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Edited Transcript of NPTN earnings conference call or presentation 2-May-19 8:30pm GMT

Q1 2019 NeoPhotonics Corp Earnings Call

SAN JOSE Jul 3, 2019 (Thomson StreetEvents) -- Edited Transcript of NeoPhotonics Corp earnings conference call or presentation Thursday, May 2, 2019 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Elizabeth Eby

NeoPhotonics Corporation - Senior VP of Finance & CFO

* Timothy Storrs Jenks

NeoPhotonics Corporation - Chairman, CEO & President

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Conference Call Participants

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* Jun Zhang

Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst

* Mauricio Alberto Munoz Roldan

Raymond James & Associates, Inc., Research Division - Senior Research Associate

* Michael Edward Genovese

MKM Partners LLC, Research Division - MD and Senior Analyst

* Richard Cutts Shannon

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Timothy Paul Savageaux

Northland Capital Markets, Research Division - MD & Senior Research Analyst

* Erica L. Mannion

Sapphire Investor Relations, LLC - President

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Presentation

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Operator [1]

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Welcome to the NeoPhotonics 2019 First 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. Please go ahead.

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Erica L. Mannion, Sapphire Investor Relations, LLC - President [2]

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Good afternoon. Thank you for joining us to discuss NeoPhotonics' operating results for the first quarter of 2019 and outlook for the second quarter of 2019. With me today are Tim Jenks, Chairman and CEO; and Beth Eby, Chief Financial Officer. Tim will begin with a review of our business in the first quarter and a discussion of business drivers and products. Beth will then provide financial results for the first quarter, and then provide the outlook for the second quarter of 2019. Beth will then turn the call back to Tim for closing remarks before opening the call for questions.

The company's press release and management 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 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, product and technology development, capital needs and availability, customer demand, inventory levels, economic and industry projections, or subsequent events. Various factors could cause actual results to differ materially. Some of these risk factors have been set forth in our press release dated May 2, 2019, and are described at length in our annual and quarterly SEC filings.

Now I will turn the call over to CEO, Tim Jenks.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [3]

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Thank you, Erica, and good afternoon. This quarter, revenue came in at $79.4 million, in line with our outlook and up 16% from the year ago period. High-speed products were 88% of revenue, up from 86% in the prior quarter, and they remain our focus. As a reminder, Q1 is our seasonal low in both revenue and gross margin due to the impacts of the Chinese New Year, making it a shorter quarter, together with annual price adjustments, which take effect in Q1.

Demand continue to pace in both the West and in China. Telecom and metro shipments are reasonably stable, and we're cautiously optimistic about DCI demand in North America for all of 2019. Much of our DCI deployment volume today is 200 gig and 400 gig, with growth coming at 600 gig. We anticipate that 400 gig will continue to deploy, while our 600-gig products continue to ramp through this and next. Subsequently, 600 gig will coexist with coming 800 gig, and of course, we will be engaged in deployments in each of these data rates.

Similarly, we see a positive outlook this year for China. Our largest customer, Huawei, conducted an analyst conference in April and forecasted meaningful revenue growth in their carrier network business and a significant ramp in 5G deployments. There has been much discussion about China customers building strategic inventory. Consistent with our comments of last quarter and based on demand for the products we supply, we are seeing some increases that are in line with what would be consumed with strong tender volumes, and we are seeing solid indications of tender activity.

We continued to see good progress with design-ins and volume growth for our 64-gigabaud product suite, and we're now testing initial products for 90 to 100-gigabaud. Note that when we talk about 64-gigabaud products, the application certainly include 400 gigabits per second and 600 gigabits per second, but not only these. In the West, these products are used by our customers to achieve 600 gigabits per second on a single wavelength for distances up to about 80 kilometers, such as datacenter interconnect.

In China, these 64-gigabaud components are being utilized initially to double the speeds of long haul, coherent networks from 100-gig to 200-gig, while keeping largely the same transmission performance. This same technology will be used across the spectrum of networks to increase the data rates and the available fiber capacity. This is important because 64-gigabaud is the next major baud rate node that will see substantial deployment in telecom networks, notably in China.

