NeoPhotonics' (NPTN) CEO Timothy Jenks on Q4 2017 Results - Earnings Call Transcript

NeoPhotonics Corporation (NPTN) Q4 2017 Earnings Conference Call March 1, 2018 4:30 PM ET

Executives

Erica Mannion - Sapphire Investor Relations

Timothy Jenks - Chairman and Chief Executive Officer

Elizabeth Eby - SVP and Chief Financial Officer

Analysts

Mauricio Munoz - Raymond James

Alex Henderson - Needham & Company

Richard Shannon - Craig-Hallum

Troy Jensen - Piper Jaffray

Tim Savageaux - Northland Capital Markets

Jun Zhang - Rosenblatt Securities

Dave King - B. Riley FBR

Operator

Welcome to the NeoPhotonics 2017 Fourth Quarter Conference Call. This call is being webcast live on the NeoPhotonics event calendar webpage at www.neophotonics.com. This call is the property of NeoPhotonics and any recording, reproduction or transmission of this call without the express written consent of NeoPhotonics is prohibited. The webcast will be available on the event calendar page of the NeoPhotonics website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations.

Erica Mannion

Good afternoon. Thank you for joining us to discuss NeoPhotonics operating results for the fourth quarter of 2017 and full fiscal year, and our outlook for the first quarter of 2018. With me today are Tim Jenks, Chairman and CEO, and Beth Eby, Chief Financial Officer.

Tim will begin with a review of the fourth quarter. Beth will then provide financial results for the fourth quarter and for the full fiscal year before providing the outlook for the first quarter of fiscal 2018. Beth will then turn it back to Tim to provide color on the market and business drivers before opening the call for questions.

The company's press release and management's statements during this call include discussions of certain Non-GAAP financial measures and information, including all income statement and balance sheet amounts and percentages other than revenue, unless otherwise noted. 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. These financial measures and a reconciliation of GAAP to Non-GAAP results are provided in the company's press release and related Form 8-K, being filed today with the SEC, and can be found at the Investor Relations section of the NeoPhotonics website.

Material contained in the webcast is the sole property and copyright of NeoPhotonics, with all rights reserved. Certain statements in this conference call, which are not historical facts, may be considered forward-looking statements that involve risks and uncertainties and include statements regarding future business results, levels of sales and profitability, subsequent events, product and technology development, capital needs and availability, customer demand, inventory levels and economic and industry projections. Various factors could cause actual results to differ materially. Some of these risk factors have been set forth in our press release dated March 1, 2018 and are described at length in our annual and quarterly SEC filings.

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

Timothy Jenks

Thank you for joining us today.

In the fourth quarter NeoPhotonics delivered solid results, with revenue of $76.9 million, representing 8% growth over the prior quarter and coming in above the top end of our outlook range. Driving this growth was a combination of increasing demand from our Chinese customers and stable demand in the other regions we serve. Our High Speed Products for data rates of 100G and beyond comprised 84% of our revenues in the fourth quarter of 2017 and were 83% of our proforma full year 2017 revenue.

Specific to China, we believe customer inventory levels have normalized for our products. As many of you will recall, in early 2017 the industry was made aware of a substantial inventory overhang of optical and semiconductor components in the Chinese Telecom OEM supply chain and as a result much of the reduced demand we experienced throughout 2017 was a result of our customers working through this inventory. In the fourth quarter we saw customer inventory levels reduce to the 3-4 week target range set by our customers – down from several months of inventory in mid-2017. More importantly, we began to see them pull a larger volume of our products, and thus far in Q1 we have seen this trend continue. That is, despite typical seasonality in the first quarter, we see Q1 volumes increasing modestly over Q4 levels.

With input from both China customers and carriers, we believe this near-term increase in demand is a step-up to specific customer shipment volumes and is not yet a firm indication of increasing end-market demand from either additional domestic provincial tenders or in support of initial 5G trials. The expectation from our customers is that both of these end-market growth drivers will materialize to some degree later in 2018.

Outside of these China specific dynamics, as I mentioned previously, in the fourth quarter we saw modest increases with strong traction in our mid- and long-term growth drivers.

Turning to products, in the fourth quarter we began shipping coherent DCO modules to initial customers and we expect volumes will grow through 2018 from a low starting base. We see strengthening demand for our Multicast Switch platform and we have increased our shipment rate accordingly.

With respect to our line side 400G and 600G product offerings, we are seeing strength in design wins, notably across all three of our leading components including our ultra-narrow linewidth tunable laser, 400G and 600G micro coherent driver-modulator and coherent receiver. Our ultra-narrow linewidth lasers are a critical element in achieving these speeds because they have the narrowest linewidth and minimal phase noise for the higher order modulation schemes – or data coding methods – that are required. When more bits are encoded on a given wavelength, there is risk of signal degradation unless very pure lasers are used. Our laser, receiver and modulator optimally work together to enable this highest performance and we are now supplying them as a full solution or as discrete elements to customers for whom the highest performance and data rates matter. Similarly, our client side and data center product offerings are also focused on 400G applications.

