Opnext Inc. F4Q10 (Qtr End 03/31/2010) Earnings Call Transcript

May.19.10 | About: Opnext, Inc. (OPXT)

Opnext Inc. (NASDAQ:OPXT)

F4Q10 Earnings Call

May 19, 2010 4:30 pm ET

Executives

Steve Pavlovich – VP, IR

Gilles Bouchard – President and CEO

Bob Nobile – CFO and SVP

Analysts

Paul Bonenfant – Morgan, Keegan & Company

John Zaro – Bourgeon Capital

[Shale Wayne] – Lotus Investment Management

Operator

Welcome everyone to the fourth quarter earnings conference call. (Operator instructions) I would now like to turn today's conference over to Steve Pavlovich, Vice President of Investor Relations. Sir, you may begin.

Steve Pavlovich

Thank you. Good afternoon and thank you for joining us. Today we will discuss our financial results for the fourth fiscal quarter ended March 31, 2010. We will begin with Gilles Bouchard, our President and Chief Executive Officer, for an overview of the quarter followed by Bob Nobile, our Chief Financial Officer, who will provide additional detail on the financial results. Then Gilles will talk about operational plans and guidance and then of course we will follow with Q&A.

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 laws and our Safe Harbor statements in the company's filings with the SEC.

So with that, I will turn it over to Gilles.

Gilles Bouchard

Thank you, Steve, and good afternoon everyone. As you have already seen from our earlier announcement in the face of a generally strong demand environment we had a disappointing outcome in our fourth quarter.

We saw customer demand build throughout the quarter especially in the month of March. This resulted in strong growth in our 40G and above and industrial and commercial businesses. Unfortunately, due to supplier [de-commitments] at the end of the quarter in our 10G and below business we were not able to execute to our plan. While the component shortages continue to be a challenge industry wide we have taken actions to improve the availability of parts from our suppliers and to increase our production capacity. I will expand on these actions later in the call.

As I said, overall we have seen a strong recovery in our core market of 10G and above optical transmission except in 40G sub-systems where customer inventory levels are still an issue. The 10G datacom market has shown steady improvement and telecom has continued to gain momentum. We have seen broad and sustained growth in 40G line side and client-side modules.

Looking at margins, non-GAAP gross margin improved by more than two points this quarter, an encouraging outcome in view of the modest quarter-to-quarter revenue growth and seasonal pricing pressure encountered in Q1. We will talk more about gross margin trends in a moment. R&D expenses were higher this quarter. You will recall we made a number of milestone announcements in our 100G program this quarter; most notably our successful field trial with AT&T and Cisco. Our efforts to advance our R&D program together with a higher level of new product introductions account for the increase in R&D spending this quarter.

I will turn it over to Bob Nobile now to review the Q4 financial results in more detail.

Bob Nobile

Thanks Gilles. Good afternoon everyone. We generated total revenue of $76.8 million representing an increase of approximately $700,000 compared to the December quarter. Sales of our 10G and below products decreased 11% to $48.9 million primarily as a result of lower 300 Pin Tunable and X2 modules.

Demand for 10G and below products was strong but component shortages limited our ability to ship. Our 40G and above revenues increased 30% to $21.8 million. This increase was driven by strong growth in 40G module sales and higher R&D contract revenues. In addition, industrial and commercial product sales increased 45% to $6.1 million. Compared to the quarter ended in March 2009 our sales decreased $6.8 million from $83.6 million. Revenues in the recently completed quarter included $14.2 million from Opnext subsystems, formerly StrataLight.

For the quarter ended in March, Cisco and NSN each represented 10% or more of total revenues. Combined, these two customers represented approximately 42% of total revenues in both the December and March quarters. Geographically, revenues in North America represented 46% of total revenue while Europe represented 25%; Japan 10% and the rest of Asia was 19%. This breakdown is fairly consistent with the December quarter. Gross margin was 18.8% compared to 15.9% for the December quarter. Non-GAAP gross margin was 20.9%, an increase of 220 basis points from 18.7% in the December quarter.

The increase in gross margin was primarily driven by higher 40G and above revenues, favorable product mix and a 60 basis point favorable currency impact partially offset by lower average selling price. Just a note on currency. The dollar averaged less than 91 Yen in Q4 and we have hedged about 75% of our Q1 exposure at roughly 92 Yen to the dollar. We have also hedged about 25% of our Q2 exposure at 94 Yen.

