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Executives

Bob Nobile - CFO

Ross Saunders - General Manager, Next-Generation Transport, Opnext Subsystems.

Analysts

Gene Munster - Piper Jaffray

Opnext Inc. (OPXT) Piper Jaffray Technology, Media & Telecommunications Conference Call November 8, 2011 3:30 PM ET

Troy Jensen - Piper Jaffray

All right, thanks for it making everyone. I am Troy Jensen, I am the analyst at the Piper Jaffray networking equipment and optical components, I’ve been a big fan of the optical space, I guess, I’m a big believer in longer term growth drivers, it will be an optical upgrade cycle, obviously it’s been really long way. In 2010, 2011 we had a little bit of demand pause, a little bit inventory overhang and now other unpristine issues with the flooding in Thailand.

So with us today is, Bob Nobile, CFO, from Opnext and Ross Saunders, one of you guys just quick give us three minute update on who you are and what’s your company?

Bob Nobile

Sure. Good afternoon everybody. As Troy said I’m Bob Nobile, I’m the CFO of Opnext and I am actually lucky employee number 13. So, I had been with Opnext since the beginning.

We are a technology leader in high-speed optical modules; we were created out of the -- spin out of the Hitachi’s optical component business back in 2000. After which and they got through the bubble, we lived the upgrade from in networks from 1-gigabit, 2.5-gigabit through the 10-gigabit cycle. And during that period until -- in around 2004 all right, when the build out really started, our revenues grew at 24% CAGR through 2010, as a result of that transition.

Currently, we are leading the upgrade into 40-gigabit and 100-gigabit network build outs. Last quarter which just ended this September, we had $86 million of revenue and of that 37% of it was 40-gigabit and above optical modules. If you kind of look at the market for that in calendar year of 2010, the market was about $1.5 billion for 10-gigabit, 40-gigabit and 100-gigabit modules.

Our revenue in that calendar year was about $300 million, so we had about an overall 20% market share and when you kind of looked at it 10-gigabit, it was bit below the 20% level, but at the 40-gigabit and above we were north of 30%. The industry analysts who are looking at that market and expecting it to grow at 20% CAGR through 2015 and ultimately end up around about $3.5 billion market. We believe we are in very good position to take advantage of that growth opportunity as this next upgrade cycle takes place, but obviously, we are dealing with the latest constrain coming out of those floods in Thailand.

And Ross leads our product marketing efforts for all of our advanced development program, so, Ross why don’t you just give a quick update on technology.

Ross Saunders

So, I mean as Bob said, the one good thing in optical network to compare to get the highest growth is predicted to be in the WM space and Opnext is very focused on the high-end stuff. So we have good exposure on the both the client and the line side for 40-GigE and the 100-GigE.

So, we have 40-GigE CFP modules, CFP plus which is even smaller form factor, 100-GigE client modules we are a leader with that as well. Even also on the line side, we have basically in our leadership position made us well we have a DPSK modulation format optimized for a lot of the kind of brownfield networks I hope that you all know. We also have a DP-QPSK over the folks in Japan which were some of the more challenge, some of the older fiber types and also now we are just introducing 100-gig coherent for the line side as well.

As people primarily are 100-gig coherent system, Ciena and the Alcatel-Lucent. We have our next generation 100-gig coherent has a very, very high performance. This is the latest in forward Error correction technology; it’s called soft decision forward error correction that allows us to basically double the distance compared to the first generation 100-gig coherent. So, we are quite excited and we are basically just bring it out through the last network sponsorship to customers as far as the end of this year and we want a mass reduction before the middle of 2012. And certainly that, something that we definitely there is, obviously with IP growth nothing is holding back there. But there is still quite dramatic growth in the IP traffic, and you see the carriers are beginning to migrate over to 40-gig and 100-gig, we are pretty well positioned there.

Troy Jensen - Piper Jaffray

Okay. So let’s start first on the topic, (inaudible). So, can you let us know your exposure there, I guess, it’s for those who don’t know a lot but five buildings in Thailand and 5 in Iran, two of them are in the water right now 3-4 feet, the other three seem to be okay, monitor, so what’s your exposure?

Bob Nobile

Of the $86 million of revenue that we had in September quarter, 43% of it represented products that were final assembled and tested at Fabrinet. We have been utilizing Fabrinet as our primary contract manufacture for 10-gigabit modules all that revenue is only 10-gigabit modules it has no effect on our 40-gig and above product portfolio nor our industrial and commercial laser business.