At the Optical Fiber Communications Conference, to be held in San Diego in two weeks, we plan to highlight new coherent line side as well as data center products including: First, a Coherent Optical Subassembly, or COSA, which integrates our 64GBaud coherent driver-modulator and coherent receiver in a compact package suitable for small form factor 400ZR pluggable modules or 600G and 1.2T daughter cards; second, a nano version of our ultra-narrow linewidth external cavity tunable laser with ASIC control circuitry, again suitable for these small form factor pluggable modules; third, high port count versions of our Multi-Cast Switch based on our low loss PLC technology that provides a cost effective path for “contentionless” ROADMs in content provider networks; next, our family of optical components for 400G PAM4 solutions, including 53 GBaud electro-absorptively modulated lasers, or EMLs, with integrated drivers for transmitters plus 53 GBaud PIN-PDs and TIAs for receivers. This is all of the optical content necessary for single wavelength 100G PAM4 and four wavelength 400G PAM4 transceivers, such as DD-QSFP; and finally High Power Lasers for use in Silicon Photonics based transceivers for short reach applications inside the data center, including 100G PSM4 and CWDM4.

The adoption of 400G and 600G data rates in DCI and Metro networks, initially in North America and subsequently in Europe and China, will provide accelerating demand for our next gen products. We believe we are very well positioned for this next gen growth driver with the introduction of our 400G and 600G product suite, new 1.2T applications and the growth of contentionless networks that I highlighted.

And now with Chinese customers’ inventory levels normalized, we continue to see stable to growing demand in all the regions we serve. We are seeing strong design wins, and as China continues to build out national backbone, provincial and Metro networks later in the year, advance in data center deployments and prepare for 5G wireless, we expect continuing growth in this key market. However, in the first half of 2018, there is uncertainty around when the next tenders or deployments within China may occur.

We believe the mid- and long-term market drivers for our business are compelling, and these drivers, complemented by our success in new product introductions, will help us drive top line growth in 2018 and to second half profitability.

I will now turn the call over to Beth to provide further detail on our financial performance.

Elizabeth Eby

Thank you, Tim, and good afternoon.

In the fourth quarter we continued to drive toward profitability and positive free cash flow. Of note in Q4, our China and Japan Bank lines have been renewed, we reduced our inventory by $15 million and achieved positive free cash flow. Our restructuring announced in Q3 is complete, with savings in Q4 of $1.5 million in operating expenses and $0.4 million in Cost of Goods Sold. The costs related to this action in Q4 of $0.6 million have been excluded from our non-GAAP results.

Moving to our results for the fourth quarter, revenue totaled $76.9 million, up 8% quarter over quarter, with 9% growth in China.

For the full fiscal year, revenue totaled $293 million, down 29% year over year, driven by delays in China tenders, an inventory over-hang after a strong 2016, and the sale of our low speed product assets. Excluding the sale of our low speed products, our revenue declined 16% from the prior year.

In Q4, China represented 57% of our total revenue and the Americas were 21%. For the full fiscal year, China was 55% of our revenue and the Americas were 20%.

Huawei Technologies, including their affiliate HiSilicon Technologies, was our largest customer again in Q4, and accounted for approximately 42% of the Company’s revenue. Our next four customers after Huawei represented 41% of total revenue in Q4. For the full fiscal year, Huawei was 40% of total revenue and the next four represented 39% of total revenue.

Our Non-GAAP gross margin in the fourth quarter was 21.3%, up 2.7 points from the third quarter of 2017 and approximately at the midpoint of our forecast. There were three primary drivers of the change: First and largest, inventory write-offs were lower than the third quarter. This good news was partially offset by both

The initial impact of annual price negotiations; and lower than expected output from our Japan fab.

In the Japan fab, full qualification and integration of our new equipment has taken longer than expected. While the main causes of this have been addressed and remediated, an approximately $3 million adverse impact will carry over into Q1.

Total Non-GAAP operating expense for the fourth quarter was $24.1 million, and includes officer severance costs and a bad debt write-off of $0.5 million. Excluding these one-time charges, operating expenses were down $1.5 million compared to Q3, as expected given the restructuring.

Non-GAAP operating loss for the fourth quarter was $7.7 million, or negative 10% of revenue, compared to negative 16% in the prior quarter, driven by improvement in gross margin and lower operating expenses as I discussed.

In Q4, we recorded a tax impact of $3.4 million, or 8 cents per share, primarily related to the tax impact of our restructuring actions in China. As we finalized our year-end tax provisions, we determined that as a subcontract manufacturer, the China subsidiary could not hold the written-down inventory. The inventory was purchased by the U.S. legal entity, driving a profit for our China subsidiary. This tax provision was the result of end of year activities and not related to the new U.S. tax law. The impact of the new U.S. tax law was minimal for us.

