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NPTN > SEC Filings for NPTN > Form 10-Q on 9-Nov-2012All Recent SEC Filings

Show all filings for NEOPHOTONICS CORP

Form 10-Q for NEOPHOTONICS CORP


9-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q for the period ended September 30, 2012 and the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2011 included in our Annual Report on Form 10-K. References to "NeoPhotonics" "we," "our" and "us" are to NeoPhotonics Corporation unless otherwise specified or the context otherwise requires.

This Quarterly Report on Form 10-Q for the period ended September 30, 2012 contains "forward-looking statements" that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. The statements contained in this Quarterly Report on Form 10-Q for the period ended September 30, 2012 that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Terminology such as "believe," "may," "might," "objective," "estimate," "continue," "anticipate," "intend," "should," "plan," "expect," "predict," "potential," or the negative of these terms or other similar expressions is intended to identify forward-looking statements.

We have based these forward-looking statements largely on our current expectations and projections about future events and industry and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified in "Part II -Item 1A. Risk Factors" below, and those discussed in the sections titled "Special Note Regarding Forward-Looking Statements" and "Risk Factors" included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, as filed with the SEC on March 30, 2012. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Business overview

We are a leading designer and manufacturer of photonic integrated circuit, or PIC-based modules and subsystems for bandwidth-intensive, high-speed communications networks.

Our products are designed to enable high-speed transmission rates and efficient allocation of bandwidth over optical networks with high quality and low costs. Our PIC technology utilizes proprietary design elements that provide optical functionality on a silicon or indium phosphide or hybrid chip. PIC devices can integrate many more functional elements than discretely packaged components, enabling increased functionality in a small form factor while reducing packaging and interconnection costs. In addition, the cost advantages of PIC-based components are similar to the economics of semiconductor wafer mass manufacturing, where the marginal cost of producing an incremental chip is much less than that of a discrete component.

We have research and development and wafer fabrication facilities in San Jose and Fremont, California which coordinate with our research and development and manufacturing facilities in Shenzhen and Wuhan, China, Tokyo, Japan, and Ottawa, Canada. We utilize proprietary design tools and design-for-manufacturing techniques to align our design process with our precision nanoscale, vertically integrated manufacturing and testing capabilities. We sell our products to the leading network equipment vendors globally, including ADVA AG Optical Networking Ltd., Alcatel-Lucent SA, Ciena Corporation, Cisco Systems, Inc., ECI Telecom Ltd., Telefonaktiebolaget LM Ericsson, FiberHome Technologies Group, Fujitsu Limited, Huawei Technologies Co., Ltd., Juniper Networks, Inc., Mitsubishi Electric Corporation, NEC Corporation, Nokia Siemens Networks B.V. and ZTE Corporation. We refer to these companies as our Tier 1 customers.


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We operate a sales model that focuses on direct alignment with our customers through coordination of our sales, product engineering and manufacturing teams. Our sales and marketing organizations support our strategy of increasing product penetration with our Tier 1 customers while also serving our broader customer base. We use a direct sales force in the U.S., China, Canada, Israel, Japan, the Russian Federation and the European Union. These individuals work with our product engineers, and product marketing and sales operations teams, in an integrated approach to address our customers' current and future needs. We also engage independent commissioned representatives worldwide to extend our global reach.

In February 2011, we completed our initial public offering of 8,625,000 shares of common stock, including the full underwriters' over-allotment option, at a public offering price of $11.00 per share. Our initial public offering generated net proceeds of $88.2 million before offering expenses. In connection with the closing of the initial public offering, all of the shares of our Series 1, Series 2 and Series 3 preferred stock then outstanding automatically converted into 6,639,513 shares of common stock on a 1-for-1 basis and all of the shares of our Series X preferred stock then outstanding automatically converted into 7,398,976 shares of common stock on a 400-for-1 basis.

In October 2011, we acquired Santur Corporation, a designer and manufacturer of Indium Phosphide (InP) based PIC products. The acquisition of Santur enhances the Company's position in PIC-based modules and subsystems for high speed networks.

On April 27, 2012, we issued and sold approximately 4.97 million shares of our common stock in a private placement transaction at a price of $8.00 per share for gross proceeds of approximately $39.8 million. The shares of common stock are restricted from transfer pursuant to a lockup agreement for up to two years, at the end of which we are obligated to file one or more registration statements covering the potential resale of the shares of common stock. We intend to use a portion of the net proceeds from the sale of the shares of common stock for general corporate purposes and to establish a presence in the Russian Federation. In addition, we intend to establish a production facility in the Russian Federation, in accordance with the terms of a rights agreement entered into in connection with the private placement, for the benefit of the global organization. The expansion into the Russian Federation is targeted for completion by July 31, 2014.

