NeoPhotonics Corporation
Q4 2019 Earnings Call Transcript

Published: 28 Feb 2020

[Operator:]

Good day and welcome to the NeoPhotonics 2019 Fourth Quarter and Year End Conference Call. This call is being webcast live on the company’s website at www.neophotonics.com at the events page of the Investor Relations section. This call is the property of NeoPhotonics and any recording, reproduction or transmission of this call without the expressed written consent of NeoPhotonics is prohibited.I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations. Please go ahead.

[Erica Mannion:]

Good afternoon. Thank you for joining us to discuss NeoPhotonics' operating results for the fourth quarter of 2019 and outlook for the first quarter of 2020. With me today are Tim Jenks, Chairman and CEO; and Beth Eby, Chief Financial Officer. Tim will begin with a review of our business progress in the fourth quarter and a discussion of business drivers and products. Beth will then provide financial results for the fourth quarter before providing the outlook for the first quarter of 2020 and opening the call for questions.The company's press release and management 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 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 on 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, customer demand, inventory levels, economic and industry projections and 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 February 27, 2020, and are described at length in our annual and quarterly SEC filings.Now, I will turn the call over to CEO, Tim Jenks.

[Tim Jenks:]

Thank you, Erica, and good afternoon. We are all aware of the coronavirus situation and our first priority is the health of our employees and those of our supply partners. In China, which represents less than half of our manufacturing footprint we were closed for an extra week during the Chinese New Year, but now our China factories are running at about two thirds of normal capacity and are increasing.Our China suppliers are recovering steadily but remain below capacity. At this point we believe very few suppliers are at risk of not being able to meet our current demand forecasts. Our manufacturing outside of China, again is more than half of our manufacturing footprint and is not directly impacted.Moving to our business. NeoPhotonics delivered a very strong fourth quarter with revenue of $103 million above the top end of our outlook range with non-GAAP gross margin at 31%. This is revenue growth of 12% from the prior quarter and 13% from the same quarter last year. 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 400 gig 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. Our strong fourth quarter performance reflects our focus on high-speed products serving industry leaders in DCI as well as the transition of cloud and hyperscale data centers to coherent technologies plus the ongoing deployment of coherent technologies in telecom and data center networks.Within China and under the Department of Commerce Denial Order on Huawei, carriers are deploying network capacity by utilizing 100 gig and 200 gig 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.NeoPhotonics has been investing in high-speed coherent technologies for a decade and we have achieved leadership in several product categories with our leading tunable laser capability, our component strength and our underlying Silicon Photonics and Advanced Hybrid Photonic Integration technologies, we are excited to have recently introduced a series of new innovative high-speed products.Addressing cloud and data center markets, our recently introduced 400 gig OSFP and CFP2 and soon to be introduced to QSFP-DD, DCO modules offer complete optical connections over ZR distances up to 120 kilometers. And form factors that plugged directly into switches and routers, greatly reducing the cost per bit of cloud and data center interconnection.Our OSFP and CFP2 DCO modules also offer ZR plus performance, extending reach to Metro distances. Our new coherent module products, which are built on our 64 gigabyte technologies, are sampling and we expect they will ramp in 2021. To further enhance our leadership position in high performance optics, we recently announced variants of these products in C++ configurations.These increase the data carrying capacity of optical fiber networks in cloud and data center applications and in telecom applications. Our C++ laser, modulator and receiver have expanded spectral bandwidth ranges to support the full Super C band, which provides 50% more spectrum than today's standard network configuration.This is important as users can significantly leverage their existing network investments by increasing fiber capacity and therefore traffic up to 50%. 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.We are demonstrating three key technical solutions that further drive economies and cost per bit performance. Our 400 ZR OSFP DCO modules are operating and carrying traffic in customer switches currently. Our new 400 gig, CFP2 DCO modules can operate over even longer Metro distances and our new C++ multiplexers and demultiplexers operate with our 400 gig CFP2 DCO modules over the entire C++ spectral band.These multiplexer products are optimized for high capacity, high baud rate, coherent transmission systems and support operation from 60 gigabytes to 128 gigabyte. Information on these new solutions will be available through our website.The next generation of networks will operate from 400 gig to 600 gig and even 800 gig and higher capacities on a single wavelength. These systems require customized channel spacings and filter shapes which we provide. Altogether our coherent modules, components and MUX and DEMUX products represent a full suite of cloud and data center, coherent interconnect solutions.As we've noted previously, the fundamental driver of our coherent business is the continued deployment of high-speed coherent ports which have been growing at approximately 20% or more each year and now will include 400 gig plugable coherent modules.We believe port growth will continue for the next several years and with some acceleration from 400 ZR on the data center side, we anticipate that 400, 600 and 800 gig component products will continue to ramp through this year and next and our new 400 ZR and longer reach 400 gig modules will begin to ramp at the end of 2020. Each of these requires best-in-class component performance and is well aligned with the needs of cloud and hyperscale data center operators as well as being aligned with our advanced technologies, high-speed capabilities and strong presence in high-speed component platforms. As a result of years of successful R&D, today we produce more of the core optical subcomponents of these innovative devices in-house than others, meaning laser, modulator, receiver, optical integrated circuits and the modules that are built from these components. We believe large new market areas for us are emerging in cloud and hyperscale data centers and in 5G wireless backhaul each with coherent connections.With that, I will turn the call over to our CFO, Beth Eby.