Non-GAAP net loss in the fourth quarter was $11.7 million compared to a loss of $10.9 million in the third quarter, driven by the one-time tax provision. Based on a fully diluted share count of 44.1 million shares, this translates to a Non-GAAP loss per share of 27 cents compared to the 25 cents loss in Q3. For the fourth quarter, Adjusted EBITDA was a loss of $0.4 million compared to loss of $4.5M in the third quarter of 2017.

Our full year Non-GAAP gross margin was 22.5%. We recorded a Non-GAAP net loss of $39.9 million for the year. Non-GAAP EPS was a loss of $0.92 cents per share and Adjusted EBITDA was a loss of $10.1 million.

I will close out my discussion of the fourth quarter and full year income statement with a review of our GAAP results. Fourth quarter gross margin was 20%, up from 15% in the prior quarter. Operating expense was $26.6 million compared to $29.4 million in the preceding quarter, primarily due to the impact of the restructuring in Q3 and the related lower costs in Q4.

Operating loss was $10.9 million for the fourth quarter, which included approximately $0.2 million of disposition and amortization costs of acquisition-related intangibles, $2.5 million of stock-based compensation expense and $0.6 million of restructuring and other related charges.

Net loss was $14.3 million for the quarter, as opposed to a net loss of $18.2 million in the prior period. For the full year, GAAP gross margin was 21%, and we recorded a net loss of $53.3 million for the year. EPS was a loss of one dollar and twenty-three cents per share.

A full reconciliation of our GAAP to Non-GAAP numbers for the quarter is included in our press release.

Turning to the balance sheet, we finished the quarter with $94 million in cash, investments and restricted cash. Cash provided by operations was $8 million in the fourth quarter. Net inventory was $67 million, down over $15 million, with 99 days of inventory on hand. Capital expenditures were approximately $6 million in the fourth quarter, down from $7 million in the prior quarter. As a result, free cash flow was $2.5 million in the fourth quarter.

As previously disclosed, we have completed our annual renewal of our credit agreement with CITIC Bank in China for 250 million RMB, or approximately $40 million at current exchange rates. Subsequent to the end of the quarter, we repaid $17 million on the expired CITIC Bank Credit line and borrowed $17 million on the new credit line.

We have also entered into a new seven year loan agreement with Mitsubishi Bank in Japan for 850 million Yen, or approximately $8 million. Part of the proceeds of this loan was used to repay the previous 500 million Yen or approximately $5 million long term loan.

Before I discuss our revenue and earnings outlook for the first quarter of fiscal 2018, I want to remind everyone of our public filings with the SEC and our Safe Harbor statement included in our press release that discusses the risks and uncertainties that could affect future performance causing actual results to differ materially from our forward-looking statements.

As Tim mentioned, the first quarter is typically our seasonally lowest quarter due to annual price negotiations and the impact of Chinese New Year. Given industry over-supply, price reductions were toward the high end of the historical range of 10%-15%. As typically occurs, these price reductions began to take effect in the fourth quarter with the full impact occurring in the first quarter followed by cost reductions throughout the year to mitigate the impact on gross margin. In Q1, volumes are expected to increase modestly as inventory levels return to normal. As I previously mentioned, Q1 also has an impact of lower output from our Japan fab of $3 million.

Given these factors, the Company’s expectations for the March 2018 quarter are: Revenue in the range of $67 to $73 million; Gross margin in the range of 15% to 19%; Non-GAAP gross margin in the range of 16% to 20%; GAAP diluted net loss per share in the range of 40 cents to 30 cents, and; Non-GAAP diluted net loss per share in the range of 32 cents to 22 cents.

These numbers are reflective of approximately 44.5 million fully diluted shares. As I have previously noted, we are focused on cash, cash flow and a return to profitability. Our operating expense reductions are complete, we have made good progress reducing inventory and we believe that our customer’s inventories have reached normal levels. As we complete amortization of under absorption charges, we remain committed to reaching breakeven with revenues in the mid-eighties and will continue actions to further reduce our breakeven point.

I’ll now turn the call back to Tim.

Timothy Jenks

Thank you, Beth.

As a Company, we remain focused on operational execution including cost containment as we await further improvements in near-term demand for our business. While we feel confident in our competitive position in the market, we remain mindful of the uncertainty around timing of additional tender awards in China. The elimination of the inventory overhang at our customers is a meaningful first step to growth in 2018, however it is difficult to frame an overall outlook for the year with the information currently in hand.

Looking beyond the near-term, we remain enthusiastic about our mid- and long-term prospects within the optical networking space. NeoPhotonics has been focused on delivering industry leading performance components and modules. We believe we are the first to deliver a suite of 64 GBaud component solutions, including Indium Phosphide lasers, modulators and receivers for speeds of 400G, 600G and beyond.

Growth drivers for our telecom, data center and cloud markets include: First, Metro deployments expanding rapidly across the globe; Second, China is continuing with high speed build-outs over the medium- and long-term and in advance of 5G wireless; both of these drivers are contributing to the continued growth of high speed port deployments, and Third, data centers and big data applications that are embracing higher modulation technologies including coherent and PAM4 architectures as their capacity needs increase rapidly. Finally, the industry momentum toward fully contentionless networks continued to build in 2017 with new carrier adoptions around the world. We added new customers and higher dimensionality Multi-Cast Switches and expect significant shipment growth over multiple years.

