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NeoPhotonics Corporation (NYSE:NPTN)

Q2 2012 Earnings Call

August 2, 2012, 05:00 pm ET

Executives

Tim Jenks - Chairman, President & CEO

JD Fay - VP & CFO

Erica Mannion - President, Sapphire Investor Relations, LLC

Operator

Welcome to the NeoPhotonics 2012 Second Quarter Conference Call. This call is being webcast live on the event calendar page of the Investor Relations section of NeoPhotonics’ website at www.NeoPhotonics.com. This call is property of NeoPhotonics and any recording, reproduction or transmission of this call without the expressed written consent of NeoPhotonics is strictly prohibited. You may listen to a webcast replay of this call by going to the event calendar page of the Investor Relations section of NeoPhotonics’ website. I would now like to turn the call over to Erica Mannion, Investor Relations for NeoPhotonics.

Erica Mannion

Good afternoon. Thank you for joining us to discuss NeoPhotonics’ financial and operating results for the second quarter ended June 30, 2012. With me today are Tim Jenks, Chairman and CEO and JD Fay, CFO.

The call today contains forward-looking statements that involve risks and uncertainties. These include statements related to NeoPhotonics’ business outlook for the quarter ending September 30, 2012, future periods and industry trends, as well as forward-looking statements that we may make in response to questions. Forward-looking statements are generally indicated by words such as “would”, “believe”, “should”, “expect”, “outlook”, “estimate,” “anticipate”, “forecast” and similar expressions that look toward future events or performance.

Actual results may differ materially from forward-looking statements. Factors that could cause results to differ materially from these statements include those described in today’s press release as well as those detailed in the section entitled "Risk Factors" of the company’s Quarterly Report on Form 10-Q most recently filed with the SEC. NeoPhotonics cautions you not to place undue reliance on forward-looking statements, and that these statements speak only as of the date they are made.

In addition, non-GAAP financial measures will be discussed today. Please visit the Investor Relations section of the NeoPhotonics Web site for a copy of the company’s press release, which contains an explanation of these non-GAAP financial measures as well as a reconciliation to the comparable GAAP measures.

Before I turn the call over to Tim, I’d like to mention that NeoPhotonics will present at the dbAccess 2012 Technology Conference in Las Vegas on September 11 and Think Equity’s 9th Annual Growth Conference in New York on September 12.

Now, I will turn the call over to Tim Jenks. Tim…

Tim Jenks

Thank you for joining us today.

I will provide a financial update and discuss progress in our overall business. I will comment on our expansions with products for Coherent and other high speed networks, on our view about the industry and its direction as a whole, and on our developments in the Russian market with the Russian Corporation of Nanotechnologies.

In the second quarter, we delivered record revenue of $63.0 million, significantly above our projected range of $55-$61 million provided in our first quarter 2012 conference call. Further, our diluted loss per share from continuing operations was $0.13, a significant improvement from a loss of $0.47 in the prior quarter.

Our non-GAAP gross margin expanded to 26.5%, which was well above our projection and an increase from 23.9% in the prior quarter. We believe we are on a sustainable path of growth and accelerating our path to profitability.

We experienced increased demand across key parts of our business, notably for high speed products used in Coherent networks as well as in Agility products and in our Access business.

These are important points as NeoPhotonics has made a sustained investment in Coherent capabilities.

We now have several products being sold in volume in this growth market and we view the change to Coherent as a sea change in network architecture, much like the change to 10 gigabit per second dense wave-division multiplexing networks, or DWDM, more than a decade ago. This year we are seeing some fruits of our labor.

We have seen some slowing in the China domestic market, more generally last year, and the first half of this year. However, the Access market in this region continued to show strength.

We have noted various reports about carrier capex being moderated somewhat, as well as our having macro-economic concerns, notably in Europe. Nonetheless our business has continued on track. We recognize that carriers are choosing carefully where to invest their capex and the areas of our steady focus – 40G and 100G Coherent and fiber-to-the-home Access – are some of their chosen investment areas.

