NeoPhotonics Corporation
Q2 2018 Earnings Call Transcript

Published: 7 Aug 2018

[Operator:]

Good day and welcome to the NeoPhotonics 2018 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 2018 and our outlook for the third quarter of 2018. With me today are Tim Jenks, Chairman and CEO and Beth Eby, Chief Financial Officer. Tim will begin with a review of the second quarter and a discussion of new products initiatives. Beth will then provide financial results for the second quarter before providing the outlook for the third quarter of 2018. Beth will then turn it back to Tim for additional color on the market and business drivers 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 are not 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 Forms 8-K and 10-Q being filed today with the SEC and can be found at the Investor Relations section of 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 6, 2018 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 for joining us today. In the second quarter, NeoPhotonics delivered strong results with revenue of $81 million, coming in well above the high-end of our outlook range of $70 million to $76 million, with our revenue representing 18% sequential growth and 11% growth over the same period last year. High-speed products for data rates of 100 gigabits and beyond comprised 86% of our revenues, which were up approximately $10 million sequentially. NeoPhotonics is a leader in high-speed digital optoelectronic solutions for the highest speed communications networks and data center interconnect and telecom network applications. With our leading solutions to these markets, we are seeing broad-based demand growth. Shipments to our American and European end-customers grew approximately 30% sequentially, led by demand for our leading high-speed products used in data center interconnect or DCI as well as Metro deployments. Sequential growth in China in the second quarter was the result of deployments at the provincial level as well as exports outside of China, despite trade tensions and ongoing uncertainties there. We do not see any share shift in China due to the ZTE ban prior to it being lifted. Thus, the impact of the ban has been net subtractive from the China market. With the ban resolved, we expect additional volume tenders and overall demand growth. Coupled with our strong topline performance in the second quarter, we achieved gross margin expansion of over 500 basis points with volume growth. Our results in the second quarter demonstrate that we are continuing to make progress on both volume growth and margin expansion. In the second quarter, revenue from our top five customers increased 27% quarter-over-quarter as these key customers succeeded in the market and we had the capacity in place to support their rapid volume ramps. This is important, as communication equipment companies' market share is consolidating among a few leaders and NeoPhotonics is levered to those market leading customers. Beyond demand for our core products, in the second quarter we saw continued progress on our new product initiatives. We increased our volume shipments of high baud rate coherent receivers and ultra-narrow linewidth tunable lasers for systems operating at 400 gigabits per wavelength, which are currently being deployed in DCI and Metro applications. Further, we continued to make good progress on new product design wins and initial shipments for products for applications at 600 gigabits per second per wavelength, including our complete suite of 64 gigabaud micro integrated coherent receiver, coherent driver modulator for CDM and ultra-narrow linewidth tunable lasers. For applications inside the data center, we are now making early shipments of 53 gigabaud lasers and drivers for single wavelength 100 gigabit per second applications. These products are key elements used in 400 gigabit client side DDQSFP and OSFP transceivers, which are expected to be deployed in large volumes starting next year. In the near term we continue to ship 28 gigabaud lasers for 100 gigabit and 2by200 Gig intra-data center applications. For next generation systems, we demonstrated at the OFC conference in March our 64 gigabaud Coherent Optical Subassembly or COSA and our Nano-Tunable Laser and we are developing even higher baud rate components for the next generation of DCI and transport systems. We continued to see strong growth in our Multi-Cast Switch shipments, reflecting both strength in Metro deployments of CDC ROADMs and the increasing use of contentionless switching solutions in data centers to manage densification. Coherent DCO module revenue grew through the quarter with customer wins and as volumes doubled quarter-on-quarter. We anticipate that new China tenders will positively contribute to increases in DCO volumes. We continue to press forward on our developments for next-gen DCO modules that are complementary to our existing market as we view these to be important solutions going forward. As such, we are designing our 64 gigabaud components into next-gen 400 Gig and beyond DCO modules, as we demonstrated in March at the OFC conference. I will now turn the call over to Beth to provide further details on our financial performance.

[Beth Eby:]

