Opnext's CEO Discusses F3Q2012 Results - Earnings Call Transcript

| About: Opnext, Inc. (OPXT)

Opnext, Inc. (NASDAQ:OPXT)

F3Q2012 Earnings Conference Call

February 7, 2012 4:30 PM ET

Executives

Steve Pavlovich – Investor Relations

Harry Bosco – Chairman and CEO

Bob Nobile – Chief Financial Officer & Senior Vice President

Analysts

Patrick Newton – Stifel Nicolaus

Natarajan Subrahmanyan – The Juda Group

Dave Kang – B. Riley

Operator

Good afternoon. My name is Sarah and I will be your conference operator today. At this time, I would like to welcome everyone to the Q3 2012 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions) Thank you. Mr. Steve Pavlovich, Vice President of Investor Relations, you may begin your conference.

Steve Pavlovich

Okay, good. Thank you. Good afternoon and thanks for joining us. Today, we will discuss our financial results for the third fiscal quarter 2012 ended December 31, 2011. We’ll begin with Harry Bosco, our Chairman 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 Harry will talk about operational plans, market trends and our expectations for the future and then followed by Q&A.

As a reminder, the matters we will be discussing today include forward-looking statements, including, but not limited to, those related to expected recovery of production capacity, expected improvement in orders for certain products, and our expectations regarding our future revenues. These statements involve risks and uncertainties that may cause actual results to differ materially from those set forth in these statements.

Among other things, our outlook for the future is based on preliminary estimates and assumptions we believe reasonable but that are beyond our control; and the market in which we operate is volatile and our strategies may not achieve the desired impact. Other factors that could cause our future to differ from current expectations include, the ongoing impact of the flooding in Thailand, including the possibility that we could encounter difficulties in replacing lost production capacity and the possibility that insurance might be inadequate to compensate us for our losses in Thailand.

These factors are not a complete list of risks and uncertainties that may affect our business. Additional information regarding these and other factors can be found in the reports we filed with the SEC, including under Risk Factors, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Forward-Looking Statements in our Form 10-K filed on June 14, 2011 as well as our press releases and other filings with the SEC. In providing forward-looking statements, we disclaim any obligation to update them, whether in light of new information or future events, except as required by law.

Finally, let me mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures. A complete reconciliation of the non-GAAP financial measure to the applicable GAAP financial measure, including a reconciliation of adjusted EBITDA to EBITDA, can be found in the press release we issued today, which is available on our website in the Investor Relations section.

So, with that, I’ll turn it over to Harry.

Harry Bosco

Thank you, Steve. And good afternoon, everyone. Let me start off today with an update on our production (inaudible) following the October flood in Thailand that halted operations at Fabrinet, our primary contract manufacturer, where the majority of our 10G products are assembled and tested. We started limited production of our 10G modules in our Totsuka, Japan and Freemont, California facilities in December. And we are on track to restart manufacturing in Thailand at Fabrinet’s Pinehurst campus this month.

The replacement test systems are being assembled and we expect to fully restore our pre-flood manufacturing capacity by the end of March. I want to thank our partners at Fabrinet for working with us to expedite our recovery and our operating teams in the US and Japan for their tireless efforts.

Along with Fabrinet, we will bring up an additional contract manufacturer in the March timeframe to enable us to dual source the assembly of our high volume modules. In addition, our temporary 10G module manufacturing in Totsuka and Freemont will be transferred back to our contract manufacturers in the June quarter.

To support our customers during the transition period, we have worked closely with them to prioritize the sequence of our production recovery to meet their critical needs. Our customers have been very supportive throughout this difficult period and they are looking forward to our return to normal operations. We thank them greatly for their partnership and support.

Before I turn it over to Bob to discuss the financial results for the quarter, I’d like to highlight a few key items. Our revenue this quarter of $53.1 million was down almost $33 million from September. 10G and below products were down about $19 million due to the flood and our 40G and above revenues were down about $12 million due to the timing of the service provider deployments of next generation systems.

As I mentioned last quarter, we have and will continue to see quarterly fluctuations in 40G and above demand. Despite the flood and fluctuating demand for our high speed products, we are still confident in our business model and our path to profitability. The market data continues to point to high demand for more bandwidth and our new product floor addresses the high growth segments of the market.