Looking forward to the first quarter of fiscal 2011 we expect our gross margin percentage to improve modestly from Q4 primarily due to higher sales volumes and lower average unit costs which in the aggregate are expected to offset the decline in average selling prices. R&D expenses were up $1.4 million to $18.9 million in the March quarter from $17.5 million in the December quarter while non-GAAP R&D expenses were $18.4 million compared to $16 million in the prior quarter.

R&D spending came in above the high end of the non-GAAP range of $16-18 million per quarter that we had previously discussed. This was primarily a result of higher material and outsourcing costs related to prototype builds. For the year-ended March 31, 2010 total non-GAAP R&D spending was $67.8 million or about $17 million a quarter.

SG&A expenses increased approximately $500,000 from $13.2 million in the December quarter while non-GAAP SG&A was $12.4 million up $1.2 million compared to the December quarter primarily due to costs associated with the OSC Trade Show in March, the resumption of payroll taxes at the beginning of the calendar year and higher costs associated with customer samples. Looking forward to Q1 we expect SG&A expenses to be slightly higher than Q4.

Operating loss for the March quarter was $18.5 million compared to an operating loss of $19 million for the December quarter. On a non-GAAP basis operating loss was $14.7 million compared to $13.1 million in the December quarter. The increase in non-GAAP operating loss primarily resulted from higher R&D and SG&A expenses that were partially offset by higher gross margin.

Net loss was $18.3 million or negative $0.20 per fully diluted share compared to a net loss of $18.6 million or negative $0.21 in the prior quarter. Non-GAAP net loss for the March quarter was $14.5 million or negative $0.16 per fully diluted share compared to $12.7 million or negative $0.14 in the prior quarter. EBITDA was negative $11 million compared to negative $11.4 million in the December quarter. Adjusted EBITDA in the March quarter was negative $9 million compared to a negative $7.3 million in December.

Cash and cash equivalents decreased by $13.7 million to $132.6 million at March 31, 2010 reflecting $2.7 million of capital expenditures, $2.5 million of capital lease payments, $8 million of cash used in operations and a $500,000 negative effect from foreign currency fluctuations. Cash used in operations included the final payment in connection with the StrataLight employee liquidity bonus plan of $2.1 million.

Now let me turn it back to Gilles to provide our market outlook, operational update and guidance.

Gilles Bouchard

Thank you Bob. Let me take a few minutes to provide a market update as well as an overview of our new product initiatives, design wins and a summary of the work we are doing to optimize our Japan operations.

First of all the market. We are seeing strength building in our core market of 10G and above transmission. While the total market is expected to grow at 15% [inaudible] over the next three years according to industry analysts, the 10G and above transmission market, or switch box, is projected to grow 25% and the 40G and above market is projected to grow 45%. Consistent with this long-term market view we saw demand pick up in the latter part of Q4, a trend which has continued into the new fiscal year.

The 10G datacom market recovered in late 2009 and the recovery has been sustained in 2010. 10G telecom continues to gain momentum and is driving a lot of the current demand upside. We are also experiencing a resurgence of the 40G market. Much of the growth is driven by major carrier deployments in China but we are now also seeing deployments in all regions of the world. Demand for 40G client modules has been especially strong after a weak year in 2009 as many of the new deployments favor 40G transponders over 4x10G [inaudible].

40G line side module demand is also picking up as we ramp up new products such as a DPSK and the 2PSK modules. Offsetting module strength on the subsystem side we expect the 40G line card business to be very weak in Q1 as customers continue to reduce their inventory levels. On the other hand, we are seeing solid demand for the chassis in which line cards are housed. This points to a more encouraging picture for the long-term sustainability of this business.

On the new product side you have been hearing a lot about our 100G initiatives, particularly the demonstration of real-time 100G coherent transmission in the AT&T network. 100G line side will continue to be a major area of investment for us in 2010 and is targeted to produce revenues in 2011. This year we have several important new products coming out primarily from our Japan operations that will contribute to revenues and margins in the near-term.

These new products include the SFP+ ER module 9 volume production which uses our new [uncooled] laser technology to provide lower cost and power consumption. This breakthrough technology is being expanded throughout our 10G product line this year. On the 40G and above segment we are ramping up our new 40G DPSK and DSR modules and 100 [GCSP] module, all of which are seeing strong customer interest.

Let me demonstrate the importance of our new product introductions. In the next six months we expect a proportion of our revenues generated by products less than one year old to be at least five times what it was in 2009. So the new product flow is good but how are we doing with market acceptance? As you know, very important to successful new product introductions are design wins and the qualification process.

