NeoPhotonics Corporation
Q3 2018 Earnings Call Transcript

Published: 2 Nov 2018

[Operator:]

Welcome to the NeoPhotonics 2018 third 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 third quarter of 2018 and outlook for the fourth 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 third quarter, color on the market and a discussion of new product initiatives. Beth will then provide financial results for the third quarter before providing the outlook for the fourth quarter of 2018. Beth will then turn it back to Tim for closing remarks 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 Form 8-K being filed today with the SEC and can be found in 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 November 2, 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 third quarter, NeoPhotonics delivered strong results with revenue of approximately $82 million, coming in at the midpoint of our outlook range of $79 million to $84 million and representing 15% growth over the same period last year. As a leader in high speed digital optoelectronic solutions for the highest speed communications networks in datacenter interconnect and telecom network applications, we are seeing broad-based demand growth for our solutions. During the quarter, High Speed Products for data rates of 100 gig and above comprised 84% of our revenues. We saw some mix changes, including an increase in certain passive products that are often used in 100 gig and above networks, but are not classified as High Speed. Similar to the prior quarter, demand remained strong across all geographies. Shipments to our western customers were up slightly, driven by demand for our leading high-speed products used in Data Center Interconnect, or DCI, as well as Metro deployments. Demand in China remained strong in the third quarter, which was the result of continuing domestic deployments as well as exports outside of China, despite trade tensions and uncertainties about new tender timing. It is important to note, during the quarter we saw a stable demand in China across the vast majority of our high speed product lines, which when coupled with the resumption of orders from ZTE supply chain partners, signals a solid demand environment going forward. We continue to monitor the US and China trade situation closely. We do see some customer actions that suggest potential securing of supply, both from NeoPhotonics and other key players in the industry. We are closely tracking customer shipments as well as their purchases to help mitigate strategic inventory buying. We continue to view the larger risk to be the broader macro-economic picture. With continued strength in demand, combined with increasing volume growth across various product lines, we achieved gross margin expansion of 400 basis points in the quarter. Turning to products, our currently available suite of 64 gigabaud high speed optical components for coherent systems, including receivers, modulators and ultra-narrow linewidth tunable lasers, are being used by multiple major customers to develop systems with 400 and 600 gigabits per second per wavelength transport capacity. Such system developments by leading OEMs, several of whom use our products, were the focus of much publicity at the European Conference on Optical Communications trade show, or ECOC, last month in Rome, Italy. At ECOC, we also highlighted our next generation of coherent products which reduce the size of coherent optics approximately in half, while featuring the highest performance levels that are required for 400 gig and 600 gig per wavelength transmission. Our Coherent Optical Subassembly, or COSA, integrates our 64 gigabaud coherent driver-modulator with our 64 gigabaud coherent receiver in a very compact form factor. Similarly, our Nano ultra-narrow linewidth external cavity tunable laser again cuts the size approximately in half, while featuring industry leading linewidth and low phase noise and with low electrical power consumption. We demonstrated these next generation high speed optics products in operation at the OFC conference last March, both individually and incorporated into a compact 400 gig pluggable module. Further on the line side, our currently shipping CFP-DCO coherent module completed another major customer qualification. And we see strength in our Multicast Switch product line trends with demand in both telecom and data center applications, as this product line offers a scalable and cost-effective solution for managing fiber densification in data centers. For shorter reach data center and client-side applications, we see increasing demand for our EML lasers and our laser sources for Silicon Photonics based transceiver modules. In addition to our 28 gigabaud EML lasers, we have introduced a full suite of 53 gigabaud components for single wavelength, 100 gig PAM4 based transceiver modules, including an uncooled, non-hermetic EML laser, along with 53 gigabaud drivers, detectors and trans-impedance amplifiers. For Silicon Photonics based modules, we offer non-hermetic continuous wave laser light sources as well as drivers for silicon modulators, and we are now receiving orders for 100 gig per wavelength applications. I will now turn the call over to Beth to provide further detail on our financial performance.