Thank you Tim and good afternoon. In Q2, we met our financial metrics. Revenue is up, gross margins are improving, operating leverage is increasing and inventories met our target. As Tim mentioned, Q2 revenue of $81 million was above expectations, up 18% sequentially and 11% year-over-year, driven by robust demand in the Americas and improved demand in China. China represented 57% of our total revenue in the second quarter, down from 61% in the prior quarter due to the relative strength of demand outside of China. Shipments to the Americas represented 22% and the Rest of the World was 21%. I will continue these breakouts going forward as a better picture of geographic splits. As a reminder, we report our geographic revenue based on shipment destination. This does not necessarily match end-customer geography. For example, we ship to contract manufacturers in Mexico and Thailand for Western customers, including the majority of the customers included in the group we refer to as our Next 4. Huawei Technologies, including its affiliate HiSilicon Technologies, was our largest customer and accounted for approximately 43% of the company's revenue. Our Next 4 customers after Huawei represented 47% of total revenue, up from 36% in Q1. Our non-GAAP gross margin in the second quarter was 20.1%, up approximately 5.5 points from Q1. Within this, product margins were approximately 30%, up four points quarter-over-quarter on higher manufacturing utilization and improved costs. Other cost of sales charges of approximately 9.5% were primarily about five points of inventory revaluation on lower standard costs, this was as expected, about three points of under absorption charges, primarily in our EML fab, slightly higher than we expected and about 1.5 point of inventory write-offs. Moving to operating expenses, total non-GAAP operating expense for the second quarter was $21.8 million, down $1 million from Q1 on the timing of R&D project spends. Non-GAAP operating loss for the second quarter was $5.6 million, or negative 7% of revenue, compared to negative 19% in Q1, driven by the gross margin improvement in the quarter. In interest and other, foreign exchange gains of $0.8 million more than offset quarterly interest charges. That same foreign exchange gain drove a higher than expected forecast tax provision for the quarter. Non-GAAP net loss in the second quarter was $6.3 million, compared to a loss of $14.6 million in the first quarter. Based on a fully diluted share count of 44.7 million shares, this translates to a non-GAAP loss per share of $0.14 cents, compared to the $0.33 loss in Q1. For the second quarter, adjusted EBITDA was a positive $3 million, compared to a loss of $5.5 million in the first quarter. I will close out my discussion of the second quarter income statement with a review of our GAAP results. First quarter gross margin was 19%, up from 13% in the prior quarter. Operating expense was $25.2 million, down from $25.8 million in the preceding quarter, primarily due to the timing of R&D related projects. Operating loss was $9.8 million for the second quarter, which included $3.1 million of stock-based compensation expense, approximately $0.3 million of amortization of acquisition-related intangibles and $0.7 million of restructuring charges. Net loss was $10.5 million for the quarter, as opposed to a net loss of $18.2 million in the prior period. Turning to the balance sheet. We finished the quarter with $68 million in cash, investments and restricted cash, down $19 million from the first quarter due to the repayment of approximately $19 million in debt as it became due, mostly in China. Net inventory was $61 million, down $8 million from the first quarter on higher demand, resulting in 84 days of inventory on hand, slightly lower than our target of 90 days of inventory. Cash used in operations was $1 million and capital expenditures were approximately $2 million. As a result, free cash flow was negative $3 million. Subsequent to the end of the quarter, we have received a letter of intent for the purchase of our Russia factory for approximately book value. We do not expect any material gain or loss on this potential transaction. If a transaction occurs, it would be slightly accretive to gross margin. We paid down the remaining China debt of $17 million as it became due. We do not plan to re-borrow in China until our latest legal dispute with APAT Optoelectronics is resolved. This is the third dispute, adding to that previously reported in our 10-Q. This does not have an impact on our China operations, as we have cash and additional credit available in the U.S Lastly, we continue to monitor the trade and tariff discussions. We have reviewed the first set of tariffs from the U. S. Trade Representative office totaling $34 billion and there is no material impact to NeoPhotonics products. We are monitoring the most recent set of proposed tariffs. We see minimal risk as the vast majority of our shipments to U.S. customers go to contract manufacturers outside of the U.S. We believe the larger relative risk is to the economy and infrastructure spending rates, both in the West and in China. Before I discuss our revenue and earnings outlook for the third quarter of fiscal 2018, I want 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. For the third quarter, we expect continued demand strength in the Americas and in provincial and Metro build outs in China. We have not yet planned for any material shipments to ZTE or its supply chain partners. Given these factors, the company's expectations for the September 2018 quarter are, revenue in the range of $79 million to $84 million, GAAP gross margin in the range of 19% to 23%, non-GAAP gross margin in the range of 20% to 24%, GAAP diluted net loss per share in the range of $0.27 to $0.17 and non-GAAP diluted net loss per share in the range of $0.17 to $0.07. These numbers are reflective of approximately 45.3 million fully diluted shares. We expect to be operating profit breakeven in the fourth quarter. As I noted at the start, we met our financial metrics for the quarter. Revenue is up, gross margins are improving, operating leverage is increasing, inventories met our target and we reduced debt. I will now turn the call back to Tim.

