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NeoPhotonics: Inventory Building May Be Playing A Role

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About: NeoPhotonics Corporation (NPTN)
by: MarketGyrations
MarketGyrations
Long/short equity, value, contrarian, Growth
Summary

NeoPhotonics reported excellent numbers in its latest earnings report and the outlook suggests that more is to come.

Fluctuations in currency exchange rates inflated EPS by $0.04 to $0.11, a sizable difference that is not expected to last.

Demand helped drive quarterly results, but there’s the possibility that inventories may have distorted the numbers.

Without knowing what impact inventories had, it’s best to be neutral on NeoPhotonics.

NeoPhotonics (NPTN) released its Q3 earnings report on October 31. The company easily beat estimates for both the top and bottom line. Not surprisingly, the stock jumped by over 20% in the aftermath of the release. But while the numbers were good, there is reason to temper expectations. There could be other factors at work that may have influenced the results. This issue will be dealt in detail next.

Q3 2019 earnings

Revenue rose by 13% to $92.4M in Q3. Net income did even better at $5.4M, a turnaround from the $2.1M net loss of a year ago. The table below lists the relevant numbers for Q3 2019 and compares them to a year ago and the quarter before.

(non-GAAP)

Q3 2018

Q2 2019

Q3 2019

QoQ

YoY

Revenue

$81.7M

$81.7M

$92.4M

13%

13%

Net income

($2.1M)

($1.2M)

$5.4M

-

-

EPS

($0.05)

($0.03)

$0.11

-

-

Source: NeoPhotonics

In addition, NeoPhotonics provided strong guidance. Net income is expected to increase from $91.1M to $94-100M and EPS from $0.05 to $0.04-0.14. This represents an increase of 6.6% and 80% respectively at the midpoint.

(Guidance)

Q4 2018

Q4 2019

YoY

Revenue

$91.1M

$94-100M

6.6%

EPS

$0.05

$0.04-0.14

80%

NeoPhotonics points to strong demand from end users as the driving factor behind the quarterly results. Management states in the Q3 earnings call that:

“We achieved strong results driven by increased partnerships with the leaders in the industry, strong end customer demand in Metro and DCI markets, our continued leadership and progress on 400G and faster solutions, and strength in China.”

A transcript of the earnings call can be found here.

In addition, demand could receive another boost from the rollout of 5G networks. These ultrafast networks will increase the flow of data, which requires a backbone that can handle the additional load with more bandwidth. NeoPhotonics could be a beneficiary as stated in the earnings call:

“I just commented a few minutes ago about the indirect effect of 5G increasing in its deployment and how that fills up the backbone networks, whether they're national backbone or provincial backbone.”

The number of 5G networks and users is set to drastically expand starting in 2020. For instance, China launched commercial 5G service on November 1. Others will follow in the not too distant future. 5G could be a catalyst for future growth at NeoPhotonics.

NeoPhotonics is diversifying its customer base

Besides great earnings, NeoPhotonics also reported progress with regard to diversifying its customer base. A big reason why the stock experienced great volatility earlier in the year was the fact that NeoPhotonics is heavily exposed to a single company, namely China’s Huawei.

So when the U.S. government placed Huawei on the Entity List, the stock sold off as a result. NeoPhotonics would not be able to supply Huawei without permission from the U.S. government due to its presence on the Entity List. The adverse impact on NeoPhotonics could have been extreme with Huawei contributing close to 50% of revenue.

Realizing the potential problems stemming from reliance on a single customer, NeoPhotonics has sought to mitigate the fallout by diversifying its customer base. The company now reports that Huawei’s share of revenue has fallen from 46% a year ago to 37% in Q3. From the Q3 earnings call:

“As a reminder, Huawei has been the largest systems supplier in our industry for several years and as a result, has also been NeoPhotonics’ largest customer. Our third quarter financial results reflect revenue from Huawei at 37%, all from products that are not subject to U.S. EAR. This is down from 46% in 2018.”

NeoPhotonics now has four other customers contributing a combined 48%. One of them held a share of more than 10%.

“Our next four customers again showed strong performance contributing 48% of revenue. Our business has continued on a strong footing with our leading western customers, especially those serving DCI and Metro markets.”

Still, China remains in first place with a 48% share. There was not much change in revenue in terms of geography. NeoPhotonics remains vulnerable if there are any flare-ups in tensions between the U.S. and China.

“Our business in the Americas was 25%, up 24%, 27% from the rest of the world down 28%, China remained flat at 48%.“

Nevertheless, NeoPhotonics has managed to reduce its exposure to Huawei. This could come in handy in case Huawei is subjected to additional sanctions that could further limit the company. If that happens, NeoPhotonics will be less affected than before.