[Beth Eby:]

Thank you, Tim, and good morning. In Q3, we again met our financial metrics. Revenue was up modestly, gross margins expanded, operating leverage increased, inventory remained at our target and we were free cash flow positive. As Tim mentioned, Q3 revenue was $81.7 million, up 15% year-over-year, in line with our outlook, and driven by strong demand in both the Americas and China. China represented approximately 56% of our revenue in the third quarter, in-line with 57% in the prior quarter. Shipments to the Americas represented 28% and the Rest of the World was 16%, as certain of our customers shifted contract manufacturing locations. Huawei Technologies, including its affiliate HiSilicon Technologies, was our largest customer, and accounted for approximately 47% of the company’s revenue, up from 43% last year. Our next four customers after Huawei represented 42% of total revenue, down from 47% in Q2. The reduction in the Next 4 customers was mostly due to inter-period fluctuations among our China customers. Our non-GAAP gross margin in the third quarter was 24%, up approximately 4 points from Q2. Within this, product margins were approximately 32%, up 3 points quarter-over-quarter on improved costs and a mix shift toward higher margin products. Other cost of sales charges of approximately 8% were primarily as expected with, about 6 points of inventory revaluation, excess inventory write-downs and other manufacturing charges, and about 2 points of under absorption charges, primarily in our laser fabs. Moving to operating expenses, total non-GAAP operating expense for the third quarter was $22.1 million, slightly lower than expected, as we met customer NRE milestones. Non-GAAP operating loss for the third quarter was 2.5 million, or negative 3% of revenue, compared to negative 7% in Q2, driven by gross margin improvement in the quarter. In Interest and Other, foreign exchange gains of $1.3 million more than offset quarterly interest charges. Non-GAAP net loss in the third quarter was $2.1 million compared to a loss of $6.3 million in the second quarter. Based on a fully diluted share count of 45.5 million shares, this translates to a non-GAAP loss per share of $0.05, compared to the $0.14 loss in Q2. For the third quarter, adjusted EBITDA was $6.2 million, compared to $3 million in the second quarter. I will close out my discussion of the third quarter income statement with a review of our GAAP results. Third quarter gross margin was 23%, up from 19% in the prior quarter. Operating expense was $27.6 million up from $25.2 million in the preceding quarter, primarily due to stock based compensation, a litigation settlement and restructuring charges. Operating loss was $8.7 million for the third quarter, which included $4 million of stock-based compensation expense, $1.2 million of restructuring charges, $0.5 million of a litigation settlement charge and approximately $0.3 million of amortization of acquisition-related intangibles. Net loss was $8.1 million for the quarter, compared to a net loss of $10.5 million in the prior period. Turning to the balance sheet, we finished the quarter with $65 million in cash, investments and restricted cash, down $3 million from the second quarter after repayment of approximately $19 million of debt. Net inventory was $57 million, down $4 million from the second quarter on strong demand and the loss of two days of production in China due to Typhoon Mangkhut. This resulted in 82 days of inventory on-hand, slightly lower than our target of 90 days of inventory. Cash generated by operations was about $14 million and capital expenditures were approximately $4 million. As a result, free cash flow was about $10 million. Before I discuss our revenue and earnings outlook for the fourth 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 fourth quarter, we expect to see continued solid demand in the Americas, additional domestic build outs in China, plus shipments to ZTE and its supply chain partners. Given these factors, the Company’s expectations for the December 2018 quarter are

[Tim Jenks:]

Thank you, Beth. As we have communicated over the last year, our focus has been on returning to profitability and we believe our results and outlook demonstrate that we are having success. We have also remained focused on execution to extend our leadership position in the high-speed digital optoelectronics market with 400 gig, 600 gig and above solutions for data center interconnects as well as telecom, and on silicon photonics innovations. With returning strength in demand for our core products and our successes thus far with multiple customers for our highest speed product introductions, we are enthusiastic about the opportunities we see in 2019 and beyond. Industry trends continue to move in our favor, notably through the push to even higher speeds such as 400 gig, 600 gig and beyond as well as the adoption of coherent architectures in metro and metro-edge markets, which we believe places NeoPhotonics in an advantageous position. Similarly, industry momentum toward fully contentionless networks continues to build both in telecom and certain data center applications, which we expect to drive growth of multicast switches over multiple years. And we are actively engaged to extend the application of our coherent product suite to adjacent markets such as cable TV and LIDAR for autonomous vehicles. This concludes our formal comments and now I would like to ask the operator to open up the line for questions. Lauren?