For the nine months of fiscal 2012 compared to the same period in fiscal 2011, we experienced an increase in demand for our 40Gbps and 100Gbps speed products as carriers continued to accelerate deployment of high capacity optical transport networks. Additionally, we experienced an increase in demand for our products as ROADM deployments continued. In the first nine months of fiscal 2012, demand for our access products also increased as fiber-to-the-home deployments continued around the world, particularly in China. The market for optical communications products remains highly competitive. We expect to continue to experience competition from companies that range from large international companies offering a wide range of products to smaller companies specializing in narrow markets. We anticipate macroeconomic conditions, including the slow recovery in the U.S., European sovereign debt issues, and concerns relating to inflation in China, could impact our Company's results.

Critical accounting policies and estimates

There have been no material changes to our critical accounting policies and estimates during the nine months ended September 30, 2012 from those disclosed in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2011 Form 10-K.

Results of operations

Revenue

We sell substantially all of our products to original equipment manufacturers, or OEMs. Revenue is recognized upon delivery of our product to the OEM. We price our products based on market and competitive conditions and may periodically reduce the price of our products as market and competitive conditions change and as manufacturing costs are reduced. Our sales transactions to customers are denominated primarily in Renminbi ("RMB") or U.S. dollars. For the three and nine months ended September 30, 2012, 42% and 46% of our sales were derived from our China-based subsidiaries, respectively, the majority of which were denominated in RMB. Revenue is driven by the volume of shipments and may be impacted by pricing pressures. We have generated most of our revenue from a limited number of customers. Given the high concentration of network equipment vendors in our industry, our top ten customers represented 91% of our revenue in both of the three months ended September 30, 2012 and 2011, and 90% and 91% of our revenue in the nine months ended September 30, 2012 and 2011, respectively.


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Three Months Ended Nine Months Ended September 30, September 30, (in thousands) 2012 2011 2012 2011 Total revenue $ 66,152 $ 42,848 $ 183,400 $ 143,845

Revenue increased by $23.3 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, representing a 54% increase. Total revenue increased by $39.6 million in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011, representing a 27% increase. The increase was primarily attributable to growth in our speed and agility products as carriers increased deployments of 40Gbps and 100Gbps telecommunications networks. The increase included NeoPhotonics developed products, as well as those derived from Santur, which was acquired by us in October of 2011. The increase was partially offset by decrease in revenue from our access products and other telecom products primarily as a result of decrease in demand relating to applications below 10Gbps.

Typically, revenue from our top 5 customers comprises more than 50% of our total revenue. In addition, our largest customer, Huawei Technologies, represented 29% and 35% of our total revenue for the three and nine month periods ended September 30, 2012, respectively, and 43% and 52% of our total revenue for the three and nine month periods ended September 30, 2011, respectively. Alcatel-Lucent SA and Ciena Corporation represented 20% and 18% of our total revenue for the three months ended September 30, 2012, respectively, and 16% and 15% of our total revenue for the nine months ended September 30, 2012, respectively. We expect that a significant portion of our revenue will continue to be derived from a limited number of customers. As a result, the loss of, or a significant reduction in orders from, Huawei Technologies or any of our other key customers would materially and adversely affect our revenue and results of operations.

In addition, we expect a significant portion of our sales to be denominated in foreign currencies in the future, and therefore may continue to be affected by changes in foreign exchange rates.

Cost of goods sold and gross margin

Our cost of goods sold consists primarily of the cost to produce wafers and to manufacture and test our products. We have a global set of suppliers to help balance considerations related to product availability, quality and cost. Components of our cost of goods sold are denominated primarily in RMB. Our manufacturing process extends from wafer fabrication through final module and subsystem assembly and test. The cost of our manufacturing, assembly and test processes includes the cost of personnel and the cost of our manufacturing equipment and facilities. Our cost of goods sold is impacted by manufacturing variances such as assembly and test yields and production volume. We typically experience lower yields and higher associated costs on new products. In general, our cost of goods sold associated with a particular product declines over time as a result of decreases in wafer costs associated with the increase in the volume of wafers produced, as well as yield improvements and assembly and test enhancements. Additionally, our cost of goods sold includes stock-based compensation, reserves for excess and obsolete inventory, royalty payments, amortization of certain purchased intangible assets and acquisition-related fair value adjustments, warranty, shipping and allocated facilities costs.