As I said previously, we believe the mid- and long-term market drivers for our business are compelling, such that we expect to drive top line growth in 2018 as well as second half profitability.

This concludes our formal comments and now I would like to ask the operator to open up the line for questions. Sophia?

Question-and-Answer Session

Operator

[Operator Instructions] And we’ll take our first question from Simon Leopold with Raymond James.

Mauricio Munoz

Thank you for taking my question. This is Mauricio in for Simon today.

Timothy Jenks

Hey Mauricio.

Mauricio Munoz

Hey, Tim. How are you? Just a quick housekeeping item for Beth. You talked about Huawei being a 10% customer this quarter and you also disclosed that the next large four customers contributed to approximately 39% of your sales. Were there any other standalone, 10% customer on the December quarter?

Elizabeth Eby

Yes, Ciena was at 19%.

Mauricio Munoz

Okay, thank you. And then, I just wanted to jump into China. Can you give us some color on this uptick in demand that do experienced from China this quarter?

Timothy Jenks

Do you want to say that again please that you say.

Mauricio Munoz

Yes, I know, if you can give us some color on this uptick in demand that you experienced from China this quarter?

Timothy Jenks

So, the biggest impact we believe, Mauricio is, as I indicated in my prepared remarks that, at mid-year, we had significant inventory overhang at certain customers. And by year end, they had moved to inventory levels in the range of three to four weeks and so, with that inventory depletion, then they increased their procurement of parts that actually come from our production and our VMI. So, that’s actually the largest impact we believe.

Mauricio Munoz

But you don’t expect that to be the case also in the March quarter, right? I think that’s what I hear in the call and that’s what I am trying to…

Timothy Jenks

I think the impact of the step-up if you will is – has now happened. And so, the March quarter is actually the result of the actual demand. But you also have to consider the fact that, volumes are up and ASPs are down.

So, as Beth said, we saw volumes go up and overall for the year, we see, in China we see 100-Gig port count being up in the range of 10% or more, but prices are down normally 10% to 15% higher end of that range this year. So, we would say that overall for the year, it would be kind of flat to slightly up. But, just in the first quarter, what we are seeing is the impact of higher volumes and lower prices. So, this is of course reflected in our guidance.

Mauricio Munoz

Yes, thank you. And then, so just wanted to switch towards – to this opportunity on North America, metro in North America. Some of your competitors have suggested that the ramping in the Verizon metro projects could start accelerating in the second half of the year. I am wondering what’s your visibility there and if you can help us, I guess, provide more qualitative or quantitative color regarding that initiative and the impact in NeoPhotonics?

Timothy Jenks

Well, let’s see. For the Verizon supply chain, there are two principle network equipment manufacturers, both of whom are customers for NeoPhotonics. What we see of course is the total demand and in fact, those customers are really generally reflected in the – as Beth referred to the next four, after our largest customer, we don’t have a specific real visibility to Verizon.

But, we do see them as generally the trajectory for 2018 as I said in my prepared remarks as it was relatively stable in the fourth quarter and changes from that are reflected in our outlook for the first quarter.

Mauricio Munoz

I guess, what I am trying to get at Tim, do you say that – do you expect a growth in 100-gig revenue port in the 10% range within price declines close to this 15% from China. I guess that, my question is, would you – do you think that your 100-gig and above business is going to grow in fiscal year 2018 if you include the contributions from the Verizon metro projects?

Timothy Jenks

We expect that we will be able to drive growth in 2018. There is two big things. As I said, we would expect that based on the 100-gig. The increases in ports offset by pricing, that’s flat, in China it might be flat to slightly up.

And then you have to layer in new products as well and I highlighted in my prepared remarks, some of the new products that are into revenue now. So, we would think that on the basis of a same product mix, it would be relatively flat and then it would be, we are driving some growth with the new products. Does that answer your question?

Mauricio Munoz

Yes, and thank you for taking my questions.

Timothy Jenks

You bet, thank you, Mauricio.

Operator

And next we’ll go to Alex Henderson with Needham & Company.

Alex Henderson

Great, thanks. Tim, I was hoping you could give us some sense of what the impact if it would measure to be around the work down of inventory in 1Q? I assume that you are trying to bring it down towards 90-days from, I believe you said 99 days. So, is there a couple of points fixed to overhead variance?

Elizabeth Eby

So, we’ve gotten it down to 99 days. Frankly, that was the easy part. We are now in to get to 90 days. We are in the, okay, what products are they pulling versus what products are we able to get – do we already have an inventory versus we have to produce.

We expect to – where you are going, we expect underabsorption to be relatively low in Q1 which does help, but we also have the impact of that $3 million of the Japan hit. That’s right, that four points.

Alex Henderson

So it’s $3 million…

Elizabeth Eby

That meets of nicely.