[Tim Jenks:]

Thank you Beth. As a leader in high speed digital optoelectronic solutions for the highest speed communications networks in data center interconnect and telecom network applications, the growth drivers for our business remain compelling. Our broad high speed product suite complemented by our successes in new product introductions are pushing the existing performance envelope and driving top line growth in 2018. We remain focused on operational execution including cost containment, as we leverage increased business demand to accelerate our path to profitability. We remain enthusiastic about our mid and long term prospects as well. First, NeoPhotonics has focused on delivering components and modules with industry leading performance, which puts us in position to benefit from the current demand acceleration as well as the transition to 400 gigabit data rates. We expect that in 2019 we will see 400 gigabits become a standard building block for data center bandwidth and we are a key vendor for all distances. And even higher speeds are expected in the not too distant future, for which we are working with the leading global customers as we develop higher speed, highly integrated, low power products. Second, deployments of coherent systems into metro and increasingly metro-edge applications is continuing, first in North America and across the globe. And third, we believe that with the ZTE resolution, China has returned to a normalized demand environment and will continue its 100 gigabit and beyond network builds in support of the roll-out of 5G wireless systems. Industry momentum toward fully contentionless networks continues to build with new adoptions happening which will include certain data center applications that we expect to drive growth of multicast switches over multiple years. And we are actively engaged to extend application of our coherent product suite to adjacent markets such as LIDAR for autonomous vehicles. As Beth said, we met our financial metrics and with our new product traction and increasing momentum in our core markets, we are optimistic for continued improvement going forward. This concludes our formal comments and now I would like to ask the operator to open up the line for questions. Carina?

[Operator:]

[Operator Instructions]. We will take our first question from Simon Leopold with Raymond James. Please go ahead.

[Simon Leopold:]

Thank you very much for taking my question. First, I just wanted to get two housekeeping items out of the way. First one is, did you have 10% customers other than [indiscernible]? Can you give us a little bit more color on that?

[Beth Eby:]

We did have two other 10% customers. But we are going to stick to what we have been talking about for a couple of quarters and just talking about Huawei plus out Top 4.

[Simon Leopold:]

Can you tell us how big the two others were without necessarily telling us the identities?

[Tim Jenks:]

Let's see.

[Beth Eby:]

So one of them was 25% and the other one was 10%.

[Simon Leopold:]

Great. Appreciate that. And then in terms of, I wanted to check the update on the breakeven level, on the last earnings call we talked about a mid-$80 million sales level as where you thought you would be at breakeven. Given the forecast for the next quarter and the gross margin, it looks like you kind of get closer there, but this quarter's gross margin was little bit lighter, the outlook a little bit lighter than we had expected. So just wanted to get an update on where you think breakeven is?

[Beth Eby:]

So as I just said, we expect to be operating profit breakeven in Q4. And as we have been talking about for the last couple of quarters, we are a little lighter on breakeven than we expected as we are still taking underload charges in our EML fab. What we have said consistently is, we are breakeven in the mid-$80 million, once we get through the underload charges. [indiscernible].

[Simon Leopold:]

Okay. So unchanged [indiscernible].

[Beth Eby:]

[Indiscernible] on gross margin and we will get to op profit breakeven in Q4.

[Simon Leopold:]

Right. I guess what I am try to verify is, it's the same as it was last quarter?

[Beth Eby:]

It's a little lighter on gross margin than that we expected.

[Simon Leopold:]

Okay. And then last thing I would like to understand is, certainly it's great that you outperformed on sales this quarter, but evidently bit surprised given that you thought your forecast was presumably reasonable and you were not sandbagging. So could you help bridge what were the elements of the upside because it does not look like it's a pull in from the third quarter? So I wanted to get a better understanding of why there was better demand? What did you miss that ended up benefiting you in the second quarter?

[Tim Jenks:]

Yes. As I said in my remarks, Simon, certainly Western customers were quite strong and so that was a bit above our forecast, but also China was stronger than our forecasts. So both of them coming in stronger than forecast resulted in the upside that we saw.

[Simon Leopold:]

And is it possible that that upside might of related to fear of tariff issues? Or you would look at that as completely independent?

[Tim Jenks:]

Well, let's see. The thing I would say is that we had a couple of things that we looked at carefully, both with respect to where is the demand coming from and what are the products. And essentially we think that the mix of products is very aligned with the shipment levels and we really don't see any appreciable change in that. But I will say that probably on the inventory level, people are not running quite as lean as they were, may be in the first and second quarter.

[Simon Leopold:]

So let me make sure I understand what that suggests. That suggests that customers may be stocking up on some inventory and that might reflect concerns about potential tariffs?

[Tim Jenks:]

I think that the real question is, what's the deployment schedule look like in China after the ZTE denial ban was removed? We did see several smaller tenders released very shortly after. And there are talking points about additional demand forthcoming. So I think it's more prepping for what's to come and that seems to be consistent across the group of customers.

[Simon Leopold:]

Great. That's very helpful. Thank you.

[Tim Jenks:]

Thank you Simon.

[Operator:]

And we will take our next question from Alex Henderson with Needham. Please go ahead.