[Beth Eby:]

Thank you, Tim, and good afternoon. Q4 was a strong finish to the year with $103.4 million in revenue higher than our outlook. Non-GAAP gross margin for the quarter was 31% higher than the midpoint of our outlook on higher volumes. Non-GAAP Q4 EPS was $0.10, $0.01 higher than the midpoint of our range in spite of $0.035 negative impact from foreign exchange. On a full year basis, our leadership in coherent product drove gross margin 5 points higher than 2018 on a non-GAAP basis and resulted in a full year non-GAAP EPS of $0.01 compared to $0.45 loss last year. We generated $25 million in free cash flow, up from $5 million in 2018.Moving to more details on Q4 performance, our non-GAAP Q4 gross margin was 30.9%, slightly above the midpoint of our range. Within this, product margins were approximately 36.8%, up 2 points from last quarter and up 5 points from last year on volume growth and improved product mix.Other costs of sales charges of about 6 points were comprised of approximately 4 points of underutilization charges, 1 point for inventory reserves and 1 point for tariff charges on product shipping from our U.S. fabs into China.Total non-GAAP operating expense for the fourth quarter was $24.3 million, up $2 million from Q3 on higher R&D spending for product launches and higher variable compensation given a full year profit for 2019. Non-GAAP operating profit for the fourth quarter was $7.6 million or 7.4% compared to 4.8% in Q3.In Q4, appreciation of the Chinese Yuan relative to the U.S. dollar drove a foreign exchange loss of approximately $1.8 million. As a reminder, the functional currency of our China operations is Yuan. The FX loss is driven by the reevaluation of China balance sheet items to the end of quarter exchange rate. The FX loss in Q4 reverses most of the FX gains in Q3.As a result, non-GAAP net income for the fourth quarter was $5.3 million compared to an income of $5.4 million in the third quarter. This translates to a non-GAAP EPS of $0.10 compared to $0.11 in Q3. Excluding the impact of foreign exchange in both quarters, EPS was $0.14 in Q4 compared to an EPS of $0.07 in Q3. For the fourth quarter, adjusted EBITDA was $12.5 million.I'll close out my discussion of the fourth quarter income statement with a review of our GAAP results. Fourth quarter gross margin is 30.2%, up approximately 2 points from Q3 and up 5 points compared to the fourth quarter of last year, driven by an increase in volume and improved product mix. Operating expense was $26.9 million, up from $24.9 million in the preceding quarter on an increase in R&D related to our new product introductions and higher variable compensation expenses.Operating profit for the fourth quarter was $4.3 million, which included $3.2 million of stock-based compensation expense and approximately $0.2 million of amortization of acquisition-related intangibles.Net profit for the quarter was $2.1 million compared to a profit of $2.3 million in the prior period. Excluding the impact of foreign exchange on both quarters, the net profit in Q4 is $3.9 million compared to a net loss in Q3 of $0.3 million.Turning to the balance sheet, we finished to the quarter with $89 million in cash, investments and restricted cash after paying down $5 million in debt. This is up $9 million from the prior period. That inventory was $47 million or 59 days down from last quarter on higher revenue as operational efficiency continues to improve. Free cash flow was approximately $13 million.Before I discuss our earnings outlook for the first quarter of fiscal 2020, 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 Tim mentioned, we're constantly assessing the impact of the coronavirus on our operations. We have included approximately $10 million of impact to Q1 revenue in our outlook, reflecting reduced production in the quarter and added supply chain risks. We have assessed our supply chain and based on what we know now, this revenue outlook is supported