Alex Henderson

So it’s $3 million plus what amount – another 150, 200 basis points?

Elizabeth Eby

$3 million plus, what? Most of the underabsorption that we are looking at is, is because of the PAM.

Alex Henderson

All right, - redundant, this is then variable.

Elizabeth Eby

Yes, exactly.

Alex Henderson

And I thought, that was the Japan, I thought you said that Japan was a function of the installation of equipment being utilized in the qualification.

Elizabeth Eby

It was, but it accounted in the same line item on the P&L variance or the gross margin variance.

Alex Henderson

So, I assume the $10 million is completed by the end of the first quarter and I think that your inventory has been down to roughly 90 days, moving in further most of those issues will prop out?

Elizabeth Eby

So, we absolutely, as you know, we are managing cash flow, inventory not estimating, we are going to get down to the full 90 days in Q1. Customers are asking for a lot of the new stuff. MPSs and the new i-tunable lasers and so we are producing a little more of the new stuff and the ultimate is going to hang up a little longer while we bleed it off.

Alex Henderson

If I would ask a question in less than two section, just to be at front of on, where do you think your gross margins will be as cover to as we get on into second or third quarter getting back up another 25% plus range?

Elizabeth Eby

Absolutely. We are exceeding for higher. Two to three quarters, absolutely.

Alex Henderson

Okay, thank you.

Operator

Next we’ll go to Richard Shannon from Craig-Hallum.

Richard Shannon

Thanks, Tim and Beth for taking my questions.

Timothy Jenks

Hey, Richard.

Richard Shannon

Let me start with the – hi. Let me start with a question on China. Tim, I think in your remarks, you said you are seeing some improvements here, maybe a little bit better than normal, but not a lot a great visibility, at least, I guess in the first half, not a clear view on the tenders. I guess, I’d like to ask what you are hearing if anything from your direct OEM customers or the carriers about when they might be coming? Any clues or any thought process around when that might happen?

Timothy Jenks

Well, first of all, there really isn’t anything that’s better than normal. The forecast for 100-gigabit ports from our largest customer is in the range of 150,000, maybe a little bit north of that. It looks more like, in the range of 200,000 ports. If you take all of the China OEMs, the timing for first half versus second half, there aren’t really any new significant tenders that are known or expected in the near-term, which causes us all to look toward the second half of the year.

So it could be in the third quarter or possibly little earlier than that we would actually have more news for tenders. With respect to carriers, of course the largest is China Mobile and we don’t see big changes coming out of China Mobile in the near-term. So, this makes us little more optimistic for the second half inclusive of the China mobile and more cautious for the first half.

Richard Shannon

Okay. That is helpful. Thanks for that Tim. I am going to follow-up on the gross margin question and ask how we should think about and ultimately try to model this as we try to think about revenue growth and maybe product mix and some cost reductions as well.

Maybe if you could help us think about that and I think in response to the last question from Alex. It sounds like you are aiming for higher than kind of mid 20% to 25%, wonder if you want to provide any more clarity on your thought process there?

Elizabeth Eby

So, a lot of our gross margin as I think you and I have discussed in the past is driven by volume. We get some unusual events like the Japan discussion. But a lot of it is driven by – we’ve got decent product margins. They are a little lower than they were in Q4 because of the – or will be a little lower because of the annual price negotiations.

We will – and I’ll just start there. So, product margins come down in Q1 and then they – with the annual price negotiations and then they start up over the year as we get cost reductions in the underabsorption with the exception of the Japan, $3 million in Q1 will go with volume. So, as revenue goes up then we will be increasing our – decreasing the underabsorption.

So increasing gross margin. And we will always be – as I’ve said before, we will also be managing inventory as well as we possibly can to minimize the impact on our cash flow. Tim, anything you want to add to that?

Timothy Jenks

Well, I think, Richard the – from a respect of asking about modeling, we think volumes would be more likely up in 3Q. So, I think that reflects in Beth’s comments.

Richard Shannon

Okay. That’s fair enough. That’s helpful, one or maybe two more questions for me. Tim, you announced and you mentioned your remarks regarding some DCO modules and it sounds like you are optimistic about that later this year.

Wondering if you could help us understand any design wins or design wins and process, you can talk about when those might happen, whether there are happening solely in China, you are seeing any other geographical areas of demand for it?

Timothy Jenks

Yes, I mean, we have both western and eastern customers. We have a number of companies that have qualified, others that are still in process. And so, because several have qualified, we have started shipments. Certainly for – in the case of China, China does reflect the overarching comments that I said with respect to first half and second half.

So, if there are more tenders and more deployments, then I would expect that business to grow faster. If that’s delayed, well into the second half, then I would expect it to grow more slowly. So, it, like the rest of Beth’s comments, volume matters a lot and for us since half of our business is in China. China is a big part of it.

Richard Shannon

Okay. And to follow-up on that topic, Tim, any sense of what kind of share you might be able to capture in DCO? There is obviously one or two big module suppliers out there, then you’ve got some of the Chinese who want to build some of them themselves. Within that context, how do you think about your share over the medium-term?