[Alex Henderson:]

Thanks. First question I wanted to ask is, if I am assuming the consensus estimates for the December quarter, it would imply to get to profitability that you are seeing a pretty significant improvement in the gross margins from Q3 to Q4 and assuming flattish OpEx. So can you talk a little bit about how the waterfall steps the gross margins up from Q2 to Q3 to Q4? What we should be assuming? Is it a function of the underabsorption starting to fallout as you ramp up towards that level? And then second and along the same lines, it looks like your inventory has come down quite substantially and as a result therefore, I would assume, that you are seeing less underweighting to your facilities. Is that an accurate read?

[Beth Eby:]

Pretty close. The refinement that we have to add is separating the types of facility. So let me do the walk and then go back to your underabsorption question. So the Q1 to Q2 gross margin improvement is mainly lower cost based on the higher volume and the batter factory utilization, offset by some inventory revaluation as we are revalue inventory at the new lower cost. We did have a slightly higher excess capacity charge going up by about 0.5 point in our EML fab. Q2 to Q3, we continue to get that increased volume and cost reduction, but we expect it to be offset by a couple of points of price erosion and mix shift to our lower margin, a couple of lower margin products. We are estimating, because we are not seeing any of the ZTE benefit come back yet, we are still estimating about three points of excess capacity charge from our EML fab. Q4, we expect again a little bit of additional volume. We will start to see the price reductions for next year hit the tail end for December. But we should start to see some of that EML volume come back as the ZTE supply chain comes back. If you remember what we said last quarter was that part of the EML underload was share loss to other laser form factors and part of it was the ZTE supply chain. So we would expect the ZTE supply chain part to come back. Alex, does that help?

[Alex Henderson:]

It does. So as I look out into the back half of the year, can you talk a little bit about what do you think the ramp of recovery at ZTE and ZTE supply chain might look like? I think, if I remember correctly, we were taking about 5% off of the top for the impact of that. So do we start to get two or three points back in the December quarter and then all five percentage points back as we get in the first half of 2019? Is that the right way to think about it?

[Beth Eby:]

I think it's a little too early for us to figure out what's going to come back when on ZTE.

[Tim Jenks:]

What I would say there, Alex, is that ZTE has certainly reengaged with us and each of their supply chain partners. It will take a quarter or two for two things to happen. One is, really to digest any changes in their plans that manifests from this time off, if you will. And then secondly, to see new orders flow through the supply chain. There is activity there, but it's hard to forecast is as the fact is we are just beginning to get the first inquiries on orders and backlog which we don't see affecting our Q3.

[Alex Henderson:]

So one of your customers that's in that supply chain gave guidance of $14 million in the third quarter and $18 million to $20 million in the fourth. Wouldn't that drive a couple of million dollars worth of revenues per quarter for your products that go into that sell-through?

[Tim Jenks:]

Well, what we are referring to is what we see on our order book and what we see in our backlog. What other companies may have, either teed up and ready to go or in their supply chain, I really can't comment.

[Alex Henderson:]

Okay. So one last question and then I will cede the floor. So as you have been talking to your Chinese counterparts, can you talk about the degree of clarity that you are getting or whether the communication channels are really still quite devoid of content? Where are we on the continuum of lots of disclosure versus very little disclosure? And particularly with Huawei and their ability to talk through to the service providers?

[Tim Jenks:]

Well, let's see. I think in general, for NeoPhotonics, we have a pretty broad group of connections to each of our customers in China but we also make a point to talk directly to carriers in China and to some extent to telecom ministry in terms of what directions are headed. But I think the conversations are pretty open and earnest. They certainly are significantly greater in the ZTE case than they were, say three or four months ago, during the ban where basically communication was largely shut down. But for the moment, it's an interesting dynamic, where as I commented my prepared remarks, we didn't see any share shift which implies that as a group of suppliers the network equipment companies were waiting for a resolution of ZTE which has now happened and therefore it was a much less dynamic environment than we might otherwise have predicted. And so now, having witnessed that, if you will, coordinated response, we now have to see what happens in the world of tenders and who gets those tenders. Certainly in the early tender after the ZTE ban, ZTE did very well. And we will see what happens going forward. We also have the added dynamic of layering in 5G plans. So I think there is a good level of communication and transparency, but that said, there is still a lot more in the realm of unknowns.

[Alex Henderson:]

So it's improved substantially but still have a fair amount of unknowns because of obviously the back half tenders' timing?

[Tim Jenks:]

Yes. And we are waiting to hear how that manifests.

[Alex Henderson:]

All right. Thank you very much. That's helpful.

[Tim Jenks:]

Thanks Alex.

[Operator:]

Okay. Great. And will take Paul Silverstein with Cowen next. Please go ahead.

[Paul Silverstein:]

Tim, before I ask my question, I have never said this on a conference call before, but whoever you are using for your conferencing coordinator, I would fire them. It took 15 minutes to get into this call. Now for my questions. Beth, did I hear the word charge in connection with an underload? I really think that that is an extraordinary item that once showed up in pro forma. Can you help me out?