by our inventory and what can be produced by our suppliers. We anticipate that the supply chain impacts may extend beyond Q1. Our suppliers are steadily increasing production and we expect to be able to ship unfulfilled Q1 demand in subsequent periods.Gross margin is relatively flat to Q4, which is unusual for Q1 on a temporary mix shift to higher margin products. Additionally, in Q1 we received a onetime license fee of $1.5 million as a credit to R&D expense that is included in our outlook. Given that the company's expectations for the March 2020 quarter are; revenue in the range of $83 million to $90 million, which includes $10 million of coronavirus impacts and reflects a slightly wider range given the uncertainty; GAAP gross margin in the range of 27% to 31%; non-GAAP gross margin in the range of 28% to 32%; GAAP diluted earnings per share in the range of $0.05 loss to a $0.05 profit; and non-GAAP diluted earnings per share in the range of $0 to $0.10 profit. These numbers are reflective of approximately $52.6 million fully diluted shares.Note that Huawei remains subject to the department of commerce denial order, we continue to ship products to Huawei that is within current regulations and de minimis content guidelines. If the existing de minimis threshold were to be lowered to 10% without other changes, we would not expect a significant direct impact to our revenue outlook.In summary, for the full year of 2019, NeoPhotonics has made substantial progress. Full year revenue was up 11% to $357 million. Gross margins were up 4 points on a GAAP statement – on a GAAP basis and 5 points on a non-GAAP basis. We exited unprofitable businesses. Operating expenses were down as a percentage of revenue. We were profitable on a non-GAAP basis for the full year and cash, investments and restricted cash increased year-on-year by $12 million, while we reduced debt by $11 million. We are pleased with the progress that we have made to become a consistently profitable business and we'll continue to focus on our execution in the current environment.This concludes our formal comments. And I would now like to ask the operator to open up the line for questions. Todd?

[Operator:]

Thank you. [Operator Instructions] We'll take our first question from Paul Silverstein of Cowen.

[Paul Silverstein:]

Thanks. I appreciate it. Two questions if I may. One, Tim, outside of China, what are you seeing in terms of demand trends broadly speaking? And secondly, on the downside risk of the equation, with respect to Huawei, I know this question comes up every quarter, but I've got to ask again, what visibility do you have into them double or triple ordering, building up inventory above and beyond their needs, which could come back to bite you at some future period if there were be a reduction in their demand related to that inventory overbuilt?

[Tim Jenks:]

Well, let's see. On the first part of the question, Paul, with respect to demand from the West is actually pretty steady. We're seeing a fairly consistent. I think that was expressed with our having both our Q4 results and our outlook for Q1. 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.

[Paul Silverstein:]

Can I sneak one more in? And Beth, in terms of gross margin, I heard you say that temporary positive trend favorably impacting gross margin. But as you look out throughout the year, I assume your higher line rate products have higher margin and those are ramping greater volume. I would think that with all the things being equal that would have an uplift on gross margin with the question being to what degree. Am I thinking about that the wrong way?

[Beth Eby:]

Well, normal trend would see us drop about 5 points in Q1, and you'll notice we aren't dropping. So absolutely over the course of the year as we get more cost reductions, our gross margin tends up. I just don't want everybody to take the normal trajectory for individual years and put it on top of Q1 gross margins.

