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 endedSeptember 30, 2020 and the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the year endedDecember 31, 2019 included in our Annual Report on Form 10-K/A. References to "NeoPhotonics ," "we," "our," and "us" are toNeoPhotonics Corporation unless otherwise specified or the context otherwise requires. This Quarterly Report on Form 10-Q for the period endedSeptember 30, 2020 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 endedSeptember 30, 2020 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/A for the year endedDecember 31, 2019 , as filed with theSEC onMarch 3, 2020 . 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. Overview We develop, manufacture and sell lasers, transceiver modules and other high speed optoelectronic products that transmit, receive and switch high speed digital optical signals for Cloud and hyper-scale data center internet content provider and telecom networks. Our solutions help network operators manage the explosive data traffic growth in Cloud and hyper-scale data centers. We specialize in products that operate at the highest speed over distance, for 100 Gigabits per Second ("G"), 200G, 400G and beyond data rates, such as at 600G and 800G. Our products have the speed, size, low power consumption and interoperability required to directly transmit data using industry standard Internet Protocol coding, or IP, over DWDM wavelengths, greatly simplifying data networks. We are the world's primary supplier of tunable lasers that emit the ultra-pure light that is required for the highest speed over distance coherent fiber optic communications links.
We integrate our lasers and our high performance coherent optical components into transmit/receive modules, or transceivers. Our high speed transceiver modules, which can operate at data rates including 400G, drive down network costs, extend reach and directly interconnect with switches and routers.
We believe we are well positioned to deliver these laser, component and transceiver module products based on our leadership in the ultra-pure lasers which power them and our comprehensive capabilities in designing and producing the highest performance Silicon Photonics and Indium Phosphide devices based on our Advanced Hybrid Photonic Integration. Moreover, we believe that our high performance materials integration platform is key our continued innovation at the highest speeds required for Cloud and hyper-scale networks. We also believe that because of our laser and component technologies, we have been first to deliver commercial volumes for each of the highest speed advances in components for chassis-based systems since the advent of coherent optics for transmission ten years ago in 2010, as maximum speeds have advanced for each wavelength, or color, from 100G (Gigabits per second) to 400G, 600G and 800G. With adoption of coherent transmission using pluggable high speed optical modules in Cloud and hyper-scale data centers, we believe our total addressable market is rapidly expanding. 31 -------------------------------------------------------------------------------- Table of Contents Our high speed optical communications technologies encode information to optical signals from electronic signals for transmission and decode it for receiving. We achieve these ultra-high speeds with coherent technology that encodes information using the phase, amplitude and polarization of an optical wavelength, packing in far more information than simple on/off encoding. We believe we are a global leader in coherent transmission technology, based on our achieved speeds, leadership in ultra-pure color lasers and optical integration for miniaturization and low power consumption. Coherent transmission is becoming the technology of choice for high speed data transmission in Cloud infrastructure and data center interconnection, in addition to telecom networks, where the highest speeds over distance were first developed. Moreover, we are the most significant producer of the pure light lasers that deliver data at the highest speeds, as we have delivered more than 1.5 million lasers used by the more than 2 million coherent ports deployed by the industry over the past 10 years (each port may use either one or two lasers). We have grown our business by delivering the highest speed over distance solutions for the Long Haul and Metro segments of the Telecom market. In recent years the Data Center Interconnect (DCI) market has become an increasing part of our revenue as DCI market adopts high speed coherent optical technologies. Until recently our largest customers, Huawei Technologies and Ciena, have been suppliers of network equipment primarily focused on the Telecom market. Other leading customers have also been telecom equipment suppliers, such as Cisco, Nokia and ZTE. Note that due toDepartment of Commerce BIS restrictions onHuawei , in the Company's outlook for the fourth quarter of 2020, there is no revenue fromHuawei . Our High Speed Products for data rates of 100G, 200G and 400G were 92% of our revenues for the three months endedSeptember 30, 2020 and 2019. Our sales concentration in High Speed Products has increased each year for