NeoPhotonics: More Than Meets The Eye

Summary

• NeoPhotonics ended Q4 and 2019 with another good earnings report and the outlook suggests more of the same.
• Strong demand from China helped boost Q4 numbers, which is not necessarily a good thing for several reasons.
• Huawei is close to a breakthrough in optical modules, which has important ramifications for NeoPhotonics.
• NeoPhotonics may continue to post good numbers, but it could also have the rug pulled from under it at any time.

NeoPhotonics (NPTN) added to its recent trend of solid quarterly reports with another good one in Q4. The Q4 report follows in the footsteps of the two before it in many ways. However, while the headline numbers suggest NeoPhotonics is making headway, there's reason to be wary of the latest results. Why will be covered next in greater detail.

Q4 2019 quarterly results

Revenue rose to $103.4M in Q4, an increase of 12% sequentially and 13% YoY. Non-GAAP net income declined slightly on a sequential basis, but more than doubled in comparison to a year ago. The table below lists the GAAP and Non-GAAP numbers for Q4 2019.

(Non-GAAP)	Q4 2018	Q3 2019	Q4 2019	QoQ	YoY
Revenue	$91.10M	$92.39M	$103.36M	12%	13%
Net income	$2.42M	$5.40M	$5.26M	-	-
EPS	$0.05	$0.11	$0.10	-	-
(GAAP)
Revenue	$91.10M	$92.39M	$103.36M	12%	13%
Net income	($6.73M)	$2.27M	$2.07M	-	-
EPS	($0.15)	$0.05	$0.04	-	-

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Source: NeoPhotonics Form 8-K

NeoPhotonics also released results for the whole year. Both the top and bottom line improved in 2019. Revenue increased by 10.6% to $356.8M. NeoPhotonics managed to turn its Non-GAAP net loss of $20.5M in 2018 into a net profit of $0.44M in 2019. NeoPhotonics barely made it, but it managed to get itself out of the red.

(Non-GAAP)	2018	2019	YoY
Revenue	$322.54M	$356.80M	10.6%
Net income (loss)	($20.51M)	$0.44M	-
EPS	($0.45)	$0.01	-
(GAAP)
Revenue	$322.54M	$356.80M	10.6%
Net income (loss)	($43.64M)	($17.08M)	-
EPS	($0.97)	($0.36)	-

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The company's outlook suggests more progress ahead. NeoPhotonics' guidance for Q1 2020 calls for revenue of $83-90M, an increase of 8.9% YoY at the midpoint. Non-GAAP EPS is forecast to be $0.00-0.10. In comparison, the company recorded a net loss of $0.19 a year ago.

(Non-GAAP)	Q1 2019	Q1 2020 (guidance)	YoY (midpoint)
Revenue	$79.4M	$83-90M	8.9%
EPS	($0.19)	$0.00-0.10	-
(GAAP)
Revenue	$79.4M	$83-90M	8.9%
EPS	($0.30)	($0.05) - $0.05	-

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The latest report shows that NeoPhotonics has made substantial progress. NeoPhotonics seems to be on a roll with a string of good quarterly reports and the company thinks there's more to come.

Q4 2019 earnings call

It's important to note that as good as the Q4 numbers were, they could have been even better if not for the negative impact of foreign exchange. Management makes this clear when they explain in the earnings call that:

"This translates to a Non-GAAP EPS of 10 cents, compared to 11 cents in Q3. Excluding the impact of foreign exchange in both quarters, EPS was 14 cents in Q4, compared to an EPS of 7 cents in Q3."

A transcript of the Q4 2019 earnings call can be found here.

Non-GAAP Q4 EPS was $0.10, which is one cent above what guidance suggested. But if the negative impact of $0.035 from forex is excluded, EPS could have been $0.135. If not for the currency-related loss of $1.8M, net income would have been $7.1M instead of $5.3M in Q4.

NeoPhotonics credits its Q4 quarterly results to a number of factors. For instance, NeoPhotonics credits its technological edge as a leading supplier of 400G and faster solutions.

"Driving these results was a combination of strong end customer demand in China, as well as from Metro and DCI markets, and our continued leadership in 400G and faster solutions. High Speed products were 92% of revenue, which was up 22% in revenue terms from the same period last year, driven by our leading coherent products."

Another important factor providing a lift was China and Huawei in particular. Huawei continues to contribute to results, despite the fact that Huawei remains on the Entity List. Being on the Entity List imposes restrictions on what NeoPhotonics can supply to Huawei. NeoPhotonics can supply 100G and 200G solutions without any restrictions, but the most advanced stuff is subject to regulatory approval from the U.S. government.

"Within China, and under the Department of Commerce denial order on Huawei, carriers are deploying network capacity by utilizing 100G and 200G coherent solutions that are not otherwise curtailed under Entities List regulations. Our Chinese customers represented 55% of revenue in the fourth quarter compared to 48% in the previous quarter. Huawei made up 41% of the total, up from 37%. Our next four customers were essentially flat in dollar terms in Q4, which is lower in percentage terms due to our overall strength."

