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Edited Transcript of NPTN earnings conference call or presentation 31-Oct-19 8:30pm GMT

Q3 2019 NeoPhotonics Corp Earnings Call

SAN JOSE Nov 16, 2019 (Thomson StreetEvents) -- Edited Transcript of NeoPhotonics Corp earnings conference call or presentation Thursday, October 31, 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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* Fahad Najam

Cowen and Company, LLC, Research Division - Associate

* 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

* Thomas Robert Diffely

D.A. Davidson & Co., Research Division - MD & 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 Third Quarter Conference Call. This call is being webcast live on the NeoPhotonics Event Calendar web page 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 is available on the Event Calendar page of the NeoPhotonics website.

I would like to now turn the conference over to Erica Mannion at Sapphire Investor Relations. Please go ahead, ma'am.

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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 third quarter of 2019 and outlook for the fourth 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 progress in the third quarter and a discussion of business drivers and products. Beth will then provide financial results for the third quarter before providing outlook for the fourth quarter of 2019 and 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, otherwise noted. These non-GAAP financial measures are not prepared in accordance with GAAP and are not a substitute for or superior to measures of financial performance prepared in accordance with GAAP. These financial measures and a reconciliation of GAAP to non-GAAP results are provided in the company's press release and related Form 8-K being filed today with the SEC and can be found at the Investor Relations section on 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 October 31, 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. NeoPhotonics recorded third quarter revenue of $92.4 million, at the top end of our outlook, up 13% from the prior quarter and similarly up 13% from the same quarter last year. We achieved strong results driven by increased partnerships with the leaders in the industry, strong end customer demand in metro and DCI markets, our continued leadership and progress on 400-gig and faster solutions, and strength in China. High-speed products were 92% of revenue, which is up 25% in revenue terms from the same period last year, driven by our leading Coherent products.

As a reminder, Huawei has been the largest system supplier in our industry for several years and as a result, has also been NeoPhotonics' largest customer. Our third-quarter financial results reflect revenue from Huawei at 37%, from all products that are not subject to U.S. EAR. This is down from 46% in 2018.

We have weathered the headwinds of Huawei technology's inclusion on the BIS Entities list thus far and we remain committed to complying with U.S. EAR.

Our next 4 customers, again, showed strong performance, contributing 48% of revenue. Our business has continued on a strong footing with our leading western customers, especially those serving DCI and metro markets.

Moving to product technology, we made several announcements for the European Conference on Optical Communications last month related to increasing data-carrying capacity of optical fiber networks, in both telecom and data center applications. Our solutions include our C++ Laser Modulator and Receiver. These products have expanded spectral bandwidth ranges to support the full super-C band which is 50% more than today's standard network configuration.

These are industry-leading solutions which allow customers to significantly expand bandwidth and data-carrying capacity of their existing and new fiber installations. Further, we announced initial shipment of new arrayed waveguide grating, AWG, multiplexers and demultiplexers for high capacity, high baud rate, Coherent transmission systems. Based on NeoPhotonics' high volume, high reliability, planar lightwave circuit platform, these new AWGs have broad and flat filter response functions over the past band to support new Coherent systems operating from 60 gigabaud to 128 gigabaud. These support both current state-of-the-art networks and the next generation at 600-gig, 800-gig and higher capacities on a single wavelength with customized channel spacings.

Inside the data center, we announced general availability of our non-hermetic 30- to 40-milliwatt DFB laser sources for silicon photonics 100 gig per wavelength FR- and DR-reach transceivers. Silicon photonics transceivers require a separate laser to supply light powerful enough to overcome intrinsic losses. NeoPhotonics' family of high-powered DFB lasers are designed to efficiently couple to the SiPho modulator chip and do not require hermetic packaging, making them an ideal choice for next generation transceiver modules.

Moreover, these capabilities open some adjacent market opportunities for our high-speed technologies over the long term.