[Paul Silverstein:]

I appreciate it. Thanks guys. I’ll pass it along.

[Tim Jenks:]

Thanks, Paul.

[Operator:]

Thank you. We'll take our next question from Tim Savageaux of Northland Capital Markets.

[Tim Savageaux:]

Hi, good afternoon, and congrats on the results. So, it looks like X the kind of a reserve you're making for coronavirus, not only your gross margin is stronger than historically anticipated on seasonal basis, but revenue would have been as well. I wonder if you could just sort of describe the demand trends exiting Q4 into Q1. Are they same, which is to say is, is China the key driver there or Huawei as you head into Q1? And are you seeing more contributions from other customers in geographies? And I kind of want to tie that to the mix comment in Q1, is there a relationship or a geographical driver there? Thanks.

[Tim Jenks:]

Okay. Well, let's see, specifically, coming out of end of year, end of fourth quarter, we did say in our prepared remarks that in the fourth quarter China was up a bit and Huawei was up a bit. And so, that demand coming out of fourth quarter China's relatively strong. I think that for the back half of the year, I think we would expect that to be normalized and relatively stronger for the West compared to China. But there are a lot of variables going on right now with the risks expressed in our statements. So that may be beyond that, it's relatively speculative.

[Beth Eby:]

And Tim, it’s not so much a geographic split on the mix as a product line split, just the products that are made outside of China tend to be a little higher margin.

[Tim Savageaux:]

Okay. Well, I'd welcome any color on where those products might beheaded regardless of where they're manufactured, if there is a specific application or demand driving that. But more broadly on growth margin, you mentioned product margin is up near 37%, which is as high as I recall. And of course some offsetting factors, but as you continue to kind of focus on operational efficiency and execute, I mean, what is the – is there a ceiling on that product gross margins? How high can that go because you're really, I don't know, if you gave a year-on-year compare for product gross margin, but I'm imagine it was up pretty substantially.

[Beth Eby:]

Yes, actually we did. The product gross margins are, let me – are up about 5 points, I think what we said, yes. So – I think as we continue to focus on products that are leadership in the market, I don't think we get – that we particularly have a ceiling on our product margins. Leadership products just naturally command the higher margin. Take a little more R&D, but they command the higher margin.

[Tim Savageaux:]

Okay. And then just to finish up, I mean, what about the – go ahead.

[Beth Eby:]

Yes, we said in that – I just went back and looked at the data. We said product margins are up 5 points compared to last year.

[Tim Savageaux:]

Yes, I get that. And then maybe take us through, and then I'll pass it on here, the puts and takes of the offsetting factors in gross margin. And so I mean you've always had some degree of underutilization, but that's I think varied historically, and obviously the tariff issue is sort of a one-off. But, Tim, maybe as you look through the year, what would be the factors moving the offsets to product gross margin and maybe minimizing those over time.

[Beth Eby:]

So the biggest thing is I'm pleased with progress that we've made on our product margin and improving those. And as we continue to release leadership product, we believe those will increase. As we've said a number of times, our goal on product – on our total margin is 35%. And what that's going to take in is some of the little more structural changes of things like underutilized indium phosphide fabs and that type of thing. And tariffs which are ameliorating at the moment.

[Tim Savageaux:]

Okay. Thanks and congrats once again on the results and the financial execution.

[Tim Jenks:]

Thanks, Tim.

[Beth Eby:]

Thanks, Tim.

[Operator:]

Thank you. We'll take our next question from Richard Shannon of Craig Hallum.

[Richard Shannon:]

Well, hey guys, thanks for taking my questions as well.

[Tim Jenks:]

Hey, Richard.

[Richard Shannon:]

Hi. Maybe a question following up here on gross margins. I'm not sure if I just missed this or you didn't mention it, but you said the gross margins in the first quarter guide here is due largely to a mix shift that's temporary. What would you say that that gross margin might've been with a normal mix? And just to be clear, is this a mix shift that something that could happen again, or are you just saying it's – right now it's just going to happen in the first quarter?

