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Executives

Jim Fanucchi - Summit IR Group

Alain Couder - Chairman & CEO

Jerry Turin - CFO

Analysts

Kevin Dennean - Citi

Ajit Pai - Stifel Nicolas

Alex Henderson - Miller Tabak

Dave King - B. Riley & Company

Hamed Khorsand - BWS Financial

Nathan Johnsen - Pacific Crest Securities

Chris Glancy - Avondale Partners

Oclaro, Inc. (OCLR) F2Q2012 (Qtr End 10/01/2011) Earnings Call November 9, 2011 5:00 PM ET

Operator

Good afternoon and welcome to the Oclaro first quarter fiscal year 2012 financial results conference call. As a reminder, this conference is being recorded for replay purposes through November 16, 2011. In addition please refer to the supplemental presentation that has been provided in the investor section of the Oclaro website. At this time, I’d now like to turn the call over to Jim Fanucchi at the Summit IR Group. Please go ahead sir.

Jim Fanucchi

Thank you operator and thanks to all of you for joining us. Our speakers today are Alain Couder, Chairman and CEO and Jerry Turin, Chief Financial Officer of Oclaro. Statements of management’s future expectations, plans, or prospects for Oclaro and its business including statements about future financial targets and financial guidance and Oclaro’s plans for future operations and any assumptions underlying these statements are forward-looking statements under the Private Securities Litigation Reform Act of 1995. There are a number of important factors that could cause actual results or events to differ materially from those indicated by such forward-looking statements including the risk factors described in Oclaro’s most recent annual report on Form 10-K and other documents we periodically file with the SEC.

The forward-looking statements discussed today represent Oclaro’s views as of the date of this conference call and subsequent events and developments may cause Oclaro’s views to change. Although Oclaro may choose to update to certain forward-looking statements based on subsequent events and developments, Oclaro was not require to and does not undertake any obligation to update any forward-looking statements as a result of future developments.

In addition, we will be discussing non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP and should not be considered as a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A table that outlines the reconciliation between the non-GAAP financial measures to GAAP financial measures is included in our earnings release which we have filed with the SEC and I refer investors to the release. I would now like to turn the call over to Alain.

Alain Couder

Okay good afternoon and thank you for joining our call. Thank you for your patience as well as because as you noticed, we delayed the call in order to give you and as concretes as possible assessment of the situation that resulted from the flooding in Thailand. So in our discussion today I will start with a review of our first quarter results and then I will provide you the context for the impact of the Thailand flood and our view on the situation.

Then I plan to discuss our plan to reduce our breakeven threshold. And after that we ask Jerry to get into the financial details. So let’s talk about the September quarter results. So the result been executed as expected. Our revenue is within guidance. The gross margin and EBITDA throughout the high end of the guidance and that’s something that has happened despite the soft market condition that led to expected sequential decline in revenue. These results demonstrate in fact that our cost reduction initiative on which we’ve been working now for several months are starting to produce result.

In September quarter we shipped a record number of high powered laser, $16 million and that’s also demonstrate that the transfer of the fab from Houston to Europe is now behind us and thus we do our full capacity to produce our power laser for our customer. We’re also pleased to see that our revenue is basically flat in the September quarter as several of our competitors saw a decline.

The other point we believe is important because we have been discussing it for quite a long time is our new product momentum. I think in the September quarter, we had measurable result. It was flat with 40G. As a result of the Mintera acquisition we were able to ship more than 10 million of our DPSK transponders and that’s something we see the big number and very much in line with the business plan.

In addition to the portfolio we have in DPSK and DQPSK, we believe we’ve been able to position us as a leader in high bit rate component and module for the Coherent Solution that we also call PMDPSK and which is a very critical technology for the deployment of high bit rate network meaning 40-G and above you know. And for example, in term of 40-G current module, we started to shipping volume and we generated more than 2.4 million of revenue in the September quarter. We’re also very pleased with the momentum. We are been confident. We have been shipping the volume as 40G modulator. We have also started to ship our 100G modulator and we have been adding 100G coherent receiver and this receiver is the smallest of the market at this point in time and quite cost effective. So coherent addition is a very important element of the future and I think we do have some leading edge product and a very good position there.

Let me switch to 10G. 10G in October is the flat market but it’s not as big as the 40G market right now, and our strength in tunable transponder, pluggable, and laser continued. The September quarter, we started to ship in volumes, the tunable XFP and we ship in particular to one of the top two telecom OEM and to one of the top service provider. So we are already shipping to the top customer with this product. But an important thing to notice is that if you look at the 10G transponder market, half of the market is done by a modulation technique that is called [zero-chirp] while the XFP that we have been shipping so far, and our competition has been shipping is a negative [chirp]. And so we introduce and probably our first to market a new version of the XFP called [zero-chirp] and we have start to sampling this one and this could give us a very strong position in the pluggable 10G devices.