[Operator:]

[Operator Instructions] We’ll take our first question from Simon Leopold with Raymond James.

[Simon Leopold:]

I want to follow-up on the comments you offered on the tariff implications. So I think, Tim, you may have alluded to the suggestion that some Chinese customers or some customers may be pulling into the December quarter before tariffs go up in March. I just want to make sure I'm interpreting that correctly, and if you can quantify? And then also, Beth offered some commentary on the implications on cost of goods sold being about 1 point. I understand obviously you've got some seasonality that drive gross margins down in March, but I'd like to get an understanding of what your expectations are for overall gross margins in 2019 in light of a theoretical tariff hit coupled with the efforts you're making to improve gross margin? Thank you.

[Tim Jenks:]

Thanks, Simon. So on the first point, we are monitoring the tariff situation, we're monitoring both the demand situation as well as supply and there are limited new announcements of tenders and there is demand strength. So the issue just there is to try and understand the balance of shipments to customers versus shipments from customers because there's some management of what their inventory is. And I think with the tariff situation, all of the Chinese OEMs are trying to make sure that in all situations, they’re mitigating any risk they are exposed to. So we similarly are looking closely to make sure we’re managing it appropriately. Beth, you want to go?

[Beth Eby:]

Sure. So speaking of the actual implementation of the tariffs, as we said last time, the US tariffs on goods coming in don't affect us a great deal, because while we have shipments to the Americas, those are mostly the contract manufacturers outside of the US, we don't ship a great deal and nothing that's material that's being impacted by the tariffs directly into the US. The tariffs that we are seeing are because we do make product in the US and we've got a couple of fabs here that we ship in to China. Those are the -- that's the one point of gross margin hit that we expect to take in next year. And as you know, I'm not going to give overall guidance for 2019 gross margin yet. It's just premature until we know the outcome of the pricing negotiations and that will start shortly.

[Simon Leopold:]

Okay. And just wanted to get another housekeeping question. Did you have 10% customers other than Huawei and if so some detail on that.

[Beth Eby:]

We had two 10% customers. One named as Huawei at 47%. We had another one at 28%.

[Simon Leopold:]

A usual suspect?

[Beth Eby:]

I'm going to respect customer confidentiality and not name them.

[Simon Leopold:]

Well, so maybe the last question I have kind of we’ll get at the identity of that customer, but I know you may not be aware of the final destination of your products by your customers, but just wondering whether you see the strength or opportunities in new deployments out of Japan, Germany and India as key drivers for your business.

[Tim Jenks:]

Yeah. We don't always see the specific end use destinations. So, we can't really confirm that, Simon.

[Simon Leopold:]

Well, but you know who your customers are. So if you see that customer doing well, I would assume that that would be associated with those trends?

[Tim Jenks:]

Yeah. I think that's accurate.

[Operator:]

And we'll take our next question from Alex Henderson with Needham.

[Alex Henderson:]

Thanks. Can we start with just some easy housekeeping? If we assume you are profitable, what would your fully diluted share count look like?

[Beth Eby:]

Above 49 once we get profitability.

[Alex Henderson:]

All right. And going over to the EML piece for a second, two points of absorption still in that fab. So, as we look forward to the ramp of your 53 gigabyte products and other related EML products, what do you think the timing is of eliminating that adjustment?

[Beth Eby:]

That one is going to depend on how fast the customers ramp. We can -- we do know that the biggest part of the ramp will be in the second half of 2019. We should start to see it in Q2.

[Alex Henderson:]

So maybe a point of adjustment in the first half and then fall out the full two points by the second half. Is that kind of the right way to think about it?

[Beth Eby:]

I think that's as good an estimate as any.

[Alex Henderson:]

Right. In terms of the MCS product, I assume that you're still kind of constrained on that product? How do we think about the size of it in terms of -- is it bigger than your breadbox at this point? And then second, what's the ramp up of available capacity that you're going to be seeing in the next couple of quarters?