Huawei accounted for 41% of revenue at NeoPhotonics, an increase of 400 basis points. Other Chinese customers contributed another 14%. In total, Chinese companies accounted for 55% of revenue, an increase of 700 basis points. China accounted for less than half of revenue in Q3, but it's now back to more than half.

Huawei remains the biggest customer at NeoPhotonics. Sales were flat at the next four customers, which suggests that most of the growth at NeoPhotonics was driven by Huawei and China. This is not necessarily such a good thing considering the possibility of trade tensions between the U.S. and China, which could always flare up in the future.

Some have pointed to this reliance on Huawei and China as a point of concern. For instance, this article goes into further detail regarding this issue. Huawei is known to have increased its inventories in response to trade restrictions imposed by the U.S. government. Other Chinese companies may be doing the same as a precaution against possible supply disruptions in the future.

"For Huawei, things differ product to product and it's difficult to say what level of ordering is versus shipments. They may build some inventory in some products and they cannot build inventory in others. So it's not something where I can provide you affixation of that. We do think there is some level of inventory build though and they'd probably like to build more than they're actually able to do."

Management acknowledges that there may be some inventory building going on, but it cannot tell for certain to what extent it is going on. Management also seems to be suggesting that the Chinese are sticking with 100G and 200G because that's all they have access to.

"And so to be a little more specific, they're really sticking to 32 gigabytes and not really moving to 64 gigabytes. And so with the 32 gigabytes they are operating the 100 gig and 200 gigabyte per second which is what their chain can currently provide."

However, the Chinese may not be opting for 400G and faster solutions at the moment, but that may soon change if recent reports are any indication.

Huawei is creating alternatives that could turn into a headwind for NeoPhotonics

NeoPhotonics is a supplier of photonic optoelectronic modules that are widely used in high-speed communication networks. Its products support data rates of 100 gigabits per second and above, including 400G and 600G. NeoPhotonics expects to ship components for 800G when it ramps up in the second half of 2020. Huawei depended on NeoPhotonics for the supply of these products for quite some time.

However, Huawei has decided to insource many components it used to get elsewhere, especially those from American suppliers. Recent reports suggest that Huawei's efforts are bearing fruit. For instance, Huawei announced not too long ago that it has developed an 800G tunable, high-speed optical module, which includes a self-designed 800G optical chipset called the OptiXtreme H7.

According to reports, Huawei is already conducting live network trials using this technology. Huawei claims that its optical module supports line rates of 200G to 800G and capacity of 48 Tbit/s per-fiber. In contrast, NeoPhotonics' most recent products support 34 Tbit/s per-fiber. From the Q4 earnings call:

"Our new components also provide more capacity per module through higher speeds and modulation formats, which in turn lowers cost per bit and electrical power consumption. Taken together, these features enable 34 Terabits or more per fiber of total capacity."

The latest reports from Huawei suggest that it is close to being able to provide next-generation communication networks that support 800G without the need for components from American suppliers like NeoPhotonics. Chinese carriers and equipment providers may no longer have to restrict themselves to 100G and 200G if Huawei can provide faster solutions.

Huawei has not yet commercialized its latest optical solutions. But once it does, NeoPhotonics may have to face reduced demand from Chinese customers if they opt for competing modules from Huawei. This could turn into a long-term headwind for NeoPhotonics, a company that depends heavily on demand from China.

Source: Wikimedia Commons

Investor takeaways

NeoPhotonics posted another good quarter in Q4 to add to the one in Q3. In some ways, Q4 was better than Q3. For instance, Q3 quarterly earnings got a boost from currency gains. Without forex, the Q3 numbers would not have been as good. But in Q4, earnings managed to beat expectations despite currency headwinds. If not for forex, the already good headline numbers would have been even better.

However, much of the growth was driven by China and Huawei. This is a problem because it raises the issue of whether the recent demand growth is real or whether it's inflated due to inventory building. If it's the latter, NeoPhotonics could see sales fall off at some point in the future. It's not a matter of if inventory building will end, but when.

This issue is especially problematic because Chinese companies account for over half of revenue at NeoPhotonics. It would be wise on the part of NeoPhotonics to mitigate the risk factor and reduce its reliance on Chinese demand. But in Q4, dependency on China went up instead of down. It's risky to have all your eggs in one basket, but NeoPhotonics seems to be heading in that direction.

In addition, there are concerted efforts in China to replace American suppliers with home-grown alternatives. Huawei seems to be close to having its own 800G solution despite being sanctioned by the U.S. government. NeoPhotonics may be able to count on Chinese demand right now, but it cannot assume that will always be the case.

So despite NeoPhotonics recent string of good quarterly results, it's best to be neutral and remain on the sidelines. NeoPhotonics may continue to post good numbers in the coming quarters and the stock could react well to those numbers, but that could end at any time. If demand from Chinese companies is pulled because they are done building inventories, subject to trade sanctions, have alternative solutions or some other reason, NeoPhotonics will be hard pressed to replace this demand. Without this demand from China, the stock will have trouble staying afloat.

Analyst’s 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.