So, besides 10G, in some of the amplifier, we introduce a that (inaudible) two new pump. One is the uncooled pump, 500mW, a non-cool pump. We have a very significant market share. And we also introduced a new design and I think we are first to market with the new designs. We shut two chip in one package and therefore provides a 600mW. Those two devices are Greener design and meet the customer need of raw power and those smaller sizes.

Another thing, well we where we are taking the lead of the market is on WSS 1/23. We were the first to sample the 1/23, (inaudible) WSS where the combination of our single is (inaudible) and our [LTD] seem to be a very good design for the (inaudible).

So while this is a totally good momentum in new product but there is also some leading edge products as that should really enable our growth in the second half of this fiscal year as market condition allow.

So, let me now switch to another different topic, you know, which is the market as a whole. You know a year ago, we were all ecstatic, we are seeing huge goals for the December quarter. Condition, as you know, have changed and market has been very soft for this calendar year. Although the fundamental of the silicon market still there, we have decided that we need to reduce our infrastructure costs to breakeven at lower revenue threshold.

And particular we are reducing our fixed portion of our infrastructure cost and that’s a way that we can better weather for the cycle silicon market. This means that we will be able to breakeven -- adjusted EBITDA breakeven at $110 million of revenue and therefore the cash flow of breakeven slightly above that depending on the amount of CapEx that we spend and we expect to be able to realize that by the June 2011 quarter.

In order to achieve that, these are the action we are taking. First, we are implementing a reduction in force in the [fab] job and in R&D that was announced last week. We also are taking the back end of some high power laser which is still done in Shenzhen through –which is done in Zurich – through Shenzhen and that should give into a $1 million of cost reduction that quarter in the next fiscal year. We are initiating a next step in the long term site consolidation strategy as a result of [Norton] acquisition. We have too many sites, so we are going to simplify our global footprint to become more effective, and we are also looking at the divestiture of a couple of non-product lines that are not really in our target market. So with these, we also made another important decision. As you might remember, in July we cancelled contract with Fabrinet and we did an extensive study last summer to understand what is the best strategy for us in terms of manufacturing. As a result of that, we have decided to outsource all our assembly and test. So the first move has been to sign a new contract with Fabrinet, as a result of -- we take into account the result of the RFQ process and that we won last summer. Now we have a new sign contract with Fabrinet.

We are also in final negotiation to outsource our Shenzhen assembly and test operation to a major contact manufacturer. This means that all our assembly and test once this transaction will be done, we expect that to all our manufacturing back-end so assembly and test are fully outsourced.

This transaction could generate more than $30 million to $40 million in net cash proceeds to the company. When the transaction closes, we expect this transaction to close in the first calendar of year 2012 and with some additional amounts that will be available later.

We also are finalizing a supply agreement with that contact manufacturer with a goal of reducing Oclaro product cost overtime.

And many of our customers have long term relationship with our potential contact manufacturer and partner and as a result, we would expect the transition to be seamless. At the same time, by keeping production in Shenzhen that we can ensure continuity of the process and quality for our customer and create a good transition for our employees. So as the result of the strategy, we will have two major contact manufacturers to take care of supply and provide Oclaro with best pricing leverage.

We intend in Shenzhen to maintain an R&D and NPI presence with about 220 employees. We are very pleased with the quality of the R&D and employee talent that we have in Shenzhen and then also the critical to support our China based customers as well as some related support functions.

So by outsourcing our Shenzhen assembly and test operation, our number of employee will decrease from 2,800 to 1,200. So the Oclaro team as a result of that will then be totally focused on its core competency. We see a geographical integration at the product level, wafer fab innovation, photonic integration, or personnel excellence, customer service and technology innovation.

So this program is clearly underway, but at the same time we have to deal with the Thailand flooding update. So let me switch to that topic. Fabrinet is a manufacturer of 30% of Oclaro’s total finished good in two factories. One is called Chokchai and the other one is called Pinehurst. Due to flooding in Thailand those factories suspended their production and Chokchai factory further studied extensive flood damage whereas the Pinehurst factory was not flooded. But Pinehurst reproduced high power lasers and printed circuit boards and the water level has declined significantly this week, so operation we started this week at Pinehurst and I will cover that later on.

Fabrinet has made some very good progress throughout making everything ready to restart production and the printed circuit boards are restarting as we see this week and this is very good news, because we use some of those printed circuit boards in our Shenzhen factory. So by restarting this week, we should have very minimum impact on our Shenzhen production.

We also expect probably the production to resume in the November, 14th week which is next week and Fabrinet has also been able to restart their Oracle server and the ERP system which means that the management preparation they are doing and shipment is now working again.

