NeoPhotonics Corporation
Q3 2016 Earnings Call Transcript

Published: 4 Nov 2016

[Operator:]

Welcome to the NeoPhotonics 2016 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. You may listen to a webcast replay of this call by visiting the event calendar page of the NeoPhotonics website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations, Investor Relations for NeoPhotonics.

[Erica Mannion:]

Good afternoon. Thank you for joining us to discuss NeoPhotonics operating results for the third quarter of 2016 as well as the company’s outlook for the fourth quarter of 2016. With me today are Tim Jenks, Chairman and CEO, and Ray Wallin, Chief Financial Officer. Tim will begin with a review of the third quarter results. Ray will provide a financial update including results for the third quarter and the outlook for the fourth quarter and then Tim will summarize before opening the call up for questions. Material contained in the webcast is the sole property and copyright of NeoPhotonics, with all rights reserved. Certain statements in this conference call, which are not historical facts, maybe considered forward-looking statements that involve risks and uncertainties and include statements regarding future business results, levels of sales and profitability, subsequent events, product and technology development, customer 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 3, 2016 and are described in our SEC filings, including our Annual Report on Form 10-K for the year ended December 31, 2015 which was filed on March 15, 2016 and our Quarterly Reports on Form 10-Q for the quarter ended June 30, 2016, which was filed on August 9, 2016. A copy of the company’s press release may be obtained by visiting the company’s website. Now, I will turn the call over to CEO, Tim Jenks.

[Tim Jenks:]

