NeoPhotonics Corporation
Q1 2017 Earnings Call Transcript

Published: 5 May 2017

[Operator:]

Welcome to the NeoPhotonics 2017 First Quarter Conference Call. This call is being webcast live on the NeoPhotonics event calendar webpage at www.neophotonics.com. This call is the property of NeoPhotonics and any recording, reproduction or transmission of this call without the express written consent of NeoPhotonics is prohibited. You may listen to a webcast replay of this call by visiting the event calendar page of the NeoPhotonics website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations, Investor Relations for NeoPhotonics.

[Erica Mannion:]

Good afternoon. Thank you for joining us to discuss NeoPhotonics operating results for the first quarter of 2017 and outlook for the second quarter of 2017. With me today are Tim Jenks, Chairman and CEO, and Ray Wallin, Chief Financial Officer. Tim will begin with brief comments on the first quarter and then discuss market dynamics currently impacting the second quarter. Ray will then provide financial results for the first quarter and the outlook for the second quarter of fiscal 2017 before turning it back to Tim to provide further detail on recent business before for opening the call for questions. Material contained in the webcast is the sole property and copyright of NeoPhotonics, with all rights reserved. Certain statements in this conference call, which are not historical facts, may be considered forward-looking statements that involve risks and uncertainties, and include statements regarding future business results, levels of sales and profitability, subsequent events, product and technology development, customer – excuse me, customer demand, inventory levels and economic and industry projections. Various factors could cause actual results to differ materially. Some of these risk factors have been set forth in our press release dated May 5, 2017 and are described at length in our annual and quarterly SEC filings. Now, I will turn the call over to CEO, Tim Jenks.

[Timothy Jenks:]

Thank you for joining us today. As we discussed on our prior call, we are pleased that our Q1 marked a milestone in our transition to a purely high-speed company with our focus on 100 gigabit and above, as networks move to 400 gig and 600 gig. Following the sale of our Low Speed Transceiver assets and with slowness in China, revenue was in line with our outlook at $72 million, quarterly shipments in the China region excluding low speed products were down approximately 40% versus the prior quarter in contrast to the growth in our business outside of China approaching 10% sequentially. Demand was very strong in China with overly optimistic forecasts entering 2017. A leading customer there accumulated significant inventory as a result. But as we discussed on our call in mid-March, demand dropped precipitously as they moved to rapidly adjust their outsized inventory to align with their production, given that expected China tenders had not materialized. I will return to this topic shortly. Coupled with these demand dynamics, our revenue performance in Q1 additionally reflects the seasonal impact from pricing, Chinese New Year and other factors as we have discussed on prior calls. Gross margin was 26% adversely impacted by unfavourable direct material procurement costs from a major contract manufacturing partner, a mix shift due to the customer - the China customer inventory, plus underutilization on lower volumes in our own plants.] The inventory overhang and customer actions to reduce it in turn reduced our Q1 outlook and will similarly impact our Q2. Notably some products with elevated levels of inventory are also among our higher margin products, such that during the period of burning off this inventory our margins are being adversely affected. We have queried direct NEM, Network Equipment Manufacturer customers and their telecom carrier customers in China and things remain slow though anticipating subsequent near term tender awards from China Mobile. We expect the national backbone business will go to existing vendors without major announcements and that provincial business will be new awards from China Mobile, as well as from China Telecom and China Unicom as the year progresses. As noted previously, we believe that the total annual port volume will be up from 2016 levels, though given tender delays thus far and with limited visibility, we expect our second quarter will be only modestly up as the significant China inventory overhang is reduced and with continuing growth in the West. Recall also that a meaningful amount of our shipments notably including those in China are from VMI, Vendor Managed Inventory. So we do not recognize revenue until our customer pulls it for use from their warehouse and provides us notification. This is different than sales and shipment by purchase order wherein delivery and recognition timing is set at the time the purchase order is placed rather than VMI where revenue recognition timing remains in the customer's control until fulfilment. We believe that in China the pulls against VMI are a very strong indicator of current customer demand. As such, such VMI planned pulls from leading Chinese customers are slow in the current period and are expected to continue that way until new tenders are awarded and their inventory depletes. That said, the finished goods in VMI is committed for sale to the end customer within a contracted period at which time the customer must take it. We saw both the build of inventory and the coming China market softness in early March and we discussed this on our last call. We now anticipate continuing China softness through Q2 as they consume inventory, followed by a stronger China market in the second half of the year as new provincial tenders are awarded and our Chinese customers increase their pulls on both our production and our higher than normal end of quarter finished goods inventory. This will lead to a normalized product mix and gross margin. Again, the overall forecast for port deployments in China are higher for 2017 than 2016 and are similarly expected to be higher in 2018 than this year. The overall demand picture and the strength of the China market remains intact. China continues to build 100 gigabit capacities, to extend such capacities to smaller cities and provinces, and they are now looking forward as 5G installations in certain cities are being planned. Shifting to the datacenter market, we are supplying key components into module supply chains, and due to the continuing demand we're experiencing we are steadily increasing output. This market contributes roughly 10% to 15% of our revenue. In light of our current visibility, we believe we're taking prudent steps in managing the business. Following the sale of our Low Speed Transceiver assets and with continued slowness in the first half of this year, we're implementing several cost savings measures, including limited restructuring actions, reducing SG&A, and thinning R&D in legacy areas. By addressing our operating expenses for the year, we expect to realize increased leverage as demand returns, as Ray will detail shortly. That said, we have production capacities in place to serve what we expect to be a stronger second half of 2017 compared to the first half. So I'll now turn it over to Ray to provide further detail on financial performance.