[Beth Eby:]

So with the extra, as I mentioned a couple of minutes ago, with the products out of our China factory is being low, significantly lower than normal because it was shut down for more than we expected, our higher margin products are greater proportion of the revenue. That's really what's driving the mix shift. So as we move back to a more balanced China products, non-China products type of a mix, then we would expect gross margin to shift back to normal proportion.I don't think without, as I said, normally we drop about 5 points in Q1, we had a relatively benign pricing environment this year. So we would not have dropped that much, but we certainly would have dropped more than – if you go and look from the 31% where we were in Q4 to the 30% which is the midpoint, we would have dropped a little more than that.

[Richard Shannon:]

Okay. And then if I can extend this into the second quarter. Obviously, you're not guiding on a revenue level, but let's just say hypothetically you're going to have a seasonally normal quarter, your environment looks pretty healthy, but let's just say it's seasonally normal. Not having a affirm handle on the magnitudes here, would you suggest the gross margin should be flat or down or could that even grow in the second quarter?

[Beth Eby:]

I don't guide as…

[Richard Shannon:]

Well, it's off of hypothetical Beth. So…

[Beth Eby:]

Yes, hypothetical. But we do, if you take Q1 to where it would have been if we'd been a more normal product mix and add since we had a – our product intros are more new products these days rather than cost reduced products. So I don't think we can take cost reductions up as high as we usually do, but we will still have some over the course of the year.

[Tim Jenks:]

Richard…

[Richard Shannon:]

Okay, that’s fair enough.

[Beth Eby:]

We’re not giving you a direction and not telling you an answer.

[Tim Jenks:]

One of the things that I think, yes, we're thinking about right now is just the impact on China. We actually reopened our China facilities at the earliest possible time. We have factory in Dongguan and Shenzhen. We opened them on February 10. And as I said, we're running at about two-thirds and they're continuing to increase as we have more production operators returning to work from other parts of the country where they may have been unable to travel.But what we can't quite do right now is we don't know what the level is going to be throughout Q2. So Beth did say some of the impacts may extend beyond Q1. We don't know the magnitude of those at this point. We're working on it every day, but this is another hypothetical, but very, very real situation that we're facing with from Q1 to Q2 in the transition.

[Richard Shannon:]

Okay, I appreciate that balance, Tim. Maybe a quick financial question for Beth and last one for Tim. On the OpEx, Beth, looks like you had a pickup in the fourth quarter. I think you say saw some project expenses for new product lines or something. Does this signal any sort of a increasing trend with OpEx? You obviously cut back as you went into last year, had a very good year, you're profitable. Could we see the OpEx consistently move higher, or are we still being very tight with it?

[Beth Eby:]

Our R&D people would tell you we're still being way too tight with it. That said, I do believe it's going to drift. It's going to drift a little higher than it was last year because we're launching new products and that takes support.

[Richard Shannon:]

Okay, fair enough. And then, Tim, my last question, wanted to ask quickly about the C++ products. Can you kind of help us understand the breadth of interest here geographically, as well as how many can or are interested in this kind of spectrum advantage this provides versus maybe some that are not capable of doing so?

[Tim Jenks:]

The C++ products do offer broader spectrum. And so the normal situation is, for example, operations for DWDM systems are in the so-called C-band around, wavelengths around 1,550 nanometers. And so in this case, you have a little more wavelength at the lower end and more wavelength at the higher end. And so you have broader C band and, and so that extra plus on the bottom and that extra plus on the top matter. Right now the primary interest is actually regionally in China. The West may be later, but right now it's primarily China. It also depends to an extent on how much fiber is available because what it really does is if you have an existing fiber plant, you can use that existing fiber plant and get more leverage from it. And, increase the capacity without on the existing fiber without having to spend a lot of money on more fiber. It is a change in the line system. So, there is an investment involved, but today focus China.

[Richard Shannon:]

Okay, perfect. Thanks for all that detail. That's all the questions from me guys. Thank you.