Thank you for joining us today. In our third quarter, NeoPhotonics delivered solid revenue results of $103.3 million, with non-GAAP gross margin of 27.6% and non-GAAP EPS of $0.06. Our reported results demonstrate strong growth in the quarter, driven by 100G and beyond demand across all high speed product families. High Speed 100G and beyond products again increased to a record 67% of revenue with mid-term demand continuing to increase across all 100G products, including coherent line side products, client side components and modules and multicast switches. We experienced strong growth in the third quarter, with unprecedented customer demand for our 100G and beyond products driving record shipments in the quarter. On a year-to-date basis, our 100G and beyond revenue in the first three quarters of this year is up 38% versus the first three quarters of 2015. These trends, as well as our key market drivers, each bode well for our outlook to accelerating growth in 2017. However, during the quarter we experienced a standalone external event which impacted revenue and profits, without which our reported results would have been even stronger. At the end of the quarter, unexpectedly, a distribution partner serving parts of the China market filed for bankruptcy reorganization in Hong Kong. The result of this event was a reduction of both revenue and profits by $2.25 million, which Ray will detail in a few minutes. Excluding the impact of this event, third quarter revenue would have been $105.6 million. And our High Speed 100G and beyond product growth would have been 53% year-over-year and 10% quarter-over-quarter. We have already made adjustments to our sales structure for the distributor situation such that our business will not see any additional impact from this. As we outlined on our last call, in order to ensure NeoPhotonics has the capacity to serve the ever growing demand for our high-performance 100G products into 2017 and beyond, we are pursuing a 2-year capacity expansion program, the initial fruits of which helped drive our record shipment volumes in the third quarter. We have been adding capacity for 100G and beyond products steadily through the year and we have made progress to eliminate bottlenecks in our supply chain. As a result, we are starting to see the benefits of the increasing output for ultra-narrow line-width tunable lasers as well as coherent receivers, EML lasers, 100G client modules and multicast switches as we have discussed on prior calls. While we are working hard to increase our capacity to serve the growing market need for our products, it’s worth highlighting that capacity constraints continue to exist throughout the overall industry supply chain, which has an effect on our growth rate. As incremental industry bottlenecks are addressed, we expect the underlying market demand for 100G and beyond products will drive significant growth into 2017 and beyond. This will happen as 100G deployments continue to expand globally for both telecom and datacenter applications and as the bulk of our new capacity comes online. Taking this into account, we continue to expect revenue growth for 2016 to be approximately 22% with a higher growth rate in 2017. This is inclusive of our PON end-of-life plan. In addition to the capacity we are bringing online for our existing products and to help further drive growth in 2017 and beyond, we have also taken steps to accelerate some of our key R&D developments to intersect new market demand requirements for higher speed 400G and beyond applications and for certain products used in coherent modules. Hence, we anticipate we will see our R&D investment increase by 1% to 2% of revenue as we support these additional programs, which is inline with our target model. Moving on to the market drivers for our business, China demand remains strong as anticipated across multiple customers, though we continue to expect such demand maybe a bit lumpy quarter by quarter. Near-term, we continue to see ongoing demand from the China Broadband 2020 deployment as new channels are lighted in existing equipment, and we anticipate increasing volumes together with new awards for Phase 12 of the deployment beginning in 2017. This will happen as the Chinese carriers continue to also build out provincial networks that are ongoing and then continuing to add backbone network capacity in their national network as part of Phase 12, which all together may increase the number of 100G ports in China by 30% or more in 2017. Market strength also anticipates moving from 4G LTE to pre-5G wireless installations that are beginning to happen and then more fully to 5G in the longer term. This is a major trend and a driver for the medium and long-term. Similarly western demand is driven by North American carriers and with continued metro strength at Verizon, growing DCI deployments and new announcements for AT&T to begin initial 400G installations. In our coherent products business, we are seeing strong increases in demand, notably for micro ultra-narrow line-width tunable lasers, coherent receivers and our new coherent pluggable modules, including strong demand for components used in coherent pluggable modules. As we mentioned in our last call, demand for ACO or analog coherent optical modules is stronger in the west with DCO or digital coherent optical modules preferred in China. NeoPhotonics is benefiting from these trends due to product performance and features that are unique in our components. For example, our compact ultra-narrow line-width tunable laser has a fundamentally narrower line-width than competing products. Advanced modulations at 32QAM and 64QAM to support 400G and 600G data rates require this ultra-narrow line-width capability. For this reason, this product category is seeing very strong demand, growing by 4 to 5 times in volumes since the middle of 2015. We have previously noted that our micro coherent receivers are specially designed for use in CFP and CFP2 modules and we are designed in with several of the leading volume module manufacturers. But we are now also seeing strong traction for component designs in line cards, transponders and daughter cards for 400G applications. This is important, as the 400G market is not yet open to pluggable modules, but continues to represent an important element of industry direction and growth. At the ECOC Tradeshow in Dusseldorf, Germany in September, we introduced our Class 40 High Bandwidth Micro-Intradyne coherent receiver, which is capable of supporting 64 Gbaud symbol rates, double that of current ICRs. This augments our Class 30 coherent receiver at 45 Gbaud announced last March at the Optical Fiber Communications Conference. When coupled with our ultra-narrow line-width tunable laser, these products now fully support higher order modulation up to 64QAM, enabling network data rates up to 600Gbps over distances of 80 kilometers. NeoPhotonics is unique in our ability to provide these ultra-high speed solutions for the next generation of high-speed digital optical communications. 100G and beyond coherent transmission is the technology of choice for long-haul, metro and DCI connections. As a result, the use of contentionless switching architectures in coherent networks is expanding and is critical for Software Defined Networks for Metro applications and in some web scale content providers’ datacenters, which are driving increases in demand for our switching products. Our Multicast Switch product expands NeoPhotonics’ product line in the 100G metro ROADM market. Moreover, contentionless architectures are being trialed in several cities in China that we expect will drive rapid volume increases when deployments begin, likely in about 1 year. For applications inside the datacenter, we expect our 400G CFP8 transceiver based on eight of our 28 Gbaud EML lasers using PAM4 transmission to enter production next year and we expect that our 56 Gbaud EML lasers, which can transmit at 400G data rates with only four lasers, again utilizing PAM4, should see deployment in the following year. Before I turn the call over to Ray, as a reminder, we previously announced that we would further focus our direction on our High Speed 100G and beyond products, as we announced our planned end-of-life for certain passive optical network, or PON, products. We expect our PON products to total approximately $30 million this year, with end-of-life by the middle of 2017. With our announced EOL of this business, our remaining high speed products will continue to fuel our growth. Among these and first in growth are our coherent components, which reflect the significant increases in capacity and output in which we are investing. Second is the pending acceleration of pluggable coherent modules, in which we participate both as a component supplier and as the module supplier. Third is coherent switching, represented by our Multicast Switch product line and used in colorless, directionless and contentionless or CDC networks for metro and long-haul applications. Fourth is the very strong growth in our high-speed EML lasers and drivers, which are used in client-side transceivers for 100G at distances in the range of 10 kilometers and 400G PAM4 based CFP8 modules and lasers at similar distances. Finally, we are seeing steady performance from our passive products, such as VMUX and ROADM drop modules, which we report as part of network products and solutions. For the products I have noted, our capacity additions provide volume increases of 50% or more in coherent products and EML lasers and more than doubling of volume in switches and 100G modules next year. We have been steadily investing in and expanding our high speed capability and product solutions for several years. When our PON changes are complete, our results will no longer have to overcome headwinds from declining revenues from lower speed products. Rather, our full product portfolio will be focused on the highest performance and highest speed requirements, which are in the highest growth market segments. This concludes my comments and I will now turn the call over to Ray Wallin, our Chief Financial Officer. Ray?

[Ray Wallin:]