Based on industry analysts’ forecasts, our primary addressable market is predicted to grow more than 20% through 2015 and the 40G and above portion is predicted to grow about 40% in the same timeframe. Based on customer feedback, we expect our 10G and below market share to return to pre-flood levels once production is fully recovered. We are also well positioned with the broad portfolio family of products for 40G and above that now includes our 100G coherent modules.

Future gross margins are expected to benefit from faster growth in 40G and above revenues and from new 10G product introductions. In addition, we will continue to improve our cost structure through increased vertical integration and by closely watching our expenses.

Now let me turn it over to Bob to discuss the results in more detail.

Bob Nobile

Thanks, Harry. And good afternoon, everyone. Revenue in the quarter ended December 31, 2011 was $53.1 million, a decrease of $32.9 million or about 38% compared to the September quarter and down 45% compared to the third quarter ended December 2011. 10G and below revenue decreased $18.7 million or 42% to $26.2 million compared to the September quarter and was down $35.6 million or 58% compared to the third quarter of last year due to the effects of the Thailand flood.

About $2 million of the Q3 revenue was for products produced at our Totsuka and Freemont facilities that were previously assembled at Fabrinet, and about $14 million of Q3 revenue came from shipments by Fabrinet or inventory on hand prior to the flood. Even though we had minimal inventory of products formally assembled by Fabrinet on January 1, 2012, we expect sequential growth in our 10G and below products in the March quarter, as production ramps at Fabrinet’s Pinehurst facility and our new CM in parallel while we are continuing production in Totsuka and Freemont.

40G and above revenue decreased by $11.9 million or 37% to $20.2 million from the September quarter. This quarter, demand for 40G and 100G client-side modules declined due to the timing of service provider deployments of next generation systems. In addition, demand for 40G line-side modules declined modestly as the shift by China OEMs from externally purchased modules to internally produced modules continued.

Revenue from industry and commercial product sales decreased to $6.7 million, 26% below the September quarter and 15% below the quarter ended December 2010 primarily due to the inventory built up at our Japanese industrial laser customers after the earthquake. We anticipate that it will take about two quarters for this demand to recover.

This quarter, Cisco and Hitachi, each represented more than 10% of total revenues. And on a combined basis, they represented 43% of total revenues. In the September quarter, these two customers represented 42% of total revenues. Revenues in the Americas represented 46% of our total revenues, Europe represented 17%, Japan 26%, and the rest of Asia was 11%.

Gross margin was 3.8% in the quarter ended December 31, 2011 compared to 20.1% in the previous quarter. Non-GAAP gross margin of 7.1% was down 14.8 percentage points from the September quarter, primarily from lower revenue and the $2.1 million or 4 percentage point inventory charge resulting from a customer discontinuing use of one of our 10G products as they transitioned to their next generation technology. We have been awarded future 10G opportunities to compensate us for those losses.

Looking forward to Q4, we don’t expect additional charges for discontinued products and we expect to realize a 40% gross margin on revenues incremental to the December quarter and consistent with our pre-flood business model.

Turning to our operating expenses, R&D expense was $13.2 million in the December quarter compared to $14.0 million in the September quarter, while non-GAAP R&D expense decreased to $12.9 million from $13.6 million. SG&A expense was $12.9 million in the December quarter compared to $13.5 million in the September quarter, and non-GAAP SG&A expense decreased to $12.2 million from $12.4 million. We expect our operating expenses in Q4 will be consistent with the December quarter.

Operating loss for the December quarter was $46.2 million compared to $10.6 million in the prior quarter. The December loss includes inventory and equipment write-offs resulting from the flood of $10.9 million and $9.7 million respectively, as well as about $400,000 of direct flood-related recovery expenses.

In addition, the December loss includes the $2.1 million inventory charge previously mentioned and a fixed asset impairment charge of $1.1 million for capitalized software expenses deemed not utilizable in the future. Looking forward to Q4, we do not expect similar charges. However, we do expect that direct flood-related expenses, primarily for products qualifications, will increase to about $2 million.