more than 10 years. Networks operating at 400G and beyond data rates have adopted coherent transmission technology because of its ability to increase data rates and lower cost-per-bit. These high speed networks are among the highest growth segments of the optical communications market, and support the rapid expansion of telecom backbone, hyper-scale data center interconnect content provider networks, accommodating increased wireline and mobile traffic. We expect growth in the 400G and beyond segment of our business to be driven primarily by increased adoption of our High Speed Products in the much larger Cloud infrastructure market, the Metro market sector and in the high speed data center interconnect ("DCI") market segments. Furthermore, the advent of standardized coherent pluggable transceiver modules opens up additional use cases for coherent data links in 5G wireless back and mid-haul, tributaries for edge computing, new metro architectures and satellite communications. Specific technologies have been developed for communications inside the data center and between data centers themselves as well as between data centers and consumers. We believe our solutions are often unique in their ability to provide high integrity signals across longer distances. However, high speed coherent transmission is becoming more competitive at shorter reaches, which include applications where interconnect volumes are much larger, and where we historically have not sold our products directly. Thereby we believe shorter reaches offer us further significant growth opportunities. We believe the changes at 400G and above data rates portend a coming significant change in high speed network architectures to more efficiently implement the 400G and above technologies that we provide. This forecasted sea change is enabled by coherent techniques and Photonic Integrated Circuits, which makes possible long distance transmission by pluggable transceiver modules that connect directly into switches and routers inside data centers and that have thus far been used only for short reach connections within data centers. Such disaggregated Open Line Systems can manage optical signals between data centers with all needed channel management, amplification, traffic planning and monitoring functions. Together coherent pluggable transceivers and Open Line fiber systems make IP over DWDM possible, that is for Internet Protocol data to be transmitted over long distances on an optical channel without translation into an equipment manufacturer's proprietary format. Connections between data centers then become as simple as connections within data centers. This is a breakthrough benefit for the network operator. We believe that over the next few years, this connection architecture will become a mainstay of new installations, moving a significant portion of the capital expenditures from network equipment supplied DWDM proprietary boxes to disaggregated direct 400ZR interconnections. This approach of IP over DWDM moves Internet Protocol traffic from switches and routers directly over an Open Line system DWDM channel without passing through a proprietary network equipment transmission box. We supply both the 400G pluggable coherent transceivers and optical components for DWDM Line Systems, including Open Line Systems, that provide the filtering and control of the optical signals on the common fiber equipment. 32 -------------------------------------------------------------------------------- Table of Contents The Covid-19 pandemic is impacting our business, the business of our customers and suppliers and how we execute our business. However, despite the lasting impact, our global operations including ourChina -based supply chain partners have executed well and have largely recovered. Our priorities to address the impacts of the global pandemic on our operations are as follows:
•The health and well-being of our employees and supply chain partners is our top priority.
•We have implemented strict measures to ensure and maintain safety, including working remotely where possible, social distancing and enhanced protocols in each of our global facilities.
•We closely monitor evolving conditions and adhere to local and federal guidelines in each location in which we operate.
Business Continuity
•Our operations and products support essential communications networks globally.
•We have implemented and continue to adjust comprehensive business continuity plans in response to the global pandemic to ensure that we are able to deliver for our customers.
•We are working closely with our supply chain partners globally to ensure we have enough inventory and to support the health and safety of their employees.
•We have seen strong demand for products that facilitate increasing network bandwidth; we are working to ensure continuity between us, our supply partners and forward to our customers and their contract manufacturing partners around the world. Financial Structure
•We believe our balance sheet and liquidity position provide the flexibility needed to support our operations during this pandemic.
•We have taken and will continue to take precautionary steps, as required, to maintain our financial position.