[Raymond Wallin:]

Thank you, Tim, and good morning. Before I provide financial details, since this will be my last conference call at NeoPhotonics, on a personal note, I want to thank my team for the accomplishments we've made in the last three years, including buildout of our global finance organization. I have enjoyed working with the many talented and committed individuals at NeoPhotonics. Revenue for the first quarter totalled $71.7 million, which as we discussed on our last call was lower due to the sale of our Low Speed Transceiver assets in January and the slowness we are seeing in China, which Tim discussed. Related to our Low Speed Transceiver assets, as a reminder these products had revenue of approximately $63 million in 2016 and contributed roughly $1.5 million to revenue in Q1 for shipments in the first two weeks of the quarter prior to the close of the transaction. Sales of our high speed products were $58.7 million or 82% of revenue and networking products represented $13 million or 18% of revenue. Now revenue excluding the divested low speed products of $1.5 million for the first quarter was $70.2 million. Our non-GAAP gross margin was 26% down from 33% in the first quarter of 2016 and down from 30% in the fourth quarter as Tim explained. Total non-GAAP operating expense for the first quarter was $30.2 million, an increase of 14% versus the fourth quarter. Now this reflected some period costs and higher annual audit costs in the first quarter. Now these factors will not be continuing costs. Non-GAAP operating loss for the first quarter was $11.3 million or 16% of revenue, down from an operating margin of 6% in the fourth quarter. Non-GAAP net loss in the first quarter was $10.7 million based on a fully diluted share count of 42.6 million shares. This translates to a loss per share of $0.25. For the first quarter, adjusted EBITDA was a loss of 5.2 million. I will close up my discussion of the first quarter income statement with a review of our GAAP results. Our first quarter gross margin was 26% down from 28% in the fourth quarter, including a $2 million gain on the sale of the low speed product assets, operating expense was $30.4 million. Operating loss was $11.9 million for the first quarter, which included approximately $0.4 million of amortization of acquisition related intangibles, $1.9 million of stock based compensation expense, $0.3 million in restructuring charges and $0.1 million of costs related to divestiture of our Low Speed Transceiver product assets, along with the gain on the sale of low speed transceiver product asset of $2 million. Net loss was $11.5 million for the quarter, down from net income of $2 million in the prior period. Geographically, our revenue mix for the first quarter was 17% in the Americas, China was 54%, Japan was 5% and the rest of the world was 24%. Note that these figures are based on shipment destination, not the end use destination. Further the sale of our Low Speed Transceiver products appreciably lowered our percent of revenues from China. We had 2, 10% percent or greater customers in the first quarter of 2017. Ciena comprise approximately 14% of our total revenue, flat with a fourth quarter. And Huawei Technologies and its affiliate Hi-Silicon Technologies together comprise 41% of our total revenue compared to 53% in the fourth quarter and 50% of our total revenue, excluding low speed products for that period. Now a full reconciliation of our GAAP to non-GAAP numbers for the quarter is included in our press release. Going forward as Tim described, we are implementing a series of cost saving measures in light of both our sale of Low Speed Transceiver product assets and due to the current outlook from China. Now these changes include rationalizing the number of our product lines, reducing our real estate footprint and making certain staffing reductions in line with the elimination of our Low Speed Transceiver product line. Now we believe we will save on the order of $6 million to $9 million in annualized operating costs and we are looking further for areas to increase savings as the year progresses and we expect the full quarterly impact of our cost reduction actions to be realized by Q3 and we expect to record a pretax charge of a range of approximately $0.7 million to $1 million for severance costs in Q2. And we're seeking to continue with limited critical hiring to ensure our key R&D developments - move a pace and to maintain our production capabilities to respond to any upside. Now turning to the balance sheet, we finished the quarter with $91.5 million in cash, cash equivalence and restricted cash, down from a %105.6 million at December 31, 2016. Our restricted cash at March 31, 2017 was $3.7 million. Accounts receivable was $70.9 million, with days sales outstanding at 89 days. Net inventory was $69.2 million with 117 days of inventory on hand. Our capital expenditures were $17.6 million in the first quarter and depreciation and amortization was $6.2 million. As a reminder, we are very well along in our previously announced capacity expansion plan and to this end with both progress to date and with China overhang, we anticipate returning to our normalized CapEx of 6% to 8% of revenue in the second half. Now before I discuss our revenue and earnings outlook for the second quarter of fiscal 2017, I want to once again 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. Now as Tim noted, we expect our second quarter revenues will be only modestly up after excluding low speed product revenues for the reasons we have discussed. We are not seeing an increase in gross margin, primarily because of the temporary adverse mix impacts with low volumes on higher margin products, largely the result of China's inventory overhang. In addition, during recent quarters we have added net capacity resulting in higher depreciation costs on flat revenue in Q2. At the same time, production yields have largely normalized, so that we expect to continue increasing output with increased demand in the second half as we continue production levels in line with our customer forecast. At this point, we anticipate demand growing late in Q2 as there are some current indicators for this timing. So given these factors, the company’s expectations for the June 2017 quarter are, revenue in the range of $68 million to $74 million, non-GAAP gross margin in the range of 23% to 26%, GAAP diluted net loss per share in the range of $0.26 to $0.34 per share and non-GAAP diluted net loss per share in the range of $0.19 to $0.26 per share. Now these numbers are reflective of approximately $43.3 million fully diluted shares. I'll now turn the call back to Tim.