On a non-GAAP basis, the operating loss for the December quarter was $21.5 million compared to $7.1 million in the September quarter. The increase in non-GAAP operating loss primarily resulted from lower revenues due to the Thailand flood. Net loss was $46.3 million or negative $0.51 per fully diluted share compared to a net loss of $10.0 million or negative $0.11 per share in the September quarter.

Non-GAAP net loss was $21.6 million or negative $0.24 per fully diluted share in the December quarter and compared to a loss of $6.5 million or negative $0.07 in the September quarter. EBITDA was negative $38.9 million compared to negative $1.5 million in the September quarter, and adjusted EBITDA was negative $16 million compared to positive about $100,000 in the September quarter.

Cash and cash equivalents at December 31 were down $5.3 million from September 30, 2011. During the quarter, we used $1.4 million of cash in operations, $1.4 million for CapEx, and $2.2 million to fund capital lease obligations. We ended the quarter with $85.2 million of gross cash and $65.7 million net of short-term debt.

Excluding any benefit from insurance recoveries, we expect to use up to or about $20 million of cash in the quarter ending December 31, 2012. We expect to spend about $5 million for CapEx and to fund capital leases, while the rest will be used for operations primarily to fund the growth in accounts receivable associated with increased revenues. And these comments refer to the quarter ending December 31, 2012.

We will also enter into about $10 million of new capital leases primarily to replace equipment lost in the flood. As I previously mentioned, we incurred charges of $10.9 million for inventory and $9.7 million for equipment damaged by the flood. The inventory lost is fully insured by our insurance policies, and we expect to receive the reimbursement in Q4. The lost equipment is being handled on the Fabrinet’s insurance and we are working closely with them to complete their claim.

Now I’ll turn it back to Harry to discuss our outlook for the March quarter.

Harry Bosco

Thanks, Bob. So before we open it up for questions, let me summarize where we are. We had another quarter for demand to recover from the industrial laser inventory build that Bob mentioned. Our flood recovery plant is on track and is expected to enable us to increase our 10G and below revenues in Q4 from Q3 to the recovery full production by the end of March quarter.

The 10G market remains very important to us, and we plan to delivery working samples of our Tunable XFP this quarter with mass production by the middle of the year. Our LR4 module, the multi-wavelength 40G transceiver in a CFP package, began shipping last quarter. And the QSFP version is expected to start shipping to customers this quarter. The QSFP application and datacenters, where power density and costs are key factors, are critical for success. We view all of these as significant growth opportunities.

We shipped 100G coherent modules to core customers for qualification in December quarter, and we expect to add several others this quarter. In addition, overall 40G and above demand began to improve at the end of December quarter and was strong in January. So we expect 40G and above revenues to be strong in the March quarter. Based on these assumptions, we expect Q4 revenues to be between $70 million and $75 million.

In addition, we expect to realize a 40% gross margin on incremental revenues, consistent with our pre-flood business model. And excluding direct flood-related costs, OpEx is expected to be consistent with the December quarter. Accordingly, our pre-flood business model to achieve breakeven adjusted EBITDA of around $85 million of revenues per quarter and breakeven non-GAAP operating profit of around $100 million of revenues per quarter at 80 yen is still intact.

So with that, I will turn it back to Steve for Q&A portion of the call.

Steve Pavlovich

Okay. Thanks, Harry. So we’ll take your questions at this point. Operator, will you please provide instructions to the listeners?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Patrick Newton with Stifel Nicolaus.

Patrick Newton – Stifel Nicolaus

Yes. Thank you for taking my questions, gentlemen. First, I want to touch based on I guess the 40G side of the business. So you discussed the timing of the service provider deployment and I think the other key reason was that you didn’t have any increased captive share from a prior customer in China. So, could you help maybe differentiate between those two buckets and how big the captive portion of that is so that it can help kind of give us a better understanding of how quickly this 40G revenue can snapback?

Harry Bosco

Yes. Patrick, this is Harry. Listen, the 40G revenues, when you look at it, there is both the client side and line side. Some of the orders we are expecting in the line side came in actually at the beginning of the year as opposed to back in last quarter. In addition, the big impact was that on the client side. You equip the client side in one big blast initially when you deploy the systems and then it hits a low and comes back up. And so, from the client side, we’re seeing that come back up again. Now, from the impact of China, there are certain modules within certain China OEMs that get impacted on this. But it’s really in the DPSK, DQPSK area for a couple of them and then on the client side the other ones. But we’ve already accounted for a lot of that in our future forecast. And it really varies, quite frankly, from customer to customer.