The fundamental driver of our coherent business is the continued deployment of 100 gig and above coherent ports, which have been growing at 20% or more each year. We expect this to continue for the next several years. We anticipate that 400-gig will continue to ship while our 600-gig products ramp through this year and next, and will soon include 400 ZR rollouts. Beyond 2020 we expect that 400 ZR, 600-gig and 800-gig will coexist and we will be engaged in each of these.

These approaches all require best-in-class component performance and are well-aligned with our advanced technologies, high-speed capabilities, and strong presence in high-speed component platforms.

With that, I will 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. The third quarter came in at the high end of expectation across all of our metrics which, when combined with favorable foreign exchange, resulted in non-GAAP EPS of $0.11, well above the midpoint of our guidance range of a $0.02 profit.

NeoPhotonics continues to execute well to improve profitability and cash. As Tim mentioned, revenue was $92.4 million at the high end of our range on strength in the western metro and DCI markets and continued strength in China. Our non-GAAP Q3 gross margin was 29% at the upper end of our range, and up 3 points from last quarter. Within this, product margins were approximately 34%, up 2 points from last quarter on good execution and continued cost reductions.

Other cost of sales charges of about 5 points were comprised of approximately 4 points of underutilization charges in our laser fabs and our factories impacted by U.S. EAR and just under a point of tariff charges on product shipping from our U.S. fabs into China.

Moving to operating expenses, total non-GAAP operating expense for the third quarter was $22.3 million as expected. Non-GAAP operating profit for the third quarter was $4.4 million, or 4.8%, compared to a loss of 1% in Q2, driven by the higher revenue and gross margin.

In Q3, appreciation of the U.S. dollar relative to the Chinese Yuan drove a foreign exchange of approximately $2.6 million. As a reminder, the functional currency of our China operations is the Yuan. The FX gain is driven by the revaluation of China balance sheet items to the end-of-quarter exchange rate. We view this as temporary good news that will reverse as the Chinese Yuan appreciates.

As a result, non-GAAP net income for the third quarter was $5.4 million compared to a loss of $1.2 million in the second quarter. This translates to a non-GAAP EPS of $0.11 compared to a loss of $0.03 in Q2. The ongoing business drove an EPS of $0.07 at high end of our forecasted range for the quarter, while the after-tax FX gain drove an additional $0.04 of EPS.

For the third quarter, adjusted EBITDA was $14.2 million.

I will close out my discussion of the third quarter income statement with a review of our GAAP results.

Third quarter gross margin was 28%, up from 19% in Q2 and up 5 points compared to the third quarter of last year. The increase in Q2 was related to an increase in product margin, a lack of inventory writedowns related to the Huawei ban, and the completion in Q2 of accelerated depreciation related to the EOL of certain client module products as announced last year.

Operating expense was $24.9 million, up from $23.9 million in the preceding quarter. Q2 operating expense included a $0.8 million gain from the sale of our Russia assets that did not repeat in Q3.

Operating profit for the third quarter was $1.3 million which included $3 million of stock-based compensation expense and approximately $0.2 million of amortization of acquisition-related intangibles.

Net profit for the quarter was $2.3 million compared to a $7.3 million loss in the prior period.

Turning to the balance sheet, we finished the quarter with $80 million in cash, investments and restricted cash, up $6 million from the prior period on improved profitability. Net inventory was $49 million or 66 days, approximately flat to last quarter, on 13% higher revenue as operational efficiency continues to improve. Free cash flow was approximately $7 million.

Before I discuss our revenue and earnings outlook for the fourth 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. Demand signals from our global customers remain positive. In China, we see signals that most products are selling through to end customers as evidenced by tender activity.

Looking forward, we believe that certain key customers in China and in the west have a desire to build additional inventory to deal with surges and/or to mitigate their perceived supply chain risks. This is reflected in our outlook. We expect margins to grow with cost reductions offset by the initial impact of annual price negotiations.

With profitability, operating expenses increased slightly on an increase in variable compensation. Given that, the company's expectations for the December '19 quarter are revenue in the range of $94 million to $100 million; GAAP gross margin in the range of 27% to 31%; non-GAAP gross margin in the range of 28% to 32%; GAAP diluted earnings per share in the range of a $0.02 loss to an $0.08 profit; and non-GAAP diluted earnings per share in the range of $0.04 to $0.14. These numbers are reflective of approximately 52.3 million fully diluted shares.