Our Solutions Three critical optical components are required to make a high speed coherent transceiver: (1) a laser with a very narrow linewidth for very pure light; (2) a coherent modulator capable of changing both the intensity and phase of the optical signal to code data onto it; and (3) a coherent receiver capable of detecting both the intensity and phase of the received optical signal to "understand" its content, plus an electronic digital signal processor IC (DSP). We have been a leading volume supplier of these optical components since coherent systems were first deployed in volume for telecommunications networks a decade ago in 2010. We are now the leading supplier of narrow linewidth tunable lasers and coherent receivers to the coherent market, and we have introduced new high speed coherent modulators for 400G, 600G and above applications. The capabilities of coherent optics continue to grow with increasing photonic integration for higher performance and smaller size. These are core capabilities ofNeoPhotonics , and therefore open further opportunities for us in adjacent markets. Outside of communications, coherent technology improves sensitivity and performance for a variety of applications including inter-satellite communication links including for low earth orbit (LEO) satellites, plus industrial applications, 3D sensing for autonomous vehicle navigation, and medical imaging. We have invested and expect to continue to invest significant time and capital into our research and development operations. Our research and development activities continue to push the performance leadership boundaries in high speed digital optics, silicon photonics and hybrid photonic integration, optoelectronics control and in signal processing. We have research and development and wafer fabrication facilities inSan Jose andFremont, California and inTokyo, Japan that coordinate with our research and development and manufacturing facilities inDongguan ,Shenzhen andWuhan, China andOttawa, Canada . We use proprietary design tools and design-for-manufacturing techniques to align our design process with our precision nanoscale, vertically integrated manufacturing and testing. We believe we are one of the highest volume manufacturers of photonic integrated circuits ("PIC") in the world and that we can further expand our manufacturing capacity to meet market needs. 33 -------------------------------------------------------------------------------- Table of Contents Demand for certain of our High Speed Products that are used in metro and data center interconnect (DCI) applications inNorth America andEurope is increasing rapidly. DCI deployments inNorth America have been strong over the past two years, and our products for these applications generally ship to contract manufacturers for our system manufacturer customers. OnMay 16, 2019 , theU.S. Commerce Department's Bureau of Industry and Security ("BIS") addedHuawei and certain affiliates to the BIS Entity List ("Entity List"), with an effective date ofMay 21, 2019 . This deniesHuawei the ability to purchase products, software and technology that are subject toU.S. Export Administration Regulations ("EAR"). InMay 2020 , BIS addedFiberhome Technologies Group to the Entity List, with an effective date ofJune 5, 2020 . This denies Fiberhome the ability to purchase products, software and technology that are subject to EAR. We are committed to EAR compliance in each of the locations in which we do business. We subsequently determined that certain of our products were not subject to EAR regulations and could lawfully be sold toHuawei and/or Fiberhome. During 2018, prior to the denial order, non-EAR products were over half of ourHuawei revenue and shipments toHuawei of many of these products continued through the current quarter. Further, in 2019 we applied for licenses for certain technology subject to EAR, and we were granted a license to ship limited, but not material, volumes ofU.S. -manufactured lasers toHuawei . Similarly, in 2020 we determined that a significant portion of our shipments to Fiberhome was not be subject to EAR and shipments of certain of those products continued. OnAugust 17, 2020 BIS in theDepartment of Commerce increased restrictions onHuawei and its affiliates on the Entity List related to items produced domestically and abroad that useU.S. technology or software and imposed additional requirements for items subject to Commerce export control. OnOctober 5, 2020 the Company announced that it will manage the business without relying on future revenue contributions fromHuawei . There is no revenue fromHuawei in the Company's outlook in the fourth quarter of 2020. The Company has taken actions to better align capacity and production infrastructure with expected demand levels, with the goal of returning to profitability. The Company has taken steps to tighten production operations, account forHuawei -specific assets and inventory, consolidate Indium Phosphide production and implement an approximately 4% reduction in force. The costs to implement these changes are expected to be approximately$10.9 million , with$1.1 million in severance costs and$9.8 million in inventory and idle asset charges. The Company has taken a charge of approximately$9.4 million of these costs in the third quarter, and expects an additional$0.7 million in the fourth quarter with the remainder as accelerated depreciation charges through 2021.
