Nov 2, 2012
Executives
Erica Mannion – IR Tim Jenks – Chairman and CEO J.D. Fay – CFO
Analysts
Alex Henderson – Needham & Co. Simon Leopold – Raymond James & Associates Troy Jensen – Piper Jaffray & Co.
Brian Modoff – Deutsche Bank
Operator
Welcome to the NeoPhotonics 2012 Third Quarter Conference Call. This call is being webcast live on the event calendar page of the Investor Relations section of the NeoPhotonics website at www.neophotonics.com.
This call is property of NeoPhotonics and any recording, reproduction or transmission of this call without the expressed written consent of NeoPhotonics is strictly prohibited. You may listen to a webcast replay of this call by going to the event calendar page of the Investor Relations section of the NeoPhotonics website.
I would now like to turn the call over to Erica Mannion, Investor Relations for NeoPhotonics.
Erica Mannion
Good afternoon. Thank you for joining us to discuss NeoPhotonics’ financial and operating results for the third quarter ended September 30, 2012.
With me today are Tim Jenks, Chairman and CEO and JD Fay, CFO. The call today contains forward-looking statements that involve risks and uncertainties.
These include statements related to NeoPhotonics’ business outlook for the quarter ending December 31, 2012 and full year 2013, future periods and industry trends, as well as forward-looking statements that we may make in response to questions. Forward-looking statements are generally indicated by words such as “would”, “believe”, “expect”, “outlook”, “estimate,” “anticipate”, “forecast” and similar expressions that look toward future events or performance.
Actual results may differ materially from forward-looking statements. Factors that could cause results to differ materially from these statements include those described in today’s press release as well as those detailed in the section entitled "Risk Factors" of the company’s Quarterly Report on Form 10-Q most recently filed with the SEC.
NeoPhotonics cautions you not to place undue reliance on forward-looking statements, and that these statements speak only as of the date they are made. In addition, non-GAAP financial measures will be discussed today.
Please visit the Investor Relations section of the NeoPhotonics website for a copy of the company’s press release, which contains an explanation of these non-GAAP financial measures as well as a reconciliation to the comparable GAAP measures. Now, I will turn the call over to Tim Jenks.
Tim Jenks
Thank you for joining us today. I will provide a financial update and discuss progress in our overall business.
I will comment on our expansion with products for Coherent and other high speed and Access networks, and on our view about the industry and its direction. I will then turn the call over to our CFO, JD Fay, for a review of the third quarter.
I will close by discussing our outlook going forward with a view toward some of the key opportunities we see at NeoPhotonics and our execution plans in support of them. In the third quarter, we delivered record revenue of $66.2 million, which was slightly above the high end of our projected range of $60-$66 million provided in our second quarter 2012 conference call.
And, we are excited to report that we achieved profitability in the third quarter. Our GAAP diluted earnings per share from continuing operations was $0.02, a significant improvement from a loss of $0.13 in the prior quarter and a loss of $0.47 in the first quarter, and well above our projections for the third quarter.
Our non-GAAP gross margin expanded to 32.9%, increasing significantly from 26.5% in the prior quarter and well above our projection of 26% to 28%. This improvement is primarily the result of our continuing focus on improving the product mix and technology developments relating to our new products, particularly for high speed networks, and our efforts in operational effectiveness.
In the third quarter, we experienced 54% growth over the same period last year. This was largely due to increased demand across our business, notably for products used in Coherent and other high speed networks, as well as for Agility products.
In the third quarter of 2012, revenue from “Speed and Agility” products was approximately 59% of our total revenue, up from approximately 53% in the prior quarter, and up 17% sequentially. Within this group, revenue from our 40G and 100G products was approximately 33% of total revenue, up from approximately 25% in the prior quarter and approximately 17% in the first quarter.
We believe that this product group can continue to grow at a strong rate over the next several quarters, despite fluctuations that are typical with seasonality and carrier deployments. As we first entered this business in 2010, all of these products are derived from our advanced PIC integration technologies and are less than two year old.
After a strong second quarter with our “Access” products, revenue from this group of products was slightly down sequentially in dollar terms by approximately $2.0 million. On a year-over-year basis, revenue from our Access products has grown more than 33%, which illustrates our long-term progress in a market that is typically seasonal.
Revenue from our Access products was approximately 29% of total revenue in the third quarter; down from approximately 35% in the second quarter. This year we have been focusing on diversifying our revenues and in the third quarter, our largest three customers together comprised approximately 67% of our total revenue.