Troy Jensen - Piper Jaffray

Okay.

Bob Nobile

From an asset exposure basis, we had $31 million of equipment in Thailand, we had $16 million of inventory that split evenly between raw materials and finished goods. Unfortunately, all of our production was done at their Chokchai facility which is one of the two facilities that was breached with water, so the entire production floor had over a meter of water on it since October 22nd that’s when the production fully stopped it was kind of spotted a week before having been down for a couple of days backup for less than a full capacity. So, we really only realized about two weeks work of production in that facility this quarter.

Our action plans were in place but the good news for us is that all of the products that were final assembled and tested there had previously been done at our internal factories either in Totsuka-ku Japan, or in Fremont, California or some even at other third party stands.

We have the management expertise and people there to take that production back in-house. So we are working feverishly to get as much equipment to get as much as many parts as we can and people on board to get that production back up and running in our facilities as fast as possible.

We believe we can get some of it going by the beginning of December but it’s going to take us December and then into next quarter to ramp back up to full production.

Troy Jensen - Piper Jaffray

If you move the assembly and test, and (inaudible) test two different facility, is there any recertification process that you need to put up there?

Bob Nobile

There will be but because our internal factories are already certified by most of our customers. The extent of those recertification should be much – should be fairly quick. We are also getting great support from our customer base and they will be willing to work with us too to make that a prompt process.

Troy Jensen - Piper Jaffray

Okay. Now once you move all this manufacturing out of Fabrinet, would you intend to go back there once…

Bob Nobile

I mean that our approach all right is to utilize our internal factories for our new product development and advance research and so on. And to utilize third parties for the higher volume less sophisticated assembling and test processes. So this is clearly a step for us to get back to production as fast as we possibly can.

Troy Jensen - Piper Jaffray

Okay.

Bob Nobile

So, the objective would be to go – Fabrinet has been a great partner with us, we intend to continue to operate with them so between them and others we will look for the future production processes.

Troy Jensen - Piper Jaffray

There is a stop-gap right now, fix the flooding problem and then ultimately can go back. Obviously there is a modeled that work well, (inaudible). So what’s – during this inland process what’s the risk of market share losses.

Bob Nobile

Well, what we have had very good relationships with all of our major OEM customers. As I said a couple of moments ago they support us. We are working very closely with them right now to keep them informed as to what we can and we can’t deliver. So for a short period of time there is clearly going to be products that we can’t provide them. So they will have to go elsewhere to try and find that what we believe once our production is back the share that we enjoyed in the past will be there for us in the future.

Troy Jensen - Piper Jaffray

You said specifically 10-gigabit modules this was made quite (inaudible)

Bob Nobile

That’s correct.

Troy Jensen - Piper Jaffray

So 1-gig transceivers and they probably got to go (inaudible)

Bob Nobile

Less than 10-gigabit product got to be fairly small portion of our business and that tends to be – other part of sales.

Troy Jensen - Piper Jaffray

Okay, sorry, if I can. You guys are doing and keep this interactive, so if anyone from the audience has question just raise your hands will call you. So, the question on -- for Ross -- on the100-g coherent, so I am assuming you guys got the coherent technology from StrataLight acquisition, is that correct?

Ross Saunders

That’s correct, yes. Actually, joint want makes through this StrataLight acquisition. So, actually StrataLight, we started 100-gig coherent development about four and a half years ago, so yes it sort of came through from that, and it’s one of the good things with Opnext acquisition.

Opnext, it’s a very good 100-gig client technology. StrataLight, we are focused more on the line-side, so those are quite on line that will come from that refit there for a 100-gigs. So, now we can do the complete client side, line side, we do some integration on the components and even all the way up for line-cards. So, we basically sell, we will sell those line-cards through an OEM.

So, we think that worked pretty well there, and we appear to be -- we are kind of appreciative, eventually, ever since tend to move towards modules, but we are kind of like quite early in the market quite aggressively worked – as some MNC, it’s a standard complaint module. And definitely, we are getting quite a lot of interesting ways that customers have to integrate that to the line cards.

Troy Jensen - Piper Jaffray

So, Alcatel-Lucent, Ciena, Ericsson and Cisco have 100-g coherent systems.

Ross Saunders

Correct.

Troy Jensen - Piper Jaffray

Right. So, your address for audience would be all the other guys that are trying to do their own network, will be happy to follow-up with that.

Ross Saunders

Exactly, the way it started, I mean certainly, this is, probably about half the market it was sort of capital market where they will do their own distribute line cards 100-gig. We go after the rest of that market, so another basically half of that market.