The actions taken are expected to reduce expenses with immediate impact and
achieve an approximately
Revenue was$102.4 million in the three months endedSeptember 30, 2020 , compared to$92.4 million in the three months endedSeptember 30, 2019 primarily due to volume growth inChina and from continued strength from theU.S. and European based customers, including shipments through their off-shore contract manufacturers. Our gross profit was 23.8% of revenue in the three months endedSeptember 30, 2020 compared to 28.4% of revenue in three months endedSeptember 30, 2019 . The decline in gross margin was due to the restructuring charges for actions taken in response to the new restrictions placed onHuawei by theU.S. Department of Commerce . In the three months endedSeptember 30, 2020 , High Speed Products represented approximately 92% of total revenue, or$94.5 million and Network Products and Solutions represented approximately 8% of total revenue, or$7.9 million . In the three months endedSeptember 30, 2019 High Speed Products were 92% of total revenue, or$85.4 million and Network Products and Solutions represented approximately 8% of total revenue, or$7.0 million . The High Speed Product market segment is growing at a much faster pace than Network Products and Solutions, demonstrating our continued leadership in 400G and higher data rate solutions to address the merging needs for more network bandwidth capacity by both Cloud players and carrier. Critical accounting policies and estimates Other than the policy changes disclosed in Note 1 in Notes to Condensed Consolidated Financial Statements in Item 1, Part I of this Report, there have been no material changes to our critical accounting policies and estimates during the three and nine months endedSeptember 30, 2020 from those disclosed in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K/A for the year endedDecember 31, 2019 . 34 -------------------------------------------------------------------------------- Table of Contents Results of Operations Revenue Our business is focused on the highest speed digital optics and signal processing communications applications. In the three months endedSeptember 30, 2020 , our High Speed Products for data rates of 100G and beyond comprised 92% of our revenues. We sell substantially all of our products to original equipment manufacturers ("OEMs") and their contract manufacturers. Revenue is recognized upon transfer of control of the product to the buyer. 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 or as manufacturing costs are reduced. Our first quarter revenue is typically seasonally lower than the rest of the year primarily due to the impact of annual price negotiations with customers that occur at the end of the prior year and lower capacity utilization during the holidays inChina . However, this historical pattern should not be considered a reliable indicator of our future revenue or financial performance. Our sales transactions to customers are denominated primarily inU.S. dollars, with small portions in Chinese Renminbi ("RMB") or Japanese Yen ("JPY"). When BIS addedHuawei and certain affiliates to the Entity List in the second quarter of 2019, we began shipping only certain products that have been determined by us to not be subject to EAR. Similarly, when BIS added Fiberhome to the Entity List in the second quarter of 2020, we began shipping only products determined by us not be to subject to the EAR. InAugust 2020 , BIS added additional restrictions onHuawei imposing new export control requirements for items that useU.S. technology or software. As a result of theAugust 2020 restrictions, we will manage the business without relying on future revenue contributions fromHuawei . We expect this Entity List to continue to affect our revenue and operations. There is no revenue fromHuawei in the Company's outlook in the fourth quarter of 2020. Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except percentages) 2020 2019 $ Change % Change 2020 2019 $ Change % Change Total revenue$ 102,398 $ 92,392 $ 10,006 11%$ 302,970 $ 253,448 $ 49,522 20% We generate most of our revenue from a limited number of customers.Huawei has consistently been our largest customer, which was again the case in the three months endedSeptember 30, 2020 , as it accounted for approximately 44% of our revenue in the third quarter of 2020 and 37% of our revenue for the three months endedSeptember 30, 2019 . In addition toHuawei , we have several large customers which may or may not exceed 10% of revenue in any given quarter. Two other customers were greater than 10% of our revenue for the three months endedSeptember 30, 2020 and one other customer was greater than 10% for the three months endedSeptember 30, 2019 . AfterHuawei , our next four largest customers accounted for 39% and 48% of our revenue in the three months endedSeptember 30, 2020 and 2019, respectively.