Good afternoon and thank you for joining us today. I will start with the third quarter financial results and close with the outlook for the fourth quarter. In Q3 we reported revenue of $103.3 million, non-GAAP gross margin of 27.6% and adjusted EBITDA of $8.3 million or 8% of revenue and non-GAAP earnings of $0.06 per share. Notably this was the strongest shipments quarter in the company’s history, both in total revenue and volume and also that we grew approximately 24% organically over the same period last year. While these results were very strong, we had cash flow from operations of approximately $4 million. And the cash flow from operations was impacted by an increase in accounts receivable from shipments accelerating in the second half of the quarter. Further, we spent approximately $15 million to expand production capacity. As good as the quarter was, on September 30, 2016, one of the company’s distributors filed for reorganization in Hong Kong. As a result of the uncertainty associated with recent payments and receivables associated with this distributor, the company reduced revenue and profits reported in the third quarter by approximately $2.25 million. Now, the impact from this on the financial results for the third quarter of 2016 was a reduction in non-GAAP gross margin of approximately 1.6 percentage points and non-GAAP EPS of $0.05 per share. Now, since the process is a reorganization, there may be opportunities for recovering a portion of this amount as the court makes decisions on creditors and the terms of the restructuring. Now, let’s walk through our third quarter ending September 30, 2016 financial results in more detail. And I will focus most of the discussion around non-GAAP results which exclude stock-based compensation expense of $8.8 million, driven by the higher stock price during the quarter and inclusive of an incremental approximately $5 million accelerated charge I will briefly explain later, along with amortization of acquisition related intangibles of $1.3 million. And we have posted a full GAAP to non-GAAP reconciliation at our website at www.neophotonics.com and in our press release which may be useful when comparing GAAP to non-GAAP results. Excluding the impact of these events, our financial results in the third quarter would have been revenue of $105.6 million, gross margin of 28.1% and breakeven earnings per share. Our non-GAAP gross margin would have been 29.2% and non-GAAP EPS would have been approximately $0.11. Revenue of $103.3 million was above the midpoint of our outlook range, up 24% from the year ago period and up 4% from our prior quarter. High seed revenues were 67% of total revenue and network products and solutions were 33% of the total. Geographically, our revenue mix for Q3 was 19% in the Americas compared to 20% in the prior quarter. China was 61% of revenue, up from 60% in the prior quarter. And Japan was 5% and the rest of the world was 15% of total revenue, both remaining the same as the prior quarter. We had two 10% or greater customers in Q3, with Ciena at 15% of our total revenue, compared to 16% in Q2 and Huawei Technologies including Huawei affiliate Hi-Silicon Technologies at 48%, compared to 45% in Q2. In total, during the quarter we had four customers who represented 5% or more of revenue, which demonstrated the continued strength we are seeing across all of our largest customers. Now, on a non-GAAP basis, gross margins were 27.6% in the September quarter, which was below the lower end of our guidance range of 29% to 31%. And gross margins were impacted by the previously discussed distributor reorganization charge of $2.25 million in addition to the absorption of some mid-year higher volume related price adjustments, PON under-recoveries and additional ramp-up costs. Non-GAAP operating expenses were 24% of sales, towards the upper end of our guidance range due to new product R&D, principally for advanced coherent developments. Non-GAAP operating income and net income were each 3.7% and 2.8% of revenue respectively, resulting in earnings of $0.06 per share, based on a fully diluted share count of 46.7 million shares, which would have been $0.11 per share without the impact of our distributor’s reorganization. In Q3, the normalized non-GAAP tax rate was approximately 15% and the GAAP tax rate was 19%, which excludes the tax effects of the distributor reorganization. And we expect our Q4 2016 GAAP tax rate to be approximately 15% and our non-GAAP effective tax rate to be approximately 7% based upon our current tax environment. Now, turning to our GAAP results, we took an accelerated stock-based compensation charge for the third quarter of $5 million. As previously disclosed in the company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015, certain of the company’s key personnel and executive officers hold performance stock awards with vesting provisions tied to the market value of the company’s common stock price. Now, these performance awards vested in Q3 as the average closing price of the company’s common stock over a period of 20 consecutive trading days exceeded $15 per share, resulting in the company recording a non-recurring charge of approximately $5 million of incremental stock-based compensation expense. All of these awards are now fully vested and there are no additional unvested performance awards outstanding. But, an additional approximately $1million of stock-based compensation expense will be recognized in cost of goods sold in Q4 from the acceleration of these performance awards. Now, GAAP Q3 gross margin was 27% down from 28% in the prior year period and from 28% in the second quarter of 2016. Now, the gross margin was not impacted by incremental stock-based compensation expense associated with the vesting acceleration as noted above as our GAAP accounting policy is to amortize this over inventory turns. GAAP operating expenses were $33.8 million, or 33% of revenue, inclusive of $8.5 million of total stock-based compensation expense driven by the non-recurring vesting acceleration of the performance based awards. Now, as a result of these charges, on a GAAP basis in the September quarter, we had a net loss of $7.2 million, or $0.17 per share, reflecting one-time charges of $0.12 for the extra stock-based compensation and $0.05 for the distributor reorganization based on a GAAP share count of 42 million shares, reflecting the requirement to use basic share count in a net loss situation. Now, as Tim noted earlier, we are midstream in our 2-year capacity expansion efforts. And during the quarter, we spent approximately $15 million in CapEx, or approximately $30 million year-to-date in line with cash flow from operations and keeping us on track to be halfway through our expansion-related spending by year end. Now, considering this capacity expansion and balanced by our solid working capital and balance sheet management, our overall cash position declined by $10.6 million resulting in our ending the quarter with $102.9 million in cash, cash equivalents, short-term investments and restricted cash. Now, our total debt was $44.5 million, down $0.9 million. Accounts receivable increased by $8.8 million in Q3 ending at $95.7 million, with days sales outstanding of 83 days. Now, net inventory decreased $1.3 million in Q3 to $60.2 million, with days of inventory on hand further decreasing to 71 days from 77 days in the prior quarter reflecting strong demand for our products. Now, reflecting Tim’s comments regarding our markets and our capital expansion plans, we expect to achieve the following financial results for the December quarter inclusive of our PON products

[Tim Jenks:]

Thank you, Ray. Demand for High Speed 100G and beyond solutions is at unprecedented levels within each of our markets. And this makes us very optimistic about growth prospects going forward. As mentioned, we now expect to grow approximately 22% this year versus the 11% we grew last year, and we have increased our current R&D investments in order to accelerate launches of key products that we expect will begin to contribute to revenue in 2017 and continue to contribute to accelerated growth beyond next year. We anticipate Q4 sequential revenue growth of almost 10% after the strong uptick of our shipments in Q3 acknowledging charges against some of those shipments due to our former distributor and we are continuing to launch products and capabilities in support of the industry need for speed at 200G, 400G and even 600G data rates. This concludes our formal comments. And now, I will ask the operator to open up the line for questions. Yolanda?