[Tim Jenks:]

So, the overall volume here is -- it's still in the single digit percent, but it's high single digit percent. And it can be a little lumpy, just because it has a combination of telecom and data center applications. The data center is what kind of adds, if you will, the lumpiness. At this point, we're not really limited by capacity.

[Alex Henderson:]

So you’re no longer constrained? That's good? Okay. The other question I wanted to ask and then I'll cede the floor is, given the ramp up of 400 and 600 gig components that -- where you seem to be winning substantially higher market shares, how should we feather that in over the next two or three quarters, when does that start to materially impact the growth rates and start to drive some improvement in the top line?

[Tim Jenks:]

Well, let's see. 400 gig, I'm going to describe a couple of different things. So 400 gig broadly includes the line side 400 gig and above, so 400 gig and 600 gig and on the client side, generally is referring to the single wavelength 100 gig, which also applies to certain devices at 400 gig. We are shipping 400 gig products today, which include things that are expressly rated at either 400 gig or 600 gig, but also just things that are at 64 gigabaud and those actually have gotten to kind of very low double digits or maybe 10% of revenue, but I think the thing that we should think about is second half of 2019 being a time when we would expect these things to actually grow at a higher clip.

[Alex Henderson:]

So would it be fair to say that the significant pickup in market share in the high growth in those lines would offset -- substantially offset any slowdown in a 100 gig 200 gig products, how should we be thinking about the mix shift as we shift into this? It sounds like you're gaining substantial share within the components space as we move?

[Tim Jenks:]

Well, I'm not really -- I think we're not really expecting much in the way of slow down on a 100-gig. I think we serve some customers who might be early in their 400-gig launches. So the 400 gig is really additive to the business at 100 gig, but I do expect that over time, you see additional competition at 100 gig and then that will also happen at 400 gig. So just in terms of the rate of deployment though, for 400 gig and above, we would expect the higher rates of deployment in the second half of ’19.

[Operator:]

And we'll take our next question from Richard Shannon with Craig Hallum.

[Richard Shannon:]

Hi, guys. Thanks for taking my question as well. Maybe a follow up Tim on the last couple of questions here and maybe asked more specifically indirectly, what do you think your share looks like in the kind of the higher speed 400, 600 gig versus what you had saw in the 100 gig generation?

[Tim Jenks:]

Market share is really product dependent and so essentially, as we said in our prepared remarks, we do have a full suite of 64 gigabaud components, laser modulator and driver. I think, our share is higher in laser and that really has to do with the narrow line within low phase noise that is related. We don't enjoy as high a market share in the other products just because, there are alternatives to those, but overall, I think we're doing pretty well on the 400 gig design win process.

[Richard Shannon:]

Maybe I’ll stress that a little bit here Tim and ask specifically on the lasers, do you think you’ve gained share in the higher speed lasers, relative to prior generations?

[Tim Jenks:]

I don't think we accurately know the answer to that Richard.

[Richard Shannon:]

Okay. That’s fair. Let me jump over to EMLs, I know you talked about the start of revenues, maybe in the second quarter and a nicer ramp in the second half of next year. Maybe you can delineate that between the 28 and 56-gig and specifically do you see much volume, both from your capability as well as the demand happening that soon?

[Beth Eby:]

My commentary was all 53, 56 gig. So Tim, you want to –

[Tim Jenks:]

Yeah. I think Beth’s comments, looking out in 2019, we would see increases in all of the 53 gig product. I think the 28 gig is the mainstay today. We do have reasonable demand. I think as we said in our prior conference call, EML lasers are among the products that we do sell into the ZTE supply chain through supply chain partners and as those have come back into orders and beginning shipments, that would be principally 28 gibabaud. So, as we get to the second half of 2019, we'll be having a mix of both products.

[Richard Shannon:]

Okay. That is helpful. Maybe just one quick financial question for Beth. What are you expecting for cash flow in the December quarter?

[Beth Eby:]

We're expecting single digit CapEx, low single digit CapEx and it’s a little early for me to speculate on exactly how we're going to do on the working capital and inventory. We're trying to get, as I mentioned in the prepared remarks, we’re a little light on inventory at the moment. We're trying to get some of our finished goods inventory built back up. So, we could be slightly negative in the fourth quarter.