[Timothy Jenks:]

Thank you, Ray. As I noted earlier, we believe that demand for 100 gigabit and beyond products will be stronger in the second half of 2017 than in the first half. The market dynamics driving growth in the optics market and which we have discussed on previous calls remains very robust. The China market is a timing issue related to the transition from national backbone deployments to provincial backbone and Metro deployments and related to the accumulated inventory overhang. Worldwide Metro and Datacenter Interconnect 100 gigabit coherent deployments continue to grow and now exceed long haul levels by ports. CapEx by web scale content providers remains robust, with multiple mega data centers planned are under construction, resulting in high demand for short reach and long reach 100 gigabit client optics modules and components. 100 gig is now standard and all line side and client side applications and networks are moving rapidly to 200 gig and 400 gig with 600 gig on the horizon for Datacenter Interconnect fat pipe applications. This is important as we believe we are well-positioned to serve these growing 400 gig and beyond markets with both new products and expanded capacity. In line with these drivers, over the last few months we announced a number of exciting new products which will accelerate our growth in 2017 and beyond, targeting growth in Metro, provincial China backbone and Datacenter Interconnect networks is our pluggable coherent CFP-DCO module which supports for 100 gig and 200 gig utilizing 16 QAM modulation. For high capacity Datacenter Interconnect and Flex Coherent Metro markets, we demonstrated our 64 - 64 CFP2-ACO pluggable module capable of single wavelength 400 gig and 600 gig connections with a baud rate of 64 giga baud and supporting up to 64 QAM modulation, which means it could handle all data rates from 100 gig up to 600 gig. We also announced a partnership with Ciena to develop, manufacture and sell a new single wavelength 400 gig, 5 by 7 inch transponder utilizing Ciena's wavelength, WaveLogic Ai DSP chipset. Together these products comprise a suite of 400 gigabit modules supporting a full range of modules and applications in key growth market segments. Supporting our models, we also introduced and demonstrated a new 64-gigabaud micro modulator with integrated drivers designed for use in such CFP2 and smaller coherent module applications and providing data rates of 400 gigabit and faster. This is important as our new micro modulator completes our full line of coherent components for 400 gig and beyond and it fulfils all the performance requirements for the most demanding high-speed coherent transmission applications, including high bandwidth, low power consumption and very small size. Adding this modulator to our portfolio expands our total addressable market or TAM by an estimated $400 million. Continuing our focus on switching for colorless, directionless and contentionless or CDC network architectures suitable for SDN networks. We introduced the new 8x6 multicast switch and we continue to innovate on this front as we are working with each of the leading systems companies who support the most advanced DTC network architectures. For applications inside the datacenter, we introduced our new non-hermetic laser rays to drive short reach silicon photonics based interconnects and modules notably in PSM 4 and CWDM, QSFP28 modules. Finally, we announced our new low power consumption 28 gigabaud EML laser with integrated driver, designed for LR and ZR reaches at 100 gig, 200 gig PAM4 and 400 gig PAM4applications. We also demonstrated our 400 gig CFP8-LR8 pluggable module and we anticipate that our next generation 56 gigabaud EML laser's which can transmit at 400 gigabit data rates using only 4 lasers. Again, utilizing PAM4 should see deployment the following year and will enable even smaller DD-QSFP and OSFP modules for 400 gigabit datacenter use. The mid and long-term market drivers for our business remain compelling. China remains committed through the China broadband 2020 initiative to continue build out of the national backbone network and expand build outs in 100 gig provincial and Metro networks. As we've noted, our OEM customers in China expect these actions to increase the number of 100 gigabit ports in China in 2017 over 2016. So with deployments being anticipated to ramp in the second half of the year. In North America we continue to see strong demand driven by North American carriers with continued Metro strength at Verizon and AT&T and growing DCI deployments. Finally, before opening up the call for questions, I would like to thank Ray Wallin for the contributions he made in NeoPhotonics over the last three years. Leveraging his expertise, Ray played an important role in building strength in our finance organization, and has added to the strength of the company's financial position. We wish him success with his future endeavours. This concludes our formal comments and now I'd like to ask the operator to open up the line for questions. Matt?

[Operator:]

Thank you. [Operator Instructions] And we will take our first question from Simon Leopold with Raymond James.

[Simon Leopold:]

Great. Thank you very much for taking the question. I want to just get a couple of housekeeping nuggets [ph] out of the way if I might first, and then get into real questions. Just CapEx in the quarter please?

[Raymond Wallin:]

$17.6 million.

[Simon Leopold:]

$17.6 million. And you indicated trending back down in the second half of the year. What do you expect for the second quarter?

[Raymond Wallin:]

Let’s see here. Well it's going to trend down slightly, Simon to about 15, and then in the fourth quarter it drops off - second quarter we were up 15, third and fourth quarter drops off precipitously.

[Simon Leopold:]

Okay. And then I don't believe you gave us the typical segment breakdown between the networks in 100 gig and above?

