the June quarter while non-GAAP selling, general and administrative expenses were $11.3 million in both periods as higher trade show costs in the September quarter, as well as lower selling related expenses.

Operating loss for the September quarter was $17 million as compared to an operating loss of $23 million for the June quarter while non-GAAP operating loss was $8.2 million compared to $8.5 million in the June quarter.

The reduction in non-GAAP operating loss primarily resulted from the improvement in gross margin and lower operating expenses partially offset by an approximate $2 million negative effect from foreign currency exchange fluctuations.

Net loss was $17.9 million or negative $0.20 per fully diluted share compared to a net loss of $23.7 million or negative $0.27 per fully diluted share for the June quarter.

Non-GAAP net loss for the September which excludes non cash charges and costs associated with the acquisition of Strata Light and stock based compensation expense was $9.2 million or negative $0.10 per fully diluted share which was unchanged from the June quarter despite a $0.02 negative effect from foreign currency exchange fluctuation and hedging programs.

Cash and cash equivalents decreased by about $10.2 million to $155 million at September 30, 2009 reflecting $1.1 million of capital expenditures, $2.7 million of capital lease payments, $7.7 million of cash used in operations and a $1.2 million benefit from foreign currency exchange fluctuations.

Other assets other than cash and cash equivalents increased by approximately $2.7 million resulting from a $2.9 million increase in accounts receivable and a $7 million increase in account payable partially offset by a $6.5 million decrease in inventories and a $700,000 net increase in accrued expenses and other current assets.

Beginning this quarter we have included a calculation of EBITDA and adjusted EBITDA on our earnings release as we believe this will be useful information for investors to gain a better understanding of our core operating performance.

Our adjusted EBITDA improved by $400,000 from the June quarter to negative $3 million despite lower sales and a $2 million negative effect from foreign currency exchange fluctuations and hedging programs.

And now let me turn it back to Gilles to discuss our operational plans, current view of market conditions and guidance.

Gilles Bouchard

Let me update you now on the four key elements of our operational plans, reduced fixed and variable costs, design wins, and R&D investments.

In the face of slumping 40G sales and challenging Yen exchange rates, we took additional actions in October which we expect will reduce the annual operating costs by approximately $3.5 million. We also continued to make progress in our variable cost initiatives. The resulting cost reductions contributed to the higher gross margins as Bob described earlier.

While the 10G market is increasingly competitive, we continue to see strong activity in 10G obligations and improved our position by more than 30 design wins this quarter. Also during the quarter, we continued to obtain 40G design wins with an additional nine qualifications bringing the total number of design wins to 42.

Of the new qualifications, six were 40G wins. The combination of new wins and product going out to existing customers supports our sustained line for demand overlapping with the migration to line side modules. Our line product has now been decoding over 14 tear networks and two additional OEM customers have begun to market our line cards to their carrier install base.

Beyond these immediate successes, our long vision to strengthen the industry through the following efforts; first, we have and will continue to penetrate through broad industry partnerships for 100G and next generation 40G products.

Second, we’ll lever the system expertise into the development of software and chip sets thus driving the migration to software. And finally, we will leverage our long standing optical expertise to advance tectonics integration.

Our customers need strong partners to show the development efforts and Opnext’s unique position will enhance the stability such as network modeling, line card reference designs and access to prototypes and for carrier trials. Thus far we have signed contracts to several customers and are in discussions with others. The value of agreements sold is approximately $7 million to date.

During the quarter we received payment of $2 million in association with these contracts but the revenue has been deferred until the completion of milestones leading to delivery of the final products. We believe this early engagement including strong communication of customer commitment to our technology and validation of our vision.

Based on the new business developments and continued cost reductions we have retained our $95 million non-GAAP EBITDA break even points with a lower exchange rate of 90 Yen per dollar.

Now let me touch on what we’re seeing in the market place. As I mentioned earlier, the current downturn in our Fuji business has resulted from the build up of company metrics and deferred spending for economic reasons. These trends are affecting both our establishing line card business and our emerging module business, especially in U.S. networks.

In contrast, carrier 40G carrier in China and other emerging markets has developed rapidly while generally being smaller in size and scope. Design wins in these emerging markets have involved both line cards and module based solutions.

Finally, in Europe and regional U.S. markets, 40G performances are expected to develop slower because of the technical challenges and poor economics versus 10G. Deployments are in early stages and we don’t expect an acceleration until later next year.

Consequently we expect 40G product sales to decrease with sales likely to bottom and some recovery likely starting in Q4. The potential market continues to recover. Our telecom product sales are pushing pre downturn levels on the strength of SFP modules. Our datacom products continue to rebound and Q3 looks strong.