Timothy Jenks

Well, I think about it this way. There are large known players who ship digital coherent optic modules. And certainly in the case of our largest customer, we are a significant merchant seller of the components that are used in the building of DCO modules by customers.

So, we participate both in the sale of components into other people’s DCOs, whether it’s OEM or merchant and then, our own DCO products leverage our component capability, but I would expect our overall DCO share will continue to be modest for a while. But our participation in the DCO market is meaningfully higher, because of our component sales.

Richard Shannon

Okay. So that is helpful. I’ll jump out of line, maybe jump back in a bit later. Thanks. Thank you, Tim and Beth.

Timothy Jenks

Thanks.

Operator

And next we’ll go to Troy Jensen with Piper Jaffray.

Troy Jensen

Hey, congrats on the strong top-line.

Timothy Jenks

Thanks, Troy.

Troy Jensen

First of all – you are very welcome. Beth, I think you said profitability maybe $88 million in revenue to hit and Tim, I think you said, you have planned to hit profitability in the second half of the year, right? Are those statements correct and do you have visibility on that second half?

Timothy Jenks

So, the two statements are correct and no, we don’t have visibility for the second half. What we do know is that, in discussions with both customers and carriers – notably in China, first of all, we think that we’ve gotten a consistent message from carriers and customers that the second half will be much stronger than the first and the reason for that tends to be citing the potential for additional tenders.

But there aren’t tenders announced yet. So, we have to be cautious. But the comments on profitability in the second half and profitability tied to mid-80s revenue, those are consistent comments about our expectations.

Troy Jensen

Okay, understood. And Tim, I view as a China expert and just love to get thoughts on the new China five year plan. To me, it seems like they VTE trade restriction pretty seriously in there focused on moving a lot to its domestic suppliers. So, what type of risk is that to you? And I realize it can’t happen near-term, but can they hit some of these 2020 targets and 2022 targets and what does that mean to you?

Timothy Jenks

Yes, so, there are – the new announcement is to have a China Telecom Ministry five year plan. But the trend of improving capability with domestic suppliers is something that’s been going on for, more than a decade. So, we do see, for example, Huawei with their affiliate HiSilicon, which we – each quarter we do highlight.

They have some level of module production internally. This has been going on over time. It is accounted for in both our product roadmaps and our investment plans. When we add in the kind of the sovereign plan, if you will, that is a trend where they’ve been localizing certain communications technologies really for the last 20 years.

And so, it is an ongoing process. It’s not a new process. I think what’s important for us is to stay ahead of the innovation development and recognize that localization is more readily achieved in the assembly and test process, i.e. affecting modules first. With respect to components, it is more challenging and takes longer and then the vertical integration in terms of the optical ICs with the laser or photodiode chips, that is the most challenging.

And so in NeoPhotonics, we really tried on our innovation path to have deep vertical integration with all elements of the chips, the LDs the PDs, the optical ICs, as well as the components and it is consistent with our intent to stay ahead on the innovation path.

Troy Jensen

Okay, right, understood, and last question for me would be, do you have a timing or a timeline for when do you think you can launch a CFP2 DCO?

Timothy Jenks

So, we haven’t announced that product yet. There are actually, I think a broader set of topics to talk about in the CFP2 DCO and that is there are three next-gen modules. Some may argue that CFP2 is a current-gen, certainly, it is in the market, but then there is an OSFD form factor that’s planned as well as the DDQSFP form factor planned.

And as I said in my prepared remarks, we have each of the components available for the small form factor versions, i.e. smaller than the CFP2 and so, really for us, it is marching with the availability of merchant DSPs to go with each of these form factors along the way and not solely focus on – for example, CFP2 because there are already two smaller next-gen form factors described in the market.

Troy Jensen

Okay, so… go ahead.

Timothy Jenks

Yes, it’s an important thing each year also to look at the roadmaps of customers and of course we are having this conference call two weeks before the biggest trade show of the year rather than after. So, we can talk about that in a few weeks again.

Troy Jensen

It’s perfect. Look forward to seeing you at OSC.

Timothy Jenks

Thanks, Troy.

Operator

Your next question comes from Tim Savageaux with Northland Capital Markets.

Timothy Jenks

Hello, Tim.

Tim Savageaux

All right, we are having some issues here hang on. All right, can you hear me?

Timothy Jenks

Yes, indeed. Loud and clear.

Tim Savageaux

All right. Excellent. Well, I’ve got a couple questions as well. And the first one is kind of a high-level question, which is kind of trying to relate sort of coming out of Barcelona here and hearing a bit about 5G, there is some chatter along those lines. And in trying to relate what’s happening say at Verizon to what might happen in China, which is to say, if you look at your business levels with CMS, your commentary on the Multi-Cast Switch front, all this would seem to support what we’ve heard from several other vendors with regard to kind of the near-term acceleration there.

