NeoPhotonics Corporation (NPTN) CEO Timothy Jenks on Q1 2019 Results - Earnings Call Transcript

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About: NeoPhotonics Corporation (NPTN)
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Earning Call Audio

NeoPhotonics Corporation (NYSE:NPTN) Q1 2019 Earnings Conference Call May 2, 2019 4:30 PM ET

Company Participants

Erica Mannion - Sapphire Investor Relations

Timothy Jenks - President, Chief Executive Officer, Director and Chairman

Elizabeth Eby - Senior Vice President and Chief Financial Officer

Conference Call Participants

Michael Genovese - MKM Partners

Richard Shannon - Craig-Hallum Capital Group

Tim Savageaux - Northland Securities

Simon Leopold - Raymond James

Jun Zhang - Rosenblatt Securities

Operator

Welcome to the NeoPhotonics2019 First Quarter Conference Call. This call is being webcast live on the NeoPhotonics event calendar webpage at www.neophotonics.com. This call is a property of NeoPhotonics and any recording, reproduction or transmission of this call without the expressed 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 Mannionat at Sapphire Investor Relations. Please go ahead.

Erica Mannion

Good afternoon. Thank you for joining us to discuss NeoPhotonics’ operating results for the first quarter of 2019 and outlook for the second quarter of 2019. With me today are Tim Jenks, Chairman and CEO, and Beth Eby, Chief Financial Officer.

Tim will begin with a review of our business in the first quarter and a discussion of business drivers and products. Beth will then provide financial results for the first quarter and then provide the outlook for the second quarter of 2019. Beth will turn the callback to Tim for closing remarks 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 are not 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 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, product and technology development, capital needs and availability, customer demand, inventory levels, economic and industry projections, or subsequent events. Various factors could cause actual results to differ materially. Some of these risk factors have been set forth in our press release dated May 2, 2019 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, Erica and good afternoon. This quarter revenue came in at $79.4 million, in-line with our outlook, and up 16% from the year ago period. High Speed products were 88% of revenue, up from 86% in the prior quarter, and they remain our focus.

As a reminder, Q1 is our seasonal low in both revenue and gross margin due to the impacts of the Chinese New Year, making it a shorter quarter, together with annual price adjustments which take effect in Q1. Demand continued apace in both the west and in China.

Telecom and Metro shipments are reasonably stable, and we are cautiously optimistic about DCI demand in North America for all of 2019. Much of our DCI deployment volume today is 200 Gig and 400 Gig with growth coming at 600 Gig. We anticipate that 400 Gig will continue to deploy while our 600 Gig products continue to ramp through this year and next.

Subsequently, 600 Gig will coexist with coming 800 Gig, and of course we will be engaged in deployments in each of these data rates.

Similarly, we see a positive outlook this year for China. Our largest customer, Huawei, conducted an analyst conference in April and forecasted meaningful revenue growth in their Carrier Network business and a significant ramp in 5G deployments. There has been much discussion about China customers’ building strategic inventory.

Consistent with our comments of last quarter, and based on demand for the products we supply, we are seeing some increases that are in line with what would be consumed with strong tender volumes and we are seeing solid indications of tender activity. We continued to see good progress with design-ins and volume growth for our 64 Giga baud product suite, and we are now testing initial products for 90 to 100 Giga baud.

Note that when we talk about our 64 Giga baud products, the applications certainly include 400 Gigabits per second and 600 Gigabits per second, but not only these. In the west, these products are used by our customers to achieve 600 Gigabits per second on a single wavelength for distances up to about 80 kilometers, such as datacenter interconnect.

In China, these 64 Giga baud components are being utilized initially to double the speeds of long-haul coherent networks from a 100 Gig to 200 Gig while keeping largely the same transmission performance. This same technology will be used across the spectrum of networks to increase the data rates and the available fiber capacity.

This is important because 64 Giga baud is the next major baud rate node that will see substantial deployment in telecom networks, notably in China. On the telecom side, the adoption of new technologies may be slower, but may have a longer lifecycle and higher aggregate volume than DCI. As a result, NeoPhotonics will benefit from 64 Giga baud in both DCI and telecom deployments.