Business with our western customers has been gaining strength faster than with our Chinese customers over the past year and that trend continued in the third quarter. Alcatel-Lucent, Ciena and Huawei Technologies, each comprised more than 10% of our revenue in the third quarter, and Huawei now accounts for 29% of revenue.
Our top 10 customers comprised 91% of our total revenue in the third quarter, and of these customers, 8 of 10 grew sequentially from the second quarter. There are several reasons we were able to return to profitability.
First, we believe we are on a growth path resulting from investments we have made in technology and new products as the markets for Coherent and other high speed networks expand. Second, our focus on revenue mix has yielded improvements in favor of our Speed and Agility products.
Finally, our acquisition of Santur has been fully integrated and is performing well, and accelerated our path to profitability as we forecasted last quarter. The impact of each of these business trends, together with strong operational performance in terms of productivity gains, contributed favorably to our gross margins for the third quarter.
And, when combined with the growth potential for NeoPhotonics products at our Western customers, we are optimistic about our business prospects for 2013. As many of you know, NeoPhotonics is a technology company that designs and produces photonic integrated circuit, or PIC, based modules and subsystems for bandwidth-intensive and high-speed communications networks including Coherent 40G and 100G data rates.
Our products are designed to enable cost-effective, high-speed data transmission and efficient allocation of bandwidth over these networks. We sell our products to the leading network equipment vendors globally.
Our technology differentiation is the result of our ability to develop and produce both monolithic and hybrid photonic integrated circuits in high volumes with high yield and superior performance. We deliver integrated photonic solutions with low optical loss in channelized devices, high sensitivity for receivers, and in small sized photonic chips with reliable and repeatable product performance.
And we are increasingly integrating sophisticated electronics to provide complete opto-electronics solutions. Essentially this enables us to deliver high performance and low cost by design.
Our direct customers, the network equipment vendors, supply their systems to global telecom service providers. During the third quarter of 2012, these network equipment vendors and their service provider customers continued to spend on capacity expansion to accommodate traffic growth, which is driven by video, mobile video, the proliferation of network-attached devices, social networking and other elements of mobility and virtualization, that are enabling consumers to access bandwidth-intensive content anytime and anywhere over fixed and wireless networks, including “4G” / LTE.
We continue to make note of various reports about carrier capex being only slightly up on a global basis, as well as noting macro-economic concerns, particularly in Europe, as well as slower growth in China. Nonetheless, our business has continued to show positive and consistent trends over the last four quarters.
We recognize that carriers are choosing carefully where to invest their capex and the areas of our steady focus – 40G and 100G Coherent, client-side high speed for the enterprise, and fiber-to-the-home Access – are some of their chosen investment areas. We are continuing to focus on our strategic plan and technology developments that we believe position us favorably with our customers for a reacceleration in deployments.
We believe the combined growth of the market for Coherent networks and the use of high speed modules on the client side can help to fuel NeoPhotonics growth in the quarters ahead. These markets are in their early stages of development and we believe that we will see continued increases in demand.
To help meet this demand, we increased our output of 100G client modules, including in the CFP form factor, in the third quarter. These products are relevant to a broader group of customers – not only network equipment manufacturers and their telecom carrier customers but also to companies building and providing data centers and a range of enterprise companies deploying routers, switches and storage gear.
Through 2015, we believe our client side products will have expanded our potential Total Addressable Market by more than $300 million. And, with recent qualifications at multiple customers, we believe that these products can be meaningful contributors to our performance in the quarters ahead.
At this point I’ll turn the call over to JD to review our third quarter financial performance, and fourth quarter 2012 projections.
J.D. Fay
Thank you, Tim, and good afternoon. For the third quarter of 2012, revenue was $66.2 million, which was 54% higher than our third quarter 2011 revenue of $42.8 million, and up 5% from the second quarter of this year.
Our reported revenue is above our projected range and another quarter of record revenue for the company. GAAP gross margin for the third quarter was 31.2%.
Non-GAAP gross margin for the third quarter of 2012 was 32.9%, significantly above both our projection and the previous quarter’s Non-GAAP gross margin of 26.5%. Further, our non-GAAP gross margin was better than the 27.8% result from the third quarter of 2011.
Non-GAAP gross margin for the third quarter of 2012 excludes amortization of purchased intangibles and other assets relating to the acquisition of Santur of $0.9 million, and stock-based compensation expense of $0.2 million. As Tim highlighted, we achieved profitability in the third quarter.
Income from continuing operations for the third quarter of 2012 was $0.7 million, as compared to a loss from continuing operations of $3.7 million in the second quarter and a loss of $4.2 million in the third quarter of 2011. Diluted income per share from continuing operations for the third quarter of 2012 was $0.02, a significant improvement from the loss per share of $0.13 in the prior quarter.