On the telecom side, the adoption of new technologies may be slower, but may have a longer lifecycle and higher aggregate volume than DCI. As a result, NeoPhotonics will benefit from 64-gigabaud in both DCI and telecom deployments. In parallel, our passive products provide complementary functions to coherent components, enabling multiplexing functions for new line systems to accommodate 64-gigabaud wavelengths. We've achieved substantial design-ins for these products as well, expanding our potential opportunity beginning next year.

As data rates continue to rise, the very pure light transmitted by our lasers becomes increasingly important. Our ultra-narrow linewidth tunable lasers have the right performance to be the laser of choice for the highest speed systems.

We recently announced limited availability of our Nano-ITLA, which maintains the high performance of our current tunable laser in a form factor approximately 1/2 the size of the prior generation in all dimensions, which is critical for enabling next-gen coherent pluggable transceivers.

Building on our success with 64-gigabaud discrete components, we are extending our offerings to 90 to 100-gigabaud network applications with our recent announcements at the OFC Trade Show during March. These included our Class 50 Coherent Receiver, or ICR, and coherent driver modulator, or CDM, which are based on our indium phosphide photonic integration platform. This is important, as we view indium phosphide as optimal to support 90 to 100-gigabaud for up to 800 gigabits per second on a single wavelength, further increasing data rates across multiple reaches. Moreover, this platform will continue to be the platform of choice at even higher speed targets above 100-gigabaud, which we will continue to support.

For applications in pluggable modules where size, power consumption, and scalability are as important as speed, we demonstrated our silicon photonics 64-gigabaud COSA, which combines the modulator and receiver in a single compact package. In addition, we did live demonstrations of our silicon photonics-based Pico Tunable Laser, which is also optimized for pluggable silicon photonics-based high-speed interconnects. These products are key for coming 400ZR deployments, which can reduce the cost and complexity of DCI networks, and also telecom networks. Therefore, 400ZR may have multiple applications that require unique specifications. Our 400ZR coherent optics are designed with these different requirements in mind.

For applications inside the datacenter and for 5G front haul and backhaul, we continue to make progress with our current fixed wavelength 28-gigabaud EML lasers and with our next-generation 53-gigabaud EML lasers with integrated drivers, both of which support PAM4 operation to reach 50 and 100 gigabits per second, per wavelength, respectively. For shorter reach silicon photonics-based transceivers, we also offer high power, non-hermetic, fixed wavelength lasers as well as drivers for silicon photonics-based modulators to support 100 gigabits per second per wavelength and 400-gigabit module applications. We expect such 400-gig intra datacenter deployments to start towards the end of this year and to ramp substantially next year.

The drivers for the markets we serve are well aligned with our advanced technologies, high-speed capabilities, and strong presence in high-speed components. As bandwidth needs and optical networks increase, coupled with the beginning of 5G wireless infrastructure deployments and continued demand with hyper-scaled data centers, I am optimistic about NeoPhotonics' new product prospects.

With that, let me turn the call over to our CFO, Beth Eby.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [4]

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Thank you, Tim, and good afternoon. As Tim mentioned, revenue was $79.4 million, up 16% year-over-year and down 13% from Q4, reflecting the usual seasonal declines related to the Chinese New Year holiday, the impact of annual price reductions as well as some supply constraints on purchased subcomponents.

China was stable at 57% of total revenue compared to 59% in the prior quarter and 61% in the first quarter of last year. The Americas was 18% of total revenue, down from 20% in the prior quarter, and the rest of world was at 25%, up from 21%, as Western customers shifted between contract manufacturing locations. Huawei Technologies, including its affiliate, HiSilicon Technologies, was our largest customer and accounted for approximately 49% of the company's revenue, up from 44% last quarter and about the same as the first quarter of last year at 48%. Our next 4 customers were 37% of revenue, lower than last quarter and about the same as last year at 36%. The drop from last quarter is mostly as a result of the lower revenue from our China customers other than Huawei.