[Operator:]

Certainly. Thank you, sir. [Operator Instructions] We will hear first from Alex Henderson with Needham. Please go ahead, sir.

[Alex Henderson:]

Hey, guys.

[Tim Jenks:]

Hi, Alex.

[Alex Henderson:]

First question and it’s really just to get the data right, you said that the non-PON revenue was what to what and compared to what to what? I didn’t catch it.

[Ray Wallin:]

So, the revenue-less PON, this is talking about the fourth quarter.

[Tim Jenks:]

You want the third quarter?

[Ray Wallin:]

Third quarter or the fourth?

[Alex Henderson:]

Yes, both.

[Ray Wallin:]

Both okay.

[Alex Henderson:]

Yes, please.

[Ray Wallin:]

Well, let’s start with the fourth quarter. So, we said that the guidance for revenue would be $109 million to $115 million or about 5.5% to 11% sequentially. If I exclude the PON, those numbers will go from $109 million to $105 million and the $115 million goes to $111 million, there was about a $4 million change. So, that would be up from $97 million in Q3. That was the Q3 number. And so the increase quarter-to-quarter, when you exclude PON at a $105 million to $111 million, would be 8% to 15% sequentially versus the 5.5% to 11%.

[Alex Henderson:]

What was the PON in the third quarter?

[Ray Wallin:]

$97 million.

[Tim Jenks:]

$6.7 million.

[Ray Wallin:]

$6.7 million. So it would be…

[Alex Henderson:]

Got it. Thanks. The second question is obviously this distributor was out of left field, we weren’t – certainly weren’t expecting that.

[Tim Jenks:]

We could.

[Alex Henderson:]

But you weren’t. So, it sounds like what happened is you sold the product, they sold the product or did whatever they did with it. The revenue that you would have gotten from that is not something you can be sure you are going to get hence even though the product probably went through the distributor, you can’t recognize road if you get the revenue in. Is that correct?

[Ray Wallin:]

That is correct. Yes so what happens there is certainly the pass-through distributors. So, the actual revenue or the product actually ended up in customer’s hands. There is some inventory left to distribute or there was just a few hundred thousand dollars, but all that shipment went through to the end customer, but because the collectibility wasn’t assured from the distributor, we are not able to recognize the revenue of $2.25 million and of course, all the profit associated with it. We weren’t able to take that either, so the double hammy.

[Alex Henderson:]

Okay. I just want to make sure I understood the mechanics of it. And then the forward-looking I assume that since this happened before the end of the close of the quarter that there is no impact in the 4Q as a result of this or is it that now creates a rerouting problem that could cause some impact in terms of logistics and deliverables?

[Ray Wallin:]

Well, I will just say the answer to your question is should be no impact from this particular issue. We have already rerouted the sales channel. So, they were selling directly to the end customers at this point. And so there has been no interruption in terms of our sales for the fourth quarter at all. Now, we may – there is going to be a bankruptcy. We may get some – I don’t know it certainly won’t be resolved by fourth quarter. There are possibilities of getting reimbursements here that I don’t want to go through. So, there will be no impact. If there is an impact, it would only be a positive impact.

[Alex Henderson:]

Right. In terms of the gross margins, they did come in a little even after adjusting for the distributor issue still are at the lower end of band and it sounds like you had some ramp up costs with new capacity coming on in the quarter. How should we think about the slope of what’s going on there? I mean, it seems quite clear that ought to be improving as your volumes ramp.

[Ray Wallin:]

Yes. So, we are guiding non-GAAP gross margins at 30% to 33%, with the midpoint of 31.5%. So, if you adjust for the distributor issue and say okay, gross margins were say, roughly 29%, so we are guiding up about 2.5 points on gross margin we have been talking about. We are seeing an acceleration in our gross margin as we go forward.

[Alex Henderson:]

Right, okay. And the capacity coming on stream in the upcoming quarter is it comparable to what came on last quarter?

[Tim Jenks:]

Generally, Alex, this is Tim. Yes, generally, it is – so output is higher as Ray made a comment about the cash flow from operations, because we had a fair amount of AR come in, because essentially we have been accelerating this through the second half of the quarter and that continues in the fourth quarter. And the capacity is higher, the output is higher, the shipments will be higher and therefore our outlook on revenue was higher.

[Alex Henderson:]

Thanks.

[Ray Wallin:]

Thanks Alex.

[Operator:]

We will take our next question from Troy Jensen with Piper Jaffray. Please go ahead.

[Troy Jensen:]

Thanks for taking my question, gentlemen. Quickly Tim, I am curious – or Ray what was your expectation for your PON business for Q3 three months ago?

[Ray Wallin:]

So we actually expected it to be just a little bit lighter than it actually came in. We forecasted it to be a bit north of $4 million and it actually been $6 million.

[Troy Jensen:]

Okay. So that probably paid a little impact too on to the gross margins being lower than we thought?

[Ray Wallin:]

That is correct.

[Tim Jenks:]

Plus there is – there is still some overhead as a result of PON business being shifted around. So those costs get reflected in our quarter as well, so.