Patrick Newton – Stifel Nicolaus

I mean, if you look at the $11.9 million decline sequentially, can you help kind of bucket that? I mean, was China, that customer going away with that half of it, was it a smaller percentage? Just to try to – or maybe a different way to ask the question is, is where – how quickly do you think you could potentially rebound to reach that kind of mid-to-high $30 million a quarter run rate that we saw in the beginning of 2011?

Bob Nobile

Patrick, this is Bob. The China portion was actually a smaller element of the total. We’ve been talking about this trend now for two quarters in a row, and we actually see that portion of the business coming back in the – going into the March quarter. And based on the guidance that Harry has given here, we actually see the 40G and above business getting back to around the September levels as we get to March.

Patrick Newton – Stifel Nicolaus

All right. That’s helpful. And then I guess, as I look at Fabrinet coming back on and you guys having a second contract manufacturer, is there any material pricing difference between the mix that you are going to be allocating to Fabrinet and this other contract manufacturer? And then also, do you have kind of an expectation of how much you’re going to be allocating to each player?

Harry Bosco

We haven’t concluded yet, Patrick, how much we’re going to allocate to each player. We are moving some new products into the second contract manufacturer right now. And obviously, cost is going to be very important to us and it depends on the contract negotiations we do with each one of them. But having that competitive structures is good for us also.

Patrick Newton – Stifel Nicolaus

Okay.

Bob Nobile

Patrick, we’re going to have some ups and – pluses and minuses in each of these. But the point is that as we move forward, the business model that we have of 40% gross margin on the incremental revenues stays intact, taking that into consideration.

Harry Bosco

Also, Patrick, we are going to – our plan is to move our 40G and 100G into these contract manufacturers in the future. So we want alternative suppliers [ph].

Patrick Newton – Stifel Nicolaus

Okay. And then just – I believe you made a statement that 10G and below share, you expect to return to pre-flood levels relatively quickly. And I guess what gives you, I guess, confidence that there’s been no permanent share loss in that share level should snap back so quickly?

Harry Bosco

We’ve been in constant communication with our customer base, and they have been very cooperative with us as far as – as soon as we get the new products qualified through the new manufacturing process, we should be relatively quickly. They have assured us that we’re going to go back to our original allocations.

Patrick Newton – Stifel Nicolaus

Perfect. Thank you for taking my questions.

Steve Pavlovich

Okay. Next question?

Operator

Your next question comes from the line of Natarajan Subrahmanyan from The Juda Group.

Steve Pavlovich

Subu? We don’t we move on? I think he probably got cut off. He’ll come back on. So let’s go to the next caller.

Operator

Mr. Subrahmanyan, your line is now open.

Natarajan Subrahmanyan – The Juda Group

Can you hear me, guys?

Harry Bosco

Yes, we hear you.

Steve Pavlovich

You’re fine now, Subu.

Natarajan Subrahmanyan – The Juda Group

Okay. All right. Great. So, two questions. First, for the June quarter, do you expect any impact from the Thai flooding at all or do you expect production to be back to a 100% level? And if so, do you expect revenues to be back closer to September 2011 in June, given there’s no share loss in 40G rebounding?

Harry Bosco

Subu, yes, we expect to be back to those levels right now because our production will be up to 100% capacity – pre-flood capacity. And again, the orders come in on the new stuff.

Natarajan Subrahmanyan – The Juda Group

And for the 40G – 40 and 100G client side, you mentioned timing of service provider. Was it one service provider? Was it kind of multiple service providers that the timing impacted the client side? And I think I wanted to make sure I understood right that between the line-side impact, which you’ve been feeling for some time, and the client-side impact, which is more lumpy, the bigger impact for December was client side.

Harry Bosco

It’s the client-side, exactly right. And what happens is they build up the inventory, they put it out, and then they stop ordering for a while and then they get another blast of orders. And we’ve already seen some of that come back already.

Natarajan Subrahmanyan – The Juda Group

Got it. And the service provider deployment timing that impacted it, was that one service provider or across some service providers, across your systems vendor customers?