[Operator:]

And we'll take our next question from Fahad Najam with Cowen and Company.

[Fahad Najam:]

I apologize I joined the call a bit late, so if you’d addressed this earlier, I apologize for asking to repeat yourself. But can you remind us, if those issues that you guys are facing in the Japanese fab, are those largely behind you at this point?

[Beth Eby:]

What we said in the prepared remarks, Fahad, was that we are going to be -- we've got about two points of under absorption in our laser fabs right now. So, the yield issues are certainly behind us, but the demand being slightly lighter than we would like is -- still happened in Q3.

[Tim Jenks:]

Yeah. I would tell you also, we did say last quarter that we expected the underutilization to continue through the fourth quarter. That is the case and then we also did suggest that we would have more loading increasing with the resumption of shipments to the ZTE supply chain and that is happening, but these things take time to ramp up. And so overall, I think we're on the right trend, but we're not quite there yet.

[Fahad Najam:]

Tim, if I ask you for a more broader question. I listened to the questions earlier to get an indication that you seem to have suggested that some customers are pulling in orders ahead of the tariffs kicking in. But if I were to ask you to take a more broader view of the situation, to what extent should we be concerned in the investment community that the Chinese indigenous suppliers are maybe incrementally gaining share and maybe not as good in technology as you are today, but narrowing the gap. Over the last few months, have you seen any noticeable change in the competitive dynamic in China?

[Tim Jenks:]

Well, I think, the key point Fahad is the timeframe that we're talking about. Over the last couple of months, no, we really haven't seen any change at all. Over the last couple of quarters, if we extend over the course of the last couple of quarters or even the last two years, the entire and trade and tariff discussion didn't exist two years ago. And so that's all new and so some of our customers in China are large companies that are wanting to make sure that they have secure supply chains and they have some level of angst about the changing tariff situation. But on a broad based question about the China competitors, in a relatively short timeframe, it isn't a major change at all. Over a much longer time, I think companies are working hard on their technology and they do get more competitive over the long haul. But, quarter-to-quarter or even year-to-year, the difference is small.

[Fahad Najam:]

I appreciate the color. If I may ask a question on where you guys are in terms of the plan to ship the DCO modules, are you still on track for realizing revenue from these modules starting in ‘19 and also can you provide a little bit of the color on where the partnership with Ciena stands on using their DSP. I think, there was a bit of confusion post ECOC Oclaro citing that maybe Ciena might not pursue this license, supplying its DSP to suppliers may end up making modules itself. So any color there, any update?

[Tim Jenks:]

Yeah. Two things. First of all, we've been shipping DCOs actually since the second half of last year. So, we've been shipping -- we started shipping actually the end of last year. We've been shipping all this year. The numbers are not large and so we have been winning additional customers and we'll continue on that track. With respect of the Ciena partnership, we're an engaged and active partner to Ciena. Ciena actually has announced in the partnership that it's around actually finished modules, for example, modules that do single wavelength, 400 gig transmission and so NeoPhotonics is actively engaged with Ciena on that. They have not made any announcements about actually selling their DSPs. It's actually partnering with companies specifically on the module level. I hope that helps.

[Operator:]

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

[Tim Savageaux:]

Congrats on the results and especially the outlook. Let’s start with a kind of a couple of high level demand questions and ask you too. And you mentioned, I think, some positive comments about China tender activity. We've heard from other suppliers in recent reports here, including some of your customers. And I wonder, if you could sort of dive deeper into what you're seeing out there from a China demand perspective and also whether we can reasonably tie some of that activity into more kind of catching up to metro builds that may have been delayed or to what extent can we connect some of this activity to impending 5G rollouts? And I'd ask that question both for China and maybe throughout the rest of the world, as you're seeing kind of demand develop for 2019? And I'll follow up from there.

