NeoPhotonics Corporation
Q2 2017 Earnings Call Transcript

Published: 4 Aug 2017

[Operator:]

Welcome to the NeoPhotonics 2017 Second 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. The webcast will be available on the event calendar page of the NeoPhotonics website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations.

[Erica Mannion:]

Good afternoon. Thank you for joining us to discuss NeoPhotonics operating results for the second quarter of 2017 and outlook for the third quarter of 2017. With me today are Tim Jenks, Chairman and CEO, and Sandra Waechter, Interim Chief Financial Officer. Tim will begin with a review of the second quarter results. Sandra will then provide financial results for the second quarter and the outlook for the third quarter of fiscal 2017 before turning it back to Tim to provide color on market dynamics, and discuss busines0s drivers and new products before opening the call for questions. The company's press release and management's statements during this call include discussions of certain non-GAAP financial measures and information, including all income statement and balance sheet amounts and percentages other than revenue, unless otherwise noted. These non-GAAP financial measures are not prepared in accordance with GAAP and should not be considered as a substitute for or superior to measures of financial performance prepared in accordance with GAAP. These financial measures and a reconciliation of GAAP to non-GAAP results are provided in the company's press release and related Form 8-K, filed today with the SEC, and can be found at the Investor Relations section of the NeoPhotonics website. Material contained in the webcast is the sole property and copyright of NeoPhotonics, with all rights reserved. Certain statements in this conference call, which are not historical facts, may be considered forward-looking statements that involve risks and uncertainties, and include statements regarding future business results, levels of sales and profitability, subsequent events, product and technology development, capital needs and availability, 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 August 3, 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. In the second quarter, NeoPhotonics delivered revenue of $73.2 million, coming in at the upper end of our outlook range, and representing sequential growth of 4% after adjusting for the sale of our low speed transceiver product assets in the first quarter. Driving our sequential increase was strength in 100G and above shipments to customers in North America as well as a stabilization of demand in China. Ciena, our largest customer outside of China, increased to 19% of revenue in the second quarter, up from 14% in the first quarter, representing an increase of approximately $3 million sequentially. Revenue in the second quarter increased in China by $1.6 million sequentially, or 4%, excluding residual revenue in the first quarter from the low speed transceiver assets that we sold. In fact, we experienced net growth at each of our Chinese network equipment customers other than Huawei, resulting in the region being up sequentially. When similarly compared, revenue at Huawei decreased to approximately 37% of revenue in the second quarter from 41% in the first quarter, a decrease of $1.4 million, which was in line with our expectations. There are industry reports of Huawei having increasing shipment volumes in the quarter. However, our shipments to Huawei remained at muted levels as they continued working through their inventory build-up as we discussed on our last call. Non-GAAP gross margin in the second quarter was 24%. We continue to experience under absorption in our manufacturing facilities as a result of lower than planned shipment volumes to China, and we recorded some obsolescence charges on discontinued products. We continue to operate our production facilities with a focus on efficiency and with lower overhead, and we expect to be able to expand gross margins as finished goods inventory depletes with higher production and shipment volumes. As we discussed on our last call, in light of both the sale of our low speed transceiver assets and the soft business levels in China, in the second quarter we implemented a series of cost saving measures including limited restructuring actions, reducing SG&A and thinning some R&D and manufacturing overheads for legacy products. As a result of these actions, Non-GAAP operating expenses decreased nearly 20% sequentially to $24.2 million. While we made good progress on these actions and we believe the business is on good footing to realize increased operating leverage when demand levels return, we continue to see near term challenges with China visibility and forecasts. For the second half of 2017, we continue to see strong demand in regions outside of China driven by North American carriers, with continued strength in metro and DCI deployments. Within China, it is too early to predict how the full year will unfold with the transition from primarily national backbone to primarily provincial deployments. Our near term growth may continue to be restricted by the China inventory overhang as certain customers are driving their inventories lower across the board. In addition, the inventory situation may impact some of our customers who also sell to customers in China as they are similarly pressured by the inventory-related actions. While these issues may overshadow metro growth and 400G wins and related early shipments in the near term, we believe that the mid- and long-term market drivers for our business remain compelling, including in China, as they continue to build out national backbone, provincial and metro networks. I will now turn the call over to Sandra, who joined us as Interim Chief Financial Officer in May. She will provide further detail on our financial performance.