[Troy Jensen:]

Yes, understood. And then maybe just two more here, the Multicast Switch opportunity in China, I think you had said at your Analyst Day that you expect the Chinese operators to make a decision on contentionless architectures sometime in November, just curious to know if they made decisions or if they are lean one way or another?

[Ray Wallin:]

We don’t expect that those decisions have been made yet. We are pretty close in touch. But they should be forthcoming soon. So we are still expecting decisions to be fairly soon.

[Troy Jensen:]

And what kind of a probability on contentionless?

[Ray Wallin:]

Our understanding is all the trials have actually done quite well. So I think the bigger question is how extensive are the CDC networks in terms of the overall rollout. I think it’s less of a question whether they would be deployed and more a question of how extensive, for example, broadly in the metro market versus metro in Longhorn.

[Troy Jensen:]

Great, okay. Understood. And then Tim, you did right after some of this information, here I just kind of didn’t capture it all but the CFP8 LR7 product, when do you expect to have that generally available and do you still think you will be first to market with it?

[Tim Jenks:]

We expect actually the CFP8 LR8 will be in general availability in 2017, likely in the second half of 2017. And we would expect that it will be the following year that we could potentially go to in LR4, which would be the so-called single lambda 100G. So the whether or not we are the first to market, I think this remains to be seen.

[Troy Jensen:]

Okay, alright guys. Good luck going forward.

[Tim Jenks:]

Thanks very much Troy.

[Operator:]

Our next question will come from Jorge Rivas with Craig-Hallum Capital Group. Please go ahead.

[Jorge Rivas:]

Hello guys. Jorge sitting on behalf of Richard, first question on gross margins, I might have missed the commentary on why the gross margins came out a little bit below the or towards the low end of it the guide, excluding the impact from the bankruptcy, was – I understand there is some more absorption coming from the increased depreciation, but was there any – maybe you saw higher sales on 20G speeds and below?

[Tim Jenks:]

Well, as the – I will make one comment and then ask Ray to follow-up. But we have some affect of mid-year volume related pricing adjustments. We did have higher than expected PON shipments with lower margins overall, which was reflected in the last question and then other impacts are ramping in mix.

[Jorge Rivas:]

Okay. So I guess touching on pricing, it seems the commentary seems consistent across the industry that these renegotiations will benign compared to previous years, so it may be towards the lower end of 10% to 15% historical range, what I want to take is for next year and along with that, is there a different type of negotiations between the metro and long-haul as you ramped your metro products to become part of the mix, but I am wondering if you are seeing higher pressure may be on the metro side than on the long-haul?

[Tim Jenks:]

Let’s see, there really isn’t a difference in the way that those negotiations take place. Really there is no difference. However, there is a difference between metro and long-haul products. And so as volume shifts increase in the metro, the metro products generally are affecting results in terms of mix. So if you think about metro products are generally – they can be smaller size, lower spec, not requiring as long the distance. For example, if we are talking about either transmitters or receivers. And so generally the pricing, the ASPs are lower, even though the margins are similar. And so that volume mix what we see is, impacts of those metro products being higher volume, but not really much difference in terms of margin. Just parenthetically I made the comment earlier with respect to bankruptcy, we did have a bit higher than expected in the PON situation, the corollary to that is, with respect to products that were affected by bankruptcy, essentially those were all high-speed 100G products. So we have a bit more of the low-speed, lower margin products in the third quarter and a bit less of the high-speed, higher margin products because the $2.25 million that Ray talked about was in the high-speed category.

[Jorge Rivas:]

Okay. And how about the – how are the renegotiations happening for next year, do you see trend towards the low end, that was the other part of my question?

[Tim Jenks:]

Well, I think generally speaking, because of the fact that volumes tend to be constrained and demand is strong, we normally expect negotiated price changes in the range of 10% to 15% per year and we may see those towards the low – bode for the lower end. But as a lot of them haven’t happened yet. We don’t know that to be the case.

[Jorge Rivas:]

Okay. Thanks for that color guys, I appreciate it.

[Tim Jenks:]

Thanks Jorge.

[Operator:]

Our next question will come from Simon Leopold with Raymond James. Please go ahead.

[Simon Leopold:]

Great. Thanks for taking my question. A couple of things Tim, first on 2017 outlook, you indicated you expected growth over 2016, which means better than 22% sales growth, during the Analyst Meeting you hosted this year, you threw out a number of 25% as, I guess an aspirational goal, can you help me reconcile the difference between the greater than 22% and the 25% number you talked about at the Analyst Meeting?

[Tim Jenks:]

Sure. The 22% is this year and of course reflects things inclusive of the PON changes as well as the bankruptcy. And so those are all fall in the 22% and consistent with our outlook for the fourth quarter. And then I think when you refer to the Analyst Day that we held in New York on September 8, we did talk about the fact that, with the industry growth, we would expect that we will – likely will exceed the 25% growth rate for next year, but essentially in line with that. I would just reiterate what we are doing on overall expansion. So in the overall expansion level, we are really growing our – all of our coherent products by 50% or more, as well as our EML lasers. And then for both switches and 100G modules, these are all growing at 100% or more. This is on a volume level as opposed to a revenue level. But then our passive products are essentially flat and so the only headwinds we have had is really in the low-speed and PON products, hence my comments about that. I hope that helps.