In parallel, our passive products provide complementary functions to coherent components, enabling multiplexing functions for new line systems to accommodate 64 Giga baud wavelengths. We have achieved substantial design-ins for these products as well, expanding our potential opportunity beginning next year.

As data rates continue to rise, the very pure light transmitted by our lasers becomes increasingly important. Our ultra-narrow line width tunable lasers have the right performance to be the laser of choice for the highest speed systems.

We recently announced limited availability of our nano ITLA, which maintains the high performance of our current tunable laser in a form factor approximately one-half the size of the prior generation, which is critical for enabling next-gen coherent pluggable transceivers.

Building on our success with 64 Giga baud discrete components, we are extending our offerings to 90 to 100 Giga baud network applications with our recent announcements at the OFC Trade Show during March. These included our Class 50 Coherent Receiver, or ICR, and Coherent Driver Modulator, or CDM, which are based on our Indium Phosphide photonic integration platform.

This is important, as we view Indium Phosphide as optimal to support 90 to 100 Giga baud for up to 800 Gigabits per second on a single wavelength, further increasing data rates across multiple reaches. Moreover, this platform will continue to be the platform of choice at even higher speed targets above 100 Giga baud, which we will continue to support.

For applications in pluggable modules where size, power consumption and scalability are as important as speed, we demonstrated our silicon photonics 64 Giga baud COSA, which combines the modulator and receiver in a single compact package. In addition, we did live demonstrations of our silicon photonics-based Pico tunable laser, which is also optimized for pluggable silicon photonics-based high speed interconnects. These products are key for coming 400ZR deployments, which can reduce the cost and complexity of DCI networks, and also telecom networks. Therefore, 400ZR may have multiple applications that require unique specifications. Our 400ZR coherent optics are designed with these different requirements in mind.

For applications inside the datacenter and for 5G front-haul and backhaul, we continued to make progress with our current fixed wavelength 28 Giga baud EML lasers and with our next-generation 53 Giga baud EML lasers with integrated drivers, both of which support PAM4 operation to reach 50 and 100 Gigabits per second per wavelength, respectively.

For shorter reach Silicon Photonics-based transceivers, we also offer high power, non-hermetic, fixed wavelength lasers, as well as drivers for silicon photonics-based modulators to support 100 Gigabits per second per wavelength and 400 Gigabit module applications. We expect such 400 Gig intra-datacenter deployments to start toward the end of this year and to ramp substantially next year.

The drivers for the markets we serve are well aligned with our advanced technologies, high-speed capabilities and strong presence in high-speed components. As bandwidth needs in optical networks increase, coupled with the beginning of 5G wireless infrastructure deployments and continued demand with hyperscale data centers, I am optimistic about NeoPhotonics’ new product prospects.

With that, let me turn the call over to our CFO, Beth Eby.

Elizabeth Eby

Thank you, Tim, and good afternoon. As Tim mentioned, revenue was $79.4 million, up 16% year-over-year and down 13% from Q4, reflecting the usual seasonal declines related to the Chinese New Year holiday, the impact of annual price reductions, as well as some supply constraints on purchased sub-components.

China was stable at 57% of total revenue, compared to 59% in the prior quarter and 61% in the first quarter of last year. The Americas was 18% of total revenue, down from 20% in the prior quarter, and the rest of world was at 25%, up from 21%, as western customers shifted between contract manufacturing locations.

Huawei Technologies, including its affiliate HiSilicon Technologies was our largest customer, and accounted for approximately 49% of the company’s revenue, up from 44% last quarter and about the same as the first quarter of last year at 48%.

Our next four customers were 37% of revenue, lower than last quarter and about the same as last year at 36%. The drop from last quarter is mostly as a result of the lower revenue from our China customers other than Huawei.

Our Non-GAAP gross margin in the first quarter was 22.4%.While Q1 is our traditional low point for the year, this was about 2.5 points lower than expected. Within this, product margins were 27%, down about 4.5 points from last quarter, which was more than expected. We saw the impact of annual price reductions, as well as a less favorable product mix, with100 Gig and 200 Gig products making up a higher than expected proportion of sales.

Other cost of sales charges of just under five points were as expected and comprised of approximately two points of manufacturing variances, as was expected for Q1, one and a half points of laser fab under-utilization; and a point of other charges, the largest of which was tariff impacts.