[Tim Jenks:]

Let me just comment first, Paul, that I am sorry you waited for 15 minutes and for anyone else who waited, I am sorry for that. Now let's go to the question.

[Beth Eby:]

So we have a standard cost model and we have an expectation of about 80% loaded in the standard cost model. So where we are under that 80% average loading, it will become a underload or an excess capacity charge. So if we get for where we have the majority of our underload charge right now for our EML fab, that means we are running substantively under that standard loading that we use to set our average cost.

[Paul Silverstein:]

Got it. Okay. So going back to, I reckon as China is a huge part of the equation, [indiscernible] well, looking outside of China in terms of demand beyond what you recognized in the quarter, I think I understood your comments, but I want to make sure I understood, when you look out over the course of the next quarter and beyond, do you see ongoing ramp in terms of demand? How would you characterized your visibility today versus 90 days ago versus 180 says ago?

[Tim Jenks:]

I think our visibility is, at the moment it appears to be quite a bit better than 90 or 100 days ago. I think the market and the customers are more optimistic. There are opportunities for not just the existing deployments being continued, but also driven by certainly the DCI deployments in the West and Metro deployments but also the prospective turn on of more 400 Gig and higher than 400 Gig products. And so those are generally layering in additionally, rather than replacing. And so I think the combination of the deployments, the opportunities, the data rates and all of those taken together, I think adds up to a more optimistic environment.

[Paul Silverstein:]

Okay. And I heard the questions posed by Alex and Simon and your responses in terms of China. But if I could ask you to just wrap them up in the same question, when you look at your visibility in China today, you would characterize that as better, worse, the same?

[Tim Jenks:]

Our opportunity in China today compared to what?

[Paul Silverstein:]

Compared to 90 days ago? Compared to 180 days ago?

[Tim Jenks:]

Well, I think with ZTE on hold and in my prepared remarks I said that the ban was net subtractive to the China demand. So with that resolved, I think, in the first instance, it's better. Second is, in the tender world we have to think about the fact that we saw some significant tenders in September of 2017 and at this point we are a year later and looking for the next meaningful tender announcements. Now along the way, there have been continuing provincial tenders but they are less visible than national tenders. So I think now with the ban resolved and with the prospects of tenders being awarded and that making for a normalized environment, I think it's better visibility and a bit more optimistic as well. So I think all those things are generally positive.

[Paul Silverstein:]

All right. One last question, if I may. And if you have said this previously, my apologies. Tim, how much DCI revenues you have today? If it's not meaningful yet, when does it become meaningful? How many customers for your DCI?

[Tim Jenks:]

So there are two things that we generally referred to, 105 to 15% of our revenue are actually components that are directly sold into applications going to data center. But to the extent that we are selling coherent components of assemblies or products that may be used in so-called pizza box solutions or solutions that are actually sold by network equipment manufacturing customers into DCI applications, that is not something that we have broken out explicitly. And it's a little harder to predict accurately for obvious reasons.

[Paul Silverstein:]

Can you tell us how many customers you have for your DCO module? I am not referring to you selling components to other DCO module suppliers, but the DCO module where you are working with either one or the other DSP suppliers? How many customers you have for the DCO module today?

[Tim Jenks:]

Well, I think the way to think about it is, as Beth talked about, with our top five customers who collectively grew by 27% sequentially, those customers, those top five customers represent generally in the range of 80% to 90% of our revenue. So if we just look at among our top 10 customers, there are about a half-dozen who directly go into these DCI kinds of applications. So five or six key customers in total for those. There are some smaller ones, but I think those are what's relevant here.

[Paul Silverstein:]

Okay. I appreciate it. I will pass it on. Thanks guys.

[Tim Jenks:]

Thanks Paul. Sorry again for your having to wait.

[Operator:]

And we will take our next question from Richard Shannon with Craig-Hallum. Please go ahead.

[Richard Shannon:]

Hi Tim and Beth. Thanks for taking my questions. I got in a little bit as well. So if I am asking questions you have already addressed here, but these are very simple high-level question regarding the commentary I did hear regarding third quarter guidance and your thought process into the fourth quarter. Specifically, how much expectation for growth from China was built into both those quarters, please?

[Tim Jenks:]

As we pointed out, we did actually see a sequential growth in China. We would expect to see additional growth going forward. However, what's not in our third quarter forecast is any material revenue from ZTE. We have seen the turn on of initial orders from ZTE supply chain, but not that's material in terms of shipment in the third quarter. So as that gets worked out, we would expect it to reflect going forward. But right now as our prepared remarks indicated, there is nothing included in the third quarter. So the real question in China is, do we have sooner releases of new tenders but the timing of that is not currently known and we do have the overtones from the tariff and trade discussions that we don't really know the outcome.