Non-GAAP income from continuing operations for the third quarter was $2.7 million, a significant improvement from the loss of $1.7 million in the second quarter and compares to the loss of $3.2 million in third quarter of 2011. Non-GAAP diluted income per share from continuing operations for the third quarter was $0.08, a significant improvement from the loss of $0.06 per share in the prior quarter and the loss of $0.13 per share in the second quarter of 2011.
Non-GAAP income from continuing operations and Non-GAAP diluted income per share from continuing operations for the third quarter of 2012 exclude stock-based compensation expense of $1.3 million, amortization of purchased intangibles and other assets of $1.3 million, acquisition- and integration-related costs of $0.2 million, the fair value adjustment to contingent consideration relating to the Santur acquisition of $0.9 million, and the income tax effects of these adjustments. Adjusted EBITDA also grew significantly in the third quarter compared to the second quarter.
Adjusted EBITDA was $6.4 million in the third quarter, an improvement of more than $4.6 million compared to Adjusted EBITDA of $1.8 million in the second quarter. The improvement was primarily due to improved operating performance resulting from higher gross margins and good cost control.
To offer additional qualitative color on our third quarter, Our strong revenue compared to our projection primarily resulted from increased demand for our products that are designed to address traffic bottlenecks in high speed and Coherent communications networks, as the demand for bandwidth continues to grow and carriers expand their network capabilities in response. The sequential improvement in our gross margin was primarily due our continuing focus on more favorable product mix with the strong sales of Coherent 40G and 100G modules, as well as our focus on mix within our Agility and Access portfolios, and continuing efforts to drive economies of scale in our supply chain.
Total operating expense in the third quarter of 2012 was $19.5 million, and compares to $18.5 million in the second quarter. Within operating expenses, research and development was $9.9 million; sales and marketing was flat at $3.4 million; and general and administrative was flat at $6.8 million.
Amortization of purchased intangibles was flat at $0.3 million. Included in the foregoing operating expenses is $1.1 million of stock-based compensation expense, $0.7 million of acquisition-related expenses, and a reduction to the estimated earn-out relating to the Santur acquisition of approximately $0.9 million.
On the balance sheet, we ended the third quarter with cash, cash equivalents and short-term investments of $105.9 million, down $1.2 million from $107.1 million at the end of the second quarter of 2012. The decrease in cash was primarily due to scheduled debt repayment of $1.3 million and capital expenditures of $4.0 million, substantially offset by strong collections in the quarter.
Total bank debt at September 30, 2012 was $23.4 million, down from $24.7 million at June 30, 2012. Accounts receivable, net, at September 30, 2012 were $68.8 million, a decrease of approximately 9% sequentially compared to the prior quarter.
Days sales outstanding was approximately flat at 98 days compared to 96 days in the prior quarter. Now, I will provide our outlook for the fourth quarter of 2012 and beyond.
As Tim communicated, we continue to believe demand is generally favorable for NeoPhotonics products, with continued potential in high speed, Coherent and Access products in 100G and FTTX deployments around the world. Nonetheless, we are cognizant of the potential impact of annual pricing negotiations with some of our tier 1 customers, and that the fourth calendar quarter is the beginning of our typical seasonally slower half of the year.
As a reminder, many of our customers slow their outside plant deployment rates in the winter months in the northern hemisphere, which can have a dampening effect on revenue in these quarters. Additionally, in the third quarter, we added customers to our vendor managed inventory program, or VMI.
For those unfamiliar with VMI, this means that we agree to a rolling production forecast with these customers; we build to that forecast and ship the products to designated locations. These locations are typically at our customers’ production facilities or their logistics centers.
While the products are located at these hubs, they remain on our balance sheet as inventory and revenue is not recognized. At the time when a customer takes a unit of product from the hub, we are notified (we call this a “pull”) and we then record revenue for that product.
The customer is not required to pull the products from the hub in the same quarter during which the products are shipped to the hub, but are typically pulled and the hub replenished on a rolling basis; and in certain cases, customers are obligated to pull products in the hub if the products have been there for a specified period of time. By supporting this model, we believe we are favorably viewed by our customers, have a closer relationship with these customers, and that we earn a larger share of the demand for such products.
In addition, we believe that the hub model can provide us better visibility into our customers’ demand levels over time – meaning over several quarters, but, as we have noted on prior conference calls, demand for VMI products within a quarter can occur close to the customer’s system shipment commitments, including very late within that same quarter, and can cause volatility in our quarter to quarter results. By adding several customers to our program, we believe approximately $2 million of products that we would expect to ship to customers in the fourth quarter would instead be shipped to our VMI hubs to establish initial levels of inventory at these customers.