During Q4 we had good progress in this area. In 40G modules we are now qualified in 52 slots across 25 customers, an increase of 7 slots and 3 customers from last quarter. In 100G we are in the qualification process of 8 slots with 5 customers, an increase of 6 slots and 4 customers. In 10G we added 16 new slots and 4 new customers.

When you look at the market opportunity along with our new product flow and design wins it paints a positive picture. However, offsetting this are supply chain and capacity challenges. To address these constraints we have been taking actions to improve our ability to meet demand. For example, we have started to rebuild our [brokerage] talks both in-house and at our suppliers which are up about 30% from last quarter. Starting last year we launched an initiative to increase the number of second sources for key components which have increased significant as of today.

Finally, we have continued to add capacity. For instance, we are increasing module production capacity by about 40% in the first half of fiscal year 2011. Nevertheless, we expect the supply chains of both semiconductor and optical components to remain constrained for at least two quarters.

Moving on to our initiatives in Japan, to refresh your memory last quarter we said we were putting a plan in place to focus our Japan operations on our core competencies and competitive strength; optical device design and manufacturing the advanced module development and new product introductions. We also said we intended to leverage across the whole company. This plan has now been executed and activities such as module and subassembly manufacturing are being outsourced off-shore. We expect these actions to reduce our [relative] exposure and provide a 2 point gross margin improvement when truly implemented over the next five quarters.

Now let’s move to Q1 guidance. For 10G and below products while supply constraints are still a challenge we expect to see solid growth from the disappointing levels of Q4. 40G and 100G modules are also expected to post strong growth which will be offset this quarter by very low sales of 40G line cards. In view of these factors we expect the 40G and above revenues to decline moderately in Q1. Finally, our industrial and commercial business posted 35% and 45% growth rates in the past two quarters and is now above [full] downturn levels. As such, for Q1 we expect revenues in this business to be flat compared to Q4.

Based on the foregoing we expect revenues to be in the $80-85 million range for our first fiscal quarter ending June 30, 2010. With that I will now turn it back to Steve to begin the Q&A portion of our call.

Steve Pavlovich

Thanks Gilles. That completes our prepared remarks and we can take your questions now. Operator, would you please provide the instructions on how to submit questions?

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Paul Bonenfant – Morgan, Keegan & Company.

Paul Bonenfant – Morgan, Keegan & Company

You talked about supply constraints leading to the preannounced sales below the forecast in March. It was 10G products and below. I am wondering if you could just be a little more specific. Was that mainly related to your 10G products? Lower speed? Both? As a follow-up question can you quantify how much revenue was left on the table as a result and was this revenue pushed into the next quarter or do you think some of it may have gone to your competition?

Gilles Bouchard

Let me start. It was essentially on the 10G product line. I think as you know we have supply constraints across the board but the one that affected the announcement we are really focused on the 10G product line.

Bob Nobile

In terms of the amount, the carryover into the quarter was probably several million dollars. We will see some of that come through in the guidance we have provided but then you also have to take into consideration the continuing challenges we have with some of the supply chain parts.

Paul Bonenfant – Morgan, Keegan & Company

You talked about SG&A being up sequentially and I am wondering if that is mainly related to the higher volumes since you don’t have the impact of OFC in the quarter. Also I don’t recall if you gave us the direction R&D would be going in the current quarter.

Bob Nobile

First off on the SG&A portion, you are correct in that part of the increase is due to the higher revenue volumes but what we have also done is we have reinstated the salaries back to fiscal year 2009 levels. As you will recall back in April at the beginning of our past fiscal year we had put salary reductions in place across the entire workforce. So those are going back in place this April 1.

On the R&D as I mentioned we averaged for fiscal year 2010 about $17 million per quarter and we expect to see those levels kind of continue into the near future here.

Paul Bonenfant – Morgan, Keegan & Company

You talked about your sub-systems revenue being down sequentially. What gives you confidence that market is coming back? Is it what you alluded to earlier the fact that you are deploying substantially more chassis today which should provide you with slots to fill going forward?

Gilles Bouchard

There are really two factors on this one. One is that for the last year we have been mostly shipping line cards into existing chassis. What we have seen this quarter on the downside is very few line card orders from our traditional customers but very large chassis orders. It does point to a positive long-term picture and we are working on the details month by month and quarter by quarter this will provide. The other element is we also have been pursuing and have been quite successful at new opportunities and we are still pursuing some for this quarter but based on where we are today we think some of those opportunities will push into some of the next quarters.