Our non-GAAP gross margin in the first quarter was 22.4%. While Q1 is our traditional low point for the year, this was about 2.5 points lower than expected. Within this, product margins were 27%, down about 4.5 points from last quarter, which was more than expected. We saw the impact of annual price reductions as well as a less favorable product mix with 100-gig and 200-gig products making up a higher-than-expected proportion of sales.

Other cost of sales charges of just under 5 points were as expected and comprised of approximately 2 points of manufacturing variances, as was expected for Q1, 1.5 points of laser fab underutilization and a point of other charges, the largest of which was tariff impacts.

Moving to operating expenses. Total non-GAAP operating expense for the first quarter was $24.2 million, as expected. Non-GAAP operating loss for the first quarter was $6.5 million, or an 8% loss compared to a gain of 4% in Q4 driven by lower gross margins and higher spending.

In Q1, appreciation of the Chinese yuan relative to the U.S. dollar drove an FX charge of $1.7 million. As a result, non-GAAP net loss for the first quarter was $9 million compared to a gain of $2.4 million in the fourth quarter. This translates to a non-GAAP loss per share of $0.19 compared with a gain of $0.05 in Q4. For the first quarter, adjusted EBITDA was a negative $0.8 million compared to $10.5 million in Q4.

I will close out my discussion of the first quarter income statement with a review of our GAAP results. First quarter gross margin was 20%, down from 25% in Q4 and up approximately 6 points from the first quarter of last year. The first quarter gross margin includes the costs related to the end of life of our client module line of $1.3 million, as we previously announced.

Operating expense was $27.7 million, down from $29.2 million in the preceding quarter on lower restructuring and litigation charges.

Operating loss for the first quarter was $12 million, which included $3.3 million of stock-based compensation expense, $1.5 million of restructuring and end-of-life asset write-down charges, and approximately $0.6 million of divestiture costs and amortization of acquisition-related intangibles. Net loss for the quarter was $14.1 million compared to $6.7 million in the prior period.

Turning to the balance sheet. We finished the quarter with $79 million in cash, investments, and restricted cash, up $2 million from the fourth quarter. Net inventory was $54 million, or 76 days, up $1 million from the fourth quarter. Free cash flow was approximately $5 million.

Before I discuss our earnings -- our revenue and earnings outlook for the second quarter of fiscal 2019, I would like 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.

As I mentioned last quarter, demand signals from our customers are positive for the year. Revenue growth for Q2 is expected to be good. Because of higher industry-wide demand, notably with the 5G launch, some of our supply constraints carry forward into Q2 and Q3.

Moving to gross margin. As we previously mentioned, 100-gig and 200-gig products were a higher-than-expected proportion of our revenue. We expect this to continue to impact gross margin through Q2, offset by higher revenue. Given that, the company's expectations for the June 2019 quarter are revenue in the range of $88 million to $93 million; GAAP gross margin in the range of 23% to 27%; non-GAAP gross margin in the range of 25% to 29%; GAAP diluted earnings per share in the range of a $0.16 loss to a $0.06 loss; and non-GAAP diluted earnings per share in the range of a $0.06 loss to a $0.04 gain. These numbers are reflective of approximately 46.6 million fully diluted shares.

In summary, Q1 came in with a different mix and unfavorable FX rates, impacting results. Based on indications from our customers, we remain positive about the market drivers for our products in the year ahead. Additionally, subsequent to the end of the quarter, we closed the sale of our Russia operation. This was one action as a part of our ongoing process to align our business with those product lines that are the strongest and most profitable.