These products may or may not be pulled within the quarter depending on demand and the level of safety stock these customers have previously maintained. Our projections for the fourth quarter are adjusted for this expected impact, and accordingly we anticipate revenue for the fourth quarter ending December 31, 2012 to be in the range of $58 million to $62 million.
Non-GAAP gross margin is anticipated to be in the range of 29% to 31%, and is primarily dependent on volume given the seasonally lower quarter, and any pricing changes that result from negotiations for future business and market share that typically occur in the quarter. We anticipate Non-GAAP diluted income per share from continuing operations to be break-even plus or minus five cents in the fourth quarter.
The Non-GAAP outlook excludes the expected amortization of purchased intangibles and other assets of approximately of $1.7 million and the anticipated impact of stock-based compensation of approximately $1.4 million. Of these amounts, approximately $1.1 million is estimated to relate to cost of goods sold.
The share count assumption used to estimate the fourth quarter is approximately 30.5 million. This estimate can change based on stock and option activity in the period.
Looking at our performance on an annual basis, using the midpoint of our fourth quarter projections, our annual 2012 revenue would be approximately $243 million, which would represent over 20% growth compared to 2011. And, importantly, our annual non-GAAP earnings per share from continuing operations would improve by $0.20 per share compared to 2011, demonstrating our focus on achieving profitability and improving operating performance.
Moreover, with our continuing focus on leading solutions built upon our PIC integration technology, we expect continued growth in 2013 and beyond. To this end, we believe that we can grow revenue 8% to10% in 2013, and at that level of projected growth be profitable on an annual basis for 2013.
Now, I will turn the call back over to Tim.
Tim Jenks
Thank you, JD. Our business has been on a positive trend and I want to talk about our vision for 2013 and beyond, and our products and technology developments that will help us execute against our business goals.
We believe we are well-positioned in Coherent and high speed applications – notably 100G. With a broad set of design wins at leading customers and with growing volumes, we expect to see continued success from these markets.
It is important that the industry is driving to higher speeds with multiple factors pushing the optical upgrades and the proliferation of optical interfaces. We believe that critical to serving this demand is that our technology – our PIC technology that combines both Active and Passive elements – is differentiated, and is a critical element in Coherent and other high speed applications.
Historically, optical components have been described as either Passive products or Active products. Active products included laser diodes and photodiodes and their derivatives – these were the products that converted electrical signals to light signals, or back again from a signal to an electrical pulse, and operated at a data rate such as 2.5G, 10G, 40G, and now 100G.
Transceivers were Active products, as they contained both lasers for transmission and photodiodes for reception. Similarly, filters and switches were passive products as they manipulated light, but did not generate or convert it to electrical signals, and these products operated at frequencies far below the data rate.
Things are changing today as we integrate components, combining active and passive elements to create new functionalities. And this is at the core of our Coherent devices – they can receive a high speed coded optical signal and manipulate it to separate its information and then convert it to the needed electrical impulses –at data rates of 100Gbps.
This matters because Actives have always been viewed as speed-specific. That is, devices that are 10G are not 100G, and vice versa.
However, a Passive device can often operate on networks of different speeds. As the architecture changes from 10G to 100G, the Active products all change, but many of the Passive products do not.
This means that the transition to high speed networks has the potential of being relatively smoother for our business. Similarly as networks move in the future from 100G to 400G and beyond, the basic architectures being used in 100G Coherent transmission are expected to continue.
We believe that these trends in the nature of optical transmission give our technology – and, our business – long “legs” for the future. In earlier describing our revenue from our Speed and Agility products, I spoke specifically about 40G and 100G revenue.
The remainder of this group is comprised of revenue from “Agility” products, which includes a range of solutions deployed in agile networks and enabling wavelength switching. In the third quarter, the “Agility” portion was up slightly in dollar terms.
Today, the preponderance of these products are being deployed in 10G networks, but they are also expected to be deployed in high speed networks, where the demand on switching grows with the growth in traffic and speed. Demand for these products is generally in line with the ROADM market, so we have seen somewhat softer demand over the past two quarters, however, we believe that 40G and 100G networks will continue using the existing Agility and ROADM solutions until next generation ROADMs come to market, which I will discuss shortly.
Now I would like to talk about the plan for achieving our growth goals. We have delivered consistent growth over the last five years with a compound annual growth rate over 20%.