[Raymond Wallin:]

Well I'd say the 2% on the high speed and 18% on the network solutions.

[Simon Leopold:]

Okay, great. Thank you. Sorry if you gave that, I missed it.

[Raymond Wallin:]

Okay.

[Simon Leopold:]

And then in terms of kind of what's going on with the gross margin and the cost reductions, a couple of questions sort of trying to understand that. So a little bit surprised about the gross margin weakness here particularly relative to the forecast for this quarter. So one of the things I'm trying to understand is how much is fixed asset, how much is underutilized staff. Is there any way to give us a little bit of color between those two factors and maybe the metrics of where your headcount is and where it could go?

[Raymond Wallin:]

So if you look at the gross margin in Q1, you know, 26% versus Q4, call it 30% on a non-GAAP basis. You know if we kind of bridge that, it's about 2 points from the material cost that we talked about prior, it is about a point from utilization, about a point from mix.

[Simon Leopold:]

Okay. And where is your head count on the quarter?

[Raymond Wallin:]

So we have as a total company we had 1,951 people. We could give you a breakdown by function if you like, but it’s you know, roughly 2000 for us at the whole company.

[Simon Leopold:]

And where do you expect to be at the end of Q4?

[Raymond Wallin:]

You know, I think - the number of - the total number of people Simon includes deal that varies by production levels, so it's hard to say. We don't have a quarterly forecast of headcount.

[Simon Leopold:]

Okay. Well, I guess what I'm trying to get at is making sure I get comfortable with where OpEx is going in terms of restructuring, but roughly speaking if your operating expenses pro-forma are about $30 million this quarter, we should be thinking that December should be in the neighborhood of $28 million, is that correct?

[Raymond Wallin:]

No actually Simon, it is going to be substantially less than that. I would say that by the time we get to the fourth quarter of 2017 on a non-GAAP basis, our OpEx will be closer to $25 million to $26 million probably on the lower side.

[Simon Leopold:]

Okay. That’s very helpful. Thank you. And then I want to come back to the inventory topic, and I'm sorry for taking so much time here, but so many moving parts in the space. In the past, I think many of us have had the impression that the use of vendor managed inventory would reduce the risk of inventory buildup and that does not seem to be the case. So I understand things age out of the VMI hubs and get shipped to the customer anyway. So there's some risk. But could you help us bridge and get comfortable with why vendor managed inventory didn't address the idea that inventory could get built up in the channel?

[Timothy Jenks:]

Yeah. This is Tim. Simon, I think it's - with the things going on right now, it's particularly important point. So the existence of vendor managed inventory at certain customers means that they have strong control over a certain amount of inventory that's actually in their warehouse, and therefore they are able to meter that with their production demand rather than continuing to receive product that they may have ordered in prior months or even quarter, that is due for delivery and will be delivered whether or not they have the production demand to take it. So with VMI in this particular situation, there is less inventory buildup. In fact, you know, in the VMI hub that is a difference. So I think we noted the demand situation actually on our last call and that it had you know, began to see it in very early March, and ultimately that's an ongoing conversation with the customer not only how much inventory might be in hubs, but also what their intentions are to use it or to pull it. So ultimately going forward that same pattern will play out as production levels increase or fluctuate over time.

[Simon Leopold:]

Great. And one last just trending question. It sounds if the market and industry are shifting more quickly than some had expected from CFP form factors to QSFP28 form factors and that may be reflective of what's going on in web scale and not just the telco side of the world. Can you help us understand your positioning in this and your view on that market transition? Thank you.

[Timothy Jenks:]

Okay. The QSFP market of course, we're referring significantly to both the data com and the client side in the CFP2 we're referring primarily to the - CFP and CFP2 we're referring primarily to the client side. We sell components at both. But you know, while there is continuing CFP and CFP2, the growth rate in the QSFP28 is considerably higher, so there is a shift in the preponderance of production moving to the QSFP28. And that is consuming a greater portion of the components as well. Does that get to your point?

[Simon Leopold:]

A little bit, but - so are you - do you have any products in the QSFP28 market or are you just selling components into others who make QSFP28?

[Timothy Jenks:]

We sell components to others who make QSFP28, that's correct.

[Simon Leopold:]

And how material is that within your business?

[Timothy Jenks:]

In my comments, I noted that you know, overall this is in the range of 10% to 15% of our revenue.

[Simon Leopold:]

Okay. Appreciate it. Thank you for taking so many questions.

[Raymond Wallin:]

Yes, Simon, one point, just adjusting for the sale of our low speed products, you had asked the question about high speed versus network products and solutions and with that adjustment its actually closer to 84% and 16%, okay?

[Simon Leopold:]

Great.

[Raymond Wallin:]

Thank you.

[Timothy Jenks:]

Thank you, Simon.

[Operator:]

And we will now hear from Richard Shannon with Craig-Hallum.

[Richard Shannon:]

Hi, guys. Thank you for taking my questions as well. Maybe I'll follow up on of those and this is partly borne out by a comment, Tim I heard in your prepared remarks and other one that I might have heard as I was a bit distracted during early part here. But the comments that I heard, I think I heard you say is that you're expecting demand to improve late in the second quarter and I think you're referring to China. And I'm wondering about your earlier comments about the VMI hub whether there's any relationship there. So I guess maybe I'll just start with the first part of that which is, can you help us understand what you mean by expecting demand improve late in the quarter?