[Tim Jenks:]

Okay. So, the situation in China, key points are number one status of tenders, number two, status of the Chinese suppliers and number 3, 5G. So, the tender environment and the supplier environment are I think closely tied. What we see is continuing action with domestic deployments. We referred to these in past calls with the national backbone build and the provincial builds. So these continue, but then we did have the situation during 2018 of the ZTE ban that was put in place and then resolved. And ZTE is from our perspective still in the process of working to catch up essentially a number of things that might have been tender releases during the course of the ban, we believe were largely delayed. And so essentially the market waited for the ZTE situation to be resolved, the domestic market. And so now ZTE is working hard with their supply chain partners to catch up on things that were on hold for several months. With respect to 5G, there is some very early activity this year, but really we'll see that start with some volume in 2019, specific timing for ramp is not something that we have very good visibility to tell you about.

[Tim Savageaux:]

And well with that demand environment, I think if you look at the guidance for Q4 and consider the access sale, I mean, you're kind of back toward levels that you saw in 2016. I think the real delta from here to there, as you’ve been pretty disciplined on the OpEx side is gross margin. So Beth, I wondered if you could sort of step through the same math for the guide, which is a mid-range 26 in terms of where you expect product margins to be and what the offsets might be and how you guys expect that to progress throughout ’19, which is to say, at what point do product margins intersect with product margins, somewhere in the lower 30s?

[Beth Eby:]

So we do expect the product margins to drop a couple of points in Q4, as we get the initial impact of the price reductions. What always happens every year with the price reductions, you get -- you start to see them in the beginning of December and then they fully play out in Q1. So, product margins will come down a little bit and then we expect to get to, we always have and if you go through the historical numbers, we've got -- always had 3 to 4 points of other cost of sales, type of charges. So that's not a bad thing to keep modeling through and then we have the somewhat overlapping that, but we have a couple of points of under absorption on our laser fabs that we've been discussing. Going forward through -- into 2019, we, as usual, expect gross margins to continue to improve, as we both ramp through the year and get cost reductions through and -- but we do expect, as I mentioned, we do expect a little bit of impact from tariffs as long as those remain in place.

[Tim Savageaux:]

Got it. And then, sorry, just a final follow-up for me and this is focused on some of the emerging parts of your business and you mentioned multicast switch as kind of a high single digit contributor and I think it's notable that that's heading into both the datacenter and metro deployments. If you take another couple of emerging pieces, say 400, 600 gig in cloud, let's call it, both intra and inter data center. In addition to MCS, if you aggregate those three or however you want to approach it, what level of materiality are we at in terms of the total contribution of the business?

[Tim Jenks:]

Well, I think the -- just adding up, you start with multicast switch and high single digits and then -- and with respect to the highest data rates, 400 gig and above, I said earlier, those were kind of at the 10% level. Yeah. And the other thing is that, that takes you to 20 plus percent. So, let's call it, 20% to 25%.

[Operator:]

We'll take our next question from Dave Kang with B. Riley FBR.

[Dave Kang:]

So first question is on the Chinese ports. So, is it -- you’re still expecting 10% growth this year and what's your view for next year.

[Tim Jenks:]

We haven't given any annual guidance. So I think, we'll just guide quarter to quarter.

[Dave Kang:]

Okay. And then speaking of quarter-to-quarter, what about fourth quarter revenue outlook. Can you go over some of your growth assumptions, I guess, you're calling for about 8 million sequential growth. Are we expecting -- should we expect similar comparable growth from both North America and China or is one going to dominate the other?

[Tim Jenks:]

Well, in our prepared remarks, Dave, what we talked about is we do expect continued strength in the Americas and with the China business, we also expect to layer in more from the ZTE and its supply chain partners. And so I think, those are primarily elements, but we also have the effects that Beth talked about, which is offsetting pricing impact and then the thing that we're looking hard at is what are people doing, particularly in China with respect to the trade situation. Thus far, that's pretty muted, meaning, customers, at any point in time, might have a little bit of inventory and that ebbs and flows, based on what they anticipate with respect to tenders. So I think to some extent, we've been trying to move more raw material to finished goods and then have a bit more ability to react opportunistically. With respect to the China OEMs, there are other things playing out. So, just for example as ZTE tries to catch up, they’ll -- at least in the short term, they might be just a little bit stronger, but then when they get to a more normal environment, which we said in our prepared remarks, might take a couple of quarters, then that would level out.

[Dave Kang:]

And speaking of ZTE, did you disclose what their revenue was for third quarter and what do you expect for this current quarter?