Moving to operating expenses, total non-GAAP operating expense for the first quarter was $24.2million, as expected. Non-GAAP operating loss for the first quarter was $6.5 million or an 8% loss, compared to a gain of 4% in Q4, driven by lower gross margin and higher spending.

In Q1, appreciation of the Chinese Yuan relative to the U.S. dollar drove an FX charge of $1.7 million. As a result, non-GAAP net loss for the first quarter was $9 million, compared to a gain of $2.4 million in the fourth quarter.

This translates to a non-GAAP loss per share of $0.19, compared with a gain of $0.05 in Q4. For the first quarter, adjusted EBITDA was negative $0.8 million, compared to $10.5 million in Q4.

I will close out my discussion of the first quarter income statement with a review of our GAAP results. First quarter gross margin was 20%, down from 25% in Q4 and up approximately six points from the first quarter of last year. The first quarter gross margin includes the costs related to the end-of-life of our client module line of $1.3 million, as we previously announced.

Operating expense was $27.7 million, down from $29.2 million in the preceding quarter, on lower restructuring and litigation charges.

Operating loss for the first quarter was $12 million, which included $3.3 million of stock-based compensation expense, $1.5 million of restructuring and end-of-life asset write-down charges and approximately $0.6 million of divestiture costs and amortization of acquisition-related intangibles. Net loss for the quarter was $14.1 million, compared to $6.7 million in the prior period.

Turning to the balance sheet, we finished the quarter with $79 million in cash, investments and restricted cash, up $2 million from the fourth quarter. Net Inventory was $54 million, or 76 days, up $1 million from the fourth quarter. Free cash flow was approximately $5 million.

Before I discuss our revenue and earnings outlook for the second quarter of fiscal 2019, I would like 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 I mentioned last quarter, demand signals from our customers are positive for the year. Revenue growth for Q2 is expected to be good. Because of higher industry-wide demand, notably with the 5G launch, some of our supply constraints carry-forward into Q2 and Q3.

Moving to gross margin, as we previously mentioned, 100 Gig and 200 Gig products were a higher than expected proportion of our revenue. We expect this to continue to impact gross margin through Q2, offset by higher revenue.

Given that, the company’s expectations for the June 2019 quarter are; revenue in the range of $88 million to $93 million; GAAP gross margin in the range of 23% to 27%; non-GAAP gross margin in the range of 25% to 29%; GAAP diluted earnings per share in the range of a $0.16 loss to a $0.06 loss, and non-GAAP diluted earnings per share in the range of $0.0 6 loss to a $0.04 gain. These numbers are reflective of approximately 46.6 million fully diluted shares.

In summary, Q1 came in with a different mix and unfavorable FX rates, impacting results. Based on indications from our customers, we remain positive about the market drivers for our products in the year ahead.

Additionally, subsequent to the end of the quarter, we closed the sale of our Russia operation. This was one action as a part of our on-going process to align our business with those product lines that are strongest and most profitable.

I’ll now turn the call back to Tim for closing remarks.

Timothy Jenks

Thank you, Beth. We continue to monitor U.S. China trade discussions as they pertain to our overall business and customers in China, and as China continues its network deployments and ramps its rollout of 5G wireless networks.

As we have communicated over the last year, our focus has been on returning to profitability as we ramp our 64 Giga baud products. We have also remained focused on execution to extend our leadership position in the high-speed digital optoelectronics market with 64 Giga baud and moving to 90 to 100 Giga baud product introductions.

Industry trends continue to move in our favor, notably through the push to even higher speeds, as well as the adoption of coherent architectures in metro and metro-edge markets, which we believe places NeoPhotonics in an advantageous position where we are seeing broad-based demand for our solutions.

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

Question-and-Answer Session

Operator

[Operator Instructions] We will take our first question from Michael Genovese of MKM Partners.

Michael Genovese

Hi, thanks very much.

Timothy Jenks

Hi, Mike.

Michael Genovese

Hi, Tim. Hi, Beth. I guess, the first question, it seems like you are stretching pretty sharp sequential improvement in gross margins in 2Q. So, can you just take up through the pieces besides volume? What else gives you the confidence that we are in the middle of the range of 27%?