The situation at the Chokchai factory is a little more complex; it does represent about 60% of the 70% of our revenue and it remains flooded. This factory produces EDC, amplifiers and modulator. We plan to restart manufacturing of these products mostly in the Pinehurst factory. At the same time, we have secured some backup for some very critical products of our customers.

We are now working with some on that to get the next inventory and the equipment and the material out of the Chokchai factory in such a way that we can do a detailed assessment of their condition. Fortunately, before this flooding we were able to move a portion of the light weight equipment to the second floor so not everything is flooded. We have already started to capture equipment that is still underwater and since the flooding our primary objective has been to mitigate the [structure] of our customer and therefore we have decided to restart production mostly at (inaudible) to bring about potential requalification of the distinct products by our customers.

This is also where we’ve strong employees and that we can ensure the continuity of process and quality. We have created a situation on comment to Fabrinet and Oclaro to always start of production. We have a detailed understanding of which piece of equipment can be salvaged and we expect to all of that done within a couple of weeks, you know and given that our understanding of the situation becomes better and better day by day, we may hold another conference call mid-December to give you an update on the situation.

At this point we expect the revenue impact on the December quarter to be a $25 million to $30 million and on the March quarter to be at $10 million to $20 million and we expect to be back to normal in the June quarter.

I would like to thank our customers for their understanding in getting production restarted as quickly as possible while giving top priority to the product for which we are the sole source as you can imagine.

So, that’s the final situation and everything we are doing to recover as quickly as possible. Let me talk of briefly about the market and the customer. In telecom and high power lasers, the fundamental continue to very strong and with all the Thailand flooding, we were contemplating a revenue for the second quarter of fiscal year 2012, we have taken a modest increase for the December quarter.

But lately we are seeing some softness from the top 3 customer, Huawei, Alcatel and Ciena where we are seeing some strengthening of our Tier II customers. So that's about balanced. As a result of the flooding in Thailand we are also seeing two counterbalancing trends. First some of the products that our competitor were manufacturing in Thailand such as small form factor transponder, tunable XFPs are produced in Shenzhen factories and therefore we could increase capacity to help them, our customer and supply what our competitor cannot supply.

On the other hand, we have the opposite situation where some of our customer will be sourcing Oclaro products that we are producing in Fabrinet, as that's the way it’s going to be. We expect those two trends that will balance each other over time and therefore we do not expect any loss of market share overall. In the first three weeks orders has been about 10% stronger than last quarter. However due to the impact of the Thailand floods, I think it’s too soon to draw a conclusion.

So before asking Jerry to continue I would like to take this opportunity to thank our employees for the dedication in solving this crisis and I also want to acknowledge the support of our supplier in our process. Jerry?

Jerry Turin

Thanks, Alain. Our revenues for the quarter ended October 1, 2011 were a $105.8 million compared to a $109.2 million in the prior quarter. While down, we view our revenue performance as relatively consistent with last quarter, if you consider that approximately 2.8 million of shipments got held up at the very end of the quarter due to a major typhoon in Hong Kong. As Alain noted and as you have seen from our press release by now, non-GAAP gross margin and adjusted EBITDA were at the higher end of our guidance range.

Looking a little deeper into our product revenue categories and here I refer you to page seven of the slide package accompanying this conference call. We’re disclosing a greater level of revenue granularity in the past to more clearly convey the trends of our business. You will see that our telecom component revenues which include lasers, modulators, laser pumps, receivers and integrated lasers and modulators were down $6.3 million from the prior quarter and have been down 11 million since the December 2010 quarter largely associated with the market slowdowns in Asia this year.

And the September quarter was also adversely impacted by approximately $3 million associated with a customer-specific evaluation issue on a legacy product which is now by and large being resolved although we do not expect the corresponding revenues to begin to ramp back until the March quarter.

Our transmission module revenues which include 10-gig and 40-gig transponders and transceivers were up $1.8 million this quarter. The overall calendar 2011 trend in this category has seen a decrease in 10-gig transponders largely associated with a soft economy and some related market slowness offset by substantial growth in 40-gig transponders which Alain provided some color on earlier.

A 10-gig tunable XFP is also starting to contribute to the growth in this category. Our amplification filtering and optical routing revenues which include amplifiers, micro-optics, dispersion compensation, wavelength selective switching module and subsystems in ROADM line cards were relatively consistent at $40 million compared to $41.2 million last quarter.

The overall calendar 2011 trend in this category has seen a decrease in tunable dispersion compensation associated with slower Asian deployment of 40-gig. We’ve seen stability in our amplifier portfolio even on a relatively soft telecom market and our WSS and ROADM product are continuing to gain traction.