[Tim Jenks:]

Thanks Richard.

[Operator:]

Thank you. We'll take our next question from Simon Leopold of Raymond James.

[Mauricio Munoz:]

Thank you for taking my question. This is Mauricio in for Simon today. I just wanted to drill – I just wanted to drill more on the potential impact of the coronavirus and your exposure to – your exposure to China. I think the sort of size, the impact for the first quarter in the approaching the 12% range, I guess at the mid-point, could you please talk about your own supply chain exposure and how are you managing that given the current restrictions as well as how things are looking on the demand side. Thank you.

[Tim Jenks:]

Yes, let me comment first overall and then ask – I'll turn it over to Beth for some comments on both supply chain and overall demand. But I think it's important to notice – note that we’re operating two plants in China and we've managed thus far to have all of our employees stay healthy. We've had a tremendous number of actions that we've put in place in our plants and these are what I'll call quite different than normal, but just what we employee social distancing and making sure that people are taking care and all of the normal above normal operating manners.So, this is not business as usual. This is business very carefully and very carefully operating in every way, keeping people's health as the primary benefit. But, we're also, with more than a thousand people and all of them being healthy. I think that's a testament to the way our China plants are operating. Now we're also working very, very closely with our supply partners and our supply partners matter as well. So far that's gone, that's gone quite well, but there's daily communication with them as they ramp up. For a little more on them and overall demand Beth, maybe I can turn it to you.

[Beth Eby:]

Sure. we've literally got daily meetings going with our supply chain people. We know what the critical components are, we know where they are. And so we, we have been able to talk to them and get assurances of how they're coming up, what inventory they can ship us, and how much they're going to be able to manufacturer of our products.So, we're comfortable with the range that we have put out there that will be supply capable for certainly for the Q1 and into Q2. As a reminder, most of our manufacturing these days is outside of China. So, and as are a lot of our supply chain partners, so those are not impacted at all and those are continuing to operate as usual with no significant impacts on their supply chains.

[Tim Jenks:]

Let's all keep in mind that from a demand point of view our business is really driven by deployment of bandwidth and that's not, it's neither consumer demand nor perishable demand. So, we don't really anticipate major changes in demand as a result of this. Business is continuing to go. Carriers are continuing to deploy, those normal drivers are actually all in place. And so I think we need to be cautious and careful given the risk, but I think we have to keep it in perspective because throughout our supply chain below us and above us, through to the carriers, business is continuing to flow.

[Mauricio Munoz:]

Thank you. Thank you, Tim and thank you Beth.

[Tim Jenks:]

Thanks. Take care.

[Operator:]

Thank you. We'll take our next question from Alex Henderson with Needham and Company.

[Alex Henderson:]

Great. Thanks. I've got a couple of questions I'd like to ask Tim. The first one is around the 100 gig, 200 gig China bias that is there as a result of the tariffs. So now that the tariffs are using on some parts is there any evidence of them thinking about shifting back to higher speeds or anything along that lines that might change the mix in China?

[Tim Jenks:]

Let's see – there isn't anything that we're seeing along those lines to change that we think that there's a pretty firm dedication to the 100 gig and 200 gig. This is both of the network equipment manufacturer and at the carrier level the implications have to do with both the tariffs and the Denial Order.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.

[Alex Henderson:]

If I could shift over to the 800 gigs segment of the market, clearly full scale deployments are 21 event, but generally the a 100 gig – the 800 gig product's are going to be reasonably available at some point in the back half of this year. Or is that more of a 21 event?

[Tim Jenks:]

Well, so the 800 gigs segment of the market doesn't exist yet. Because it hasn't launched, but we would expect it to start this year and we would expect that it would ramp in the second half but not until then.

[Alex Henderson:]

Okay, great. On the coronavirus commentary from 1Q, very clear delineation on the revenue line, but could you talk a little bit about what impact that might have on gross margins? Are you expediting any product purchases or changing supply chain anything along that lines that's also having an impact on GMs.