Elizabeth Eby

Yes, so, as you probably well know, the two biggest swing factors in our gross margin are our loading and product mix. Add to that, over the year we always do cost reductions to offset some of the price reductions that hit in Q1. So from a improvement Q1 to Q2 standpoint, I would actually like to see a couple of points higher based on the increase in loading.

Q1 is our traditional low point. If you look back at Q4, we were – our gross margin was much higher, not much – our gross margin was a little bit higher than we are forecasting for Q2. So it’s more a matter of how do we get it back up than it is, we have confidence in the snap back.

Michael Genovese

Right. So, just to clarify, in 1Q, and I think you did summarize at the end there that it was FX and mix, but just trying to take us through that, because were you surprised by the 1Q a little bit negatively surprised there and were those few factors was there anything else and what were the weighting of those two factors?

Elizabeth Eby

So, in overall EPS, the two things that were a surprise were mix showed up in gross margins. Gross margins was lower than we expected and it came in late in the quarter. So, we didn’t – the strength in the 100 Gig and 200 Gig products was definitely a surprise. On the overall, like you see, you see it below the operating profit line, that’s where we saw the FX.

Our functional currency just for you, and for everybody else on the call, our functional currency and our China operation is in the RMB. So we always have a mark-to-market as the FX rate changes. Every so often it pops up a significant factor. It did on the positive side in Q3 of last year and it did on the negative side in this quarter.

Michael Genovese

And Tim, could I get you sort of flush out more of those inventory comments you made. You made some comments about inventory, but they were brief. So, could you be a little more detail?

Timothy Jenks

Sure. The question about inventory is, how much inventory are customers acquiring versus how much are they using in their shipments. And, we make efforts to understand and look at each of these on a quarterly basis. So, essentially, what we are seeing is that, there are some increases in inventory. But when we think about the inventory, it’s product-by-product and each product can be a bit different.

We do see that shipments of products, our products and customer shipments are reasonably imbalanced and then, what we’ll do is, we will check with carriers and triangulate with the network equipment manufacturers to make sure that we have this in line. Now, what I said is that, we are seeing some increases.

But by the same token, we’ve seen some new awards by China Telecom with tenders and there is a fair amount of tender activity that is going on right now. So, a short-term increase modest level of inventories in line with what we normally see when tender activity is high. So, I hope that answers your question.

Michael Genovese

Do you have any way to compare where you think that measure of inventory is now versus, I guess, it was the beginning of 2017 when after that very first strong quarter at the beginning of 2017 is when I think it was realized or was that actually an inventory problem versus the level we were there then how does it feel now?

Timothy Jenks

Well, so then, I think, we were in a pretty different situation, because at that point of time, and I am doing this from the top of my head, but I think at the time the total port shipments for the year in China were in the range of 150,000 ports.

Now there are 250,000 ports. But they were actually forecasting at the time going up from say 150,000 ports they were forecasting to go up to 250,000 ports. And so the shipments that took place at the end of 2016 and led to the inventory overhang of 2017 was at a forecast number that they didn’t actually achieved for the next – they are hoping to achieve now. So, quite different level in terms of magnitude.

Michael Genovese

All right. Great. That’s helpful. And then, just finally, I don’t know if you gave it during the prepared remarks, did you give Ciena as a percentage of revenue?

Timothy Jenks

No, we don’t. We just give them as part of our top four.

Michael Genovese

Okay. Great. Thanks very much. It’s great to be on the conference call. I look forward to many more.

Timothy Jenks

Thanks, Mike. I appreciate it.

Operator

Thank you. We will take our next question from Richard Shannon of Craig and Hallum Capital Group.

Timothy Jenks

Hi, Richard.

Richard Shannon

Thank you. Hi, Tim and Beth. How are you?

Timothy Jenks

Good.

Richard Shannon

Excellent. I got on the call probably seconds too late to hear this summer, Tim. But I didn’t pick up the percentage of your sales from 100 Gig and higher in the quarter. What was that please?

Timothy Jenks

100 Gig was, well, so high speed was 88%, up from 86% in the prior quarter.

Richard Shannon

Got it. Okay, that’s helpful. Going back to the topic of gross margins addressed previously, it wasn’t quite clear to me whether the gross margin increase in the quarter is seeing a mix going back towards what you maybe were expecting in the first quarter or are there is some other impacts including obviously the loadings going higher, which helped you getting back to this kind of midpoint of 27%?