Three Months Ended
Revenue increased by$10.0 million , or 11%, in the three months endedSeptember 30, 2020 , compared to the same period in 2019, reflecting strong customer demand inChina , as well as Metro and DCI markets in the west, including their offshore contract manufacturers. In the three months endedSeptember 30, 2020 , High Speed Products represented approximately 92% of total revenue, at the same level as in the same period in 2019, while Network Products and Solutions represented approximately 8% of total revenue both in the three months endedSeptember 30, 2020 and the three months endedSeptember 30, 2019 . We continue to demonstrate our leadership in 400G and faster solutions to address the merging needs for more network bandwidth capacity by both Cloud players and carriers. 400ZR and 400ZR+ pluggable coherent modules were launched in the fourth quarter of 2019 and are now shipping in low volume. Nine Months EndedSeptember 30, 2020 Compared With Nine Months EndedSeptember 30, 2019 Revenue increased by$49.5 million , or 20%, in the nine months endedSeptember 30, 2020 , compared to the same period in 2019, reflecting both strong customer demand inChina , particularly Huawei building strategic inventory since the onset of the EAR restrictions and uncertainties from the US-China trade relationship, and Metro and DCI markets in the west. Increases in demand were partially offset by decreases in average selling prices. In the nine months endedSeptember 30, 2020 , High Speed Products represented approximately 92% of total revenue, compared to 90% of total revenue in the same period in 2019, while Network Products and Solutions represented approximately 8% of total revenue in the nine months ended 35 -------------------------------------------------------------------------------- Table of ContentsSeptember 30, 2020 , compared to approximately 10% of total revenue in the nine months endedSeptember 30, 2019 . We continue to be an industry leader for the highest speed over distance network solutions, supplying customers with components and modules which deliver the highest bandwidth per wavelength and per fiber for long distances. Our High Speed Product market segment consistently represents 90% or more of our business. Leveraging our highest performance products, together with 400ZR and 400ZR+ pluggable coherent modules launched in the fourth quarter of 2019, will bring revenue growth and potential expansion into other markets. In addition, Network Products and Solutions were also disproportionately impacted by the suspension of shipments due toHuawei's placement on the Entity List.
In the three and nine months ended
Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 China 56 % 48 % 59 % 51 % Americas 17 % 25 % 17 % 22 % Rest of world 27 % 27 % 24 % 27 % Total revenue 100 % 100 % 100 % 100 % Geographic revenue represents the shipment location and frequently changes based on the location of contract manufacturing, rather than end customer location. The increase in the proportion of shipments toChina during the three months endedSeptember 30, 2020 , when compared to the three months endedSeptember 30, 2019 , was mainly the result of strong demand and strategic inventory build atHuawei . The same reason for the increase from 51% of revenue in the nine months endedSeptember 30, 2019 to 59% in the same period in 2020. Shipments toChina was up$13 million , or 28%, from the same three month period in 2019 and up$50 million , or 39%, from the nine months period in 2019. Shipments to theAmericas and to the rest of the world are mainly to contract manufacturers for non-China based network equipment manufacturers ("NEMs"). Cost of Goods Sold and Gross Profit Our cost of goods sold consists primarily of the cost to produce wafers and to manufacture and test our products. Additionally, our cost of goods sold generally includes stock-based compensation, write-downs of excess and obsolete inventory, amortization of certain purchased intangible assets, depreciation, acquisition-related fair value adjustments, restructuring charges, warranty costs, royalty payments, logistics 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, factory utilization, 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, stock-based compensation, write-downs of excess and obsolete inventories and warranty costs. In addition, we periodically negotiate pricing with certain customers which can cause our gross margins to fluctuate, particularly in the quarters in which the negotiations occurred. As a manufacturing company, our margins are sensitive to changes in volume and factory utilization. The Company took decisive actions to better align capacity and production infrastructure with future expected demand levels, resulting in a$9.3 million restructuring charge to cost of goods sold, 9% of revenue, for the three months endedSeptember 30, 2020 . The restructuring charge, including severance, inventory and equipment accelerated depreciation, largely explains the 4% gross margin decrease in the three months endedSeptember 30, 2020 , as compared to the same period in 2019. Before the business change, the Company has made significant operational improvements with solid progress on cost reductions, yield