Our positive results were slightly offset by modest demand in the Other Telecom group of products, notably for 10G and below applications. I should point out, however, that this group of products grew absolutely during the quarter. Broadly speaking, we believe this is consistent with the rest of the market and is the impact of capex changes and carrier choices, which impact the 10G and below market segment. In fact, through the first half of the year we have seen diminished strength of 10G and other legacy applications as well, though the overall impact on NeoPhotonics has been more modest than for other companies who have larger exposure as a percent of their revenue to 10G.

As is typically the case for our business, our second quarter was strong, and this year it was notably strong in 40G and 100G Coherent network applications. Our customers were responding to rapidly growing demand for their Coherent systems, which include products such as Coherent Receivers, Coherent Mixers and Narrow Line Width Tunable Lasers. In addition, our high speed Client side applications include transceivers at speeds at 10G, 40G and 100G, and in various form factors including CFP, XFP and SFP+. We expect that these products will be significant contributors to NeoPhotonics results in the quarters ahead.

In the second quarter of 2012, our “Speed and Agility” product group revenue was sequentially up to approximately 53% of our total revenue. Within this group, our 40G and 100G products were approximately 25% of revenue and we believe it will continue to grow at a strong rate. Access products contributed approximately 35% of total revenue and our Other Telecom products were approximately 12% of total revenue. All three of our product groups grew sequentially in the second quarter, delivering 24% year over year growth.

Business with our western customers has been gaining strength faster than with our Chinese customers over the past year. While our China business was 53% of total revenue in percentage terms and grew in absolute terms quarter on quarter, its growth trend is lower than that of key western customers.

We believe North American carriers are increasing their investments in Coherent and other high speed network deployments while reducing spending on more traditional 10G and other legacy networks.

NeoPhotonics’ business has been strong in Coherent and high speed applications – that is, 40G and above. We believe we are well-positioned in this burgeoning market. With winning designs, at leading customers and with growing volumes, we expect to see continued success from these markets. It is important that the industry is driving to higher speeds with multiple factors pushing the optical upgrades and the proliferation of optical interfaces. We believe that critical to serving this demand is the fact that our technology – our PIC technology – is differentiated and is a key element in these Coherent and other high speed applications.

Our demand was notably strong from several of our largest Western customers as carriers accelerated their investments in high speed Coherent networks and as they leverage the capabilities of our leading western customers including Ciena, Alcatel-Lucent, Cisco and others. Asia and in particularly China, also performed well in Access products. More Fiber-to-the-Home products, also with increasing speed, means more need for managing backbone networks at high speed; and all of this is pushing up demand for Coherent capabilities.

Broadly speaking, NeoPhotonics’ core business is in providing photonic integrated circuit, or PIC, based modules and subsystems for bandwidth-intensive and high-speed communications networks including Coherent 40G and 100G. Our products are designed to enable cost-effective, high-speed data transmission and efficient allocation of bandwidth over these networks. We sell our products to the leading network equipment vendors globally.

NeoPhotonics technology differentiation is the result of our ability to develop and produce both monolithic and hybrid photonic integrated circuits in high volumes with high yield and superior performance. We deliver integrated photonic solutions with low optical loss in channelized devices, high sensitivity for receivers, and in small sized photonic chips with reliable and repeatable product performance. Essentially this enables us to deliver high performance and low cost by design.

Our direct customers, the network equipment vendors, supply their systems to global telecom service providers. During the second quarter of 2012, these network equipment vendors and their service provider customers continued to spend on the growth of traffic, supporting the rapid expansion of bandwidth demand driven by video, mobile video, the proliferation of network-attached devices, social networking and other elements of mobility and virtualization, that are enabling consumers to access bandwidth-intensive content anytime and anywhere over fixed and wireless networks, including “4G” / LTE.

Our largest customers are the leaders of network equipment. Huawei Technologies, Alcatel-Lucent and Ciena together accounted for more than 70% of our revenue in the second quarter, which is up from 61% in the first quarter. Huawei represented approximately 40% of our second quarter 2012 revenue and Alcatel-Lucent and Ciena each contributed more than 10% of our revenue. In total our top 10 customers for the quarter represented approximately 90% of total revenue, which is consistent with the prior quarter. Year to date, Huawei represents 38% of total revenue, which is down from our 2011 full year total of 51% for Huawei. Revenue from our other leading Western customers is among our fastest growing.