Gross profit as a percentage of total revenue, or gross margin, has been and is expected to continue to be affected by a variety of factors, including the introduction of new products, production volume, production volume compared to sales over time, the mix of products sold, inventory changes, changes in the average selling prices of our products, changes in the cost and volumes of materials purchased from our suppliers, changes in labor costs, changes in overhead costs or requirements, revaluation of stock appreciation unit awards that are impacted by our stock price, and any reserves for excess and obsolete inventories. Our newer and more advanced products typically have higher average selling prices and higher gross margins. Average selling prices by product typically decline as a result of periodic negotiations with our customers and competitive pressures. We strive to increase our gross margin as we seek to manage the costs of our supply chain and increase productivity in our manufacturing processes.


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                                                             Three Months Ended September 30,                                 Nine Months Ended September 30,
                                                            2012                            2011                            2012                            2011
                                                                     % of                          % of                             % of                           % of
(in thousands, except percentages)                 Amount           Revenue         Amount        Revenue          Amount          Revenue         Amount         Revenue
Cost of goods sold                               $    45,536              69 %     $ 30,827             72 %     $   135,773             74 %     $ 106,034             74 %




                              Three Months Ended            Nine Months Ended
                                 September 30,                September 30,
                             2012            2011         2012            2011
             Gross margin        31 %            28 %         26 %            26 %

Cost of goods sold increased by $14.7 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, representing a 48% increase. Cost of goods sold increased primarily from higher sales volumes, additional direct labor and overhead costs, as a result of increased salary and employee benefit costs, and the amortization of intangible assets. The acquisition of Santur significantly increased our cost of goods sold. Gross margin was 31% for the three months ended September 30, 2012, compared to 28% for the three months ended September 30, 2011. The increase in gross margin was primarily due to higher revenue during the quarter as a result of higher demand of our speed and agility products for 40Gbps and 100Gbps telecommunications networks.

Cost of goods sold increased by $29.7 million in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011, representing a 28% increase. $28.0 million of the increase was due primarily to the acquisition of Santur. Gross margin was 26% for the nine months ended September 30, 2012 and 2011, which remained relatively constant notwithstanding a change in product and customer mix.

We expect to experience increased demand for certain of our products that can have lower than average margins, which can cause our gross margin to be lower than the comparable year-ago periods. In addition, we may experience higher China manufacturing labor cost due to future laws and regulations in China, and our gross margins and results of operations may be adversely affected.

Operating expenses

Our operating expenses consist of research and development, sales and marketing, general and administrative, amortization of purchased intangible assets, and adjustment to the fair value of contingent consideration. Personnel costs are the most significant component of operating expenses and consist of costs such as salaries, benefits, bonuses, stock-based compensation and, with regard to sales and marketing expense, sales commissions. Although our operating expenses are denominated primarily in RMB and U.S. dollars, most are denominated in U.S. dollars.

                                                               Three Months Ended September 30,                                 Nine Months Ended September 30,
                                                             2012                             2011                            2012                            2011
                                                                      % of                           % of                              % of                          % of
(in thousands, except percentages)                  Amount           Revenue          Amount        Revenue          Amount           Revenue         Amount        Revenue
Research and development                          $    9,893               15 %      $  7,059             16 %     $   29,753               16 %     $ 19,816             14 %
Sales and marketing                                    3,354                5 %         3,103              7 %          9,783                5 %        8,318              6 %
General and administrative                             6,770               10 %         5,877             14 %         20,616               11 %       14,613             10 %
Amortization of purchased intangible assets              321                0 %           104              0 %            996                1 %          668              0 %
Adjustment to fair value of contingent

consideration (850 ) (1 )% 0 0 % (246 ) 0 % 0 0 %

Total operating expenses $ 19,488 29 % $ 16,143 38 % $ 60,902 33 % $ 43,415 30 %


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Research and development

Research and development expense consists of personnel costs, including stock-based compensation, for our research and development personnel, and product development costs, including engineering services, development software and hardware tools, depreciation of capital equipment and facility costs. We record all research and development expense as incurred.

Research and development expense increased by $2.8 million in the three months ended September 30, 2012, compared to the three months ended September 30, 2011, representing a 40% increase. This increase was primarily due to a $3.0 million increase in additional payroll and employee-related costs mainly due to our acquisition of Santur.

Research and development expense increased by $9.9 million in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011, representing a 50% increase. This increase was primarily due to a $9.7 million increase in additional payroll and employee-related costs mainly due to the result of our acquisition of Santur.

We intend to continue to invest in research and development and expect this expense to increase as we grow our business. As a percentage of total revenue, our research and development expense may vary as our revenue changes over time.

Sales and marketing

Sales and marketing expense consists primarily of personnel costs, including stock-based compensation and sales commissions, costs related to sales and marketing programs and services and facility costs.