improvement and effective cost absorption through higher volume, which increased gross margin by 6% in the nine months endedSeptember 30, 2020 , as compared to the same period in 2019, despite the$9.3 million restructuring charge. For the nine months endedSeptember 30, 2019 , there was$3.6 million , 1% of revenue, forHuawei special inventory reserves, and$2.3 million , 1% of revenue, of accelerated depreciation for end-of-line products. TheChina government has imposed tariffs affecting products manufactured inthe United States . Certain products manufactured in ourU.S. operations have been included in the tariffs imposed on imports intoChina fromthe United States . These tariffs were$0.7 million and$1.5 million for the three months and for the nine months endedSeptember 30, 2019 , respectively. Starting inMarch 2020 , tariffs on most of the products we imported intoChina have been eliminated and these tariffs were$0.9 million for the nine months endedSeptember 30, 2020 . 36
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Table of Contents Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except percentages) 2020 2019 $ Change % Change 2020 2019 $ Change % Change Cost of goods sold$ 77,994 $ 66,193 $ 11,801 18 %$ 215,338 $ 195,837 $ 19,501 10 % Gross profit$ 24,404 $ 26,199 $ (1,795) (7) %$ 87,632 $ 57,611 $ 30,021 52 % Three Months Ended Nine Months Ended September 30, September 30, 2020 2019 2020 2019 Gross profit as a % of revenue 24 % 28 %
29 % 23 %
Three Months EndedSeptember 30, 2020 Compared With Three Months EndedSeptember 30, 2019 Gross profit decreased by$1.8 million , or 7%, to$24.4 million in the three months endedSeptember 30, 2020 , compared to$26.2 million in the same period in 2019. Gross margin decreased to 24% in the three months endedSeptember 30, 2020 , compared to 28% in the three months endedSeptember 30, 2019 . Excluding the$9.3 million restructuring charge, gross margin would be 33%, 5% improvement from the same period last year. Improvement of$6.4 million was mainly from cost reductions, product mix and yield improvement, net of annual price reduction, offset by$4.4 million from the inventory write-down and accelerated depreciation charges of$4.1 million .
Nine Months Ended
Gross profit increased by$30.0 million , or 52%, to$87.6 million in the nine months endedSeptember 30, 2020 , compared to$57.6 million in the same period in 2019. Gross margin increased to 29% in the nine months endedSeptember 30, 2020 , compared to 23% in the nine months endedSeptember 30, 2019 .$9.3 million of restructuring charge, 3% of revenue, was included in the nine months endedSeptember 30, 2020 , without which the gross margin would be 32%. Included in the nine months endedSeptember 30, 2019 were a special$3.6 million , or 1% of revenue, Huawei EAR special reserve inJune 2019 , and$2.3 million , 1% of revenue, accelerated depreciation for end-of-line products ended byJune 30, 2019 . The increase in gross profit was primarily driven by$36.5 million of improvement from cost reductions, product mix and better yield net of the annual price reduction,$3.9 million of inventory write-down and$1.9 million increase in accelerated depreciation. Operating expenses 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, other variable compensation. Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except percentages) 2020 2019 $ Change % Change 2020 2019 $ Change % Change Research and development$ 15,276 $ 13,688 $ 1,588 12 % 40,849 42,164$ (1,315) (3) % Sales and marketing 3,692 3,832 (140) (4) % 11,630 12,058 (428) (4) % General and administrative 7,758 7,403 355 5 % 23,350 22,330 1,020 5 % Amortization of purchased intangible assets - - - - % - 119 (119) (100) % Asset sale related costs 87 12 75 625 % 219 388 (169) (44) % Restructuring charges 141 3 138 4,600 % 141 261 (120) (46) % Gain on asset sale - - - - % $ -$ (817) $ 817 (100) % Total operating expenses$ 26,954 $ 24,938 $ 2,016 8 %$ 76,189 $ 76,503 $ (314) - % 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 equipment and facility costs. We record all research and development expense as incurred. 37 -------------------------------------------------------------------------------- Table of Contents Three Months EndedSeptember 30, 2020 Compared With Three Months EndedSeptember 30, 2019 Research and development expense increased by$1.6 million , or 12%, in the three months endedSeptember 30, 2020 , compared to the same period in 2019. The increase was primarily due to$0.7 million higher payroll and related expenses,$0.6 million increase in project development expenses, and an increase of$0.3 million in variable compensation. Nine Months EndedSeptember 30, 2020 Compared With Nine Months EndedSeptember 30, 2019 Research and development expense decreased by$1.3 million , or 3%, in the nine months endedSeptember 30, 2020 , compared to the same period in 2019. The decrease was primarily due to$2.5 million lower development and other expenses including a$1.5 million one-time license fee recorded as a reduction to research and development expense in the first quarter of 2020 and a general push-out of research and development project spend due to the Covid-19 pandemic, offset by$1.2 million increase in variable compensation.