[Tim Jenks:]

We didn't. We did have some shipments to ZTE in the third quarter, but it was pretty small. And last quarter, we said that we didn't really expect much business with ZTE and we had a small amount. I think it's important to note that at the time that the ban hit, we didn't have any finished goods necessarily, because we're generally supplying into supply chain partners and so the types of products that we sell then have 8 to 12 week lead times and if you recall during the third quarter, when the ban was resolved, that was less than 8 weeks before the end of the quarter. So, it was very difficult to have much in the way of third quarter shipments because we didn't have any finished goods. They had to go through the entire supply chain. We did have a small amount in the third quarter, but we would expect it to be larger in the fourth quarter.

[Beth Eby:]

And Dave just to -- when the ZTE ban hit, we issued a press release that said that we have expected ZTE and their supply chain partners to grow to about 5% this year and that's pushed out. So they won't be a 10% customer that we’ll disclose this year.

[Dave Kang:]

But you think they'll be maybe like mid-single digit percent this quarter, current quarter?

[Beth Eby:]

No. I think, we had expected them and their supply chain partners to grow to 5%. And that was before the ban and now everything's pushed out.

[Tim Jenks:]

Yeah. When we say the supply chain partners, Dave, some of the things that we sell through to ZTE include a number of components. So it's not just ZTE is the direct customer we're referring to, but it's also referring, for example, to companies that make modules that they sell to ZTE and they may buy certain components from NeoPhotonics. So, the sum of all of those was, what we said, could reach 5%. So any given customer would be low single digits.

[Dave Kang:]

And then on the upcoming price reduction, you think it will be the usual 10% to 15% or maybe is it closer to 10 or closer to 15?

[Tim Jenks:]

Well, we have some important ones that haven't happened yet, so we can't really say what it's going to be. Those numbers have -- the ranges that you just expressed have been around for a lot of years. So we don't have a different metric to go by. So I'll say that that could be the case.

[Dave Kang:]

And my last question is, one of your competitor is already ramping CFP2-DCO. So what do you think the runway is for CFP-DCO? And are they used for different applications?

[Tim Jenks:]

Two things. Yeah. The CFP-DCO versus CFP2-DCO do have some different applications. The CFP-DCO is a product that has both, quite a lot of deployment, notably in China, but it spans the range of applications in transport. And so the ongoing sale of DCO will continue as long as, if you will, they have empty slots and line cards that will continue to use additional DCOs. And then, the applications for CFP2-DCO, this is the lower power application as well. So, in general, that has to be taken into account. The market expands with the advent of CFP2, but particularly in the China market, the bulk is CFP.

[Dave Kang:]

But just out of curiosity, is CFP2-DCO on your horizon?

[Tim Jenks:]

There are a range of things that are on our horizon at different data rates. In the case of CFP2, the preponderance today is in 100 and 200 gig. The CFP is today primarily 100 gig and then a lot of the development actually now is looking out to 400 gig. We haven't announced any additional modules at this point.

[Operator:]

And we'll take our next question from Alex Henderson with Needham.

[Alex Henderson:]

I did get cut off back there, so I may have missed a question or two. If I ask something that has been asked, I apologize. Going back to ZTE for a second, I was somewhat surprised when I looked at the ZTE filings in September that their inventory appears to be pretty much at the same level that it was at before the embargo was imposed on them. Can you talk about a little bit about what you think is going on there? Is that a function of, they've got a lot of finished product that is missing, just one or two key elements before we can ship and therefore the inventory looks high, but it's still waiting for the components to go into the transceivers and things of that sort to go into it or is there some other metric going on there, because I was surprised at how strong their inventory was, how does that jive with your commentary that they're catching up still?