Sales and marketing expense increased by $0.3 million in the three months ended September 30, 2012 compared to the three months ended September 30, 2011, representing an 8% increase. This increase was primarily due to a $0.2 million increase in additional payroll and employee-related costs mainly as the result of our acquisition of Santur.

Sales and marketing expense increased by $1.5 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, representing an 18% increase. This increase was primarily due to a $1.5 million increase in additional payroll and employee-related costs.

We expect our sales and marketing expense to increase as a result of the acquisition of Santur and as we grow our business, expand our marketing activities, increase the number of sales and marketing professionals and incur higher stock-based compensation expense and employee-related costs accordingly. As a percentage of total revenue, our sales and marketing expense may vary as our revenue changes over time.

General and administrative

General and administrative expense consists primarily of personnel costs, including stock-based compensation, for our finance, human resources and information technology personnel and certain executive officers, as well as professional services costs related to accounting, tax, banking, legal and information technology services, depreciation of capital equipment, facility costs and restructuring charges.

General and administrative expense increased by $0.9 million in the three months ended September 30, 2012, compared to the three months ended September 30, 2011, representing a 15% increase. This increase was primarily due to a $1.0 million increase in payroll and employee-related costs.

General and administrative expense increased by $6.0 million in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011, representing a 41% increase. This increase was primarily due to a $3.5 million increase in payroll and employee-related costs, $1.2 million increase in overall expense as a result of our acquisition of Santur, a $0.6 million increase in integration expenses as a result of acquisition activities, a $0.3 million increase in professional services expense related to public company compliance expenses and legal fees, and a $0.2 million increase in depreciation expense.

We expect our general and administrative expense to increase as we incur costs associated with being a public company and as we expand and grow our operations and business. As a percentage of total revenue, our general and administrative expense may vary as our revenue changes over time.


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Amortization of purchased intangible assets

We completed a series of business acquisitions in 2005 and 2006 and, more recently, in the fourth quarter of 2011, which included the acquisition of intangible assets. These intangible assets are being amortized over their estimated useful lives. Amortization expense relating to technology and patents and leasehold interests are includes within cost of goods sold, while customer relationships and noncompete agreements are recorded within operating expenses.

Amortization of purchased intangible assets increased by $0.2 million in the three months ended September 30, 2012, compared to the three months ended September 30, 2011, representing a 209% increase. Amortization of purchased intangible assets increased by $0.3 million in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011, representing a 49% increase. The increases were primarily due to amortization of purchased intangible related to our acquisition of Santur.

Adjustment to the fair value of contingent consideration

In connection with our acquisition of Santur in October 2011, we may be required to pay the former stockholders of Santur up to an additional $7.5 million in cash, contingent upon Santur's gross profit performance during 2012. The fair value of the contingent consideration was measured at the date of acquisition and is remeasured each reporting period and any changes in the fair value of the contingent consideration are recognized as a gain or loss in the consolidated statements of operations. As of December 31, 2011, the fair value of the contingent consideration was $1.5 million. As of September 30, 2012, the fair value of the contingent consideration was $1.3 million and is included in other current liabilities on our consolidated balance sheet. During the three and nine months ended September 30, 2012, we recorded adjustments to the fair value of the consideration of $(0.9) million and $(0.2) million, respectively. We expect the amount of contingent consideration accrued to fluctuate throughout the remainder of the fiscal year as a result of changes and other economic conditions.

Interest and other income (expense), net

Interest income consists of income earned on our cash, cash equivalents and short-term investments. Interest expense consists of amounts paid for interest on our short-term and long-term debt borrowings. Other income (expense), net primarily consists of gains from the sale of equity shares of an unconsolidated investee, government subsidies, and foreign currency transaction gains and losses. The functional currency of our subsidiaries in China is RMB and the foreign currency transaction gains and losses of our subsidiaries in China primarily result from their transactions in U.S. dollars.

                                      Three Months Ended           Nine Months Ended
                                         September 30,               September 30,
      (in thousands)                  2012            2011         2012          2011
      Interest income               $     147        $   76      $    424      $    155
      Interest expense                   (135 )         (52 )        (434 )        (230 )
      Other income (expense), net         154           191          (538 )      14,299

      Total                         $     166        $  215      $   (548 )    $ 14,224

Total interest and other income (expense), net decreased by $0.05 million in the three months ended September 30, 2012, compared to the three months ended September 30, 2011. Total interest and other income (expense), net decreased by $14.8 million in the nine months ended September 30, 2012, compared to the nine months ended September 30, 2011. The decrease for the nine months ended September 30, 2012 compared to same period in 2011 was primarily related to a gain of $13.8 million from the sale of an unconsolidated investee recorded in the second quarter of 2011.

We expect our interest income to remain relatively modest given the low yields available in the marketplace and lower investable balances. . . .

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