In summary, while we continue to monitor the evolving status of U.S.-China trade and the global macroeconomic environment, we have made the changes necessary to drive a profitable second half of 2019. The NeoPhotonics team is executing well and we will continue to drive toward a consistently profitable business.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we'll take our first question from Simon Leopold with Raymond James and Associates.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [2]

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This is Mauricio in for Simon today. Beth, you mentioned -- you talked about several customers in China but also western customers looking to build inventory. Can you please give us more color on the, I guess, the end customers and the end products where you're sort of seeing this trend?

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

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I think it's -- we have a number of customers that are interested in building inventory. In China we think that Huawei has largely to date been unable to accumulate meaningful inventories on the products that we supply, based on both their feedback and our own analysis, and in the west inventory builds are not large but customers have expressed interest to us in being able to buffer any demand surges and/or cover perceived supply risk in terms -- just in terms of things possibly being short.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [4]

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And these, I guess, inventory, be hard to accumulate some inventory. With respect to the western customers, it is more for DCI or metro or telco metro?

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

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I don't think we know in all cases the end use application. But broadly, I would have to say it includes both. And there may be some reality in the fact that this is unlikely to be reduced unless the trade tensions return to some sense of normalcy, and it's also just related to who will consume available capacity. But it's just the current state of affairs with trade.

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Mauricio Alberto Munoz Roldan, Raymond James & Associates, Inc., Research Division - Senior Research Associate [6]

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So as we look forward to your fiscal year '20, should we take into account that this inventory builds that you are experiencing, particularly in the December quarter -- I'm assuming that part of the bid in expectations, in guidance, could be somehow related to these demand purchases. How should we think about that, as we model our 2020 expectations for NeoPhotonics?

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

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Well, you know what, I think the point here is that there is some inventory risk but also customers are going to retain some level of inventory until there's resolution of U.S.-China trade. We can't predict when that will be or to what extent.

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Operator [8]

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

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [9]

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Could you give us a little bit more color on where's the [stress] on DCI and the U.S. metro, and what kind of outlook for those deployments in the next few quarters?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [10]

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I didn't hear quite all of your question. Some color on, what was the first part of it? Could you just repeat it, Jun?

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [11]

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Yes, sure. So the DCI, you mentioned the stress in the DCI and the metro deployments in the U.S. market. So could you give us more color on that, and also do you think that this is going to be sustainable growth into next year or this is just all about inventory [view]?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [12]

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So generally, we're serving some of the industry's largest players and from a supply point of view, their business tends to be relatively steady. So it's -- it does affect DCI and metro, the specific mix is not something we can precisely say. However, you know, I think there's a general view that the first half of the year will be a bit lighter than the back half of the year. General indications are suggesting that there is more business late in the year and so we would expect that, and then of course as we noted in the last set of questions, the inventory situation is on top of that. So relatively steady, higher in the second half, offset by any changes in inventory.

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Jun Zhang, Rosenblatt Securities Inc., Research Division - MD & Senior Research Analyst [13]

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And also after all this market consolidation with a couple of large M&A happened over the last 1 or 2 years, do you see any of the structure change in terms of your position in the product and also the competition landscape?

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

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Well, you know, the first and obvious point is that there are in terms of quantity, there are fewer number of competitors although the competitors who have consolidated are larger. I think for us, our strength is in high-speed Coherent. This is a part of the market that has continued to see growth and has forecasted increasing port count over the next several years, and so at the highest speeds and the highest baud rates, each of the companies that have been involved in M&A are not necessarily in those specific segments. But I think there are opportunities for us where if an end use customer is depending on a couple of vendors and then some of them consolidate, then they're going to be looking again for additional vendors. So that does make a difference. I think the notable one there is when Acacia and Cisco complete the transaction they're working on, it consolidates both a network equipment company and a component and module vendor. So that may create some more opportunity.