Elizabeth Eby

Yes, it’s very much loadings-related. We are expecting the same level of proportion of the 100 Gig and 200 Gig product mix to carry from Q1 to Q2. Surprised with some of the downside in Q1.

But – so we are expecting to carry that through and we’ve got obviously, given that we don’t have the two week holiday, much higher loadings in Q2. But 400 Gig was increasing in Q1, just not quite as much as we expected. Things strengthened in 100 and 200.

Timothy Jenks

Yes, we also see some customers actually, the customers were a little surprised, because some of the 100 Gig, 200 Gig systems continue to have very strong shipments. And so that flows through to us.

Elizabeth Eby

But it will be a loadings improvement and with a couple of cost reductions hitting in Q2.

Timothy Jenks

So what you should expect going forward though, is just a pretty steady increase about the 64 Giga baud product. So, the 64 Giga baud products as I said in my prepared remarks, those are used in 400 Gig and 600 Gig systems in the west and they are also used, for example in China to move the long-haul networks from 100 Gig to 200 Gig.

And the increase in proportion of 64 Giga baud products will have a favorable uplift effect on overall margins.

Richard Shannon

Okay, perfect. Two quick questions for me. I’ll jump out of line. You mentioned continuing capacity constraints on this quarter. Can you quantify that expense please?

Elizabeth Eby

So, it was supply constraints, not capacity constraints.

Richard Shannon

Okay. Right.

Elizabeth Eby

Some of our purchased sub-components. And I would say in Q1, it was $2 million to $3 million.

Richard Shannon

Okay. And – but they are continuing into second quarter, correct?

Elizabeth Eby

They are ameliorating in the second quarter and they should be gone in the third quarter.

Richard Shannon

Got it. Okay. Last quick question for me, Beth…

Elizabeth Eby

I thought they were going to be gone in Q2, as well. So, if demand keeps going up, we will – the supply constraints will lap longer.

Richard Shannon

Okay. All right. Good to know. Last quick question for me. I think you mentioned shares outstanding for the quarter that I would assume maybe based on a negative earnings number. What would that be if there positive?

Elizabeth Eby

40 – I am going to limit.

Timothy Jenks

Why don’t we look that up and try and come back up?

Elizabeth Eby

Let me look that up and I’ll email it to you, Richard.

Richard Shannon

Sounds good.

Elizabeth Eby

Because I am turning on…

Timothy Jenks

Thank you, Richard.

Richard Shannon

Thank you.

Operator

Thank you. We will take our next question from Tim Savageaux of Northland Securities.

Tim Savageaux

Hi, good afternoon.

Timothy Jenks

Hi, Tim.

Tim Savageaux

Let me actually pick up on that last comment from Beth, which I think indicates demand for Q2 is, I mean, it’s coming in a little bit stronger than you might have expected and I want to try to put that into some context.

So you had – earlier this week, one of your suppliers, maybe peers in the ecosystem did talk about an upgrade of China Mobile’s background to a 200 Gig although characterized that as that’s coming into second half.

We combine that with growth maybe as stronger than expected outlook for you guys in Q2 and your commentary about an increasing mix of 100 Gig and 200 Gig products. Should we refer that you are seeing the impact of that build currently? Is that something that you think might still be out in front of us? And I’ll follow-up from there.

Timothy Jenks

Well, in my prepared remarks, I did say that we are seeing solid tender activity. We haven’t seen public – any public information on China Mobile but we are seeing solid tender activity.

Tim Savageaux

My question is that tender activity reflected in your outlook for Q2, tender activity might also suggest things sort of coming down the line a bit depending on where we are in that tender process?

Timothy Jenks

No, it’s definitely reflected in our outlook for Q2 and the tender activity also included the China Telecom volume and that is resulting in the higher forecast for the outlook for Q2.

Tim Savageaux

And that it sounds like it could have been, if it’s a linear rate at maybe a million or too higher ex the supply constraints, is that fair to say?

Elizabeth Eby

I’d still stick with the two to three that we are just concluding to.

Tim Savageaux

In Q2.

Elizabeth Eby

Stick with just satisfy and keep pushing out.