And, one might pause that that is somewhat related to their plans for kind of an integrated network that supports 5G backhaul and a lot of other stuff. Well, we heard a lot of that commentary coming out of the Chinese carriers this week as well. And so, I guess, my question is, would you agree in that sort of correlation between – and I think you explicitly stated you haven’t seen any 5G-related activity yet.

But I’d be interested in your perspective on how you would relate what’s happening at Verizon or other carriers to our earlier and pursuing that and what you might expect to happen at Chinese carriers who have sort of put forward the same type of goals with regard to 5G deployment and what sort of fiber infrastructure might be required to actually make that happen?

Timothy Jenks

Well, that was a lot of questions. I’ll – just on the 5G…

Tim Savageaux

Really, really, really one question with context is what it was.

Timothy Jenks

So, the – our understanding of the Chinese situation, Tim, with respect to 5G is that, their initial trials in the second half, customers have said pretty clearly to be ready in the third quarter and initial shipments in the fourth quarter, that would allow trials to begin in the second half. And then, essentially, equipment deployments then are larger in 2019 and then, services turn on in late 2019, 2020.

But the other thing is just – there is some important developments with respect to – not just the wireless aspect, but the overall network and having the network architecture being able to continue to scale. So, some customers are doing rather innovative things to be able to have their existing 100-gig infrastructure convert to 400-gig infrastructure.

And then have the capacities moving further out in the network in order to support the rollout of 5G. So, there are some important dynamics that are moving through the industry currently with some important innovation. So, we are actually looking forward to have this rolls out.

Tim Savageaux

Well, I hear you on that, but that would pre-suppose the existence of a 100-gig metro infrastructure. I guess, my point was, we are fairly confident that does exist Verizon, the confidence is that that does exist in China is a little bit more spotty at this point.

So, I guess, the point of my question was, how whether it could any of this happen in the absence of a fair bid of metro or even sort of quasi access-oriented fiber upgrade activity. Well, this being meaningful either initial trials or any kind of pretention to volume deployments of 5G networks?

Timothy Jenks

Well, our understanding actually is that, for the initial deployment in China, there are a targeted number of cities. So, I am not debating your point about metro. However, on the assumption that that – between one and two dozen cities that are in the initial rollout, those do have certain metro architectures in place today.

And we would expect that that goes as planned, as announced and then, we have seen the rate of deployment in China accelerate rapidly. So, the metro and provincial deployments have been going on. The provincial deployments have both added capacity and new build, but the initial 5G won’t be all over the country, it will be in one two dozen cities.

Tim Savageaux

Understood. Okay, next topic. So you mentioned that new number, on the call that number was 200,000 and that’s a number I’ve heard before quite recently actually, and coming as it does, post Chinese New Year, I wonder if you could try to put that number in context. You seem to be sort of lumping some other OEMs in there and so maybe the – maybe we need to recast previous numbers. I understand what that 200,000 what we’ve seen before.

Timothy Jenks

Well now, let’s be real clear. So, I said for our largest customer, it’s in the 150,000 to slightly above and then, but if you take the Chinese carriers in total, we have to add in for example, Huawei, ZTE, FiberHome, then you get to a range of 200 or a bit above. So, the difference between 150 and 200 is the difference between Huawei and the China NEMs.

Tim Savageaux

I understand that, still a new number to me. Now you do have various of your suppliers and god only knows where this visibility comes from talking about very strong sequential increases.

In the June quarter, with regards to their optical IC businesses, and of course various inventory situations may change, but I guess, from your perspective, that 200,000 line number is not a number that’s changed for you over time. Although, it sounds like the 150 plus may have changed a little bit to the plus side.

Timothy Jenks

We’ve seen the 150 go up and down a little bit. So there is a little bit of fuzziness around that number. And with respect to individual component suppliers or optical IC suppliers, we have talked, you and I have talked certainly in the past about the difference between living in a world where vendor managed inventory is more real-time versus if there is existing inventory that is still being burned off, that may mean that the current quarter is lower and then out a quarter or two it would go up. So, I think there are differences between each of the companies in the supply chain that that maybe explanatory for your question regarding optical IC.

Tim Savageaux

I could not agree more. Final question. What happened in Japan? Was that just a buzz in the fab? I mean, what happened?

Elizabeth Eby

So we’ve brought some – pretty much everybody knows, we’ve added some capital equipment in our laser lines, all of them and as we are bringing a couple of pieces of equipment online starting in the end of Q3 and into Q4, the characterization was not going as quickly as we expected. So, output was lower.

Tim Savageaux

Got it. And so, but what you did say was, gross margins that ex this buzz would be 400 bps higher in Q1. Is that right?

Elizabeth Eby

Yes. There is a $3 million impact in Q1. So, yes, that’s about four points on a $70 million number, midpoint.

Tim Savageaux

Okay, thank you.

Timothy Jenks

Thanks, Tim.

Operator

[Operator Instructions] And we’ll take our next question from Jun Zhang with Rosenblatt Securities.

Jun Zhang

Well, thanks for taking my questions. So I have a two questions about top-line. The first about is 25G EML. So, Tim, do you – when you guide about 25 plus percent gross margins, for the next couple of quarters, do you think, do you consider the improving yield rates for your 25G EML laser product line? That’s first question.