Our business has stabilized in lower levels and we will continue to be selective on the pricing environment and we expect industrial and commercial businesses to continue to recover after having bottomed out in our fiscal first quarter.

So while recent customer engagements have been very positive and suggest an improving tone, we expect to see continued degradation in our market in the December quarter with continuing growth in 10G while our 40G business will be challenging.

For these reasons we expect revenues to be between $75 million and $80 million for our third fiscal quarter ending December 31, 2009.

And with that, I’ll turn it back to Doug to begin the Q&A portion of our call.

Douglas Dean

That completes our prepared remarks, and now we’ll be glad to take your questions. The operator will now provide instructions on how to submit your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Daniel Morris – Oppenheimer.

Daniel Morris – Oppenheimer

Could you talk a little bit more about what your Yen exposure is now? I know you’ve been taking steps to reduce it.

Robert Nobile

Over time we’ve been able to reduce our cost of goods Yen exposure from about 80% of our total cost down to the mid 30’s. That came from two fronts; the changes that we made in our procurement efforts as well as the acquisition of StrataLight helped us there.

And then on our operating expense side, still about a third more significant piece of that being on the R&D portion of that on our expenses in Japan.

Daniel Morris – Oppenheimer

With regards to the 40G decline that you’re seeing and I know you’ve associated that with inventory reductions, how confident are you that the inventory reductions and reins on projects as opposed to the share loss?

Gilles Bouchard

We know for sure it’s not share loss because as you know it’s a great market in which we have high market share and so we have pretty good visibility to what’s happening. So it’s clearly due to the level of caution on spend and customer entry levels and it would definitely factor in starting in Q3 and Q4.

Daniel Morris – Oppenheimer

It sounded like you added another nine design wins on the 40G side. Would you say your share of the nine wins, has it been increasing, decreasing, holding?

Giles Bouchard

Basically we are present in just about every design win in 40G. It’s a very concentrated market. I think we’re very involved with opportunities and on the line side again, we’ve got six new design wins this quarter, so I think design wins is very high. Again, we do have the market downturn here which is independent of the market share and design win situation.

Daniel Morris – Oppenheimer

And turning to the gross margins, with the 40G declining and revenues also declining sequentially how should we think about margins?

Robert Nobile

Looking toward the third quarter we’re expecting our margins to deteriorate, and we will receive benefits as a result of the higher volumes of 10G and industrial communications products as well as our continued efforts on cost reductions in both fixed and variable.

But with the decline in the 40G revenues as you indicated and the little bit of currency and your normal quarter over quarter ASP decline, we don’t believe that the benefit from the 10G side and the costs are going to be able to offset the downside.

Daniel Morris – Oppenheimer

Any help on how much that might be? 100 basis points or is it…

Robert Nobile

I think you should look to several.

Operator

Your next question comes from [John Zorrow – Borjing Capital]

[John Zorrow – Borjing Capital]

It seems a little stunning to me that given what’s happened to everyone else out there in the marketplace that you have had as much of a fall out looking out further, and I guess the question is for the last three quarters you keep saying that it’s not market share loss. It’s not anything else, but there are other people that have done better and particularly with an outlook. So I guess what’s puzzling, I understand the currency issues but we’ve gone through this whole Strata Light and that was supposed to help you and that didn’t help you because of the problems that obviously happened with the economy, but it just appears that, I don’t think you’re naïve but something’s going on out there with you guys and I don’t know how you address that but not everybody is experience, people are experiencing the opposite of what you’re experiencing right now. They’re actually seeing better, they’re starting to see a better environment even if it’s temporary. You’re basically coming to us and saying you don’t see that.

Gilles Bouchard

You look at the 10G market which is more than half of our revenue, my understanding is what other people are saying, very solid growth, very positive tone. What’s very different with Opnext is we’re very high exposure to 40G and that’s what’s attractive but it’s also hurting us right now.

So the 40G market is going through the same adjustments and gyrations that the 10G market went through a couple of quarters ago. And because we have such high exposure and such high market share, we are indeed being exposed to it. So I truly think our presence and I think over overly strong presence are on the high end of the market.

[John Zorrow – Borjing Capital]

We go through quarter after quarter after quarter with you the same thing. It’s always someone else and how you are positioned and it just seems unusual that here we are in another quarter and everyone knew what was going on with 40G so it just seems that you are hard a little bit heavier.

Operator

Your next question comes from Paul Bonenfant – Morgan, Keegan & Company.