[Richard Shannon:]

Okay. And just to follow-up on that last comment, Tim. So is it safe to assume that you are call for breakeven on an operating level in the fourth quarter, does that assume any real contribution from potential new tenders coming in China?

[Tim Jenks:]

Well, in the fourth quarter, it certainly could. But again, we don't specifically know how it will play out. Until it happens, we don't know how it's going to happen.

[Richard Shannon:]

Okay. But you don't need much of any of that to happen to hit that revenue required to get to operating breakeven, correct?

[Tim Jenks:]

Yes. We think that's in the cards. We think that we will be able to do as we indicated.

[Richard Shannon:]

Okay. All right. Fair enough. Maybe one last question for me and I will jump out of line. You talked about being optimistic in the medium to long-term on 400 Gig and faster or higher applications. Do you have any sense of the contribution of revenues from that category today? I am sure it's pretty small but any characterization you can provide would be interesting to hear about.

[Tim Jenks:]

So the 400 Gig is important for a couple of reasons. I think at present, it's probably in single digits. It's material but it's still relatively small. But what matters, I think, is how 400 Gig plays out over the next year or two because you have applications for 400 Gig that will include, including 40 Gig in the data center, you will have the rollout of 400 ZR interconnect as well as our 400 Gig, 600 Gig and beyond on online side. So all of the positioning of the high-speed products, components and modules alike, will be quite important in terms of the growth prospects between 2019 and 2020. I think these are key developments and quite important.

[Richard Shannon:]

Okay. That sounds fair. I think it's all my questions. I will follow-up later when I get the full transcript. Thanks Tim. Thanks Beth.

[Operator:]

And we will next hear from Tim Savageaux with Northland Capital Markets. Please go ahead.

[Beth Eby:]

Hi Tim.

[Tim Savageaux:]

Hi. Good afternoon. Can you hear me?

[Tim Jenks:]

Yes, indeed.

[Tim Savageaux:]

Great. Taking nothing for granted on this particular call. First question for me and congrats on the strong results in the quarter, first off.

[Tim Jenks:]

Thank you.

[Tim Savageaux:]

Is what your assumptions might be on the operating expense side, you have been in this kind of $22 million to $23 million range throughout the year, can we assume that that's where you would expect to be in closing the year? Or are there any items that might drive OpEx higher or lower as we move toward the end of the year?

[Beth Eby:]

I would expect us to be as we put through the next quarter $22 million to $23 million for the next quarter and depending upon results, we may have a little bit more profit dependent spending in the fourth quarter.

[Tim Savageaux:]

Right. Well, yes, SG&A type spending, from a revenue perspective. Okay. Fair enough. And then, if I heard you right, it sounds like, to the extent we may have been assuming, I don't know, something closer to high 20s, 30% exiting the year. It sounds like you feel like you are going to, even if some of those charges dissipate, coming a little below that. So that does imply revenue continuing to increase to some degree. At this point, would you say that sequential growth in Q4 is most likely to be driven by ZTE coming back as it appears and you may be lagging that a bit with maybe some of your customers having some product ready to go in inventory and then needing to reorder?

[Beth Eby:]

Yes. Q4 is a traditionally strong quarter. So we would expect a fair amount of strength continuing on the China side, but also on the DCI size, right. That's where the real strength came in Q2. So we would expect that to continue to ramp. And your general outline of, we are expecting growth going into Q4 on the revenue side and little lighter expectations on gross margin than we were shooting for at the end of the year, is accurate.

[Tim Savageaux:]

Great. And on to that DCI point, you had a new 10% customer join the list, although maybe not, depending on who it is. But I was interested in maybe if you had any color as to whether that's a customer that we could more traditionally associated with data centers or more traditionally associate it with telecom networks?

[Tim Jenks:]

So we have a couple of customers that hover in that range. Beth reported on the Next 4 customers representing 47% of our revenues. So you can see that we have several that are in the high single digits and this quarter it just happens that one gets actually into the double digits. But it's generally that way most quarters. I don't think that there is a great aha moment in that.

[Tim Savageaux:]

Fair enough. Is there one an aha moments in expansion of your business in China outside of Huawei? That looks like it continues to grow as well. We have seen that as kind of a recurring theme among at least a couple of suppliers thus far this quarter? Or is that once again, maybe geographic locations of CMs and whatnot? Or can we look at your total China business relative to what you are doing Huawei and seeing expansion with other OEMs within China?

[Tim Jenks:]

Yes. We are calling on all the OEMs in China. You have some interesting things going on in China because in addition to Huawei's strength you have the ZTE denial ban being put in place and then set aside. And then you also have the other notable one in China is usually FiberHome Technologies. FiberHome Technologies is in the process of a transaction with Datang Telecommunications. And so there are a number of moving parts in the industry. You just had a big China Tower IPO here last week. And so there are a lot of moving parts. I think there are there is a lot of opportunity as well. I think we are very well positioned for continued growth in China. And therefore, as Beth said in her prepared remarks, the biggest question is really, overall economic and deployment schedules as to how the business grows. I think we are well-positioned but we have to see how it plays out with new tenders and the relative share for each of the China major players.