I have talked in prior calls about our hub-based vendor-managed inventory approach, or VMI. We believe that by supporting this model we are favorably viewed by these customers, and that we earn a larger share of customer demand for these products. Moreover, we have increasingly seen some customers pull us hard for shipment of critical products; this is because we operate a vertically-integrated manufacturing capability as we operate our own chip fabs and assembly factories and we believe we are more capable of fast response to demand peaks than some of our competitors.

Now I will talk further about our acquisition of Santur Corporation, which closed last October. Santur was a private company, and this transaction has been a meaningful success for us. This acquisition enhanced our core PIC technology with PIC-based laser array and high density PIC-based packaging technologies for communications networks. Having completed this integration, NeoPhotonics has a broad array of PIC components, one of the broadest in the industry, and we are one of the largest volume producers of these products based on photonic integration, and in particular, for 40G and 100G Coherent and cloud computing markets.

We have made substantial progress in scaling products from Santur, which have made a strong contribution to the NeoPhotonics portfolio. I believe our customers are pleased as well.

We are now leveraging indium phosphide as an integration platform for 40G, 100G and beyond PIC-based products, expanding our potential Total Addressable Market while working to improve our cost position for these important elements in our modules and subsystems.

With our acquisition of Santur, and with other competitor consolidations, we see the consolidation trend continuing within our industry and we believe we are a well-positioned company with unique value in our array of PIC-based capabilities that our customers require, in many cases as the preferred solutions for advanced network architectures.

Finally, on our conference call last November, we believed that we could return to profitability in five to seven quarters, which would now be two to four quarters. We have made significant progress toward profitability, so at this point we are accelerating this estimate under our current plan to 1 to 3 quarters, which would be ahead of schedule.

At this point I want to talk briefly about the industry as a whole. While demand has been high for key parts of our business, we see softness in parts of our industry due to the global economy, as well as the impact of the major shift in network deployments and expansion from legacy 10G to Coherent architectures. Given our exposure to Coherent architecture, we believe we are relatively better positioned to capture future demand compared to other companies with significant 10G and below business. If the industry rebounds sooner or faster, then we would expect to see a commensurate increase in our overall growth.

We believe the combined growth of the market for Coherent networks and the use of high speed modules on the client side can help to fuel NeoPhotonics growth in the quarters ahead. We believe that these markets are in their early stages of development and that we will see continued increased demand. Accordingly, we expect to increase our output of 40G and 100G client modules, including in the CFP form factor. These products can be relevant to a broader group of customers – not just Network Equipment Manufacturers but also to data centers and the broad range of enterprise companies that use routers, switches and storage gear. This action is intended to expand our Total Addressable Market. As a result, we believe we are well-positioned to continue to gain share as high speed network deployments accelerate in 2013 and beyond.

We believe our product development actions are having a positive impact on our potential for future growth. We are sampling our multicast switch, or MCS, to initial customers. Our MCS adds to our line of patented Agility solutions for wavelength switching in ROADM networks. The MCS product expands the flexibility of a node to enable any port to drop any wavelength, from any direction, and to allow two identical wavelengths from different directions to be dropped through the same switch – that is, colorless, directionless and contentionless, or “CDC”.  Our Multicast Switch product is designed to be most efficient in Coherent optical networks, where the final optical filtering can be performed by, for example, our integrated Coherent receiver. Our MCS is used with ROADM products such as Wavelength Selective Switches to deliver CDC capability.

Now I will move to our initiative in Russia. In the second quarter we announced a strategic investment by Rusnano, a $10 billion sovereign investment corporation located in Moscow. Rusnano acquired 4.97 million newly-issued common shares of NeoPhotonics stock in a private placement transaction at a price of $8.00 per share for proceeds of $39.8 million before costs. Their purchase price represented a 78% premium over the Company’s closing trading price at the time.