[Tim Jenks:]

Well, the thing about it, I think is, when the ban happened, people wondered if there would be share shift. There really wasn't share shift in the domestic market. Essentially, customers that were actively deploying ZTE equipment then were in a position where they had to wait for ZTE to resolve the supply chain ban and then come back online. It's a big machine and in order to turn on shipment of complex systems with hundreds of components, you actually have to have all the components. And so I think ZTE has been working aggressively to ramp up their supply chain and get things back underway, but it's a lot more complex than turning on a light switch. It's essential that they have all of the products running that their supply chain is, if you will, fully oiled and they've been very engaged with their supply chain partners in doing this. And so, I think, we see our products are pretty specific and they're not necessarily commodity parts and essentially as an indicator. I said to an earlier question that these things can take 8 to 12 weeks. And so when they turn back on, it takes some, let's say, that amount of time and a bit longer to get going. And therefore, last quarter, we said we wouldn't have any material sales from ZTE, we would in the fourth quarter, that is in our outlook and then we would expect more normalized environment by the time we get to 2019. But 2019 is why Beth says that it's a bit pushed out. Does that help?

[Alex Henderson:]

That’s useful. Thank you. Just a down below the line, can you talk a little bit about what you're thinking on the tax line as we go through – go in to ’19. Should it be about the same as ’18, lower or higher, any puts or takes on that?

[Beth Eby:]

I would expect a little bit higher, because we will be profitable. We have tax loss carryforwards in the US, but we still have 35% tax rates in Japan and 25% in China.

[Alex Henderson:]

And similarly on the interest and other line, any thoughts on that area, as we go into 4Q, what we should be using for that? I mean, obviously, you had a nice currency benefit in 3Q?

[Beth Eby:]

Yeah. I'm not going to forecast currency benefit. I do expect our debt to remain about the same.

[Alex Henderson:]

So probably just drop the currency out and everything else stays the same?

[Beth Eby:]

Yeah.

[Alex Henderson:]

Okay. One last question and probably you’re not going to answer it, but I'll give it a shot anyway. How should we be thinking about kind of the long term model here? You haven't really talked about a longer term structure of the company for a long time, because you've been working through the profitability issues, but as we start to think about getting profitable, is it 2 or 3 years to get to double digit margins and do you think it's a 10% growth company off of this base or better, what kind of thoughts would you leave us relative to the broader picture, not necessarily for the next couple, 3, 4 quarters, but longer term?

[Tim Jenks:]

Well, let's see. The opportunities that we're looking at pretty optimistically are in the 400 gig, 600 gig and above and these do take some time for our customers at the systems level to ramp their innovations. We have important design wins, we're shipping all of the 64 gigabaud products. We think we have an advantageous and leadership position there. This generally applies first in system applications that are at a pizza box or a line card level. Pizza Box referring to a shelf installation and a line card more of a proprietary OEM system. And so these are being deployed today at 400 gig and then we think in 2019, we'll start to see some 400 applications. This actually increases the amount of business that, at a component module level, but is less than pizza boxes and line cards and more directly in modules. Each of these, I think, our growth opportunities that really are second half 2019 and beyond, ZR will really, it will begin the second half of ’19, but it's more of a 2020 event. We expect that we'll have continued deployments and growth with respect to multicast switches and EML, CML lasers as we go from 28 gigabaud to 53 gigabaud. And then finally a range of innovations that have to do with our lasers for silicon photonics based transceivers. These are applications that are DR1 and FR1 as well, excuse me, DR1 and DR4, as well as FR4 applications for silicon photonics based devices. And so, we have a range of innovations across both line side and client data center that I think positions us well for continued growth beyond 2019 into 2020 and 2021. I think for the next 12 months, we're in the situation of having very strong design win positions, but we will be increasing spending to support some of those 400 gig innovations as Beth talked about and then getting the products into production and ramping for 2020. I hope that helps.

[Alex Henderson:]

I was really looking for broader perspective of whether you thought you were a double digit growth company or whether that’s too far reach and whether you think you can get to double digit operating margins.

[Tim Jenks:]

Yeah. I think, if we're talking about financial outlooks, I think we'll stick to quarter-to-quarter.

[Operator:]

That concludes today's question-and-answer session. I'd like to turn the call back to Tim Jenks for any additional or closing remarks.

[Tim Jenks:]

Thank you, Lauren. Thank you to all the listeners for your time and interest in NeoPhotonics today. We do look forward to updating you on our progress in the future. Have a good day. Bye.

[Operator:]

And that does conclude today's conference. We thank you for your participation. You may now disconnect.