[Sandra Waechter:]

Thank you, Tim, and good afternoon. I am pleased to talk to you on this call today. I will start with the second quarter financial results and close with the outlook for the third quarter. Revenue for our second quarter totaled $73.2 million, with strength in North America and sequential growth in China, as Tim mentioned. Sales of our High-Speed Products were $59.4 million or 81% of revenue and Networking Products and Solutions represented $13.8 million or 19% of revenue. Our Non-GAAP gross margin was 24%, down from 26% in the first quarter of 2017, reflecting excess and obsolescence charges on discontinued products as well as under-absorption, given China softness. Total Non-GAAP operating expense for the second quarter was $24.2 million, a decrease of 20% versus the prior quarter, driven by the cost savings measures in the quarter Tim highlighted earlier and a sequential reduction in higher than typical audit related costs in the first quarter. Non-GAAP operating loss for the second quarter was $6.7 million, or negative 9% of revenue; an improvement of $4.5 million from a negative operating margin of 16% in the first quarter. Non-GAAP net loss in the second quarter was $6.6 million compared to a loss of $10.7 million in the first quarter. Based on a fully diluted share count of 43.2 million shares, this translates to a Non-GAAP loss per share of 15 cents compared to a loss of 25 cents per share in the prior quarter. For the second quarter, Adjusted EBITDA was breakeven at $0.0 compared to a loss of $5.2 million in the first quarter of 2017. I will close out my discussion of the second quarter income statement with a review of our GAAP results. Second quarter gross margin was 23%, down from 26% in the first quarter of 2017. Operating expense was $26.5 million compared to $30.4 million in the preceding quarter. Recall that the prior quarter operating expense included a one-time gain on sale of our low speed transceiver assets. Operating loss was $9.7 million for the second quarter, which included approximately $0.3 million of amortization of acquisition-related intangibles, $1.9 million of stock-based compensation expense and $0.7 million of restructuring charges. Net loss was $9.3 million for the quarter, improving from a net loss of $11.5 million in the prior period. Geographically, our revenue mix for the second quarter, excluding low speed transceiver product revenues from the first quarter, was as follows

[Timothy Jenks:]

Thank you, Sandra. Long term market dynamics driving growth in high speed optics remain robust. As a company, we are focused on high speed telecom and data center markets and applications, and the drivers we see for these include

[Unidentified Analyst:]

And then Sandra, maybe you can help us understand the continue declining in gross margin in the quarter and also on guidance. Given the sequential revenue line improvement, and what we think is the liners suite of products following the spin of your low speed business. Are we seeing a sequential improvement in gross margin?

[Sandra Waechter:]

So I think I heard a couple of questions there. One is related to our Q2 gross margin relative to Q1. And that different is largely attributable to excess and obsolescence charges on discontinued products which we view as an anomalously event. And the second is related to under absorption in China. As we noted, there have been an increase in our inventory level and the capitalized under absorption will flow into our Q3 margin which does put our Q3 margin into perspective.

[Unidentified Analyst:]

Let me make sure I understood. The excess on absolute charges, is that also embedding into your non-GAAP gross margin?

[Sandra Waechter:]

Yes, it is.

[Unidentified Analyst:]

One last one on products. The multicast switch business team and are you still on track to double your revenue contribution for this business in 2017? And then we’ve been hearing from market analyst that China is looking to deploy CDC ROADMs using WSS rather than multicast switches for the contentionless functionality. If this is something that you’re also seeing and if so, how this impact what we originally thought could be an incremental business for you?

[Timothy Jenks:]

So the first part of the question is, are we on track. Generally we are on track. Although part of our forecast had been increases in China that at the moment are looking later in the year. So it will be close as to whether it doubles year on year. Secondly, with respect to the deployments in China for CDC networks, those are expected to use both WSS and multicast switch. The multicast switch really offer the lower cost and better performance alternative. And essentially, the expectation is those installations, as they go to CDC, will be using multicast switches which we have developed and qualified for use in the China networks.

[Unidentified Analyst:]

So you’re not seeing a slowdown in adoption in China because they are awaiting for CDC ROADMs based on WSS rather on multicast switches for the contentionless functionality.

[Timothy Jenks:]

Yes. We're not seeing any slowdown at all in that sense. But be mindful that most of our multicast switch shipments thus far have been really to North American carriers, notably the Verizon supply chain. And so from that level, the China business would be increasing total demand from the primarily North American deployments thus far.

[Operator:]

And next we’ll take a question from Alex Henderson from Needham and Company.