[Simon Leopold:]

No, I appreciate that. And I think you disclosed in the prepared remarks that quarterly CapEx of $15 million, I am just wondering what you are thinking about is the CapEx budget for the December quarter as well as 2017 CapEx?

[Tim Jenks:]

So, yes, what we said was our spending thus far and Ray you may want to comment on this, but our spending in the quarter was $15 million. We said that it’s $30 million of spending year-to-date. So, that’s on plan. We expect to be halfway through the spending by year end. And we comment on spending, because obviously the spending itself follows by payment terms timing the actual installation and commissioning. So, we are probably well past the halfway part in terms of the capacity increases. But from a spending level, by year end, we would be at the halfway point. Ray, do you want to weigh in on this?

[Ray Wallin:]

Yes. Maybe I give you some numbers here. We talked about the $30 million of the cash outflow for the first three quarters of the year and that’s pretty much in line with our cash flow from operations about $29 million and EBITDA about $33 million. But however, we actually have in-house and in-service and some of this is not paid for approximately $50 million of the capital. So, you can see from actually bringing it in-house, getting it qualified and so on and so forth and well down the path over $90 plus million plan.

[Simon Leopold:]

Okay. And so just from a perspective of just modeling cash flow for the fourth quarter, what should we assume on the CapEx line?

[Ray Wallin:]

Well, I think it’s safe to assume probably about $23 million.

[Simon Leopold:]

Okay. And then one last question from me is I don’t know that you can actually quantify it, but if you can give us some perspective on the 200G and 400G products versus the 100G products in terms of margin profile, ASP profile, how do they compare? So, when should we be tracking the breakdown, not just the 100G and above, but when does it become important for us to understand the mix of 100G versus 200G versus 400G? Is there anything you could do to help us with that?

[Tim Jenks:]

Yes, the differences between a 100G and 200G are not really appreciable. Those products tend to be similar and used at both data rates or in fact in dual rate products. They are different configurations and different products for 400G. This is true for a number of the laser products and a number of the receiver products. And those are ramping pretty significantly. It’s still small numbers. But we are essentially quarter-on-quarter growth rates are significant and the growth rates year-on-year, ‘17 over ‘16 will be in the 2x to 4x that of 2016. But I think the margins are higher, but because the volumes are low, it’s hard for me to quantify it off the top of my head, Simon, but I understand the question, and I think what we will try and do is give some additional insight of that going forward. I don’t think it will have a meaningful impact really until late in 2017 and then really in 2018. So, I think for the next couple of quarters, the variations there are small.

[Simon Leopold:]

Okay. Yes, I guess, all I would ask today is keep that in mind so as it becomes more material to modeling, if you could help us with that? Thanks.

[Tim Jenks:]

Okay.

[Simon Leopold:]

That’s all I had. Thank you.

[Tim Jenks:]

Great. Thanks, Simon.

[Operator:]

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

[Tim Savageaux:]

Hi, Tim.

[Tim Jenks:]

Hi, good afternoon.

[Tim Savageaux:]

Couple of questions. First kind of on the demand fronts with regard to China, so you did look to have seen even, I guess, even considering the distribution issue, a pretty solid uptake with Huawei in the quarter and also hard getting back to some pretty constructive comments at the Analyst Day about overall China demand. You did make a comment about potential lumpiness here and there. I don’t know if that was meant to indicate anything and so it wouldn’t seem to be the case in your guide. But, however, if you can kind of discuss what you are seeing near-term kind of in China relative to the uptick we did see and then kind of step back through what your expectations might be for ‘17?

[Tim Jenks:]

Okay. Yes. So, I talked briefly about the China broadband 2020 and we have been enjoying the so-called Phase 11, which went through the tender process in the first quarter and then we saw quite a surge in the first quarter over the fourth quarter of 2015 as they start to deploy the Phase 11 equipment. What happens after that initial surge is that essentially the carriers are adding more wavelengths to the initial equipment installations and so that Phase 11 has been playing out over a period of time. Now, the next due phase for tender is the so-called Phase 12 and we would expect that the Phase 12 bidding happens reasonably early in 2017, but the actual deployment maybe 6 months later after the bidding. And so the timing of – as we saw in the first quarter of 2016, we saw a surge from Phase 11. I would call that a large positive lump. And when we see Phase 12 after the tenders are awarded and deployment starts, we simply would expect a similar profile that would be – there maybe a surge. So, again, it could be a little lumpy. Now, generally we are talking about the national backbone and then there are also provincial builds that are going on. So, you have got provincial networks that are generally controlled locally and you have less overall visibility, but they do significantly add to total volume, but they tend to be a bit spiky. And so because they are controlled locally, you have less visibility to them and it’s harder to predict. We are much more dependent on each of our customers’ forecasts. And so we are very optimistic about the overall volume. We talked about the total growth rate. All of that is very good. But our ability at this point of time to predict the quarter-on-quarter level, it may not be a smooth ramp. And so I am not signaling anything more than that other than the fact that we saw that Phase 11 was lumpy and Phase 12 may also be.

[Tim Savageaux:]

Understood. And maybe that’s an indicator given the timing of Phase 12 that Q1 ‘17 might see some more typical seasonality versus type of fairly dramatic uptick we saw last year, which results in a tough comp and I think that might be a potential interpretation of that as well...

[Tim Jenks:]

That could be with the other variable being what happens in provincial deployments.