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Operator [15]

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We'll take our next question from Richard Shannon with Craig Hallum and Company.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [16]

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You talked about customers both in China and in western countries that are -- want a little bit of inventory stock. What does that suggest for the potential price negotiations as you go into next year? Could it be better than normal, or is it too soon to tell?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [17]

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It's always too soon to tell, up until we get through most of the fourth quarter. But we are -- I give it in the historical range of 10% to 15% price decline. I think there's maybe a little less pricing power this year on behalf of our customers, but a little early.

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Richard Cutts Shannon, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [18]

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Okay. As we look into the -- obviously after a very nice guide here for the first quarter, how should we think about the first quarter both from a sales perspective and gross margins? I know you're not going to give exact numbers because you probably don't know them, but maybe give a sense of what you think seasonality looks like relative to normal, obviously noting that there's not a lot of normal in the optics business? And then what does that mean for gross margin? Is that seasonality different than you've seen in past years?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [19]

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No. I would -- part of the -- remember, there's 2 major impacts to the gross margin drop in Q1, one of which is the pricing environment where -- because of the annual price negotiations. But the other one is that we've just got a shorter production quarter. We've got a lot of production in China and we lose 2 weeks out of the quarter every year. So we usually end up with an underutilization charge in Q1. Our normal trend, and you've seen it this year, is we drop in Q1 gross margin and part of that comes back immediately and part of that comes back over the year as we get cost reductions. We've seen very good cost reductions this year, and we're still working on next year but we have hope to do so.

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

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Okay. My last question, maybe I'll jump out of line here. The last couple quarters you talked about 400-gig or at least more directly from your product point of view, 64 gigabaud. And Tim, I'd love to understand what you think your design win rate looks like for that generation versus prior ones. Is it at least as good? Is it better? Just any way you can characterize that, how it looks so far, would be great to hear.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [21]

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So certainly we've been talking about 400-gig for a while, and now we've also said that revenue from that has -- it's more than 10%, it's material overall. And we're also winning both design wins there and then at 600-gig, this is essentially products that are designed to operate at 32 gigabaud or 64 gigabaud. The fact of the matter is, in the current China deployment, there's a little mixed toward the 32-gigabaud which are perhaps older designs but they tend to be using 100-gigabit-per-second data rates with 32 gigabaud products. Then to deploy a certain amount of bandwidth, it actually has a favorable impact on volume for the near term. This is instead of just moving immediately to 200-gig at 64 gigabaud for the transport networks. So I think we're doing fine on the design wins. I think it's a similar pace to the past. But the 400-gig cycle has long legs, and 600 gig is very much in the ramp. So I hope that helps.

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Operator [22]

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We will take our next question from Fahad Najam with Cowen & Company.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [23]

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I want to first ask some classifications, if we can please. Remind me what was the revenue contribution from the next top 4 customers?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [24]

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It was, the next 4 customers in the quarter were at 48%.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [25]

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And what was the second largest customer, if you haven't given that data?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [26]

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We've only given the first one, but you know, as a group, we give the next 4.

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

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But we did have another 10% customer.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [28]

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Okay, that's helpful. Now in terms of just the model, can you just help us understand what the revenue mix from North America, China and outside rest of the world was?

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

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Yes. Our business in the Americas was 25%, up 24%, 27% from the rest of the world down 28%, China remained flat at 48%. So not much of a story there but also remember, Fahad, this is not end-use locations. This is the locations of customers' contract manufacturers.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [30]

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Got it. So now to my question. Regarding the inventory build comment, on the risk of inventory being built at both western and Chinese customers, do you have a -- can you share with us what amount of your fourth quarter guide is baking in inventory level, this additional demand for inventories?