This investment aligns with our strategy to accelerate deployment of our PIC technologies, to grow globally, with particular emphasis on fast growing and emerging markets. Industry analysts have estimated the telecom equipment market in Russia to have been approximately $5 billion in 2011, of which 10% was estimated to be the share of optical telecommunication equipment; and we believe the market for optical equipment is growing approximately 8 to 10% annually in Russia. Further, carriers in these markets are actively deploying high speed, agile and fiber-to-the-home networks – which can include NeoPhotonics content. For example, Huawei reported Coherent system deployments with companies including Rostelecom and MTS (or Mobile TeleSystems) in Russia, and with Beltelecom in Belarus. Thus, we see some of our customers targeting service providers and investing locally in Russia and more broadly in Eastern Europe. Over time, we will be investing in our Russia presence and more closely serving our customers there.

In summary, we are pleased with our progress in developing our customer diversification, and also with the favorable response of our customers to our new, Coherent and other high speed products, as well as our enhanced technology and product portfolio. We believe that our multi-quarter trends of broadly growing revenue from our leading customers, and from 40G and 100G products are positive, particularly as the momentum for deploying high-speed line-side and client-side networks leveraging Coherent and PIC technologies gains momentum. We continue to believe Coherent is key; that we are in a strong position today given our design win and market share awards earned with our Tier 1 and other customers, and that these trends will continue to favor NeoPhotonics in this industry.

At this point I’ll turn the call over to JD to review our second quarter 2012 financial performance, and third quarter 2012 projections.

JD…

JD Fay

Thank you, Tim, and good afternoon.

For the second quarter of 2012, revenue was $63.0 million, which was 24% higher than our second quarter 2011 revenue of $51.0 million, and up 16% from the first quarter of this year. Our reported revenue is also 9% higher than the midpoint of our projection, and another quarter of record revenue.

GAAP gross margin for the second quarter was 24.8%. Non-GAAP gross margin for the second quarter of 2012 was 26.5%, above both our projection and the previous quarter’s Non-GAAP gross margin of 23.9%. Importantly, our non-GAAP gross margin was slightly better than the 26.4% result from the second quarter of 2011, illustrating the return of our margins to pre-acquisition levels.

Non-GAAP gross margin for the second quarter of 2012 excludes amortization of purchased intangibles and other assets relating to the acquisition of Santur of $0.9 million, and stock-based compensation expense of $0.1 million.

Loss from continuing operations for the second quarter of 2012 was $3.7 million, as compared to a loss from continuing operations of $11.8 million in the first quarter and income of $13.7 million in the second quarter of 2011. Diluted loss per share from continuing operations for the second quarter of 2012 was $0.13, a significant improvement from the loss per share of $0.47 in the prior quarter.

Non-GAAP loss from continuing operations for the second quarter was $1.7 million, which was also a significant improvement from the loss of $5.4 million in the first quarter and compares to break-even in second quarter of 2011. Non-GAAP diluted loss per share from continuing operations for the second quarter was $0.06, which was much better than the midpoint of our projected loss per share of $0.18, and a $0.16 per share improvement compared to the first quarter of 2012.

Non-GAAP loss from continuing operations and Non-GAAP diluted loss per share from continuing operations for the second quarter of 2012 exclude stock-based compensation expense of $1.0 million, amortization of purchased intangibles and other assets of $1.4 million, acquisition- and integration-related costs of $0.9 million, the fair value adjustment to contingent consideration relating to the Santur acquisition of $1.3 million, and the income tax effects of these adjustments.

We also returned to positive Adjusted EBITDA in the second quarter, which was $1.8 million. This represents an improvement of more than $4 million sequentially compared to the Adjusted EBITDA loss of $2.4 million in the first quarter, and was primarily due to improved operating performance resulting from higher gross margins, good cost control and therefore, a lower net loss. This is another example of our return to positive results.