[Tim Savageaux:]

Great. And last question for me. And I think you made it pretty clear that the visibility has gotten substantially improved to some degree over the past 90 days. I wonder if you might comment on the environment you are seeing now in China? And maybe what you might expect from a tender standpoint relative to, not 90 days ago, but maybe closer to 900 or about three years ago? So looking at the 2015, 2016 timeframe, your business, both with Huawei and in China, is about two-thirds of peak levels. You refer to a more normalized environment. And I guess that was maybe above normalized, but is there any chance given the growth that you are seeing now and assuming that no macro disruption, that we re-attain peak levels in China in calendar 2019?

[Tim Jenks:]

Yes. So when you refer to peak levels in China, let me just state a couple points of history. We actually, as I noted in my prepared remarks, our high speed products were 86% of revenue and up about $10 million sequentially. The high speed products, in the current quarter, are approaching the highest quarters of the 2016 timeframe, though not quite at the highest level. Back in the 2015, 2016, we had additionally in NeoPhotonics a set of low-speed transceiver products and essentially in 2016, we reported revenue of $411 million. But if you back out the low-speed transceiver products, which the assets were sold in the beginning of 2017, the corresponding number for 2016 would have been $348 million. So at the $81 million we just reported, we are really not at two-thirds, we are really closer to 85% or 90%, I think, of that level. And so we do think that we are in a normalized environment. We do think that we have interesting prospects with 400 Gig, with the rollout of 5G and with new tenders after kind of a year of really no tenders since September 2017. Does that answer your question?

[Tim Savageaux:]

It does. Thanks.

[Operator:]

And moving on, we will take our next question from Dave Kang with B. Riley FBR. Please go ahead.

[Dave Kang:]

Thank you. Good afternoon. First question is, in the previous quarter's call, you said something to the effect of like maybe 10% growth for the port count for this year. Has been number changed? And any color as far as like the mix between first half versus second half? Is it like 30/70? 20/80? Any comment on that topic?

[Tim Jenks:]

Yes. You know, Dave, I think the total China ports we had suggested that it was up about 10%. We think that's still accurate. With respect to first half versus second half, we would expect that the second half is a bit stronger than the first half. We are certainly seeing that with volumes being shipped to China. We did say in our last conference call that we are beginning to see a normalized environment. We then had the ZTE denial ban. But now what we would expect is that, second half is higher, so perhaps 60/40. And then we have the re-initiation of ZTE which will contribute as well. In total, the real question is, how many ports does ZTE ship because they will undoubtedly ship fewer high-speed ports than they might have been planning at the beginning of the year. But I think the overall demand environment and the balance of second half to first half is pretty consistent.

[Dave Kang:]

Got it. And then speaking of ZTE, can you remind us which products you are shipping to them or will be shipping to them in the second half?

[Tim Jenks:]

Yes. I think for each of our customers, we generally haven't talked about specific products that are sold. We have a range of products that we sell to ZTE and we also serve a number of ZTE suppliers. So they span a range of both coherent products and client side product.

[Operator:]

Moving on, we will take our next question from Jun Zhang with Rosenblatt Securities. Please go ahead.

[Tim Jenks:]

Did Dave have any other questions?

[Operator:]

I am sorry. Dave, your line is open.

[Dave Kang:]

Okay. Thank you. Actually yes, there may be one or two more. I think I may have missed it, but the CFP-DCO, I think you said revenue doubled. Did I hear that correctly? And did you give out what the percentage was, in terms of total sales?

[Tim Jenks:]

I did say that it doubled sequentially. And I did say that I expected that on for the tenders in China could increase it. We didn't say specifically what the numbers were.

[Dave Kang:]

And then just on that topic, as you know that your main competitors in that market, they already have the CFP2-DCO.

[Tim Jenks:]

My competitor, where did you say, in Denmark?

[Dave Kang:]

No. Acacia has already a CFP2-DCO. So what kind of a disadvantage are you, CFP versus CFP2? And when do you plan to have that CFP2 going forward?

[Tim Jenks:]

Yes. So essentially, particularly in the China market, there is a large deployed base of ports that are continuing to be filled by CFP form factor. And so for that market, some of the newer applications than [indiscernible] receptacle. And then certainly in the West, we are also looking at the expectation for OSFP and/or DD-QSFP in the 400 Gig domain. So different markets have different needs. As I said in my prepared remarks, we are working on next-gen DCO modules that use the 64 gigabaud suite. We haven't made specific product announcements, though we did do demos at this past trade show. So with respect to a specific product, when we have a product announcement then I will make that comment.