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

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So you've heard us talk about, Fahad, that we do a backward-looking triangulation of every quarter on the number of ports shipped out and the amount of inventory that we think was built. So our indications are always backward-looking. So based on those triangulations, we don't think there was much in Q3. Our customers are telling us that there's some inventory level in Q4 but we don't know how much it is. And until the end of the quarter, we won't know.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [32]

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All right, appreciate it. I tried asking. Tim, regarding China, the thought arises that given Huawei has been handicapped in many ways on getting access to the most cutting-edge technology that maybe it handicaps that ability to be competitive at the most highest speeds, 600-gig, 800-gigs and on. So is it -- are you seeing any trend in China where the Chinese operators are kind of lowering their requirement to accommodate for Huawei, and if that's the case, I'd say instead of going to 400-gig backbone they're all going to 100-gig backbone because the Chinese can't -- Huawei can't address that. Then what's the -- how should we be thinking about such a mix going forward and the margin impact associated with that?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [33]

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I think it's a relevant topic to the last set of questions I commented on this, in the sense that we do see that China carriers have changed their deployment plans to some extent -- to really the systems that Huawei can build. And so they tend to be the 32-gigabaud systems that they can exercise their supply chain appropriately, and it does provide perhaps an additional volume benefit for a certain amount of bandwidth. But you know, they've pushed out movement to the 64-gigabaud. But there are some other things going on. We do see a fair amount of tender activity. Beth commented a bit about that. We noted literally today, the Wall Street Journal reported that the MIIT, the Ministry of Industry and Info Technology in China, said that the 3 national carriers are going to open up their 5G rollouts in an additional 50 cities. And that of course, it's an indirect element but it loads up backbone networks. So they're going to continue to need some more bandwidth. So and then, directly to your point of their supply chain, generally speaking, the limit is electronic ICs. It's not necessarily optics. And so you know, our business, as a result, has benefited from that fact. I hope that helps.

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Operator [34]

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We'll take our next question from Tim Savageaux.

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

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A couple of questions. I think you went through the geographic breakout. I just want to confirm that you only had one additional 10% customer on the quarter.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [36]

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We had two 10% customers.

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

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I mean outside of Huawei, yes.

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

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One of the --

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

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Okay.

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

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One of which was Huawei.

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

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So moving back to kind of the macro level, there have been a lot of references today, both this morning and this afternoon, to multi-year growth and visibility. You mentioned 100-gig port growth and one of your competitors this morning did the same and also made reference to a tremendous, quote-unquote, amount of tender activity. So I guess my simple question is, what has happened to give you guys all this multi-year visibility?

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

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Well, first of all, I don't think we've commented on any multi-year visibility, so --

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [43]

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Well, you talked about 100-gig ports growing 20% for several years, I guess is what you specifically said.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [44]

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Yes. So industry projections are, you know, showing continued growth in coherent ports. But visibility and forecasts are not the same thing. So you know, we see the forecast and it's really analysts and analytics as opposed to comments that you may be referring to from this morning where certain companies may have talked about either anecdotal evidence on tender activity, or perhaps multi-year agreements. So we see macro trends where there's a continuing level of interest in deployment of coherent ports. I just commented a few minutes ago about the indirect effect of 5G increasing in its deployment and how that fills up the backbone networks, whether they're national backbone or provincial backbone. And recall from prior conversations, in China if there are national tenders, there's a bit more visibility. When it's a provincial tender, there isn't a tremendous amount of visibility but there may be anecdotal evidence. So what we're seeing is China is continuing to move forward with its level of deployment. They're continuing to -- each of the 3 wireless carriers are continuing to open new deployments, and then all of that portends additional capacity requirements on the backbone networks that our core products serve. I hope that addresses the question.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [45]

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It does. And just to quickly follow up on that, I mean, you did make reference to China tender activity earlier in the call. I guess where would you characterize that on the continuum from anecdotal to visibility in terms of your commentary or how you're seeing tender activity in China?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [46]

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Well, let's see. Compared to historical, the actual published visibility is a bit less because of kind of the movement from national as the preponderance of tenders, to provincial as the preponderance of tenders. We have seen certain published information coming from China Mobile. The numbers are not large, but it does suggest with various awards that there isn't much of a share shift between any of the major equipment companies and then there are continued deployments of existing systems and additional capacity to the installed base. So in spite of the trade ban, business is continuing to roll in China.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [47]

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Got it. And if you specifically look at your Q4 revenue guide, do you see any change -- just talking sequentially, I guess -- between what you saw in Q3 where it looked like, yes, you saw kind of equal amounts of at least absolute dollar growth in China and in the rest of the world. As you look forward to Q4 is there any bias in terms of oh, you know, customers or geographies in terms of what you expect to drive that growth?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [48]

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We expect it to be about level in Q4.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [49]

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Okay. So similar, I guess?