Our industrial and consumer revenues, which include high powered laser and VCSELs, we’re up to the $17.1 million from $14.6 million last quarter. Our high powered laser business has fully recovered from the fab transfer. However, the consumer markets for VCSEL lasers are going through a soft period. Major customer revenues for the quarter included Huawei at 13%, Fujitsu at 11%, Cisco at 11% and Alcatel-Lucent to 10%.

Turning to margins, our non-GAAP gross margins for the quarter, which excludes stock compensation, were 23% consistent with the prior quarter. While we had a positive margin impact from growth in our relatively high contribution margin industrial laser product, this was offset by reductions in revenues of our telecom components and 10-gig transponders, which also have relatively high contribution margins.

The 2011 telecom slowdown has hit these telecom components and 10-gig transponders harder than many other product categories. Since the December 2010 quarter, they’ve gone down from 45% of our product mix to 32% of our product mix in the September quarter. On this change in mix, there’s been a primary factor in our gross margin decreasing to 23% in September 2011 versus 30% in 2010, both in terms of the mix but also in terms of the revenue -- loss revenue themselves.

European currency rate movements and an increase in depreciation were also relevant factors. Our non-GAAP R&D, which excludes stock compensation was down $17.3 million from $18.5 million in the prior quarter. Our non-GAAP SG&A, which excludes our compensation was $16.7 million compared to $15.9 million in the prior quarter. The increase was primarily associated with the timing of our annual audit.

Stock compensation for the quarter was $300,000 in cost of sales, $360,000 in R&D and $900,000 in SG&A. Our restructuring acquisition and related costs for the quarter included a credit associated with an update for the purchased accounting for 2010 acquisition of Mintera.

Adjusted EBITDA was negative $4.5 million in the September quarter of our first quarter of fiscal 2012 compared to negative $4.7 million in the prior quarter. I would like to highlight in our second fiscal quarter ending January 1, 2012, certain flood related expenses including impairment of fixed (inaudible) inventories will be excluded from adjusted EBITDA. They will also be excluded from non-GAAP gross margin to the extent appropriate.

Our share count for September was $49.4 million and we expect this to be relatively unchanged for the next quarter. Before the balance sheet, let me go back to Alain’s commentary on our breakeven action plan as well as our efforts to move towards the more variable cost model. As Alain mentioned, we have [actioned] in process that are expected to take our EBITDA breakeven level to a $110 million of revenues by the June 2012 quarter. We expect to see additional improvements from these actions, continuing beyond June to the end of 2012.

Looking back to the end of the June 2011 quarter, we reflected on the cyclicality of the telecom optical market began to focus on improving our return on invested capital and on maximizing the variable element of our business model while reinforcing our commitment to our core value proposition in the way for a fab level.

We have been working hard on this all summer and now into the fall. Our successful divestiture of our Shenzhen manufacturing facility combined with successful execution of the other actions referred to by Alain. We will ship approximately one third of our manufacturing overhead, or approximately $8 million for the quarter, from our fixed cost base into a variable model. In the future, we intend to update you on our corresponding progress as appropriate.

Now let me move to the balance sheet, and my focus will be on cash and the corresponding drivers of cash. Our cash at the end of the September quarter was $51.7 million, down from the prior year quarter. We have also drawn $19.5 million under our line of credit.

Our September quarterly cash flows reflected timing of accounts receivable received at the quarter-end as well as the level of payment associated with relatively high levels of both material purchases and capital expenditures in the previous quarters which were paid for in this September quarter.

Let me explain these points, and relate them to our expectations for December cash flows. Our accounts receivable were $81 million at the end of September compared to $83 million at the end of the prior quarter. We collected $6.5 million of the September receivables, items which has been doing the last week of September, and the first week of the following quarter, which is our current fiscal December ‘10 quarter.

Our inventories were a $100.5 million at the end of September compared to a $102 million at the end of the prior quarter. Material purchases into our internal back-end manufacturing facilities in the September quarter were down by something in the neighborhood of $12 million compared to the previous quarters on run rate. This bodes well for reducing inventories and our corresponding payments by a significant amount in the December quarter.

From a fixed asset point of view, our CapEx in September was $6.2 million, down from an average of $11.5 million over the prior three quarters. We currently expect CapEx in the December quarter to be higher than September, including capital associated with the flood recovery. Though most likely still lower than these recent averages.

Determining the capital investment associated with flood recovery is clearly a work in progress and so this estimate is subject to change. And while we expect insurance to cover a substantial portion of this investment, there are no guarantees as to the amount, timing and/or ultimate receipt of corresponding claims.

Each of the balance sheet items I described, positions us well in terms of cash for the December quarter. Prior to the Thailand floods, we expected to be cash flow neutral in the December quarter. And even at the current time we expect the Thailand floods to have minimal impact on December cash flows.