Moreover, revenue grew 54% in the third quarter compared to the same period last year. In the quarter, we saw strong growth resulting from broad acceptance of our products for Coherent and other high speed networks.
We believe this trend can be important to our future growth, and is one supported by the investments we have made in these technologies over the last five plus years. With the important changes in our industry to embrace Coherent technology as a sea change in network architecture, together with other competitor consolidations, we believe it is increasingly important to have direct control of the key technologies that are integrated into our PIC based product platforms.
We also believe that several technologies are critical for 100G transport solutions, including indium phosphide (InP) PIC narrow linewidth tunable lasers, PIC high speed modulators, PIC coherent receivers, and PIC transmitter and receiver arrays. With our acquisition of Santur in 2011, and our value proposition in our array of PIC-based technologies demanded by our customers, in many cases as the preferred solutions for advanced network architectures, we believe we are well-positioned for future growth in the industry.
Coherent technology, and in particular 100G Coherent technology, is one of the principle building blocks for next generation high speed networks. We believe that 400G and 1Terabit systems will use optical building blocks from 100G.
As a result, we anticipate continued growth in the deployment of Coherent architectures for transport and then for metro networks, and thus a greater opportunity for NeoPhotonics. We also expect to see continued increases in the deployment of 100G and increases in the long haul market due to these carrier upgrades.
We expect to see continued growth in pluggable modules connecting point-to-point links, using CFP and derivative form factors, including those that we provide to customers in North America today. These 100G transceiver products are gaining favor for use among leading edge router producers, driven by the rapid build-out of advanced wireless networks.
In switching, we expect to see a new generation of ROADMs in the next several years, which can be a potential driver to our future growth as well. One such development is the colorless, directionless and contentionless, or CDC, ROADM, which is being widely evaluated in the industry.
There are a number of critical technology elements to CDC ROADMs, including free space wavelength selective switches (WSS), and PIC-integrated Multicast Switches with EDFA array amplification. As mentioned on prior conference calls, we have sampled our Multicast Switch and we are pursuing qualifications with initial customers.
Our Multicast Switch, or MCS, product is designed to be most efficient in Coherent optical networks. Our MCS product expands the flexibility of a node to enable any port to drop any wavelength, from any direction, and to allow two identical wavelengths from different directions to be dropped through the same switch – that is, colorless, directionless and contentionless.
We believe that the MCS represents a critical enabling technology for CDC ROADM systems. In our Access business, we expect to see continued deployment of Access Passive Optical Networks, or PON, in many locations around the world.
We believe that the GPON standard of PON is a leading architectural approach, and portends favorable benefits to NeoPhotonics due to the breadth of our available GPON products. In this area, we have introduced a GPON Optical Line Terminal, or OLT, that incorporates embedded Optical Time Domain Reflectometry, or eOTDR, which is designed to provide carriers a cost effective path to monitor their fiber infrastructure during network operation.
We also have introduced a mode-coupled receiver into a GPON OLT, which is a central office device that incorporates key elements as PICs, and which is designed to enable broader deployment of GPON networks by carriers at significantly reduced deployment costs. We believe that engineering a cost-effective, PIC-based transceiver can be the beginning of a proliferation of PIC-based products for Access, which have been mostly non-PIC to date, and which is a very large market.
We believe our product development actions, which are deploying PIC-enabled capabilities into the fastest growing segments of optical communications, can have a positive impact on our potential for future growth. We have product development centers in North America and China, each having a core expertise.
We believe this is an efficient and cost effective technology development model. We are vertically integrated in our approach to manufacturing and we view operational expertise as a core capability.
We produce our PIC chips in owned fabs in Silicon Valley and we do the vast majority of our assembly and module testing in owned factories in southern China. Geographically, we have expanded our footprint to serve customers directly in parts of the world that are expanding their use of carrier grade networks.
Last year we opened a design and sourcing center in Japan and this year we created a subsidiary in Russia. In summary, we are pleased with our progress and we remain focused on critical actions to serve our customers as a strategic supplier.
Our customers have actively embraced our new, Coherent and other high speed products, as well as our enhanced technologies for their next generation of systems. We believe that our multi-quarter trends of broadly growing revenue from our leading customers, and from 40G and 100G products are important, particularly as the momentum for deploying high-speed line-side and client-side networks leveraging Coherent and PIC technologies continues to gain momentum.
We believe that Coherent is a key network architecture for the next several years; that we are in a strong position today given our design win and market share awards earned with our customers, that these trends can continue to favor NeoPhotonics and that we can benefit from added spending on high speed deployments at carriers. This concludes our formal comments and now I will ask the operator to open up the line for questions.
Question-And-Answers