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

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Yes.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [51]

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Yes, similar.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [52]

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To Q3, great.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [53]

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Yes. Similar east versus west, and you know, on a proportional level, yes.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [54]

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And I think the last one for me for now, you'd mentioned some product announcements around silicon photonics coming out of ECOC, and I guess in general, as you look at the intra-data center opportunity and maybe you can respond to this in the context of how you talked about 400 or 600 gig, or maybe there's some overlap there. Is that yet at a level that you would consider material for the company in terms of laser volumes into that opportunity, or when would you expect that to be the case?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [55]

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Yes. So what we're referring to here is in particular, starting from the announcement that I referred to in the prepared remarks, we're talking about laser products that are used in FR and DR silicon photonics-based transceivers. And so on a percentage basis of revenue, it's still relatively small. And I think that's going to stay the case until such time as actually, the deployment rate of those silicon photonics-based transceivers become the main story, which they have not yet done. And there's lots of interest, lots of activity, and forecasted steep ramps. But you know, for it to be a material needle-mover, we need several quarters yet.

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Operator [56]

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We will take our next question from Michael Genovese with MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [57]

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Can I just get the Huawei percentage in the quarter again? I missed that.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [58]

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Sure.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [59]

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37%.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [60]

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Huawei was 37% and in the prepared remarks we said that was down from the 2018 full-year number, was 48%. So we're down from last year it was 48%, now we're running about 37%.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [61]

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I think my questions kind of touch on --

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [62]

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Just a correction, Mike. It was 46%.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [63]

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In 2018.

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

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In 2018. My mistake. Sorry.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [65]

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Okay. I'm going to ask you some questions, what we've been talking about, some of the themes are slightly differently -- when you reported the last quarter, you suggested at that time that you had pretty good 4th quarter visibility and that the quarter would probably be about flat sequentially. And now, you're guiding up. I'm wondering, does the -- how much of the change and that things being better, is this inventory build that you're expecting? And how much is other things strengthening outside of the inventory build? And any detail you could give on what's actually gotten better would be helpful.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [66]

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Well you know, this is actually key to why we talked about it in our prepared remarks. We did see it as similar, and then to some extent, we do see customers asking for us for a bit more. But also being interested in a bit of potential inventory. So there is a risk that that difference, you know, over time proves out to be important. We can't quantify it fully at the moment. Maybe, Beth, you might have a further view.

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [67]

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Well, I don't think I -- to what I said earlier, I don't know that we know until after the quarter is over because I think -- I'll just use Huawei as an example. They would have thought that they would have been able to build some inventory already, but demand remained strong. So we don't know what of this is really an increase in demand, because part of the reason customers want to build some inventory is to protect against surges in demand. So until we're after the fact of we don't really know what was sold through in demand versus what's inventory buffer.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [68]

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Okay. That's helpful, and I want to also sort of clarify some of what we're talking about with this inventory build. It sounds to me, but I just want to make sure this is right, that you're saying that Chinese customers would be building inventory because of the geopolitical tensions or the trade tensions, sorry. And that U.S. customers, or North American or western customers, are building inventory because of demand surges? Or are they also concerned about the trade tensions?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [69]

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I think it's potential demand surges. Again, this is all anecdotal conversations. It's potential demand surges or perceived supply chain risk if other customers, because of geopolitical tensions, are going to buy extra inventory of certain parts.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [70]