For example, the impact of lower revenues in December will not impact our cash flows until the March quarter when the lower level of payments becomes due from customers. In addition, most of the cost incurred in responding to the flood this quarter will not impact cash flows until paid in the March quarter. As a result however, the fallout of the floods is likely to have an adverse impact on our cash flows for the March quarter.

In the meantime, as noted a few moments ago, the successful completion of a transaction to outsource our Shenzhen manufacturing operations could generate $30 million to $40 million of net proceeds in the March quarter with additional possible upside later.

We also have our line of credit. Based on our evaluation of our expected borrowing base and subject to our current understanding of the circumstances in Thailand, we believe we will have $20 million of additional availability in addition to what we've already drawn without tripping any thresholds that would subject us to covenants.

We also expect to receive advance payments under the insurance policies of our contract manufacturer in Thailand and/or own insurance policies. Although the timing and amount of any advance payments cannot be determinate at this time, we expect the insurance advances to the extent offered to be most likely received in the December quarter and it’s not been in the March quarter.

We files claims under both property and business interruption insurance and again the total announcements and the final timing of related payments, if any cannot be determined at this time.

We’re also considering the divestiture of non-core product lines and in the month of October we sold a small equity interest in a privately help European based optical company for approximately $3.5 million.

Now let me summarize our key messages today; our September quarterly results were as expected. Our new product momentum is accelerating. The telecom market continues to experience short term uncertainty, but the drivers remain strong. Our higher powered laser business has recovered from the fab transfer. We’re actively rescaling in response to current market dynamics and to establish a more variable cost model.

We are reinforcing commitment to our core value propositions of vertical integration at the product level, differentiation at the wafer and fab level, photonic integration, relentless innovation, operational excellence and customer service. We’re facing a short term two quarter challenge because of Thailand; however, we have the potential to emerge from crisis, better position and going in.

And to the extent our understanding of the circumstances in Thailand or in any of the other matters discussed today changed, we will as appropriate provide future updates via press release and/or conference call as warranted later in the quarter.

So let me conclude by reiterating guidance for our second fiscal quarter ended January 1, 2012. We expect revenues to be $75 million to $85 million. Non-GAAP gross margin to be 13% to 17%. Adjusted EBITDA to be negative $18 million to negative $13 million.

Operator, please go ahead and open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Kevin Dennean with Citi. Please go ahead.

Kevin Dennean - Citi

I guess, just first housekeeping; Alain, you kind of gave us a revenue walk beyond the December quarter, could you just repeat that again please?

Alain Couder

Basically, what I said is by the December quarter, we give you guidance and for the following process, we said that it will be in the $10 million to $20 million range compared to previous forecast.

Kevin Dennean - Citi

And then on the divestiture of the Shenzhen assets, should we expect you to book a loss on that sale versus book value of those assets; can you quantify how much of your PP&E goes away in that transaction?

Jerry Turin

Probably a little detail, you know too detail to be disclosed Kevin. However, it is probably fair to say that while we’re monetizing a nice amount from the transaction in establishing what we feel will be favorable supply agreement going forward, we may not necessarily monetize every penny of the related book value, but that’s still subject to final negotiation.

Kevin Dennean - Citi

Understanding that you are trying to restart some of the impacted products that were in Chokchai up at Pinehurst. The product momentum that you saw in the September quarter, how should we think about that being impacted by the Thai flooding situation?

Alain Couder

Basically in terms of new product introduction, the impact should be minimum because all the strategy that is being done is in Shenzhen or in [Samina] sector you know. In term of the tunable XFP, it is done in Shenzhen and in term of the high power laser two is done in Shenzhen only one cell is done in Fabrinet and in term of WSS number fairly small, so the impact should not be very significant. So I think overall is not a major impact on new product momentum.

Operator

Thank you and our next question comes from the line of Ajit Pai with Stifel Nicolas.

Ajit Pai - Stifel Nicolas

So the question I think has more to do with the divesture and looking at the breakeven that you’ve talked about. So yes it’s great that you have got cash proceed, that you will get cash proceeds and shift fixed cost, available cost, but just in terms of the margin profile of the company especially the gross margin, if you are outsourcing that business and whoever gets that business will be capturing some gross margin. So could you help us understand at the revenue level we have had over the past couple of quarters, what the gross margin in the outsource model is expected to be and whether the gross margin from a longer-term perspective, you know, yes you’ve reduced $8 million in fixed cost, but they are going to give up you know some of that to margins that the vendor, the manufacturing folks will take, what that could look like, at the same revenue level as in the most recent quarter and especially going out, whether we have got to change our sort of gross margin outlook for the company?

Jerry Turin

So, Ajit it is difficult to go back and relate that to past revenues. However, there is a goal or principle, we are looking at in terms of these switches. Initial cost neutrality with long-term upside from additional efficiencies and scale of the partner and ultimately you know with a pricing approach that does have a volume aspect associated with it.