To offer additional qualitative color on our second quarter,

Our strong revenue compared to our projection primarily resulted from increased demand for our products that are designed to address traffic bottlenecks in high speed and Coherent communications networks, as the demand for bandwidth continues to grow and carriers expand their network capabilities in response. In the second quarter, we experienced growth in all three of our product groups – Speed & Agility, Access and Other Telecom.

In the second quarter, “Speed and Agility” product revenue was approximately 53% of our total revenue, which was also up in absolute terms. The Speed and Agility product group is comprised of 10G and above products, which means it also includes our high speed, 40G and 100G products. This 40G and 100G subset comprised approximately 25% of our total revenue in the quarter, which was up from approximately 16% of total revenue in the first quarter, up from approximately 11% in the fourth quarter of 2011 and up from approximately 1% in 2010.

Revenue attributable to “Access” products was approximately 35% of total revenue, which was up appreciably from approximately 29% in the first quarter; and revenue attributable to our “Other Telecom” products was approximately 12% of total revenue, also up in absolute terms.

The sequential improvement in our gross margin was due to favorable product mix with the strong sales of Coherent 40G and 100G modules, continuing results from cost control and integration initiatives, as well as efforts to drive economies of scale in our supply chain.

Our operating activities also benefited from cost control and integration efforts. Total operating expense in the second quarter of 2012 was $18.5 million, a significant reduction compared to $22.9 million in the first quarter.

Within operating expenses, research and development was $9.3 million; sales and marketing was $3.4 million; and general and administrative was $6.7 million. Amortization of purchased intangibles declined approximately 9% sequentially to $0.3 million. Included in the foregoing operating expenses is $0.9 million of stock-based compensation expense, $0.9 million of acquisition-related expenses, and a reduction to the estimated earn-out relating to the Santur acquisition of approximately $1.3 million.

On the balance sheet, we ended the second quarter with cash, cash equivalents and short-term investments of $107.1 million, up from $83.8 million at the end of the first quarter of 2012. This increase in cash was driven primarily by our $40 million sale of Common Stock in a private placement transaction during the quarter, partially offset by capital expenditures of approximately $2.9 million, repayment of notes payable of approximately $3.2 million and scheduled debt repayment of approximately $1.3 million, with the remainder primarily attributable to spending to build inventory that largely converted in to accounts receivable in the quarter.

Total bank debt at June 30, 2012 was $24.7 million, down from $25.9 million at March 31, 2012.

Accounts receivable at June 30, 2012 were $75.3 million, an increase of approximately 26% from the prior quarter’s balance of $59.7 million, with growth above our sequential revenue growth of approximately 16% largely due to the building of sales during the course of the second quarter. Days sales outstanding improved to 96 days from 106 days.

Now, I will provide our outlook for the third quarter of 2012.

As Tim conveyed, we continue to believe demand is generally favorable for NeoPhotonics products, with the potential for continued strength in high speed, Coherent and Access products. We also believe that the markets we serve with integrated optics are generally performing better in 2012 relative to 2011.

Accordingly, we anticipate revenue for the third quarter ending September 30, 2012 to be in the range of $60 million to $66 million.

Non-GAAP gross margin is anticipated to be in the range of 26% to 28%, and is primarily dependent on volume and product mix.

Non-GAAP loss per share is anticipated to be in the range of $0.02 to $0.10. As Tim noted, we now believe that we will achieve profitability under our current plan in the next 1 to 3 quarters, a timeline that has been updated.

The Non-GAAP outlook excludes the expected amortization of purchased intangibles and other assets of approximately of $1.6 million and the anticipated impact of stock-based compensation of approximately $2.0 million. Of these amounts, approximately $1.2 million is estimated to relate to cost of goods sold.

The share count assumption used to estimate the third quarter is approximately 30.3 million. This estimate can change based on stock and option activity in the period.

This concludes our formal comments and now I will ask the operator to open up the line for questions.

Question-and-Answer Session

[Q&A Session Conducted]

Tim Jenks

Thank you for joining us today.

Before we conclude, I would like to thank our shareholders for their time today and their continued interest in our company, and our customers and our exceptional employees for their dedication and diligent efforts. We look forward to our next update with you regarding our progress.

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