I'll now turn the call back to Tim for closing remarks.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [5]

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Thank you, Beth. We continue to monitor U.S./China trade discussions as they pertain to our overall business and customers in China and as China continues its network deployments and ramps its rollout of 5G wireless networks. As we have communicated over the last year, our focus has been on returning to profitability as we ramp our 64-gigabaud products. We have also remained focused on execution to extend our leadership position in the high-speed digital optical electronics market with 64-gigabaud, and moving to 90 to 100-gigabaud product introductions.

Industry trends continue to move in our favor, notably through the push to even higher speeds as well as the adoption of coherent architectures in metro and metro edge markets, which we believe places NeoPhotonics in an advantageous position, where we are seeing broad-based demand for our solutions.

This concludes our formal comments, and now I would like to ask the operator to open up the line for questions. Jonathan?

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take our first question from Michael Genovese of MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [2]

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I guess the first question, it seems like you're expecting pretty sharp sequential improvement in gross margins in 2Q, so can you just take us through the pieces besides volume? What else is it that gives you the confidence that where the middle of the range is 27%?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [3]

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Yes, so as you probably well know, the 2 biggest swing factors in our gross margin are our loadings and product mix. Add to that over the year we always do cost reductions to offset some of the price reductions that hit in Q1. So from a improvement Q1 to Q2 standpoint, I would actually have liked to have seen it be a couple of points higher, based on the increase in loadings. Q1 is our traditional low point.

If you look back at Q4, our gross margin was much higher -- not much. Our gross margin was a little bit higher than we're forecasting for Q2. So it's more a matter of how do we get it back up than it is do we have confidence in the snapback.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [4]

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Right. So just to clarify, in 1Q, I mean, I think you did summarize at the end there that it was FX and mix, but just kind of take us through that because were you surprised by the 1Q -- a little bit negatively surprised there? And were those the 2 factors? Was there anything else? And what were the weighting of those 2 factors?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [5]

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So in overall EPS, the 2 things that were a surprise were mix, which showed up in gross margin. Gross margin was lower than we expected, and it came in late in the quarter, so we didn't -- the strength in the 100-gig and 200-gig products was definitely a surprise. On the overall -- you see it below the operating profit line, that's where we saw the FX.

Our functional currency, just for you and everybody else on the call, our functional currency in our China operation is in the RMB, so we always have a mark to market as the FX rate changes. Every so often, it pops up as a significant factor. It did on the positive side in Q3 of last year, and it did on the negative side in this quarter.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [6]

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And, Tim, could I get you to sort of flesh out more of those inventory comments you made? You made some comments about inventory, but they were brief, so could you be a little more detailed?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [7]

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Sure. The question about inventory is, how much inventory are customers acquiring versus how much are they using in their shipments? And we make efforts to understand and look at each of these on a quarterly basis. So essentially what we're seeing is that there are some increases in inventory, but when we think about the inventory it's product by product, and each product can be a bit different. We do see that shipments of our products and customer shipments are reasonably in balance, and then what we'll do is check with carriers and triangulate with network equipment manufacturers to make sure that we have this in line.

Now what I said is that we are seeing some increases. But by the same token, we've seen some new awards by China Telecom with tenders, and there's a fair amount of tender activity that is going on right now. So a short-term increase, modest level of inventory is in line with what we normally see when tender activity is high. So I hope that answers your question.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [8]

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Do you have any way to compare where you think that measure of inventory is now versus, I guess it was the beginning of 2017 after that very first strong quarter in the beginning of 2017 is when I think the world realized there was actually an inventory problem. Versus the level we were there then, how does it feel now?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [9]

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Well, so then I think we were in a pretty different situation because at that point in time, and I'm doing this from the top of my head, but I think at the time, the total port shipments for the year in China were in the range of 150,000 ports. Now they're 250,000 ports, but they were actually forecasting at the time going up from, say, 150,000 ports, they were forecasting to go up to 250,000 ports. And so the shipments that took place at the end of 2016 and led to the inventory overhang of 2017 was at a forecast number that they didn't actually achieve for the next -- they're hoping to achieve now, so quite different level in terms of magnitude.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [10]

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Great, that's helpful. And then, just finally, I don't know if you gave it during the prepared remarks, did you give Ciena as a percentage of revenue?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [11]

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No, we don't. We just give them as part of our top 4.