Sales and marketing
Sales and marketing expense consists primarily of personnel costs, including stock-based compensation and other variable compensation, costs related to sales and marketing programs and services and facility costs.
Three Months Ended
Sales and marketing expense remained flat in the three months endedSeptember 30, 2020 and decreased by$0.1 million , or 4%, compared to the same period in 2019. Nine Months EndedSeptember 30, 2020 Compared With Nine Months EndedSeptember 30, 2019 Sales and marketing expense decreased by$0.4 million , or 4%, in the nine months endedSeptember 30, 2020 , compared to the same period in 2019 from lower levels of travel and fewer marketing events due to the Covid-19 pandemic offset by$0.3 million increase in variable compensation. 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 and facility costs.
Three Months Ended
General and administrative expense increased by$0.4 million or 5%, in the three months endedSeptember 30, 2020 , compared to the same period in 2019. The increase was mainly from$0.8 million increase in payroll and related expenses, net of general decrease in facility expenses. Nine Months EndedSeptember 30, 2020 Compared With Nine Months EndedSeptember 30, 2019 General and administrative expense increased by$1.0 million or 5%, in the nine months endedSeptember 30, 2020 , compared to the same period in 2019. The increase is mainly from a$1.1 million increase in payroll and related expenses,$1.2 million increase in variable compensation, net of a general decrease in facility and other expenses. Amortization of purchased intangible assets Our intangible assets are being amortized over their estimated useful lives. Amortization expense relating to technology, patents and leasehold interests are included within cost of goods sold, while customer relationships are recorded within operating expenses. Purchased intangible assets related to customer relationships were fully amortized as ofDecember 31, 2019 . Asset sale related costs We incurred$0.1 million and$0.2 million in the three and nine months endedSeptember 30, 2020 , respectively, and less than$0.1 million and$0.4 million in the three and nine months endedSeptember 30, 2019 , respectively, in asset sale related costs for legal and other professional services. 38
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Interest and other income (expense), net Interest income consists of income earned on our cash, cash equivalents and short-term investments, as well as restricted cash. Interest expense consists of amounts incurred for interest on our bank and other borrowings. Other income (expense), net is primarily made up of government subsidies as well as foreign currency transaction gains and losses. The functional currency of our subsidiaries inChina is the RMB and of our subsidiary inJapan is the JPY. The foreign currency transaction gains and losses of our subsidiaries inChina andJapan primarily result from transactions inU.S. dollars. Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except percentages) 2020 2019 $ Change % Change 2020 2019 $ Change % Change Interest income$ 21 $ 95 $ (74) (78) %$ 141 $ 293 $ (152) (52) % Interest expense (263) (483) 220 (46) % (942) (1,472) 530 (36) % Other income (expense), net (3,317) 2,960 (6,277) (212) % (2,314) 2,452 (4,766) (194) % Total$ (3,559) $ 2,572 $ (6,131) (238) %$ (3,115) $ 1,273 $ (4,388) (345) % Interest expense included in interest and other income (expense), net decreased by$0.2 million in the three months endedSeptember 30, 2020 , as compared to the same period in 2019. The decrease in interest expense was due to a$14.0 million decrease in outstanding borrowings fromSeptember 30, 2019 toSeptember 30, 2020 and lower interest rate on our Wells Fargo loan. Other income (expense), net included in interest and other income (expense), net, decreased by$6.3 million in the three months endedSeptember 30, 2020 , as compared to the same period in 2019, with$6.0 million exchange loss fromU.S. dollar depreciation against both the Chinese Renminbi and Japanese Yen and$0.3 million lessChina government subsidy granted. Interest expense included in interest and other income (expense) net decreased by$0.5 million in the nine months endedSeptember 30, 2020 , as compared