[Alex Henderson:]

So I was hoping if you could talk a little bit about the inventory situation. I was under the impression that the trajectory of business fairly flat on an absolute demand level. But the inventory was drawing down over the course of the June quarter. And as a result would clear at some point during the third quarter, and that ultimately the gap from the level of revenues you're generating to the real level of demand in the field that you would recover to the real level of demand in the field. And that that inherently would be sequentially up revenues even in a flat demand environment. Is that what's occurring here, or just at a lower rate of change between the two quarters? Or do you expect the inventory to continue to be a drag into the fourth quarter? When do you think the inventory actually clears out at most of your vendors - customers?

[Timothy Jenks:]

The situation as you stated I think is – quite reflective of what actually is going on. So we’ve seen inventory clear on some products but not all and that's indicated by just kind of take up levels by customers on certain products. As I said in the prepared remarks we saw for example in our largest customer we think their shipments in the second quarter were higher than our reflected shipments to them in the second quarter. And then as we look across the customers and their build rates for the year things do increase through the remainder of the year. So it's hard to say doesn't happen in July or does it happen in August we have seen some products where the take up rates have picked up so we think those are largely clear, but we don't think it's completely over. Then for our business we have some amount of increase in finished goods inventory through that period of time. And so we have to work through that ourselves through the remainder of the year.

[Alex Henderson:]

So is there a change in your expectation in terms of the rate of when that inventory clears from say where you were thinking mid or late the second quarter versus where you are now is there anything changed in your thinking or it’s just the processes – extended processes it just takes time?

[Timothy Jenks:]

It is a little bit later and lower than I expected this time a quarter ago and I think that reflects in our outlook. So I think it's pushed out a bit and that is largely because of the situation with China Mobile and China Telecom as I addressed in the prior question set. That said our customers in China notably Huawei a significant portion of their business is not dependent on the China carriers. And so we have a continued amount of vendor managed inventory pools through the course of the quarter and we’re following that closely. So I think the timing month-to-month for a given product is difficult to predict, but I think we’re probably down to one or two months before it's largely cleared as you say.

[Alex Henderson:]

So just going back into the broader question of your inventory so how long do you think it takes for you to clear out what you've got in terms of excess inventory that will then allow you to start to get the rebound in your gross margins on a volume production basis?

[Timothy Jenks:]

Well I think we send in the prepared remarks that we expect to have continuing on absorption through the end of the year and that is the case because of both the amount of inventory and the level of demand. So really through the third and fourth quarter.

[Alex Henderson:]

So I’m trying to separate between the two as opposed to just simply unabsorbed overhead because you've got unutilized production versus you actually drawing down inventory this in your stocks?

[Timothy Jenks:]

We don't really expect I think Sandra said in her remarks that we don't expect much change in the inventory or therefore in the gross margin in the current quarter for that reason but okay.

[Operator:]

Our next question will come from Tim Savageaux with Northland Capital Markets.

[Tim Savageaux:]

Couple questions and forgive me if I have I missed some of those commentary upfront, but you seem this time fairly modest decline in China in the second quarter and obviously some strength, significant strength in the rest of the world. I wondered did you provide kind of any similar metrics for the extent you’re looking at flattish Q3 can you provide any quantification about sort of the extent of the decline in China if there is one versus any potential strength in the rest of the world?

[Timothy Jenks:]

Yes, we didn't provide any outlook for the geographic mix although as we did say the business in China did decrease – or actually the business in China sequentially increased the business that Huawei decreased net-net the region increased. So we’re feeling that we have seen a stabilization in the demand levels in China but we do need to see these standards and the provincial and Metro builds roll through as a result, but we’re feeling that – we have seen a bit of stabilization.

[Tim Savageaux:]

So you’re now looking for sort of incremental downtick in China more kind of flattish in both regions I guess China and rest of the world?

[Timothy Jenks:]

Yes, but I’ll be careful in answering that Tim because customer-by-customer it maybe not be the same. So you just as we saw the second quarter up China as a region we did see our largest customer down. And so the third quarter has limited visibility and it’s exacerbated by the inventory situation. So it's really hard to predict with high confidence.

[Tim Savageaux:]

Understood second question you had mentioned a couple of measures to address the cash situation and the balance sheet including some borrowings I wonder if that includes potential monetization of real estate assets and as you can discuss the potential value there and any opportunities to unlock that value?

[Timothy Jenks:]

So NeoPhotonics owns real estate in both Japan and China. So if you're referring to those.

[Tim Savageaux:]

Yes.

[Timothy Jenks:]

We have the ability to leverage that in terms of debt we don't have current plans for selling those assets.

[Tim Savageaux:]

Can you estimate at all what kind of capacity you might have there?