Over time, as we keep inventing on it, we have good vertical integration then to the chip level, we are going to carry on doing investments, getting the size smaller, and getting the cost down. And in over time, we expect that even that 50%, we are initially they are going with the speed approach over time they are likely to migrate over to module just like they have done at 10-gig and 40-gig.

Troy Jensen - Piper Jaffray

So, it’s probably something about smaller market then over time, we will go.

Ross Saunders

That’s right. Probably just depends, it still depending on the price in order to compare. There is no real religion there. If you can hit this performance point and hit the cross point then you pull (inaudible) if you can make the economic mark they are still open to the things that we use modules.

Troy Jensen - Piper Jaffray

Yeah okay. Bob can you explain or remind us your relationship with Juniper, I think they brought some intellectual property from you quarter or two ago?

Bob Nobile

Yeah, several quarters, we, part of being intellectual property that came to us with the StrataLight acquisition, in that we continue to develop with -- developed post-acquisition. Juniper interest in a market which wasn’t on our radar scale. So, with that we were able to -- it was a $26 million opportunity to provide them with the technology to use in their field which did limit our marker opportunities.

Troy Jensen - Piper Jaffray

So, they are using it on like a 100 giga links and routers or PTX?

Bob Nobile

Ross, you can provide a more technical answer on this.

Ross Saunders

Yeah, I mean actually to be honest we don’t know how they are going to take the IP and put it into the product, of course you would assume it is going to be next-generation IP optical platforms. So, really we did a deal there where it’s a good win-win for both parties. That all said, its kind of a market off to the side, we were just really not going after anywhere, so it’s a good win-win, it helped benefit the seller (inaudible).

Troy Jensen - Piper Jaffray

Okay. And now if you strip out -- let's strip out supply side issues right now. Can you talk about demand right now that we kind of have the reset issue what are you seeing this throughout this year here on the demand?

Bob Nobile

Well, you mentioned it earlier at the start of the discussion here. In a demand, especially on the telecom side has been a bit sluggish through this calendar year. And on our earnings call we discussed we indicated that if we are kind of seeing that what we saw at this quarter kind of pulling towards the December quarter.

Then on, in addition to kind of just the sluggishness resulting from the general slowness and overall economy, you have got the impact that have taken place in China where their growth rates are slowing down.

In addition, they had inventory build up that you refer. So, you kind of have both of those impacts affecting demand, especially if it’s a 14 Gpb and above level from China affecting the last quarter and kind of going into this quarter as well with several of the major Chinese OEMs moving a good chunk of there requirements back to internal.

And many of them OE have always dual-source. They use a is a portion of the requirements were done the internal production and use third quarters like us, and the remainder of their requirement. But what we have seen on the last quarter and into this quarter that they are not significantly utilizing more internal requirements than using third party product.

Troy Jensen - Piper Jaffray

So, outside of Huawei in China, if you like demand has steadily improved throughout the year.

Bob Nobile

Especially, the datacom side has, I would say that the telecom side is still been a bit sluggish.

Troy Jensen - Piper Jaffray

Okay. How mush of your business is datacom versus telecom?

Bob Nobile

Well, its customers separate to, and specially 40G and above, right. But when you are looking at our 10 Gig and below business it’s probably around two-thirds telecom and a third datacom.

Troy Jensen - Piper Jaffray

And then, this Cisco your largest datacom customer?

Bob Nobile

Cisco is our largest datacom customer. Juniper is a very good customer, Lloyds as well. Extreme Networks and (inaudible).

Troy Jensen - Piper Jaffray

How about, can you talk about tunable XFP, I know you guys have had reference diagrams and planned a launch pretty soon, I mean after very growth area in Opnext, so just update us on that product portfolio.

Bob Nobile

Yeah. And we talked about some of the sluggishness in the 10 gig telecom side. Part of that is the transition of the 300-pin fixed format, as well as the fixed XFPs into tunable XFPs. Our product is in the development. We have our own ship to utilize in that product. We expect to be sampling that in the beginning of the new calendar year and hope to be in mass production with it by the middle of the year.

Troy Jensen - Piper Jaffray

Mass production in middle of the year, okay and perfect. And can we talk lets talk about the business model, Opnext has I think you got NSUs kind of impacting on the cost side, on the margin side, so what are you guys doing right now to increase the gross margin and minimize the cash burn, and any operating losses?