In the meantime, the majority of our fixed costs and we really scale more efficiently where we have the capacity, is in the wafer fabs which is where we remain extremely committed.

Ajit Pai - Stifel Nicolas

Got it and then just a follow up on looking at the impact on your balance sheet, when you close the quarter you haven’t had, you know, Chokchai be impacted in Thailand et cetera. Is there any kind of hint that you would expect to be taken on inventory or any other items you know outside of the insurance claims all of that right now because they are still uncertain, but is there anything that we should be assuming as being hit right now that could be reversed in the future and if you could quantify some of that, that would be great?

Jerry Turin

So, certainly I expect we will have, inventory losses and capital losses, you know for the equipment, cannot quantify it as this time. Certainly we will have the amount of the corresponding write off in our December results and I would expect that to be something that's not recovered with upside in the future. So for example if inventory ended up under water and is unusable and therefore written off, that's not something we will be able to resell later and have a margin pick up.

Ajit Pai - Stifel Nicolas

But you wouldn't be getting it from the insurance companies, they should be reimbursing even the insurance company or Fabrinet you know have insurance to cover it. So it’s either your or their insurance should be able to more than offset that, right.

Jerry Turin

Well, I would hope to recover from a cash point of view right so that deductions and so forth aside are deductibles and so forth aside, there is we would expect to recover a substantial portion of the cash impact, but I don't think at this time that our receipt of insurance proceeds would be something that represents one-time margin impact and if so it wouldn't represent margin impact that would be relevant from a long-term trend of our business are really meaningful.

Operator

Our next question comes from the line of Ehud Gelblum with Morgan Stanley.

Unidentified Analyst

It’s actually [Stan Gobler] dialing in for Ehud. My first question is, I just wanted to ask you about the divestiture of the facility. It seems that Fabrinet now on their conference call communicated an interest in expanding their operations to even outside of Thailand and I was wondering if you can talk to us about how secure that sale of the facility is at Shenzhen to this third party and whether there's still a chance that perhaps you could still offer that to Fabrinet, if there's interest.

Alain Couder

I don't think we want to comment on that at this point in time. We have renegotiated the new contract with Fabrinet, so we have thinking of the relationship with Fabrinet for the future and this is what we establish and I think what we disclosed about the other potential contract manufacturing is everything we can disclose at this point in time.

Unidentified Analyst

Then in terms of the percentage of manufacturing that will be done between your remaining facility and the new manufacturer and also Fabrinet, what is that mix looking like going forward once the sale is completed?

Jerry Turin

So going into this quarter, we did roughly 60% of our production in Shenzhen and that’s the facility we’re talking about today. We did roughly 30% in Fabrinet facilities and there is probably, roughly 10% maybe a little bit less than 10% in a few select smaller contract manufacturing relationship. It should be similar profile going forward subject to the ups and down in the next quarter or two of recovering in Thailand which of course you know adds volatility to that mix in the short term.

Unidentified Analyst

And just my last question is on the gross margin. If you run the calculation on the fixed cost that you mentioned backing into the one third comment. It seems that ex in these type of margins that a third party manufacturer can take, you could go all the way up to as much as 30% margins if I got the variable margin of that right and then the EMS player could take something like 7% back on that. And then effectively you are back to a 23% margin from last quarter which would fit well with your comment about pretty neutral gross margins. Where can we see upside from that going forward in that relationship and could you also –

Jerry Turin

I don’t understand your numbers and I'm not sure that the point we’re trying to make. So it’s not cost neutral to gross margins today. It’s cost neutral as far as the cost of operating assay versus the charge back cost net of efficiencies and other improvement. So it should be relatively neutral to our business model as opposed to, you know, neutral to the relatively low gross margins we’re at today.

Alain Couder

It’s important point based on those where (inaudible) then with contract manufacturing this summer. In the new contract with Fabrinet and the contract we are discussing right now is this other potential contract manufacturer, we have incentive ability in those contracts for them to cost reduce of product over time. And therefore -- and that’s also why we are keeping a significant work force on new product introduction in Shenzhen as they will be co-located in Asia and be able to have a non-going production activity with those two. The other thing is that when you have two major contract manufacturers, when we get new product to market then we left an opportunity to both of them, (inaudible) need to know another price level is that we didn’t have before.

Jerry Turin

Yeah, I think there’s may be some another concept or two that we’re elaborating on to a line. We looked at this contract manufacturers and their business model and strategy objectives, more and more, you know, they’re looking at optical components as a key value proposition in vertical integration of their business. A more and more while the optical gets complex there’s more electronics content and this large [GMF] suppliers have greater purchase scale and can gain efficiencies from supporting their customers that are some of our customers as well. So I think one of the things we determined in the last few months that we’ve been through this process is contract manufacturers are probably in a position to deliver more of a value proposition may be at some points in the past in our space.