Paul Bonenfant – Morgan, Keegan & Company

You talked about your annual OpEx declining $3.5 million as a result of the restructuring actions that you took in October. When should we see this show up? Could you clarify that? And could you also tell us how we should think about that split between products, R&D and SG&A?

Robert Nobile

Those actions took hold in the second week in October so we’ll get most of the quarter we benefit that annual number this quarter. The majority of it is in cost of goods, I’d say closer to 70% of it with the rest being in OpEx.

Paul Bonenfant – Morgan, Keegan & Company

So the #3.5 million is an annualized number.

Robert Nobile

It’s an annualized number, that’s correct.

Paul Bonenfant – Morgan, Keegan & Company

You talked about your 40G business going down. Is this tied to a specific customer or customer set or is this more broad based. You may have addressed this and I may not have picked it up.

Giles Bouchard

The way I described it is relating to the core of our line side market which is U.S., so it’s several customers and several carriers but it’s highly concentrated as well.

To simplify, when I look at the 40G line side market in three segments; emerging economies and regional and metro, and the later one is emerging market, very small. We see activity in emerging economies in China but from a smaller base so most of the hit right now is the U.S. applications.

Paul Bonenfant – Morgan, Keegan & Company

I think you mentioned that next quarter should be the bottom in the slow down for 40G. Do you expect to get back to a $30 million run rate again in calendar year 2010?

Gilles Bouchard

Definitely yes. The rate and the speed we’ll get it is of course depending on a lot of other actions that will be taken by the carriers in the next few months so we’ll be monitoring this very closely.

Paul Bonenfant – Morgan, Keegan & Company

You also talked earlier and it sounded to me like you had turned away business because of a very competitive pricing environment. Would that be fair to say and could you comment on whether the pricing environment is any more or less competitive than it was last quarter?

Gilles Bouchard

The only place where we’re seeing sometime very irrational pricing is at the very low end of the market so the 1G, the 2.5G which is as you know a very small market for us. So there’s a low market with ties with our business where pricing becomes irrational is really a small portion of our business.

Paul Bonenfant – Morgan, Keegan & Company

Competitors have reported in the last few weeks. Several have cited capacity constraints and stock outs. I’m wondering if you’re seeing this in any of your lines of business that are doing well and that have tailwinds into next quarter.

Gilles Bouchard

We definitely see tension in the pricing for the 10G products. Again, at this point I can’t tell you whether it will have any affect on our numbers and our guidance. I think our teams are working it, but again the 10G market is performing well and it definitely creates some tension in the supply chain.

Paul Bonenfant – Morgan, Keegan & Company

Are you ready to call an inflection point on the cash or do we need to get to the EBITDA break even point first?

Robert Nobile

Let’s talk about some of the pieces. Looking forward, we’ll continue to have a little under $3 million of capital lease payments each quarter. CapEx for the first half of the year was about $3 million in total. We’ll expect that to increase a bit in the second half of the year but nothing too significant.

We do have about $9 million left to pay under the employee liquidity bonus plan coming from the StrataLight acquisition, and $7 million of that will be in the current quarter for December with $2 million in March.

As we look to the second half of this year, our working capital items should be self funding so when you take the six payments that we have, anticipate working capital being about break even. The rest will be dependent on how the P&L develops.

Operator

Your next question comes from [Sven Enma – Thomas Weisel Partners]

[Sven Enma – Thomas Weisel Partners]

I wanted to ask how many 40G revenue generating customers you currently have.

Robert Nobile

We have 42 qualified 40G slots. That over 21 customers and it represents more than 14 specific carrier deployments.

[Sven Enma – Thomas Weisel Partners]

Could you also say who was a 10% customer this quarter or not?

Robert Nobile

They were not.

[Sven Enma – Thomas Weisel Partners]

In terms of if you look at the word exchange rate currently, U.S. dollar versus Yen, how big of an impact would you expect to have on your next quarter’s EPS from that?

Robert Nobile

Given that the rates kind of fell this quarter, our effective rates for the September quarter was probably close to 91 to 92. The dollar/Yen has been trading at about 90 and our go forward impact still kind of falls within this $250,000 to $275,000 per quarter impact for one year.

So assuming the rates kind of stay the same as they are today, the impact going into the December quarter should be fairly minimal.

[Sven Enma – Thomas Weisel Partners]

In terms of operating expense in the next quarter, should we expect them to decline and how much?