[Timothy Jenks:]

Well, yeah, because the indicators that we see are actually production rates and current production rates are actually now up from the first quarter. So when we're referring to China and in particular large customers in China, what we observe is what the inventory is and the pull rates are. So notably through the first quarter there was an accumulation of inventory and there was a relatively low production rate that caused the inventory to move up quite a bit. And this is primarily key technology products, and in early March that situation precipitously changed where customer forecasts precipitously dropped such that they were not going to pull the remainder of the quarter and that was reflected when we did our call in mid-March. What we see now is higher production rates than at that time and we're also seeing that inventories are being bled off, they are diminishing. And so ultimately with the other element in this somewhat complex puzzle is the fact that the move from national backbone networks to provincials means that big announcements about tenders diminish. So when there's a national backbone tender award it's centrally announced and better known and what we're seeing is some feathering in of provincial awards, awards that are smaller in size and you know with less headlines. And so it becomes a bit more important to pay attention to the production rate and the use of inventory.

[Richard Shannon:]

Okay. So just to be clear, is this expectation of ban improving the second - late in this quarter is that either the direct comments from your customers or more calculations by you using that production rate and where are the level of the inventory in the hub sits right now?

[Timothy Jenks:]

It’s actually customer comments.

[Richard Shannon:]

Okay. That’s helpful. Time, I think you mentioned that in the first quarter China was down 40% sequentially, where the rest of the world is up 10% did I hear that - those comments correctly?

[Timothy Jenks:]

You did.

[Richard Shannon:]

And so what's baked into your guidance for the second quarter for both those geographical segments?

[Timothy Jenks:]

We're expecting that our growth in the West is continuing. China is not in terms of our outlook.

[Richard Shannon:]

Okay. So some sort of negative number there, outside of that positive in the rest of the world then?

[Timothy Jenks:]

Yes. That’s correct.

[Richard Shannon:]

Okay. That's helpful. I guess, the third question and I'll jump out of the line here, just to touch on the gross margin topic here. It sounds like the - I guess from our perspective is lower than expected gross margin guidance for the second quarter, I think you mentioned this is in part due to mix with a lot of weakness coming from your highest margin leading edge products. It sounds like from your previous comment Tim that you expect those to pick up here with the demand late in the quarter. Any way that you want to help us think about how that inflection goes from the second quarter to third quarter on gross margins. I know you haven't given us the revenue number, but any way to bridge that forward would be helpful please?

[Timothy Jenks:]

First of all, since you just asked that question about the trending in the West versus trending in China. So as we see demand increases in China, it doesn't necessarily mean that there's an increase in shipments in the second quarter in China. And so that's reflected in our outlook. There is inventory on hand and you know while in VMI case there may be a limited amount of inventory, there nonetheless it can be lead time subsequently. So we're not - in our outlook we're not reflecting that there's an uptick in shipments in China, okay. With respect to gross margin trends, the impact of mix on margins is notable, it's significant. And you know, we had a strong fourth quarter. We were shipping products that had a more normalized mix. And that being you know pretty favourable, means that those products were then in ample supply in customer inventory. So what we have to see is, is we have to see the inventory deplete and then you know that could return. But as the demand increases we get two benefits. We get the benefits of product mix going back to normal and then we get a benefit from better absorption, better utilization on our production. So the two negatives we have right now with increased demand bring to two positives going forward. So we should go back to a more normalized gross margin.

[Richard Shannon:]

Okay. That's fair enough. I appreciate the walkthrough there. That's all question from me guys. Thank you.

[Timothy Jenks:]

Thank you, Richard.

[Raymond Wallin:]

Thanks, Richard.

[Operator:]

And we will now go to Alex Henderson with Needham.

[Alex Henderson:]

There it goes. You there?

[Raymond Wallin:]

That’s it. Yes...

[Timothy Jenks:]

Go ahead Alex.

[Raymond Wallin:]

It disappeared.

[Alex Henderson:]

Okay. A lot of noise has disappeared with the conference call as well. I just wanted to go back to the gross margin. So two 2 points from depreciation, one from utilization, one for mix is what I heard you say is that correct?

[Raymond Wallin:]

The mix is generally what I was addressing with the prior call. But you know in - let me just ask the question. It's a bit different for what we saw Q1 and Q2 i.e. what we realized versus what we're expecting. So can you direct your question Alex?

[Alex Henderson:]

The question is, what did you say about the gross margin pressure in the comments earlier. There was static on the line and I didn't hear it. Was it two points of depreciation, one utilization and one mix was that what you said?

[Raymond Wallin:]

Yeah, let me go through that Alex. You know so we had in the fourth quarter of 2016, we had a non-GAAP gross margin approximately 31%. And going into 1Q of ’17, that's about 27% percent. So it’s about 4 points there. So if I look at the factors that would bridge that difference, the major factor was in terms of material costs being higher in our outside vendor - outside production vendor that we use. Number two, is the under utilization of the factory as a result of the drop off in the revenue. And number three is aforementioned mix effects that we had. So I'd say it's one half to the material costs and quarter to the utilization, a quarter to the mix.

[Alex Henderson:]

I see. So as we look out into the back half of the year. Could you give us some sense given what you think mix is likely to do and therefore you know shifting the numbers based on say $80 million in numbers or $90 million or $100 million in quarterly revenues what does it take to get back to you know 28% or 30% or 32% gross margins without being a forecast, but rather giving some sense of when we forecast what would be the implications for margin recovery structure?