[Timothy Jenks:]

Well let’s see I would expect that the range of value is approaching $50 million but not significantly above that.

[Tim Savageaux:]

And final question, do you think the company can achieve breakeven and look you can define that how would you like earnings, EBITDA, free cash flow in the fourth quarter?

[Timothy Jenks:]

So I’ll let Sandra to comment on this in just a second, but I think at the end of 3rd March we did point out that on EBITDA basis we were breakeven as currently reported in the second quarter, but Sandra you want to talk about this one.

[Sandra Waechter:]

Absolutely Tim as mentioned we were breakeven in the second quarter on an adjusted EBITDA basis and we would expect to be positive on an adjusted EBITDA basis for both the third and the fourth quarter of this year.

[Tim Savageaux:]

And just to reiterate and you do expect capital spending to come down to that kind of single-digit millions type level in Q4?

[Sandra Waechter:]

I would say we maybe low double-digit in Q4.

[Operator:]

[Operator Instructions] Our next question will come from Dave Kang with B. Riley.

[Dave Kang:]

Just can you go over, I missed your comments about Comerica and Japan and also borrowing in China, can you just go over some of those numbers once again?

[Sandra Waechter:]

Certainly, so at this point in time we have borrowed $20 million from Comerica on our $30 million facility and we have borrowed $17 million from Civic in China and then we have capacity on that civic line up to $39.2 million and we have additional capacity of approximately $17.7 million from Shanghai Pudong in China.

[Dave Kang:]

Got it.

[Sandra Waechter:]

Does that answer your question?

[Dave Kang:]

Yes but then you said something about Comerica end of August and Japan due like September-October. Can you repeat those dates again?

[Sandra Waechter:]

Yes, absolutely. The Comerica line expires on August 31, and the Civic line is due for its renewal on September 30. So we have two lines that are up for renewal in the third quarter. And as I previously mentioned, we are talking to all parties about potential expansion and of course, an extension of our capacity.

[Dave Kang:]

I don’t know if you guys talked about backlog. Can you just talk about how your backlog has behaved this year?

[Timothy Jenks:]

The most important thing, Dave, I think with respect to backlog is, we do note in the current quarter, for example, that 37% of our revenue was the Huawei and on a geographic basis, our exposure to China on a regular basis is in the vicinity of 50%. Most of that business is served by vendor managed inventory or versions of vendor managed inventory, and a result that is a more forecast based and backlog based. It's also worth noting that of our top five customers, in fact, all of them have versions of vendor managed inventory. So we do see ups and downs overall in our backlog. I think from the end of the fourth quarter through this year as you asked, our backlog actually came down a bit because certainly the China business is not all VMI. And so that business did come down a bit. But we have seen some level of stabilization, but the specific backlog that would exclude the largest customers and largest China customers isn't necessarily reflected in the full business.

[Dave Kang:]

And regarding inventories, any risk of write-down? I mean whatever the amount.

[Timothy Jenks:]

One of the things that Sandra talked about is the fact that we did have some [E&O] reserves that we took this quarter. We look at that some carefully, and Sandra might want to comment on that, but we do look at it some carefully and we do it really with respect to what is the current outlook. So if the outlook has adjusted, we adjust accordingly. So I don't think there's an increased risk if that's what you're asking.

[Dave Kang:]

And lastly on cost savings program. So OpEx came down, sounds like it’s still ongoing. Can you quantify maybe for what duration/timeframe we’re talking about?

[Timothy Jenks:]

Sandra, you want to talk about that?

[Sandra Waechter:]

So I would say that OpEx controls are in place, and we are always monitoring our OpEx levels. We would expect that we will see fairly tight spending controls in the third quarter and potentially into the fourth quarter. It really is dependent on our visibility with our various customers around the world.

[Timothy Jenks:]

Dave, you may or may not have heard the comments on the call. But from the first quarter to the second quarter, our OpEx actually did drop by about 20%. Sandra recalled the fact that we recorded a gain in the first quarter. But nonetheless, we dropped 20% in OpEx. So I think we've been reasonably effective. And then as we anticipate seeing some level of pickup in demand, we think that that would help quite a bit with the operating leverage going forward.

[Operator:]

And that does conclude our question-and-answer session for today. I'd like to turn the conference back over to Tim Jenks for any additional or closing remarks.

[Timothy Jenks:]

Thank you very much, Melissa. I want to thank everyone for your time and interest in listening to the conference call with NeoPhotonics today. We look forward to talking to you on our next call. Good bye.

[Operator:]

That does conclude our conference for today. Thank you for your participation. You may now disconnect.