Tim Savageaux

Fair enough. And then, last one from me. You mentioned obviously, testing at 800, but some initial ramps, I mean, do you think your contribution from 600 Gig in particular will be material in any way in the first half of calendar 2019 or do you expect that to be more meaningful in the second half?

Timothy Jenks

So, the – as I said in my remarks the 64 Giga baud products are used in 400 Gig and 600 Gig. And so, to the extent that certain customers will use comparable products in 400 and 600 it’s difficult for us to be precise about how much is specifically going into 600 vis-à-vis certain 400 devices.

That said, there are certain customer systems that we expect would be additive in terms of revenue in the second half. So, I would expect what we’ll see is, we will see an increase of 64 Giga baud and it’s highly likely that that reflects increased 600 Gigabit activity if you pardon my parsing bauds and bits.

Tim Savageaux

Got it. Thanks very much and congrats on the outlook. I’ll pass it on.

Timothy Jenks

Thanks, Tim.

Operator

Thank you. [Operator Instructions] We will take our next question from Simon Leopold of Raymond James.

Timothy Jenks

Hi, Simon.

Simon Leopold

Thank you for taking my question. Yes, Tim, Beth.

Elizabeth Eby

Good morning.

Simon Leopold

Yes, hi. Did you guys have another second 10% customer this quarter? Can you please quantify the contribution from the second customer?

Elizabeth Eby

We are going to stick to quantifying those in our – actually – yes, we said, it was your quantification with you. We just released our K and we said there were 24% for 2018.

Simon Leopold

No, I am talking about the first quarter, did you have a second 10% customer?

Elizabeth Eby

I am aware, actually – just we had a 10% - second 10% customer and we are not going to quantify it at this time.

Simon Leopold

Okay. All right. Thank you. And then, yes, if we can go back and drill a bit on the quarterly gross margins, maybe you can give us a run down and perhaps you did this earlier, sorry, I think I joined the call a bit late. But, if you can give us a run down on the sources are contributing to the weaker than anticipated gross margins for the quarter.

I think I am just a bit surprised to hear that 100 Gig and 200 Gig products has – similarly lower than the gross margin for 100 Gig and 200 Gig products for south of 27%. So, if you can talk a bit about this product. Are we talking about client side or on the coherent line? Thank you.

Timothy Jenks

Yes. So, couple things there. We did talk about the fact that, we have higher than the original forecast for 100 Gig and 200 Gig and that’s what customers ordered and it did reflect overall. It’s not necessarily whether it has above or below average margin, the specific number that you quoted.

But essentially, the 100 Gig and 200 Gig reflect the fact that some customers are selling older systems that have perhaps longer legs than anticipated. And as a result, there are higher volumes for a 100 Gig and 200 Gig and because the systems are older and the product is more mature, they maybe lower margin at this point.

Elizabeth Eby

And the two biggest swing factors in our gross margin are loadings and mix.

Simon Leopold

Great. Thank you. That’s helpful. And then, With respect to China, can you give us an update on how you are seeing the market developing in 2019? I think, you previously talked about a 15% growth in high speed coherent ports for the region. Are there any changes on the forecast? And then I have a follow-up.

Timothy Jenks

Okay. Yes, and so, as I responded to a prior questioner, we are seeing solid tender activity. I commented specifically on China Telecom and the prior questioner did ask about China Mobile. We haven’t seen any public information or announcement, so, there. But nonetheless, with the tender activity going on, the forecast previously had been in the range of 230,000, 240,000 ports.

This is across all of the China-based customers. It could go up a little bit from there. Maybe it gets to as high as 250,000 ports. But that remains to be seen when we actually have announcements on all tender sizes which we do not have at this point. So, I think, we will stick with our 15% growth until we actually have more solid information on tender size.

Simon Leopold

Thank you, Tim. And then, a last one from me. Maybe, I was wondering if you can give us an update on what you are seeing as far as potential inventory builds in the region ahead of the – in the region, I mean China, ahead of the – trading negotiations between the U.S. and China.

I think last quarter, you talked about some moderate to – moderating levels of inventories exiting in the fourth quarter and, yes, if you can comment on that? Thank you.