[Tim Jenks:]

So given the fact that, we're running for the smaller half of our production, which is the part that's in China, as I said, it's running at two thirds capacity. So, there's not a lot of expediting that's actually going on. But by the same token we see that among competitors as well. So, we don't expect demand is shifting at all. And so I think demand is strong and steady. Production is increasing for the part of our production that is in China and has some impact. We have supply chain risks. We don't have supply chain problems and I think we're managing those closely. So, hence best prepared remarks, commenting on the fact that working with and talking directly to our suppliers. We're feeling pretty comfortable as we've provided in our outlook.

[Beth Eby:]

We are baking a little bit of extra underutilization into our forecast.

[Alex Henderson:]

I see. Okay. And just going back to the product utilization, I mean, obviously that's a mix of various products that caused that. Can you remind us, which pieces are the most under utilized, where the variance is, what products need to ramp in order to bring the utilization rates up? Is it EML technology? What is it, that's, that has to kick in. Obviously, you had a really strong quarter here in the fourth quarter on the top line. And I would assume the utilization rates at that level to be quite a bit better. What was the utilization rate in 4Q? How much is it falling as we look into 1Q?

[Beth Eby:]

Yes, as we've talked about before a few times, Alex, what really drives our under-utilization is our Indium Phosphide factories. That's the majority of it. We do have a little bit of under utilization in Q1 as you would expect in China. All of that built into our forecast.

[Alex Henderson:]

All right, so just to the Indium Phosphide volumes ramp, what level of revenue would you need to get to in order to utilize, get the utilization to fully fallout?

[Beth Eby:]

It's not a product or it's not a total revenue. It's a mix. That's a mix question. We've been, we added a lot of Indium Phosphide capacity back in 2017 and we're still growing into it. We said, this story back in the beginning of 2018 couple of times I think, but we lost some market share from our EML back to the DML and that hasn't come back.

[Alex Henderson:]

One last comment from me, and then I'll exit the floor. You guys did a great job. Congratulations. We certainly were worried about it. Thanks.

[Tim Jenks:]

Thank you.

[Operator:]

[Operator Instructions] We'll take our next question from Fahad Najam of Cowen.

[Fahad Najam:]

Hey guys, thank you for taking my question. If I could ask you on any linearity you are seeing in the last few weeks as this coronavirus starts to blow up, are you seeing your non-Chinese customers kind of ramp demand just to kind of have their own supply chain risk and if that's the case, what would be the true demand run rate going forward? How do you see that?

[Tim Jenks:]

So overall Fahad, I would say no, we don't really see that as a trend. We do see isolated spots where if we have a competitor that may be, for example Hubei province, we might have seen a few orders, but generally we don't see our customers ramping demand on account of this.

[Fahad Najam:]

Got it. [indiscernible] I think on their earnings call mentioned that 800 gig components will be in short supply this year which will gate the 800 gig ramp. Are you fully capable of shipping 800 gig components?

[Tim Jenks:]

Yes, we are and we're not supply constrained.

[Fahad Najam:]

Awesome. Thank you. And one last question for Beth if I may, Beth just related to Alex's question, given that two thirds of your folks in China are back to work, what's the full OpEx impact of that? Is there – I see that your OpEx is coming in at about 26% at the midpoint of your revenue. What will be the true normalized OpEx run rate?

[Beth Eby:]

So the difference in our OpEx Q1 that I mentioned was a $1.5 million credit for a license sale that we did. There's no impact on OpEx in – because most of our OpEx is salaried. We do have a little bit of change on DL. Our direct labors cost of sales and that's all it's baked into our gross margin forecast.

[Fahad Najam:]

Thank you so much for the answers. Appreciate it. That's all for me.

[Tim Jenks:]

Thanks Fahad

[Operator:]

At this time, we have no further questions in queue. I'd like to turn it back to Tim Jenks for closing remarks.

[Tim Jenks:]

Thank you very much for your interest in NeoPhotonics. We appreciate the diligent work of our employees and also of our suppliers to drive our progress and we look forward to updating you in the future. Have a good evening.

[Operator:]

This concludes today's call. Thank you for your participation. You may now disconnect.