Results were good, but maybe not that good

However, while the numbers from NeoPhotonics look outstanding, they did benefit from fluctuations in currency exchange rates. Without the added benefit from forex, EPS would drop from $0.11 to $0.07. From the Q3 earning call:

“The ongoing business drove an EPS of $0.07, at the high end of our forecasted range for the quarter, while the after-tax FX gain drove an additional $0.04 of EPS. For the third quarter, adjusted EBITDA was $14.2 million.”

Furthermore, NeoPhotonics does not expect this windfall to last.

“In Q3, appreciation of the U.S. dollar relative to the Chinese Yuan drove a foreign exchange gain of approximately $2.6 million. As a reminder, the functional currency of our China operations is the Yuan. The FX gain is driven by the revaluation of China balance sheet items to the end of quarter exchange rate. We view this as temporary good news that will reverse as the Chinese Yuan appreciates.”

So while NeoPhotonics did have a good quarter, business was not as good as the headline numbers would suggest.

Inventory building may have distorted quarterly results

Besides forex, there is another factor that may have muddled the quarterly numbers. For various reasons, a number of customers may have acquired additional inventory in order to hedge against possible disruptions in their supply chains. From the Q3 earnings call:

“So we don't know what of this is really an increase in demand because part of the reason customers want to build some inventory is to protect against surges in demand. So until we're after the fact of we don't really know what was sold through in demand versus what's inventory buffer.”

Management thinks that some customers may be building inventories, but doesn’t know to what extent it is taking place.

“We did see it as similar, and then to some extent we do see customers asking for us for a bit more, but also being interested in a bit of potential inventory. So there is a risk that that difference, you know, over time proves out to be important. We can't quantify it fully at the moment.”

Furthermore, NeoPhotonics does not always know what end users wind up doing with the products they’ve received.

“I don't think we know in all cases the end use application. But broadly, I would have to say it includes both. And there may be some reality in the fact that this is unlikely to be reduced unless the trade tensions return to some sense of normalcy, and it's also just related to who will consume available capacity. But it's just the current state of affairs with trade.”

This could be especially true in China where customers have reasons to be concerned that they may no longer be able to source supplies from U.S. companies. Building up inventory is one way to mitigate against such an eventuality. If this is indeed what’s happening, then real demand is lower than what the numbers reported would lead you to think.

This issue of inventory risk is unlikely to be resolved as long as trade tensions exist. Nevertheless, the possible side effect is that revenue at NeoPhotonics could experience a substantial drop in the future once the inventory building phase passes. It’s a risk that cannot be quantified, yet will remain hanging over NeoPhotonics. When it will end can also not be predicted.

Source: Wikimedia Commons

Investor takeaways

NeoPhotonics had a great quarter. The company managed to turn a net loss from a year ago into a net gain thanks to strong demand. Further gains could be in store once 5G networks become more commonplace. NeoPhotonics also managed to lessen its dependence on Huawei and diversify its customer base.

On the other hand, the currency gain takes off some of the shine from the report. But the biggest damper has to be the issue of inventory building. It may not be known to what extent it influenced the quarterly numbers, but it calls into question what the real numbers would be assuming inventory building did take place.

There’s the possibility that NeoPhotonics could be much worse off than the headline numbers suggest. There is also the added risk that NeoPhotonics could experience a sizable drop in revenue once customers decide that there’s no longer a need to acquire extra inventories. The stock would of course not respond well to any big revenue declines down the road.

NeoPhotonics could be doing as well as the quarterly results suggest, but it could also be much worse off. There is just no way to tell for sure. It’s a gamble that people have to take, which is not something that everybody is willing to put up with.

While it may be tempting to turn bullish based on the headline numbers and the big subsequent move in the stock, there’s too much of a risk that the numbers are distorted. A reversal of currency gains alone will cut into future earnings.

The recent appreciation of the stock has also benefited from good news in the trade conflict between the U.S. and China. The perception is that a trade resolution will help a company like NeoPhotonics, especially with regard to its key customer Huawei. However, the stock could easily give back some of its recent gains if it turns out that all the recent optimism was premature. It’s quite possible that there is no trade deal on the horizon.

Taking all of this into account, the prudent move with regard to NeoPhotonics is to stay neutral. There’s no going around the fact that the numbers could be distorted and not sustainable. Anyone going long runs the risk of taking a sizable haircut if that turns out to be the case.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.