Timothy Jenks

Yes, sure. So, I did say in my prepared remarks that we are seeing some increases, but it’s in line with the tender activity and we are seeing solid tender activity. I did also say that it does reflect the fact that relative to the tender activity we are seeing the inventory – any inventory that is built – is in line on a quantitative basis with the tender actions.

Now when you connect it specifically to the U.S. China trade, I think it’s important just to say that some companies may actually see this as a bigger issue and that will reflect to some extent whether there is any alternative vendors for their products. So, in our case, for example, a number of the products that we sell into China, we do have competition.

We may, in some cases be the preferred vendor. But we also do have competition. So, if our customers have the ability to mitigate risk, then we would expect that they would do so. Some other U.S. based companies may feel it differently if the China customers view them as higher risk or if they are sole source on a particular part. Does that answer your question?

Simon Leopold

Yes. Very helpful. Thank you. Thank you, Tim. Thank you, Beth.

Timothy Jenks

Very good. Thanks, Mauricio.

Operator

Thank you. We will take our next question from Jun Zhang of Rosenblatt Securities.

Jun Zhang

Hi.

Timothy Jenks

Hi, Jun.

Jun Zhang

Thanks for taking my question. So, there was some talks that NeoPhotonics bring some new clients in the North American markets. And could you comment a little bit about that?

Timothy Jenks

No, I don’t think I can. I think what I said in my prepared remarks are that, we’ve had good design-ins with our 64 Giga baud products. I also said that we’ve had good design-in activity with our passives products which complement the use of 64 Giga baud wavelengths in systems. But individual customers or system design wins generally are subject to confidentiality agreements. So, I’d find it difficult to comment.

Jun Zhang

Okay, okay, got it. No problem. And for the – I think a lot of question asked about China. Could you also comment about the U.S. and European demand for the first half? And also, what kind of trends you are seeing?

Because in the I think people kind of concerned about your second largest client, their comments on the second half that you ask the North American demand, the growth kind of slowing down little bit from the first half and could you talk a little bit about what you are seeing in the North American market? What kind of a demand trend looks like in the second half? Thanks.

Timothy Jenks

Yes, well, I think that your comments are well placed and it is a little bit of a risk in the sense that – as I said in my prepared remarks, the telecom and metro business seems to be reasonably stable. We are cautiously optimistic about DCI for North America. At the moment, it seems stable, but we are only guiding for the second quarter.

So the second half is really beyond our current horizon. That said, we are aware of a number of new customer systems that are coming into the marketplace. So then it’s a question as to whether those are timely new entrants and whether they ramp or whether they actually get pushed out into early 2020. I think that remains to be seen.

But, I think we are well positioned either way in the sense that we have the design-ins and they go into both telecom systems and for DCI. But I guess, I would just agree with you that, there is some uncertainty about the second half relative to the first half in the sense that, right now, we’ve just provided an outlook on the second quarter.

And the second quarter is looking pretty strong relative to the first quarter, it’s an uptick. But we are not at a point of being able to guide for the third quarter or for the second half.

Jun Zhang

Yes, sure. Got it. Thanks. And then my last question is about the operating margin size. So it seems that you have increased, I think R&D cost in the March quarter and do you have a plan in the following quarters to do some cost reduction on operating level in order to improve that operating margin? Thanks.

Timothy Jenks

Yes, you may recall in our comments last quarter, we did talk about the specific requirements that when we guided for the first quarter that we had some important programs that had near-term spending. And that did reflect. Beth may want to comment on the longer-term view.

Elizabeth Eby

Yes, we specifically said, we’d be between 24 and 25 for the year mostly on external payments related to new chips and products. Something that we continue to watch closely. But we are on track for the year.

Jun Zhang

Okay, great. Thanks a lot.

Timothy Jenks

Thank you, Jun.

Elizabeth Eby

Thanks, Jun.

Operator

Thank you. At this time, there are no further questions in the queue. I would like to turn the floor back over to Tim Jenks for closing remarks.

Timothy Jenks

Thank you, Jonathan. Thank you all for your time and interest in NeoPhotonics. We look forward to updating you on our progress in the future and to seeing many of you at investor conferences taking place in May and June. Have a good day.

Operator

Thank you ladies and gentlemen. This concludes today's teleconference. You may now disconnect.