[Dave Kang:]

Got it. Thank you.

[Operator:]

And moving on, we will take our next question --

[Tim Jenks:]

Okay. Thank you. Go ahead Jun.

[Operator:]

Sure. Certainly. We will take Jun Zhang from Rosenblatt Securities.

[Jun Zhang:]

Hi. Thanks for taking my question. So the first question, Tim. You reported $81 million revenue in Q2 and you guided mid-point of about $82 million. So could you talk, break down by the market like what's the seasonality looks like in China, U.S. and European markets for your guidance? Thanks.

[Tim Jenks:]

Yes. Well, I think the big thing here, Jun, is that we don't have any loading in Q3 for ZTE yet. So as that loads, then it could be providing some level of uplift. But we don't have that knowledge yet.

[Jun Zhang:]

Okay. Great. And also, Beth, could you talk a little bit about when do you think that the underload cost for the Japan EML actually will go away? When that's going to happen? Thanks.

[Beth Eby:]

The thing is that we have plenty of capacity for are some of the next generation products Tim talked specifically about, the 53 gigabaud set of products that will ramp in 2019. We have got another couple of products that could ramp with that. And as the ZTE supply chain comes back, we would absolutely expect additional orders there.

[Jun Zhang:]

Okay. Great. And the last question is about tariff. So Tim, could you talk a little bit about your thoughts over the potential increased tariff on optical modules made in China? If you ship those modules back to U.S. clients, do you think that the tariff going to increase the cost or you have to lower your price to the U.S. clients? So how the tariff potentially affect the pricing environment and your cost structure? Thanks.

[Beth Eby:]

So I will take that one and Tim can add on. Well, one, most of our shipments do not come directly back into the U.S. And two, we don't ship modules. We ship parts. So when I said the classification reviews that we went through, that's what we were looking at.

[Tim Jenks:]

Yes. And I think Beth said in her prepared remarks that for the preponderance of Western customers, we may ship to places including Mexico or Thailand that are generally contract manufacturers for Western customers. And so when we refer to, it's interesting for Western customers, part of our revenue classification geographically would be in Rest of World and that's exactly the reason why. So when we ship a module or we ship a component, where we ship it for NeoPhotonics business today and inclusive of the business we do with Western customers, inclusive of U.S. customers, generally speaking, the ship to destination of U.S.A. is very small.

[Jun Zhang:]

Okay. Great. Thanks. That's all my questions. Thanks a lot.

[Beth Eby:]

Jun, before you --

[Tim Jenks:]

Do you have any other specific questions, Jun? Because go ahead.

[Jun Zhang:]

No. That's all my questions. Thanks a lot.

[Tim Jenks:]

Yes. Let me just comment on one thing to you is that you had asked us on a couple of prior conference calls about other assets in China. And I think it's worth pointing out that over the last quarter we had gone through a number of activities looking at our assets in China. We do have clarity on the question you have asked in the past which is, with respect to real property in China, we have official valuations now that are in the $90 million to $100 million range versus balance sheet numbers of about $10 million. And so that's just a question that you had asked in the past. And so I think I will let you know.

[Jun Zhang:]

Great. Thanks a lot.

[Tim Jenks:]

Okay. Operator, are there anyone else cycling back?

[Operator:]

Certainly. I am sorry. And we will take our final question from Mark Kelleher with D.A. Davidson. Please go ahead.

[Tim Jenks:]

Hi Mark.

[Mark Kelleher:]

Great. Hi Beth. Hi Tim. Thanks for squeezing me in here. Congrats on a great quarter. I wanted to just the DCI business, the Americas business was very strong. Are there any products that you could call out as doing particularly well?

[Tim Jenks:]

Yes. So essentially for DCI, a lot of this is the 400 gigabit coherent products. And I said those are generally, they are ramping currently and they are single-digit percent and single-digit millions, but approaching $10 million and 10% pretty rapidly. So we expect that to continue to grow. But it's a healthy growth rate. So that matters.

[Mark Kelleher:]

Okay. And Beth, you mentioned selling a Russian factory. Does that imply inflow of cash coming from that?

[Beth Eby:]

Well, it is a potential transaction, but it was of interest for the end of the quarter. The offer that we have received approximates our book value on it. So we don't expect any gain or loss on it. May be a modest amount of cash.

[Mark Kelleher:]

Okay. Great. That's all I have got. thanks.

[Tim Jenks:]

Thank you Mark.

[Operator:]

And I would like to turn the call back over to Mr. Jenks for any additional or closing remarks.

[Tim Jenks:]

Thanks Carina. Thank you all for your time and interest in NeoPhotonics. I appreciate the questions and the discussion and we look forward to updating you on our progress in the future. Have a good evening. Bye.

[Operator:]

Once again, that does conclude today's conference. Thank you for your participation. You may now disconnect.