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Right. And then my last question is just this one, I mean, this has been a good conference call and you guys sound confident about what's going on out there. But I just want to ask you your comfort level knowing that customers are building inventory because that -- in the optical industry building inventory sounds bad to people -- or sounds -- brings up bad memories, right. But sort of this type of inventory build with this reason at this point in time, are you comfortable with this? Are you worried about maybe we'll be at -- in a couple of quarters, we'll get a lot of the revenues well below where we are now because of inventory, or how comfortable are you that you don't think that something like that would happen?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [71]

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Well, you know, Mike, I know you have a long memory. And you know, it would be wrong to say that we have comfort with it. But it's the neighborhood we live in and the time we live in. So what we try and do is we try and get a handle on what is the magnitude, and then what might be the effect over how much time. So again, as we said earlier, if there is some level of inventory then at some point they will use it. And so we can say now that they're -- you know, for the concerns on either trade tension or supply chain -- and supply chain is indirectly also related to trade tensions. Essentially, unless there's some level of settlement that causes our large Chinese customers to suddenly be comfortable with U.S. trade policy and U.S. supply partners, this won't change. And so we have a choice. Our choice is to supply or not supply, and we generally choose to supply.

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Operator [72]

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(Operator Instructions) We'll take our next question from Tom Diffely.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [73]

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I was hoping you could give us a little bit of color. Hoping to get a little color on what you're seeing in China outside of Huawei at this point.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [74]

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Well you know, the 3 principal national carriers, China Mobile, China Telecom and China Unicom all rely on a constant set of network equipment manufacturers. And outside of Huawei, that's ZTE Fiberhome and Alcatel Shanghai Bell, Nokia being the principal there. And in general, the concern that we have expressed on prior conference calls were when there are perturbations at -- in U.S.-China trade, or with the entities listings, has generally been whether or not there's meaningful share shift. Huawei has been an important customer to us, Fiberhome and ZTE are also customers of ours at varying levels. And it's important to our business to know if there are share shifts going on. I commented a little bit earlier, Tom, about the -- we do see some numbers being published recently in a tender award from China Mobile where Huawei actually won about 65% of the ports. It was a relatively small total number, but the breakdown between each of the network equipment companies and the share awards they got in this tender really suggested no material change from historical view that we're used to. And so the Chinese network equipment companies other than Huawei, they are -- on one hand, they're holding their own, but they're really unable to make material gains and share within the domestic market. That's how we see it today.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [75]

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And then did you mention earlier that you had an inventory writedown from Huawei?

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Elizabeth Eby, NeoPhotonics Corporation - Senior VP of Finance & CFO [76]

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In Q2 we had a $3.6 million inventory write-down of Huawei-specific inventory, that was EAR product.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [77]

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Okay. And then finally are you seeing a trend towards longer contracts or longer supply agreements with built-in price declines versus the annual price negotiation?

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [78]

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You know, I think the short answer is, is yes. But to put a little more color on that, the current state of affairs is not necessarily normal. And customers around the world, the realization is a couple of the largest systems companies on -- in the world are Chinese. And because the largest of them, Huawei, is subject to the entities listing, they're less able, perhaps, to flex their procurement muscle than they might under what we previously viewed as normal. But both they and other customers, therefore, are always looking for how to operate the most effectively in this competitive neighborhood, and if you have a new normal then you end up with variations on the theme. And I think that's what you're referring to here. People are, in short, what they're really interested in as opposed to having, quote-unquote, a long-term price agreement with fixed price reductions, what they're really interested in is securing supply rather than -- securing supply with cost reductions built in, rather than either having to beat up their suppliers for cost reductions or worrying about consolidation in their supply chain that might interrupt what they had planned on. So I think these are some of the dynamics that open alternatives from what we're used to.

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Operator [79]

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This concludes today's question-and-answer session. I will now turn the call over to Mr. Tim Jenks for closing remarks.

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Timothy Storrs Jenks, NeoPhotonics Corporation - Chairman, CEO & President [80]

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Thank you very much to everyone for your time and interest in NeoPhotonics. We appreciate the diligent work of our employees and our suppliers, and we look forward to updating you on our progress in the future. Happy Halloween.

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Operator [81]

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Ladies and Gentlemen, this concludes today's teleconference and you may now disconnect.