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Operator [12]

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Thank you. We'll take our next question from Richard Shannon with Craig-Hallum Capital Group.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [13]

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I got on the call probably seconds too late to hear this number, Tim, but I didn't pick up the percentage of your sales from 100-gig and higher in the quarter. What was that, please?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [14]

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So high-speed was 88%, up from 86% in the prior quarter.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [15]

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Got it, okay; that's helpful. Going back to the topic of gross margins addressed previously, it wasn't quite clear to me whether the gross margin increase in the quarter is seeing a mix going back towards what you maybe were expecting in the first quarter, or were there some other impacts, including obviously the loadings going higher, which helped you getting back to this kind of midpoint of 27%?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [16]

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It's very much loadings-related. We are expecting the same level of, proportion of the 100 and 200-gig product mix to carry from Q1 to Q2. Surprised at some of the downside in Q1, but so we're expecting to carry that through. And we've got obviously, given that we don't have a two-week holiday, much higher loadings in Q2. But 400-gig was increasing in Q1, just not quite as much as we expected. We're still seeing strength in 100 and 200.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [17]

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We also see some customers actually -- the customers were a little surprised because some of the 100-gig, 200-gig systems continue to have very strong shipments, and so that flows through to us.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [18]

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But it will be a loadings improvement and -- with a couple of cost reductions hitting in Q2.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [19]

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So what you should expect going forward, though, is just a pretty steady increase about the 64-gigabaud product. So the 64-gigabaud products, as I said in my prepared remarks, those are used in 400 and 600-gig systems in the West, and they're also used for example in China to move the long-haul networks from 100 to 200 gig. And the increase in proportion of 64-gigabaud products will have a favorable uplift effect on overall margin.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [20]

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Okay, perfect. Two quick questions from me, and I'll jump out of line. You mentioned continuing capacity constraints this quarter. Can you quantify that extent, please?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [21]

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So it was supply constraints, not capacity constraints. It was supply constraints.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [22]

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Okay, right.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [23]

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Yes, some of our purchased subcomponents. I would say in Q1, it was $2 million to $3 million.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [24]

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Okay, but they're continuing in the second quarter, correct?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [25]

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They're ameliorating in the second quarter, and they should be gone in the third quarter.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [26]

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Got it, okay. Last quick question from me, Beth.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [27]

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I thought they were going to be gone in Q2 as well, so as long as -- if demand keeps going up, the supply constraints will last longer.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [28]

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Okay. All right, good to know. Last quick question from me: I think you mentioned shares outstanding for the quarter that I would assume would be based on the negative earnings number. What would that be if they were positive?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [29]

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I'm going to -- let me…

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [30]

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Why don't we look that up and try and come back up…

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [31]

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Let me look that up, and I'll email it to you, Richard.

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Operator [32]

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We'll take our next question from Tim Savageaux from Northland Securities.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [33]

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Let me actually pick up on that last comment from Beth, which I think indicates that demand for Q2 maybe is coming in a little bit stronger than you might have expected, and I want to try to put that into some context. So you had a -- earlier this week, I guess one of your suppliers, maybe peers in the ecosystem, did talk about an upgrade of China Mobile's [background] to 200-gig, although characterize that as something that's coming in the second half. When we combine that with both maybe a stronger-than-expected outlook for you guys in Q2 and your commentary about an increasing mix of 100 and 200-gig products, should we infer that you're seeing the impact of that build currently? Is that something that you think might still be out in front of us? And I'll follow up from there.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [34]

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Well, in my prepared remarks, I did say that we are seeing solid tender activity. We haven't seen any public information on China Mobile, but we are seeing solid tender activity. Timing (inaudible).