Paul Bonenfant – Morgan, Keegan & Company

I am wondering if we are ready to call an inflection point on the cash burn here or do we have to get to EBITDA break-even first and if so has that break-even point changed in terms of an operating model target or do you have any updates for us there?

Bob Nobile

No, the non-GAAP EBITDA breakeven target remains consistent at $95 million of revenue per quarter. Getting to that will get us to a better position to get to a positive cash flow position. As we look at least to the first half of this year we will continue to use cash. Gilles talked about an increase in capacity. Some of that capacity will require additional funding from us although a good amount of it will come from improved testing procedures and improved productivity as well as the reuse of some of the equipment throughout the organization.

Our capital lease payments should stay relatively consistent with what you saw this past quarter and the rest will depend upon how the P&L develops as well as how well we manage working capital. Our receivables tend to be in a good position at about 64 days DSO and we would expect those levels to continue. Inventory at the end of the quarter was about 138 days. We would expect the days to come down as the year progresses, however the dollars may increase a bit to support the revenue growth and then payables and accruals should kind of trend with the business.

Paul Bonenfant – Morgan, Keegan & Company

Is there an implicit assumption for the Yen exchange rate on the $95 million?

Bob Nobile

Yes. Again, that hasn’t changed either. That is just 90 Yen to the dollar.

Paul Bonenfant – Morgan, Keegan & Company

If you could I think you mentioned you had reduced your exposure to the Yen. Could you update us ballpark where it is relative to COGS and OpEx?

Bob Nobile

It is approximately $25 million net exposure per quarter.

Paul Bonenfant – Morgan, Keegan & Company

Can you ballpark how that splits between COGS and OpEx?

Bob Nobile

Think of it this way. From a cost of goods perspective, we are down in the mid 30’s of a Yen exposure there. Total OpEx is about that percentage as well. If you recall those numbers back a year or so ago were 80% exposed on the COGS side and 50 on the OpEx side.

Paul Bonenfant – Morgan, Keegan & Company

So they have come down?

Bob Nobile

Yes.

Operator

The next question comes from the line of John Zaro – Bourgeon Capital.

John Zaro – Bourgeon Capital

I guess I was expecting after your last call and the conversations we have all had in the interim that you were going to give a little more detail of a roadmap of how we were going to get to break-even. Also, a roadmap of exactly what you were going to do on cost cutting in Japan. So I am a little confused that the sort of two lines thing about what is going to happen and your break-even is still $95 million is the answer to where we are going. The reason why I ask is because obviously you have looked at all of your other competitors and they all seem to be doing quite well in the last 2-3 quarters. I know you are spending a lot of money. We have all been very patient on that. I was kind of expecting a little bit more on how you were going to get there.

Gilles Bouchard

Let me try to throw a few things out there that…

John Zaro – Bourgeon Capital

As you remember Gilles when you and I met back in December you told me we were only going to have to wait for this next six months. We are now at the six months. Your stock is the same price as it was before, you are still burning cash and we are nowhere.

Gilles Bouchard

Your question is about break-even, right?

John Zaro – Bourgeon Capital

Breakeven and also just the cost cutting overall in Japan because 2 margin points doesn’t seem like a lot.

Gilles Bouchard

We have been doing a lot of things in Japan. Let me put it in perspective. Last year when the downturn occurred we focused a lot on expenses across the company and we had a $25 million cost reduction plan that has a lot of implications in Japan and the Yen exposure and the percent Bob talked about. Ever since, this year we have been focusing a lot on new products and R&D productivity. We believe the first quarter factor for us to regain profitability and leadership out of our Japan operations is through a renewal of the product portfolio.

We have talked about it before but Opnext came into 10G as a market leader but the 10G market has become very competitive and it was time for us to come up with new technology and new products. This [inaudible] is happening this year with some of the new exciting technologies I have talked about at 10G as well as a new generation of 40G and a….

John Zaro – Bourgeon Capital

Can you back up for a second? The operator just came in. Can you just back up like 30 seconds?

Gilles Bouchard

Number one was expenses for this year. Number two, R&D productivity and a whole series of new product introductions which we are right in the middle of right now. So we have completely renewed the portfolio. If you recall what I said is last year our revenue from new products, I mean this year, will be five times more the proportion of revenue to last year. So a major effort that is starting to come on in the portfolio renewal. The third element is some of the fixed cost reductions we talked about which is an additional two points which is on top of all of the other things; the new products and the expenses which come with the structural aspect which is a lot of off-shoring and outsourcing of activity in Japan.