Elizabeth Eby

That’s absolutely in there. That’s the Japan fab discussion that we mentioned and I pushed the higher gross margins to more like when volume comes back in Q3. Just so, I am not misleading anyone.

Jun Zhang

Okay, great. And second question about the CFP-DCO product you announced yesterday. So, Tim, could you talk about a little bit about more what’s the addressable market for that is more of a telecom market for it. But right now, it’s more of a datacenter market. What’s the potential revenue size from this product line? Thanks.

Timothy Jenks

So, actually, I think you are referring to a press release we said yesterday, we actually announced this product approximately a year ago and what we announced yesterday was that it’s in general availability.

And it has applications in metro and DCI. The fact that it is in general availability, it’s essentially a product that we’ve essentially put in capacity and started ramping. Most of our applications today are mostly telecom-related rather than DCI today. With respect to how large of a market our estimates of that market is it’s a $0.5 billion market.

Jun Zhang

Okay, great. And then my last question is that that 400G, would you see some of the initial demand on the 400 G from the clients and do you see any of – how that – how do you see the trends going forward and how NeoPhotonics benefit those 400G deployment? Thanks.

Timothy Jenks

Well, let’s see, let me first divide that into two questions, because, what’s the trend in the 100G telecom or line side market and then what might be the trend in the client side and datacenter market. In the telecom and line side deployment, the 400G essentially that activity has started where our components are being used.

The principal deployments today are often two times 200. And then, there are applications out where you can either use one wavelength for 400 gig or two wavelength for 400 gig. So, it’s a bit more advanced than in the client side datacenter and the client side – there are product configurations for PAM4 modules that are 400 Gig.

But those are not really in any meaningful volume yet. So, really I have to say that, most of the 400 Gig deployments that exists right now are line side telecom and that will probably be true for the next year or so.

Jun Zhang

Okay, great. Thanks, that’s all my questions.

Operator

And next we will go to Dave King with B. Riley FBR.

Dave King

Thank you. Good afternoon. First of all, on CapEx. What’s the budget for this year?

Elizabeth Eby

So, as we’ve said previously, we’ve got some payments to complete on the CapEx from the prior commitments in Q1 and then, we will go to about 4% of revenue.

Dave King

So, the first quarter is what, approximately?

Elizabeth Eby

Seven, as I recall I was looking at our FP&A.

Dave King

Okay, okay, good. And then, can you just talk about the OpEx leverage? I mean, assuming you get to mid-80s in the second half. Can you hold up actually or how much of the OpEx will go up?

Elizabeth Eby

So, OpEx will only have some profit-dependent increases.

Dave King

So pretty marginal.

Elizabeth Eby

Yes.

Dave King

Okay, and just wanted to clarify about the first quarter gross margin that you talked about $3 million impact. Is that part of a non-GAAP gross margin of 16% to 20%? Or has that been pro forma down?

Elizabeth Eby

No, that’s the non-GAAP.

Dave King

Non-GAAP, okay. Got it. And then, just lastly on that factored as CFP-DCO TAM, $0.5 billion, Tim, what do you think the mix between merchant versus captive is or is it all merchant?

Timothy Jenks

Well, at this point in time, I think the merchant part of it is actually relatively straightforward because there are few suppliers of DCO. So, we would expect there is pretty near balance actually between the captive and the merchant. And as I said, we participate quite a bit in the DCO supply chain as well as providing a module solution or so.

Dave King

Let me actually switch that around then, what do you think the largest Chinese customers, what do you think their mix will be versus – for the merchant versus make?

Timothy Jenks

Well, I think for the largest customer, their vast majority is captive and I think the captives can grow much faster. And what that actually is, the captive growth rate in 2018 is really dependent on mix of products that carriers announce – for example, for the second half, the merchant version is generally directed at smaller OEMs than the captive.

So, in captive, we are really talking about Huawei and their affiliate HiSilicon and being able to make us a large amount of DCOs. But for smaller OEMs the DCO is an interesting and innovative solution for them to be able to put leading coherent technology to customers with a good time to market. And so, each of them have a place.

In the case of the China market, there is a very important pace you grow value proposition that’s associated with it as well. But, I think, we’ll continue to see some level of balance between captive and merchant, but we are announcing a real proliferation as was asked earlier.

We are seeing a real proliferation in the form factors for DCO-CFPs, CFP2 OSFP, DDQSFP. They are just a proliferation of these form factors and that is really because the number of applications for them are growing.

Dave King

Got it. All right. Thank you.

Operator

And it is all the questions that we have for today. I’ll now turn the call back over to CEO, Tim Jenks for any additional or closing remarks.

Timothy Jenks

Thank you, Sophia. Thank you for – to all the participants in the call for your interest in NeoPhotonics. We do look forward to talking to you on our next call. Good bye.

Operator

This concludes today’s conference call. Thank you all for your participation. You may now disconnect.