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [35]

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Well, I guess my question is, is that tender activity reflected in your outlook for Q2? Tender activity might also suggest things sort of coming down the line a bit, depending on where we are in that tender process.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [36]

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No, it's definitely reflected in our outlook for Q2, and the tender activity also included the China Telecom volume, and that is resulting in the higher forecast for the outlook for Q2.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [37]

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And, Beth, it sounds like it could have, if it's ameliorated, maybe $1 million or $2 million higher, ex the supply constraints. Is that fair to say?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [38]

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I'd still stick with the $2 million to $3 million that we're just continuing to…

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [39]

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Would you, for Q2?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [40]

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Just satisfy and keep pushing out.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [41]

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Fair enough. And then, last one from me: you mentioned obviously testing at 800 but some initial ramps. I mean, do you think your contribution from 600-gig in particular will be material in any way in the first half of calendar '19, or do you expect that to be more meaningful in the second half?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [42]

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So the -- as I said in my remarks, the 64-gigabaud products are used in 400-gig and 60-gig, and so to the extent that certain customers will use comparable products in 400 and 600, it's difficult for us to be precise about how much is specifically going into 600 vis-a-vis certain 400 devices. That said there are certain customer systems that we expect would be additive in terms of revenue in the second half. So I would expect what we'll see is we'll see an increase of 64-gigabaud, and it's highly likely that that reflects increased 600-gigabit activity, if you pardon my parsing bauds and bits.

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Operator [43]

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(Operator Instructions) We'll take our next question from Simon Leopold of Raymond James.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [44]

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Tim, Beth, this is Mauricio in for Simon. Did you guys have another second 10% customer this quarter? Can you please quantify the contributions from the second customer?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [45]

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We are going to stick to quantifying those in our -- actually, yes, we said -- here's your quantification, Mauricio. We just released our K, and we said they were 24% for 2018.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [46]

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No, I'm talking about the first quarter. Did you have a second 10% customer?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [47]

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I'm aware. Yes, we had a second 10% customer, and we're not going to quantify it at this time.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [48]

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Okay, all right, thank you. And then, yes, if we can go back and do a little bit on the quarterly gross margins, maybe you can give us a rundown, and perhaps you did this earlier. Sorry, I think I joined the call a bit late. But if you can give us a rundown on the sources contributing to the weaker-than-anticipated gross margins for the quarter, I think I'm just a bit surprised to hear that 100-gig and 200-gig products has seemingly lower than the gross margin for 100-gig and 200-products falls south of 27%. So if you can talk a bit about these products, are we talking about client side or more on the coherent line, please? Thank you.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [49]

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Yes, so a couple things there. We did talk about the fact that we have higher than the original forecast for 100-gig and 200-gig, and that's what customers ordered, and it did reflect overall. It's not necessarily whether it has above- or below-average margin the specific number that you quoted. But essentially, the 100-gig and 200-gig reflect the fact that some customers are selling older systems that have perhaps longer legs than anticipated, and as a result, there are higher volumes for 100-gig and 200-gig. And because the systems are older and the products more mature, they may be lower margin at this point.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [50]

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And the 2 biggest swing factors in our gross margin are loadings and mix.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [51]

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Great. Thank you, yes, that's helpful. And then, with respect to China, can you give us an update on how you're seeing the market developing in 2019? I think you previously talked about a 15% growth in high-speed coherent ports for the region. Are there any changes on this forecast? And then I'm going to have a follow-up.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [52]

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Okay, yes, and so, as I responded to a prior questioner, we are seeing solid tender activity. I commented specifically on China Telecom, and the prior questioner did ask about China Mobile. We haven't seen any public information or announcements, though, there. But nonetheless, with the tender activity going on, the forecast previously had been in the range of 230,000, 240,000 ports. This is across all of the China-based customers. It could go up a little bit from there. Maybe it gets as high as 250,000 ports, but that remains to be seen when we actually have announcements on all tender sizes, which we do not have at this point. So I think we'll stick with our 15% growth until we actually have more solid information on tender size.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [53]

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Thank you, Tim. And then, last one from me: maybe I was wondering if you can give us an update on what you're seeing as far as potential inventory builds in the region -- and the region I mean China -- ahead of the trading negotiations between the U.S. and China. I think last quarter, you talked about some moderate levels of inventories exiting in the fourth quarter. And, yes, if you can comment on that, thank you.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [54]

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Yes, sure. So I did say in my prepared remarks that we're seeing some increases, but it's in line with the tender activity, and we are seeing the solid tender activity. I did also say that it does reflect the fact that relative to the tender activity we're seeing, any inventory that is built is in line on a quantitative basis, with tender actions.