Those things and their benefits are coming on board quarter after quarter. The new products are coming out this quarter and next quarter and throughout the year as well as the actions taken in Japan. So we do have a roadmap that takes us where we need to go but it is a quarter after quarter progress.

John Zaro – Bourgeon Capital

I guess the question is if you are doing this why is the break-even level never change? In other words you are doing almost $400 million. You have to do almost $400 million worth of revenue to actually make money?

Gilles Bouchard

The difference is I have talked about Japan but we have made difficult and conscious decision to invest very heavily in the 100G program in the face of the declining sub-system business. So basically the progress we are making in Japan is being bound by the increasing investment in 100G and the decreasing in the subsystem business. That is the bottom line.

Bob Nobile

So again when you take all of those things into consideration, we have been able to maintain our 40% contribution level. So as the revenues growth we will be able to realize the benefits in the margin through that metric.

John Zaro – Bourgeon Capital

Right but the issue is you are going to have to grow your revenues another 15-20% over the next quarter before you even get to break-even. It just seems kind of a stretch to me you can generate almost $400 million a year in sales and you can’t make any money. I understand why.

Bob Nobile

Gilles described the expectations for the market and we will see how the business develops based on that.

Operator

The next question comes from the line of [Shale Wayne] – Lotus Investment Management.

[Shale Wayne] – Lotus Investment Management

On the inventory I think you mentioned the DSOs [inaudible]. You also said that your buffer inventories are looking to increase. Does that mean the buffer inventories are not to be on the balance sheet?

Bob Nobile

Some of the buffer inventories are to the extent that it is BMR related inventories that were sitting at either our customers or their related CMs. But part of the buffer is sitting in our CMs and will be on their balance sheet.

Gilles Bouchard

When you look at the areas we had difficult in this quarter, the 10G, most of this production is at the worst [that our] buffer inventories don’t fit on our balance sheet.

[Shale Wayne] – Lotus Investment Management

It is sort of falling on a prior question, it just strikes me as you have ramped the revenues it strikes me you could be a little more efficient on the inventory side. Am I missing something on that?

Bob Nobile

We agree. We expect our days on hand to decline as the year progresses but the actual dollar amounts may increase.

[Shale Wayne] – Lotus Investment Management

Let me try this another way. To the extent you get to EBITDA break-even at say $400 million of revenue, I am thinking the DSOs in the mid 60’s is reasonable. Can inventories get down to 100 inventory days?

Bob Nobile

Towards the end of the year that is a goal of ours.

[Shale Wayne] – Lotus Investment Management

Totally separate, you mentioned the top 10 greater than 10% customers were something like 42% of revenues. So does that mean the revenues from the top ten customers declined sequentially?

Bob Nobile

No. The 42% represents only those customers that individually represent in excess of 10% of our total revenues.

[Shale Wayne] – Lotus Investment Management

So that is Cisco and NSN.

Bob Nobile

Correct.

[Shale Wayne] – Lotus Investment Management

What was the percentage in the prior quarter? The December quarter?

Bob Nobile

About the same.

Steve Pavlovich

About the same. The difference is we had three customers in excess of 10% last…

[Shale Wayne] – Lotus Investment Management

I understand. Without quantifying or unless you want to quantify but I am assuming you don’t, could you give me some sense on the gross margin either on a breakout basis say chassis versus line card and then separately going from 10G to 40G to 100G?

Bob Nobile

We generally don’t discuss specific gross margin on individual products but when you look at our 40G and above portfolio the margins on those products tend to be higher than the average margins on our 10G and below business.

[Shale Wayne] – Lotus Investment Management

So would it be reasonable to assume that 100G is greater gross margin than 40G? Is that your expectation?

Bob Nobile

It all depends upon the timing of the life cycle of the product. At a very initial introduction of the product you are not going to realize your best margins on it because you are dealing with the new product introduction processes in manufacturing as well as lower volumes which will add to higher material costs. As that product ramps to its maturity stage you will see increasing margins and I would expect that as it peaks those margins will be as good if not slightly better than the margins on the 40G product as it introduced.

[Shale Wayne] – Lotus Investment Management

The same comment on chassis versus line card. If I were to make the comment I would think the chassis gross margins are lower than line card gross margin would you agree or disagree?

Bob Nobile

On a general basis maybe to some extent but I wouldn’t put a great amount of credence to that.

Operator

At this time there are no further questions.

Steve Pavlovich

Thank you operator. With that we will conclude our call for today. Thanks for joining us this afternoon. We look forward to talking to you soon. Bye for now.

Operator

Ladies and gentlemen thank you for participating in today’s conference call. You may now disconnect.

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