[Raymond Wallin:]

Yes. So what we modelled Alex internally you know, based on understanding our factory utilization dynamics, also understanding the mix effects that we are seeing and the reversal of those mix effects as the inventory is being bled off in the channel. And as we cross over the $100 million mark and get into the low 100s you know, I would see gross margins returning to the very low 30s. So it could be cracking you know at 30% plus gross margin at that point.

[Alex Henderson:]

Okay. That's very helpful. And so as we're looking out and I understand that you don't want to give more than one quarter's forecast, but as we're looking out, do you expect meaningful growth in the back half as things normalized and China recovers and we still see good solid growth in Datacom, as well as outside of China end markets or would you expect a more tepid kind of environment in the back?

[Timothy Jenks:]

This is Tim. There are two parts, I think that saying that the – the customer forecasts for the total number of port deployment suggests a strong rate of growth and so suggests - it's more stepwise with our VMI situation it would reflect I think quite directly to us. But that said, we have limited visibility, and so you know our outlook for the current quarter reflects our limited visibility and it reflects the reality of what we can and cannot see. In the second half, in order for Chinese customers to actually meet their forecasts, we would see a pretty significant growth in the second half. With the move to provincial tenders the visibility is diminished versus the national tenders and therefore it's harder to predict and we can't say whether it's a step increase or a linear increase, we wish we knew that. But what we can say is as volumes increase and if they if their forecasts are in fact reasonably accurate then the rate of increase could be high. You know, I don't think anybody really has greater visibility to all of the provincial plans and I think that reflects in the industry view right now.

[Alex Henderson:]

I totally understand. So just so I understand sort of the mechanics around this, if these take longer and say it bleeds into the September and later in the September quarter for some of these orders come in, does that result in the overall demand sliding between ‘17 and ‘18. I mean does that cause some of that to flush out into the first half of ‘18 analogous to you know the very late start and 2015 4Q causing an undue strength in the first half of ’16?

[Timothy Jenks:]

We would view that as, yes to your question. A couple of points on it though. You know, certainly in the case of China Mobile as an example, we have pretty clear port forecasts for ‘17 over ‘16 but also for ‘18 over ‘17. And so things that are not deployed or installed in ‘17 would roll over to ‘18. But then be augmented by the new port deployments for ‘18. So you know and then when you get late in that period then you're starting to have some views toward what 5G installations might go in subsequently. So there are a series of steps along the way and an the impact I think we face is just the transition to a lower level of visibility because of the deployments now being more diversified across the country.

[Alex Henderson:]

Going back to the inventory side of the question for a second Tim, one of your competitors made the comment that the CFO at Huawei had made a decision based on their strong growth but lack of profitability to bring down companywide inventory resulting in a more draconian inventory overhang than would have happened had that not you know that perception and that need not changed the intention to increase cash flow. Do you view that is a factor here and if that's true does that result in a tighter inventory level as we go into the back half and into ’18, which ultimately could cause things to be - you know to have a little bit more spring in them?

[Timothy Jenks:]

We have been given the same message by the same customer group I'm sure. And so it does - it is discussed as a policy change. You know, a particular large customer has announced a number of new initiatives and some of their other businesses that are likely to be requiring cash for investment. So I think that does affect their approach to overall inventory control. It would be a one-time thing you know as they as they complete an adjustment and they deplete some of their inventory. That certainly is affecting us in the current term. But then you know rolling forward we expect it to be more aligned with whatever the current demand is.

[Alex Henderson:]

One last question, then I’ll cede the floor. Can you give us some guidance on what you're thinking on the income tax line which obviously is hard for us to manage externally given the circumstances in the forecast, what should we be thinking about for the June quarter and for the full year on that line?

[Timothy Jenks:]

I think actually it's hard to give it to you on a percentage basis, Alex, why don't I follow up with an email on that just to give you kind of a guidance around the dollar numbers, I would expect.

[Alex Henderson:]

I mean, we're talking you know $0.5 to 750 kind of number in the second quarter, is that kind of the...

[Timothy Jenks:]

Yes, that’s correct. In the second quarter, yeah, 800,000 provision probably be pretty close to the - for the second quarter...

[Alex Henderson:]

Okay, perfect. That’s good. Thank you. I’ll cede the floor.

[Operator:]

And we will now go to Paul Silverstein with Cowen and Company.

[Paul Silverstein:]

Sorry, I miss the comments, I apologize. But can you revisit your non China business, I think you say it's growing at 10%. Is there any granular insight you go off for us in terms of applications, customers or regions would you say?

[Timothy Jenks:]

Sure. The business outside of China is on product perspective or customer perspective or both reasonably diverse, these are essentially a couple of different laser products, receiver products and our switch products. And each is actually sequentially up and trending up generally. So these are areas where we have added a certain amount of capacity and over time we're increasing output and that is causing the sequential increase.

[Paul Silverstein:]

And same on the Metro road and build outs outside of China. Any update you can offer us?