Now when you connect it specifically to the U.S./China trade I think it's important just to say that some companies may actually see this as a bigger issue, and that will reflect to some extent whether there's any alternative vendors for their product. So in our case, for example, a number of the products that we sell into China we do have competition. We may in some cases be the preferred vendor, but we also do have competition. So if our customers have the ability to mitigate risk, then we would expect that they would do so. Some other U.S.-based companies may feel it differently if the China customers view them as higher risk or if they're sole source on a particular part. Does that answer your question?

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Operator [55]

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We'll take our next question from Jun Zhang from Rosenblatt Securities.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [56]

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There was some talks that NeoPhotonics doing some new clients in the North American market. Could you comment a little bit about that?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [57]

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No, I don't think I can. I think what I said in my prepared remarks are that we've had good design-ins with our 64-gigabaud products. I also said that we've had good design-in activity with our passive products, which complement the use of 64-gigabaud wavelengths in systems. But individual customers or system design wins generally are subject to confidentiality agreements, so I find it difficult to comment.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [58]

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Okay, got it. No problem. And I think a lot of questions asked about China. Could you also comment a little bit about the U.S. and European demand for the first half, and also what kind of trends you are seeing? Because in (inaudible), I think people are kind of concerned about your second largest clients, their comments on the second half the U.S. -- the North America demand, the growth kind of slowing down a little bit from the first half. Could you talk a little bit about what you're seeing in the North American market, what kind of the demand trend looks like in the second half? Thanks.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [59]

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Yes. Well, I think that your comments are well placed and it is a little bit of a risk in the sense that, as I said in my prepared remarks, the telecom and metro business seems to be reasonably stable. We're cautiously optimistic about DCI for North America. At the moment, it seems stable but we're only guiding for the second quarter, so the second half is really beyond our current horizon.

That said, we are aware of a number of new customer systems that are coming into the marketplace, so then it's a question as to whether those are timely new entrants and whether they ramp or whether they actually get pushed out into early 2020. I think that remains to be seen. But I think we're well positioned either way in the sense that we have the design-ins and they go into both telecom systems and for DCI.

But I guess I would just agree with you that there is some uncertainty about the second half relative to the first half in the sense that right now we've just provided an outlook on the second quarter, and the second quarter is looking pretty strong. Relative to the first quarter it's an uptick, but we're not at a point of being able to guide for the third quarter or for the second half.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [60]

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Yes, sure. Got it, thanks. And my last question is about the operating margin side. So since you increased I think the R&D cost in the March quarter, do you have a plan in the following quarters to do some cost reduction on operating level in order to improve that operating margin? Thanks.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [61]

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Yes, you may recall in our comments last quarter, we did talk about the specific requirements that when we guided for the first quarter, that we had some important programs that had near-term spending, and that did reflect. Beth may want to comment on the longer-term view.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [62]

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Yes, we specifically said we'd be between 24 and 25 for the year, mostly on external payments related to new chips and products, something that we continue to watch closely, but we're on track for the year.

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Operator [63]

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Thank you. At this time, there are no further questions in the queue. I would like to turn the floor back over to Tim Jenks for closing remarks.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [64]

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Thank you, Jonathan. Thank you all for your time and interest in NeoPhotonics. We look forward to updating you on our progress in the future and to seeing many of you at investor conferences taking place in May and June. Have a good day.

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Operator [65]

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Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.