Bob Nobile

We have about a $30 million per quarter net yen cost exposure, and it was you go back several years and it was mush much greater than that. We have been able to reduce that through utilizing more US dollar material third parties outside of Japan. So, looking to the short-term here, we may have a bit of an increase in our yen exposure as we move a bit more back to Japan, but we have been pretty successful on our efforts to move it out. Three years ago, over 85% of our cost of goods was denominated in yen, last quarter we were back in the low 40s. What other points you what to --

Troy Jensen - Piper Jaffray

Let's (inaudible) I mean talk me about breakeven for you guys, if you are using money, so.

Bob Nobile

We are. Again, we have been making very good progress in our margin as well as in our control of operating expenses. When you strip out the effects of the end, for the last several quarters our product cost reduction have outpaced the selling price declines and our margins the constant exchange rates were improving. This quarter, with the lower volumes or actually our margin did deteriorated then, but again if you strip out the volume effect, as well as the currency effect was still on the plus side. As a result of that, we have been able to reduce our adjusted EBITDA breakeven point from $97 million of revenue about a year ago down to $86 million which we just achieved this past quarter.

Our operating expenses, last year, last fiscal year, were averaging about $28 million a quarter. For the first half of this year, the average $26 million, and during earnings calls we talked about targeting $25 million for the current quarter. So, with the combination of those we have been successful in bringing our adjusted EBITDA breakeven point down, and we are looking to continue that again absent the effects of the (inaudible).

Troy Jensen - Piper Jaffray

Okay. The industry typically does the pricing negotiations for next year about right now. Can you talk to us about the discounts were seeing? Is industry on a better situation now because of its supply constraints?

Bob Nobile

Well, I think the impacts of the flood it’s is a little early to tell what those impacts are going to be, if any. There is the quarter that begins in January 1st has the largest price impact on it, but its not the only time that we negotiate prices. Most of our European customers tend to be on annual pricing that begins in January. Many of the Asian customers tend to be on a semi-annual basis, so some of that impact happens in January as well. And then the rest of the customers tend to be on quarterly basis. so, you kind of see that’s throughout the year. But the net effectible of that is the, although each quarter we have an impact of price adjustments, the quarter that begins in January is the largest impact. And I would say, as we sit here today and there is still many negotiations still to conclude, we are seeing it fairly consistent with the last two years.

Troy Jensen - Piper Jaffray

Okay. So Fabrinet I think you mentioned I think Fabrinet confirmed this but they do have insurance right for all the equipment. Is there any way, what about like loss revenues that is -- there's nothing you guys can do about that or is it the insurance that Fabrinet cover.

Bob Nobile

Fabrinet is contractually obligated to provide insurance for our equipment and our inventory, I mean they discuses that yesterday on their call and we discussed it on our call earlier last week. In terms of business interruption insurance, we have it for our own operations but not for third party CNs in Thailand as a result of floods.

Troy Jensen - Piper Jaffray

Okay, unfortunately not. Ross, for you StrataLight in the 40G market they were non-coherent, is that correct?

Ross Saunders

Correct. Yeah, the major part of it came through at the time of acquisition is the (inaudible) which was line cast systems which was OEM to multiple OEM partners. We took that technology and also developed 300-pin in the same module, PPSK as well. So that has been a significant -- its kind of like a highly related to the PPSK LAN card but again non-coherent and that’s been the majority of revenue over the last year or so.

Troy Jensen - Piper Jaffray

Have you guys disclosed to some of the your StrataLight customers again?

Bob Nobile

No, we have not.

Troy Jensen - Piper Jaffray

Was there going to be any files as far as --

Ross Saunders

Can't give you a brief at the time when they sold to a lot of people --

Bob Nobile

What we haven’t talked about is the 40G subsystem which is the predominant product when we originally acquired StrataLight was sold primarily to NSN. They were StrataLight's largest customer and that was ultimately used in the AT&T networks.

Troy Jensen - Piper Jaffray

But NSN is not developing its own coherent. Is that?

Ross Saunders

Yes, they do have their own coherent technologies (inaudible).

Troy Jensen - Piper Jaffray

Whether earnings-coherent or?

Ross Saunders

Yes.

Troy Jensen - Piper Jaffray

But not 100G.

Ross Saunders

Developing both and they paid a nice (inaudible).

Troy Jensen - Piper Jaffray

Is there any other questions from the audience? Right, well, that’s it. Guys, I'm out of question. I appreciate the time and good luck with your aim before you.

Bob Nobile

Thanks Troy.

Ross Saunders

Thanks Troy.

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