Robert Nobile

You have to look at the two components separately. We continue to talk about spending R&D dollars somewhere in the range of $16 million to $18 million per quarter depending upon the timing of prototype build and material requirements. We would expect the December quarter to be towards the high end of that range given some of these R&D projects and the required milestones that we’re looking to achieve.

On the SG&A side, things should be fairly consistent with the current quarter.

Operator

Your next question comes from Todd Kaufman – Raymond James.

Todd Kaufman – Raymond James

In a follow up to an earlier question about your performance relative to the competition, specifically in the 40G area, what you said, you know all the players, a relative small number of players, what do you think you’re market position is there now?

Gilles Bouchard

I really don’t think there’s any third party data.

Robert Nobile

When it comes to the 40G subsystem, our percentage is well over 50% at our specific customers. On the modules, they tend to be, and our 10G business, we’re generally in the 28% to 30% range. In our 40G modules, we’re higher than that.

Gilles Bouchard

The reason I asked Bob to answer this question is on the line card, there’s really not much open competition from optical vendors. We tend to compete more with our customers with other competitors with proprietary designs, so that’s why there’s no third party data on this.

Todd Kaufman – Raymond James

You were in response to an earlier question you were stating, it sounding like you thought you were holding your position in the market and we’re not hearing many of the other players talk about the new type of generation of the business. That’s why I was wondering what makes you think you’re holding your position if you don’t know the market share or it sounds like you’re somewhat hand waving.

Gilles Bouchard

In line cards, there’s no as I say, those tend to be single source divisions. So that pretty good to know what’s happening because in general there’s only one design that’s been deployed?

Todd Kaufman – Raymond James

And the line side is where you said you thought greater than 50%?

Gilles Bouchard

It’s about that, yes.

Todd Kaufman – Raymond James

When you look at the business today, you’re doing $80 million. You’re burning a chunk of cash and losing a fair amount of money and this has been going on. How much longer are you willing to go through this as you wait, hope or hope and wait until you actually right size this thing and get the business in order?

Gilles Bouchard

If you look at our P&L structure versus a year ago, we’re about the same revenue, around $85 million. We’ve actually increased R&D spend by more than $6 million and we’ve cut everything else. We reduced SG&A by more than $2 million in costs, etc. So we made a very conscious decision in the company to invest heavily right now in the next generation products and technology especially when it comes to 100G and next generation 40G transport.

We believe the people and the investment now will capture the market in the future. I believe we can use the strength of our balance sheet to do that and again, if you look at all third party market data, in excess of 30% of part of the market, it is the most attractive part of the market.

So we made a conscious decision again, we could be profitable today if we were spending as much R&D as are our competitors, but we made the conscious decision not to do this.

Todd Kaufman – Raymond James

The question is, you said that about two or three quarters ago and now I want to get an update. How much longer are you willing to go or is it just an indefinite perpetuity until you run out? In another two or three quarters we’re going to reevaluate things.

Gilles Bouchard

We are evaluating every quarter. Obviously the 40G downturn was a bad surprise. We didn’t expect the market to go down as fast as much and based on what happens and how fast it recovers, we’ll adapt our decisions.

Operator

Your next question comes from [Edward Savisky – ACI Research]

[Edward Savisky – ACI Research]

I wanted to ask about the 40G line size. In DQPSK wins, how many of those wins that you said you got this quarter were DQPSK flavor and as a general thing, when do you expect to see revenues, significant revenue from DQPSK modules

Gilles Bouchard

DQPSK is in qualification stages now at most customers so I don’t think we have any final design wins for that and I think those will come in the next few months and quarters. There’s a lot of debate frankly on the DQPSK market. It’s back to what I said earlier about the three segments of the 40G market. DQPSK is a good design for the third segment which I mentioned which is more metro markets where you have to give different type of qualities, and unfortunately when you do this, it’s more challenging. So we believe this market will develop but will develop more slowly.

[Edward Savisky – ACI Research]

So you don’t have any near term expectations baked in for this area.

Giles Bouchard

We have a little bit in there as far as just qualified, but I wouldn’t call it a market changer at this point.

Operator

There are no further question. Mr. Dean do you have any closing remarks?

Douglas Dean

That concludes our investor call for today. I want to thank everyone for joining us this afternoon. We look forward to seeing on our next quarterly earnings call.

Operator if you could please provide the replay instructions at this time.

Operator

Thank you for participating in today’s Opnext Incorporated conference call. This call will be available for replay beginning at 7:30 pm eastern time today, through 11:59 eastern time on November 16. The conference ID number for the replay is 37937586. The number to dial for the replay is 1-800-642-1687 or 1-706-645-9291.

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