Operator

Our next question comes from the line of Mr. Alex Henderson with Miller Tabak. Please go ahead.

Alex Henderson - Miller Tabak

So can I make one request right upfront? Please don’t put this thing on top of Cisco again. Anyway, going to the issue, a couple of things I want to ask you about, the first, can you quantify what you mean by small numbers and wave selector switches, I mean, obviously it is an area that had a lot of attention over the last 18 months, but I am assuming that you’re producing a couple of million dollar temporary revenue on that. Is that the right range and similarly can you give us a sense on what your scale on your tunable XFP product line is at this juncture?

Jerry Turin

No. We are not going to disclose revenues at that the product level, Alex. I mean when we talked recently in terms of even in this $2 million to $3 million range in WSS and that -- this is the quarter. Looking at first quarter, we ship tunable XFP beyond some late quarter revenues last quarter. So we’re certainly not scaled up to some of the first folks with a presence in the market, and we are ramping and we have presence and we are satisfied with the growth rate, but we wont be tracking product line-by-product line, quarter-by-quarter. We will be giving you color within the [reco] we provided in the presentation this time and within that we will pass it all the key trends within how those line items move.

Operator

Thank you. And our next question comes from the line of Dave King with B. Riley & Company. Please go ahead.

Dave King - B. Riley & Company

First of all, so on that tunable XFP, if you are not going to break revenues, the early sellers or number of trials with tunable XFP?

Alain Couder

But we have a fast trial efficient. We are shipping volume and in particular as I’ve said, to one major telecom OEM and one of the top two I should say, and one major service provider. So we are not in trial mode with tunable XFP for negative picture. Well, we are in something more with the new one, where have sales to market with equal to (inaudible) and the dual – the transponder market (inaudible) right now is half of the market, so far and the (inaudible) allows us to have same performance as the 300 team. So what you see is that so fast enabled XFP was able to (inaudible) high quality three of the pin transponder markets. Now with new (inaudible), we can sell the other asset.

Dave King - B. Riley & Company

Got it and then you quantify $25 million to $30 million for the December quarter for your top line. Is it too early to talk about the March quarter impact, where may be I had missed it.

Jerry Turin

I think that Ron mentioned that the term was $25 million to $30 million impact in December from what the expectations would have – yeah, 10 to 20 in the March quarter and at this time hopefully neutral in June, but of course, you know all of this will evolve over the upcoming weeks and month, Dave.

Dave King - B. Riley & Company

Okay. And then, so you know all the cut offs that came out of Chokchai are being transferred to Pinehurst. Are they all going to Pinehurst in the current buildings or are they going to building six because I guess building six won't be ready until mid-January?

Alain Couder

No, my answer is being able to give us priority and they found a 10,000 square feet of renewal for us that’s a more space of, you know, which is enough to raise our production and we will go into building six when building six will be finished.

Operator

And we have a follow-up question from the line of Alex Henderson with Miller Tabak. Please go ahead.

Alex Hunderson - Miller Tabak

Thanks. Well, I was, I haven’t finished the first one before. So, I am glad to get back in here. So can you talk a little bit about what's going on in the pricing environment? Obviously a lot of the stuff that's occurring in Thailand is straining supply channels and you are in the process of negotiating your calendar Q1 pricing, can you give us some update on how that's progressing? And I do have a follow-up.

Alain Couder

Right now we do not see any excessive price pressure. There was none before the Thailand flooding. Now with the Thailand flooding, the discussion is quite often more but the shorter supply than pricing but it is too soon to give you an estimate of what will be the overall result of that. We are probably no more than half of negotiation completed by now.

Alex Hunderson - Miller Tabak

Just a follow-up on the pricing issue. So are you saying that you would expect the pricing negotiation to essentially deliver a consistent level of price adjustments that you've had in prior periods. Is there a change in the trajectory of it?

Jerry Turin

That is why that’s what we are seeing right now.

Alex Hunderson - Miller Tabak

And just to follow upon one another issue; you talked about the tunable XFP, obviously the zero-chirp piece is critical for 300-pin replacement. I assume the service provider and customer is on the negative chirp piece not on the zero-chirp; is that correct?

Alain Couder

The service provider are right now on the negative chirp, this is correct. But on the telecom vendor you basically add some negative chirp and half on the old chirp.

Alex Hunderson - Miller Tabak

So you are qualified on both pieces at that customer?

Alain Couder

Yes.

Operator

And our next question comes from the line of our Hamed Khorsand with BWS Financial. Please go ahead.