Harry Bosco

It’s across our OEM customers really. Their customers are the ones. Typically it’s not uncommon. There is this lumpiness in their deployments.

Natarajan Subrahmanyan – The Juda Group

Understood. And final question on coherent and 40G and 100G coherent modules is – Opnext is going to participate in the 40G coherent module market since there does seem to be some demand for that, and when do you expect the 100G module market to take off? Because I would imagine the early part of market, it’s probably going to be more the line card based solutions that have initial traction.

Harry Bosco

We actually are very pleased with now. So we have shipped out the 100G coherent modules and now we’re really capacity limited. So we are building that capacity up now. And of course, you know all the compounds that have to go into these. So I think that our banking right now is the 100G coherent getting to be positioned in multiple customers, sets us in a good position to grow with those customers. On the DPSK and DQPSK, that comes in and out of different customers across multiple customer bases. In 40G coherent, we’re not participating in it right now.

Natarajan Subrahmanyan – The Juda Group

I understand. I was just wondering, Harry, if you think that’s a meaningful sized market and if you like Opnext will go in that direction.

Harry Bosco

Here is what we’re looking at, Subu. A lot of our customers have done customized solutions around the 40G coherent. And so, in looking at that market, it looks somewhat limited to us. And if a 100G comes down, which we anticipate, in costs to cross over, that I think most of our customers are going to go for 100G versus 40G coherent.

Natarajan Subrahmanyan – The Juda Group

Got it. Thank you.

Steve Pavlovich

Thanks, Subu. Next question, operator?

Operator

Your next question comes from the line of Dave Kang with B. Riley.

Dave Kang – B. Riley

Thank you. Good afternoon. First of all, what was the book-to-bill? Was it significantly over one significantly?

Bob Nobile

For the quarter ended December, Dave, yes, especially on the 40G and above side. But we need to be a little cautious in that, given the low level of revenue for the quarter. What we really need to focus on is the order flow that came in in the latter part of the December quarter. And really the strength of the orders that came in in January, that’s really what’s driving the – Harry's comment on the positive revenue guidance for the March quarter.

Dave Kang – B. Riley

And the recent strength, is that kind of across the board or is it too much concentrated on like Chinese customers per se?

Bob Nobile

No. I mean, there is some China orders in there, as I said before. The 40G line-side demand has come back a bit for the March quarter, but it is across the board on client-side, both 40G and 100G.

Dave Kang – B. Riley

And then regarding your – the annual pricing adjustment, how was it? Because one of your competitors said it was pretty aggressive.

Bob Nobile

Sorry. Say that again, Dave.

Dave Kang – B. Riley

The pricing adjustment – the annual pricing adjustment that you guys go through with your customers in January?

Bob Nobile

Yes. It came through fairly consistent with what our expectations were.

Dave Kang – B. Riley

So, nothing extraordinary then?

Bob Nobile

Nothing extraordinary, no. I mean, we will have a couple of percentage point higher impact in the March quarter than we do in the other quarters of the year, but nothing unusual.

Dave Kang – B. Riley

Okay. And then last one, on the 40G and 100G, so what is the mix right now between your client side versus line side? It seems like client side is much bigger than I originally thought.

Bob Nobile

In 40G, Dave?

Dave Kang – B. Riley

Yes, 40G, 40G. What’s the mix? Is it predominantly client side right now or –?

Bob Nobile

Yes. I mean, the client side, especially this quarter, was the majority of the revenue.

Dave Kang – B. Riley

So you mean the mix changes on a quarterly basis then, sometimes –?

Bob Nobile

Sure. I mean – that's correct. I mean, as Harry talked about these fluctuations, you get points where, I mean, we’ve had quarters where the line-side business was greater than the client-side business.

Dave Kang – B. Riley

Okay. I think that was it. Thank you.

Steve Pavlovich

Okay. Thanks a lot. Next question?

Operator

(Operator instructions) At this time, there are no further questions.

Steve Pavlovich

Okay. With no more questions, that will conclude our call for today. Thanks for joining us and we look forward to talking with you soon. Bye for now.

Operator

This concludes today’s conference call. You may now disconnect.

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