[Timothy Jenks:]

Well generally – so for Metro road and build outs we're referring in NeoPhotonics product lines to multicast switches and in my remarks we talked about the fact that you know we have –we’ve been shipping into the horizon supply chain over some time, we've qualified a new 8x16 product and then we have you know we think - we're now working with really each of the major CDC network players for multicast switches. So multicast switch is being used with other you know with wavelength selective switches from other companies. The multicast switch business we expect this year to essentially double over last year. Last year it was a bit less than $10 million, and this year we expected to be you know in the $15 million to $20 million dollar range we would expect And so that that is an area of growth overall, depending on deployments from carriers it could be lumpy quarter to quarter, but because of the fact that its project based, but that road [ph] deployment activity as it picks up it will also pick up in our shipments of switch products.

[Paul Silverstein:]

This quarter is a reminder, how far it is to forecast for you and everybody else in the business. That said, how much is visibility, how often are you on both the non-China business in terms of the ramp, as well as the situation in China and I recognize China is particular challenging, just given its nature, buy any thoughts you can share in terms of visibility rising?

[Timothy Jenks:]

Yeah, the first thing is the North American businesses is a steadier business, because it's been you know - it's in its third year now, it's continuing to ship in and there's a bit more visibility and a bit steadier. The China business is brand new, products have gone through field trial, testing qualification, but major deployments actually have not really rolled out yet. So you know though those are poised for growth and we see increases announced with you know some WSS deployments in China and then multicast switches tend to follow that. So we're optimistic about that for this year. But it's you small numbers yet on multicast switches. In terms of forecasting overall, I was following the discussion on switches, but now are you also asking more generally about all products?

[Paul Silverstein:]

Yeah, absolutely.

[Timothy Jenks:]

Okay. The visibility in China just isn't very good because of the transition to provincial networks where you don't get - you don't get the kinds of headlines to which we've been accustomed over the last couple of years. And we do see increasing production rates, that's good sign. But we don't have enough visibility to say how rapidly things will recover or ramp. So we're going to have to wait and see with the lack of visibility

[Paul Silverstein:]

All right. I’ll take the rest offline. I appreciate. Thanks Tim.

[Timothy Jenks:]

Okay.

[Operator:]

And our next question comes from Troy Jensen with Piper Jaffray.

[Troy Jensen:]

Hey, gentlemen. Thanks for sneaking me in here. Tim, it would be my expectation that kind of comes back slowly skew by skew. So I am just curious to know which ones do you think come back first, where is the least amount of inventory when you look across product lines?

[Timothy Jenks:]

Okay. Well, let's see, you know I think that for us coherent components are big parts of our product lines going to major Chinese network equipment manufacturers. So those things come back the fastest with the last question or I was referring to multicast switches, is those will come in sequentially with deployments and then the components that are not necessarily coherent components have continued to pace, they really haven't diminished at all in the current period. So, the thing that would step up most aggressively would be the coherent components.

[Troy Jensen:]

All right. That makes sense. And then how about maybe just stand for me at least, just a DCO update, maybe remind us where you are with respect to the number of DSP partners you have is a two or three now, and then just any update on trials or since when that ramps?

[Timothy Jenks:]

Okay. So the DSO product that we initially introduced in December is in a series of customers for qualification currently and that that product – the ones that are first the along qualification are all primarily with the single DSP partner. But there is availability from a second DSP partners as well though they're not as far along the qualification.

[Troy Jensen:]

All right. Well, that's good to me and good luck going forward.

[Timothy Jenks:]

Okay, Troy. Thank you.

[Operator:]

And we will now go to Dave Kang with B. Riley.

[Dave Kang:]

Thank you. Good morning. First on...

[Timothy Jenks:]

Hi, Dave.

[Dave Kang:]

On cash, hi, good morning. Hi, Ray. So your cash ended at $91.5 million, down from 105.6, so is that - $$91.5 million, does it include $26 million from PON [ph] sale and if so, does that imply like you guys use like $40 million during the quarter. Can you just go over that, can you confirm that first of all?

[Timothy Jenks:]

So actually the cash included a little bit less in PON sale, there was a number of things that are going on there, but let’s just call it $22 million cash in Q1. So if you had the cash there from the sale about $22 million and so that would have been included in the cash number that we that we reported.

[Dave Kang:]

Okay. So it's more like $35 million rather than $40 than?

[Timothy Jenks:]

Yeah. So it’s about a $35 million burn yes...

[Dave Kang:]

Okay...

[Timothy Jenks:]

So in that quarter if you kind of dissect the components of what is going on in the cash, so you had the overall cash reduction of about $14 million dollars. And so we had about $22 billion of cash receive from the sale, the Low Speed Transceiver business. And so then you know we probably burned about you know $36 million of cash, $18 million of that was CapEx and then $19 million was from cash flow from operations. It was a $5 million cash loss included in that 19. And then on top of that working capital change by about $14 million, principally from build up in inventory.

[Dave Kang:]

Right. So it doesn't sound like that's going to change that much in second quarter, I mean, is that a fair assumption or...

[Timothy Jenks:]

I think it's a fair assumption...

[Dave Kang:]

Any plans to...

[Raymond Wallin:]

Yeah, I think if I look at the same components for the second quarter you have about a $16 million working capital change versus the $14 million working capital change. We would have about a $3 million cash loss versus a $5 million cash loss. We have about $16 million in CapEx. We also have a new loan that we took and have taken out to fund CapEx in Japan and about $5 million first quarter. So the kind of the net number there is about $30 million.