Hamed Khorsand - BWS Financial

I just have one question here; earlier you had commented that you are trying to get equipment placed – or replace the new equipment? What is the lead time for that equipment; the people you buy from are they seeing delays in getting these orders fulfilled because everyone needs equipment replaced?

Alain Couder

It depends; but typically right now are able to get expedite the timing in the one to two months time. And we also – I think some equipment in our R&D side that we are moving to accelerate the restart of production.

Operator

We have a question from the line of Nathan Johnsen with Pacific Crest Securities. Please go ahead.

Nathan Johnsen - Pacific Crest Securities

Two quick ones; one what’s the size – you walked through the potential impacts over the December and March quarters. So I was wondering if we could potentially anticipate some bounce back and above kind of what you would think of it at a normalized level just as customers tends to re-balance some of their inventory of your products?

And then secondly, you mentioned that you guys were focused or I guess prioritizing the products where your sales force. I was wondering if you could potentially elaborate on what types of products you guys are still source and which one do you guys would effectively de-prioritize?

Alain Couder

In terms of source of products it is mostly into module and amplifier where we have a unique design for some customer and we also have the confidence level most of time we’re under sourced so unless it is brand new product, you know. So that basically where we are on this point and you had another question initially which was – I am sorry?

Nathan Johnsen - Pacific Crest Securities

Just wondering I mean you guys obviously had some pretty big headwinds in the December-March quarter, but wondering as you guys are able to get production back on line whether you should expect customers to replenish their inventories and efficiency at the bounce back and in above kind of normalized levels sort of a bit?

Alain Couder

Right now we are not counting on that. If it happens we will be ready to take advantage of it, that’s all I can say. But we are not planning on that at this point in time, but that’s the possibility that because there is a shortage of the market this quarter and next quarter, we could see a bounce back in the June quarter when we would be back to normal. But in the discussion we have today, we have not as too many of that at this point in time.

Operator

And our next question comes from the line of Chris Glancy with Avondale Partners. Please go ahead.

Chris Glancy - Avondale Partners

I got two quick ones; one is on the OpEx line and it was down a little bit more than I would have expected in the quarter. And just wondering how much of that may be due to favorable FX moves in the quarter and how much potentially could be due to any cost reduction you guys have already implemented and do you know you have any commentary around that will be good? And the second one is on the non-telecom side, but I want you to answer that first one?

Jerry Turin

So none of that was FX related. Early in the quarter, the FX rates moved adversely and late in the quarter they did recover nicely, but that basically led to a neutral impact. So we may have a little bit of impact, positive impact in the December quarter if they hold where they are at now, but I wouldn’t say its particularly (inaudible) particular against the backdrop of Thailand lower revenues. Some of them in the R&D line that would have been certainly the positive results of cost constraints and also some positive impact from the timing spending on materials and so forth. And SG&A was probably down slightly except for our audit fees. So a little bit of upside in cost control, but nothing dramatic and FX wasn’t the particular driver in either of those.

Chris Glancy - Avondale Partners

And then moving to the non-telecom side; since the fab transfer is complete, how should we view the high power laser sales in the out quarters and more specifically in the immediate out quarters? And specifically I am kind of wondering is that $15 million line item, A could base line to model off of or does that number include some backlog sales that may have inflated this particular quarter and then we’ll see a normalization at the end of March?

Jerry Turin

I think it’s a good base line, I mean I think its while we haven’t provided the line item quarter-on-quarter, I think the growth rate that we have seen in the last couple of quarters is we get back to that number has some of the comeback reflected within it. So we haven’t overshot. So I think $15 million is a reasonable base and you know we probably see market growth so as the market share growth on top of that, but nothing like we’ve seen in the last couple of quarters as we’ve gotten back to normal.

Chris Glancy - Avondale Partners

And just kind of dovetailing off of that, the consumer side of the laser business, any kind of color you can give on where that is relative to where it’s been in prior quarters; I know you said there is some weakness there that we’re aware of but, you know, just kind of order of magnitude maybe, so we could help look at those two pieces on non-telecom side out?

Jerry Turin

If you look at the slide where we give the line items, you can see we are talking about a category that some thing up in the $17 million range now and we’ve talked about $15 million for high power lasers, so clearly high power laser is the substantial portion of that. And you know if the implied revenues for wafers is in the $2 million range, you know, maybe it’s been as high as $3.5 million within the past year or so. We are talking about that sort of order of magnitude, so it’s not a big line and item driver at this point although it’s really nice business for us from a profitability point of view and fairly simple to execute business for us.

Operator

Ladies and gentlemen, that concludes the question and answer session, Mr. Fanucchi, please continue.

Jim Fanucchi

Thank you and thank you to everyone for participating today and we look forward to speaking with you again when we report our financial results for the December quarter.

Operator

Ladies and gentlemen, that concludes our call for today. Thank you very much for your participation. You may now disconnect.

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