[Tim Savageaux:]

Right. Understood. Okay. And within all that kind of decent high level visibility, but – good high level visibility but due to low level – or only decent granular visibility despite that, I guess, the OpEx ramp would seem to signal some confidence in how things are going to proceed going forward and that does seem to be a bit more R&D heavy both in Q3 and Q4 guide. I think you mentioned kind of accelerated activity on the 400G front. Would we look at that as kind of the primary driver of that uptick over a couple of quarters?

[Tim Jenks:]

Well, no, I said that 400G as well as certain module products. So, module products impact both ACOs and DCOs. So, we do a number of products for CFP2 and CFP both in ACOs and DCOs. And then we also have activities around the CFP8 product which we talked about and we have specific developments that are focused on the 400G market. So, each of these are big opportunities going forward and for continuing to contribute to accelerating growth. And so it really demands our continued investment in these key programs.

[Tim Savageaux:]

Okay. And final question also kind of levering that OpEx increase, you have I guess been comfortable giving growth targets for ‘17 around the top line, throughout the year bottom line execution has been bit more of a challenge, but I wonder if for ‘17, you have – obviously, we know what the overall kind of business model targets are for you, you and your peers, they are pretty similar in terms of moving towards mid-30s gross margin, moving towards mid-teens operating margins, I guess at this point for ‘17, would you expect to achieve a double-digit operating margin, given some of the margin headwinds and OpEx increases you are seeing or do you any comment on that?

[Tim Jenks:]

No. We actually would expect to, because of a couple of reasons. We have talked about the growth rates and of course the growth rates that we are more able to predict are those that we can support with our capacity additions. That puts us in a good position to forecast on the margin side. We do have – from an operating point of view, we do have fabs that we run and with added volume going through the fab that provides certain amount of leverage. And then with the accelerated top line, we would expect that the overall SG&A costs are decreasing as a percent of the total. So the answer to your question is, yes we would expect to see two digit bottom line.

[Ray Wallin:]

Both Op income and the adjusted EBITDA would be north of double-digits.

[Tim Savageaux:]

Great. Thank you very much.

[Tim Jenks:]

Thanks Tim.

[Operator:]

Our next question will come from Dave Kang with B. Riley. Please go ahead.

[Dave Kang:]

Thank you. Good afternoon. First question is regarding R&D, so you said R&D will be going up, so I will be talking maybe 13%, 14% of sales or...?

[Ray Wallin:]

Well, I think what we are looking at Dave here is about 14%, we were 14% in – on a non-GAAP basis in Q3. And our guide has us in 14% for Q4. You will see some decline in those percentages as we get into 2017. But as we put in our prepared remarks, we are spending about 1% to 2% more of revenue on R&D than we had previously talked about. And simply because we are just seeing a tremendous opportunity in front of the company and want to make sure we are there with the products, we are accelerating some programs rather dramatically.

[Dave Kang:]

Got it. And I do have a question on the price negotiation, actually more on the timing, so in the past I guess it was in the October timeframe, regarding your fourth quarter guide, what are you assuming as far as the timing of the price negotiations?

[Tim Jenks:]

Well, Dave we have – in our prepared remarks, we noted that there are actually six different customers who represent more than 5% of our revenue each. And so we are focusing on those. Some of those actually happened in October, some in November, some in December. For us it matters, not surprisingly, it matters a lot what Ciena does and what Huawei does, because between the two of those, that’s more than 60% of our revenue. And essentially, the majority of those actually happened in November, December timeframe. So they are a little bit back end loaded, but they happen kind of sequentially through the whole quarter. What we generally say is that it’s as though it affects half a quarter, but some are in October, some are in December. Does that answer your question?

[Dave Kang:]

Yes. Because I mean in the past, I mean if you look at your third and fourth quarter – I mean the fourth quarter has been seasonally weak and the way you explained to me before was, while part of that is PON weakness, but then also it was the timing, that’s why your fourth quarter was seasonally weak, but now with the PON out of the way, we should be modeling fourth quarter to be seasonally strong now?

[Tim Jenks:]

Well, yes. And hence our guide up 10% in the fourth quarter and we have assumed in their certain effects of pricing. Essentially of our – we probably have three or four key customers that are actually done as off this point in time and the remainder yet to go at the beginning of November, so the remainder yet to go. So if you think about 10 strong customers, we are not surprisingly we one-third done. And then the timing of when those are implemented, generally they are implemented in a relatively short period of time following the negotiations. So they essentially impact like one month out of the quarter, if you will. So we are feeling pretty good about the fourth quarter. Our guidance compared to our third quarter is up about 10% in revenue and up in margins and as you pointed out with the smaller impact from PON.

[Dave Kang:]

Right. And then I just wanted to clarify, I think somebody else asked it already, but then of that one-third seem down already, so it sounded like you came in the low end of the 10% to 15%, so it was closer to 10% and 15?%?

[Tim Jenks:]

Well, I think it’s – I will just say that we expect overall, given the environment to be the lower end of the total range, I would rather not comment on specific customers. And I hope that’s okay.

[Dave Kang:]

Yes, that’s fine. And then going back to one that Phase 11 versus Phase 12, so as far as the volume is concerned, to your knowledge, is it going to be – is Phase 12 going to be comparable or bigger or smaller, any information at this time?

[Tim Jenks:]

Yes. We in our prepared remarks, I said that we expected to be up in the range of 13%, it could be a little higher than that.