[Dave Kang:]

The reason I ask is because you know, and you still have about $40 million-ish debt to service. So I mean, I am sure you guys are aware of the situation. So just you know can you go over the cash situation going forward. And typically how much minimum cash balance do your major customers require like, like C&I and Huawei, I mean I'm sure they must have some kind of a minimum standard right?

[Raymond Wallin:]

Well, to answer that specific question Dave, they don't for us. They don't ask us to maintain a certain level of cash. But just getting back to where we have sufficient cash, the company, the number of actions and levers that we're polling, number one is you know we are reducing expenses, which will help our cash situation as well. Secondly, CapEx number for the third quarter will be dropping a lot from the second and first quarters. As we've said we're about you know 80% of the way through our CapEx program, so that the amount of money will spent on CapEx going forward in the third or fourth quarters is substantially less. And number three is, we do it - we also have lines of credit in China that a lot of people don't focus on. But there's a another $34 billion of borrowing capacity in China that we have available as well as a $30 million credit facility with Comerica Bank that we have available. And you know as we get through the third and fourth quarters that we talked about, we would be seeing a pickup in the second half which would ultimately generate cash for the company.

[Dave Kang:]

Got it. Just a couple of more if I could, regarding the first quarter how much revenue was impacted by the yield situation and has that been fully resolved and so there is no impact from second - in second quarter?

[Timothy Jenks:]

Dave, this is Tim. There is a little bit of bleed over in the first quarter, but that's all essentially resolved at this point.

[Dave Kang:]

Okay. And what is a split between your ITLAs and receivers?

[Timothy Jenks:]

We just report that 84% is high speed, we don't divide the specific products.

[Dave Kang:]

Can I assume receivers are still bigger than ITLAs or they are passing now?

[Timothy Jenks:]

We don't divide them up.

[Dave Kang:]

Okay. All right. Fair enough. And lastly, just on from your 8-K last night. Can you just explain what this financial covenant of 50% EBITDA by end of July, and what happens if you don't meet that covenant? That’s it from me.

[Timothy Jenks:]

Yeah. So it is part our - this leads Comerica line of credit. So one of the covenants in the Comerica line of credit is that we achieved you know 50% of forecasted EBITDA. So we provide them the forecast and we have to meet half of it.

[Dave Kang:]

By July?

[Timothy Jenks:]

Well, I mean, there is a covenant's been in there since the beginning of the arrangements been. You know, it's just a standard covenant in there. So it's nothing really materially new there it's. So that's part of our normal covenant compliance with the Comerica Bank.

[Dave Kang:]

Got it. All right. Thank you.

[Timothy Jenks:]

Great. Thank you.

[Operator:]

And our next question comes from Tim Savageaux with Northland Capital Markets.

[Tim Savageaux:]

Hi, good morning. And I was...

[Timothy Jenks:]

Hi, Tim.

[Tim Savageaux:]

Can I ask a quick product question, but before I do that, I wanted to follow up on some of Ray’s working capital commentary and really ask can us more details about anticipated working capital consumption in Q2, at that point I'd imagine that inventory might come down a bit are you looking for you know, what would be a fairly dramatic increase in receivables in the quarter and what would be behind that or any other comments on your – the comment just made on working capital consumption in Q2?

[Timothy Jenks:]

So actually in Q2 what we would be seeing is receivables and inventories versus Q1 being effectively flat, I would think, revenue revenues and flat, you know, Q1 to Q2. So we see the receivables being about flat. And then the inventories are based on our production plans for the quarter and how would describe how we're maintaining the company a production readiness for the second half revenue plan that we are anticipating. So we'd see the inventories staying about the same, I believe in Q2 as well.

[Tim Savageaux:]

So we expect payables to plummet or you know how do we get to...

[Timothy Jenks:]

We're seeing - we'll see about $10 million, we’ll see some payables plummet because you know, in payables we have payments for CapEx. And so we've paid for a good chunk of that. So we would see some payables plummet. There's also some recruiting of the current liabilities we would see a change there as well. So yeah, we would definitely see some change in the payables and accrued liabilities probably about $20 million.

[Tim Savageaux:]

All right. Okay. On to the product question, I think most of them had been asked. But Tim, you did mention I think putting kind of your cloud datacenter exposure at 10% to 15% of revenue. I wonder if you might be able to provide a little more detail in terms of what sort of products or components that go into products are kind of included in that bucket and along with that maybe give us an update on CFP2-ACO, what’s your timing is there in terms of bringing that product to market?

[Timothy Jenks:]

Sure. For the first part of your question, there are a range of lasers, different configurations, different types of lasers that we sell both for modules, as well as Cypher [ph] based lasers and ultimately in many cases with drivers, the semiconductor ICs that go with these. So you know it's principally lasers and high speed ICs that are sold into this space as components. And then with respect to the ACO, the 64 64 gig ACO that will not be a revenue producer in ’17. So we should be looking out at least a year for that one.

[Tim Savageaux:]

Okay. Thanks. Very good.

[Timothy Jenks:]

Thank you very much.

[Operator:]

And that concludes our question-and-answer session for today. I'd like to turn the call back over to Tim Jenks for any closing remarks.

[Timothy Jenks:]

Okay, Matt. Thank you. I'd like to thank everyone for your time and interest in NeoPhotonics and we look forward to talking to you again on our next call.

[Operator:]

And that concludes our conference for today. Thank you for your participation. You may now disconnect.