[Dave Kang:]

And this is all because of Phase 12?

[Tim Jenks:]

No, it’s actually not all because of Phase 12, because Phase 12, we expect that the Phase 12 will go out to bidding. The tender awards will then happen and then one quarter, two quarters later, we will start seeing deployment. So what we actually see is as I explained on earlier question, what you are seeing right now is the impact of on added wave lengths on Phase 11, you are also – and how that affects the national backbone, the national network. But there are approximately 30 different provinces and autonomous regions across the country and all of them are building out. And so essentially, you also have a pretty significant amount of volume that comes out from those provincial network builds. And it’s less clear what the specific timing of those are, but because they are locally controlled, you can have multiple provinces that go into deployment at the same time. But actually that’s a large part of the capacity increase overall is the deployments of the provincial networks on top of the national networks.

[Dave Kang:]

Got it. And the last question is did you provide what the MCS revenue was?

[Tim Jenks:]

No. We have just said in the past that it will be approaching $10 million. We don’t see any acceleration to that. We think that 2017, what we said in the past is we expect to be at least 2x 2016, but we are – in terms of the overall volume, we are not going to – we don’t actually expect to get to $10 million. So my emphasis is approaching.

[Dave Kang:]

So, then that 2x comment you said baking in China or is it just non-China and what would that number be if China does go contentionless?

[Tim Jenks:]

Well, as I said about China, we don’t think that China – in China, you got actually the initial deployments. The initial field trials were being done by China Mobile. And now you have some additional work and interest with China Telecom. So, you got two of the three carriers now working on the TDC network structures. But as the initial field trials are finished later this month then they go into the overall network planning and tenders, etcetera, etcetera. So, we have got products that are in process for those applications, but I think I commented earlier that we actually – and actually in the prepared remarks that we don’t actually expect production volumes until a year from now. So, that would be very little. There maybe some impact in 2017, but not much.

[Dave Kang:]

Okay, alright. It sounds good. Thank you.

[Tim Jenks:]

Alright, Dave. Thank you.

[Operator:]

And our final question today will come from Richard Shannon with Craig-Hallum. Please go ahead, sir.

[Tim Jenks:]

Hi, Richard.

[Richard Shannon:]

Hi, Richard. Hi, guys. Thanks for taking my questions. I apologize since you have few earnings and I jumped in a little bit late. So, hopefully, I am not duplicating from past questions here. I did want to follow-up with something topic on margin structure as we look into next year. Ray, I think you said you are aiming for double-digit operating margins. I just want to clarify a little bit that was a yearly number or a target to be reached in any one or more quarters during next year?

[Ray Wallin:]

I mean, if I look at our modeling at a period at this point that we are looking at double-digits pretty much the whole year.

[Richard Shannon:]

Okay. And does that imply or even require gross margins to be at or near the 35% gross margin, I am really thinking you can kind of had a goal for sometime before?

[Ray Wallin:]

No, it does not.

[Richard Shannon:]

It does not. Okay, that’s helpful. And then just my last quick question following up on some other ones here about how we should think about the transition into next year, I talked a little bit about pricing, but I wasn’t entirely sure how to think about volumes into next year. I am not sure if you view this quarter as being maybe a little bit more muted and maybe perhaps you are expecting more of a ramp in the next year or if you can just give us any initial thoughts in the hot linearity or excuse me the transition into first quarter next year looks like on the sales line, please?

[Tim Jenks:]

Well, this is Tim, Richard. The first thing – we talked about this distributor impact because of the fact that on a revenue level we actually shipped product at the 105.5 level. So, we reported 103, but we actually shipped an extra $2.25 million that we didn’t give credit for. So, last quarter was $99 million. So, this quarter the shipment level was between $105 million and $106 million. And now we are guiding up to midpoint would be $112 million. And so we are seeing a steady increase. And then I talked about which products volume terms might be up 50% versus which ones would be doubling. And so we are feeling actually – admittedly the ones that are doubling are generally smaller numbers than the ones that are up 50% or larger numbers. But all that said we expect to see a continued acceleration in the growth rate. And all of that does have positive impact on ability to deliver leverage in the operating model, hence, raised comments on the operating profit. Because of pricing, we tend to be a little bit lower or softer in the first quarter, but then it plays out through the year. Now, if you think about 2017, just – I think the top line would grow steadily through the course of the year based on the information we have with customers and are steadily increasing capacity.

[Richard Shannon:]

Okay. And Tim just to be clear, you are saying that, that steady improvement throughout the year includes the transmission from the fourth quarter to the first quarter?

[Tim Jenks:]

Yes, it does and it also includes the expectation we have for end-of-life of the PON business by mid-year.

[Richard Shannon:]

Okay, perfect. That’s what I was looking for. That’s all for me guys. Thank you very much.

[Tim Jenks:]

Thanks, Richard.

[Ray Wallin:]

Thanks, Richard.

[Operator:]

That will conclude our question-and-answer session for today. I would like to turn the conference back over to Tim Jenks for additional or closing comments.

[Tim Jenks:]

Thanks, Yolanda. So, in closing, I would like to thank our global employees for their commitment and their diligent efforts, which really are allowing us to expand our production capacity and to serve the growing needs of our customers. Thank you for your time and your interest in NeoPhotonics and have a good evening. Goodbye.

[Operator:]

That will conclude today’s conference. Thank you all once again for joining.