to the same period in 2019. The decrease in interest expense was due to a$14.0 million decrease in outstanding borrowings fromSeptember 30, 2019 toSeptember 30, 2020 and lower interest rate on our Wells Fargo loan. Other income (expense), net included in interest and other income (expense), net, decreased$4.8 million in the nine months endedSeptember 30, 2020 , as compared to the same period in 2019, primarily due to$4.4 million exchange loss fromU.S. dollar appreciation against the Chinese Renminbi in the nine months period year on year and$0.3 million lessChina government subsidy granted. Income taxes We conduct our business globally and our operating income is subject to varying rates of tax in theU.S. ,China ,Japan and other various foreign jurisdictions. Consequently, our effective tax rate is dependent upon the geographic distribution of our earnings or losses and the tax laws and regulations in each geographical region. Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except percentages) 2020 2019 $ Change % Change 2020 2019 $ Change % Change Income tax (provision) benefit$ 1,206 $ (1,561) $ 2,767 (177) % (1,199) (1,526)$ 327 (21) % Our income tax (provision) benefit in the three months endedSeptember 30, 2020 and 2019 was primarily related to updating the projected forecast for the tax provision for theU.S. and non-U.S. operations. We projected a pre-tax loss for ourU.S. operations and a higher effective tax rate based on our non-U.S. operations for the period endedSeptember 30, 2020 .
Our income tax provision in the nine months ended
39 -------------------------------------------------------------------------------- Table of Contents Liquidity and capital resources As ofSeptember 30, 2020 , we had working capital of$148.6 million , including total cash, short-term investments and restricted cash of$122.9 million . Approximately 26% of our total cash, short-term investments and restricted cash were held by our foreign entities, including approximately$23.6 million in accounts held by our subsidiaries inChina , of which$11.6 million was in restricted cash, and approximately$8.0 million in accounts held by our subsidiary inJapan . Cash, short-term investments and restricted cash held outside of theU.S. may be subject to taxes if repatriated and may not be immediately available for our working capital needs. Approximately$9.2 million of our retained earnings within our total accumulated deficit as ofDecember 31, 2019 was subject to restrictions due to the fact that our subsidiaries inChina are required to set aside at least 10% of their respective accumulated profits each year end to fund statutory common reserves. This restricted amount is not distributable as cash dividends except in the event of liquidation. InSeptember 2017 we entered into a revolving line of credit agreement withWells Fargo Bank, National Association ("Wells Fargo") as the administrative agent for a lender group (the "Wells Fargo Credit Facility" or "Credit Facility"). The Wells Fargo Credit Facility provides for borrowings equal to the lower of (a) a maximum revolver amount of$50.0 million , or (b) an amount equal to 80% - 85% of eligible accounts receivable plus 100% of qualified cash balances up to$15.0 million , less certain discretionary adjustments ("Borrowing Base"). The maximum revolver amount may be increased by up to$25.0 million , subject to certain conditions. The Credit Facility matures onJune 30, 2022 and borrowings bear interest at an interest rate option of either (a) the LIBOR rate, plus an applicable margin ranging from 1.50% to 1.75% per annum, or (b) the prime lending rate, plus an applicable margin ranging from 0.50% to 0.75% per annum. We are also required to pay a commitment fee equal to 0.25% of the unused portion of the Credit Facility. The Credit Facility agreement requires prepayment of the borrowings to the extent the outstanding balance is greater than the lesser of (a) the most recently calculated Borrowing Base, or (b) the maximum revolver amount. The Borrowing Base calculation contains a customary provision that gives the lender the ability to reduce the Borrowing Base by reserves that are subjectively determinable, which is considered a subjective acceleration clause. We are required to maintain a combination of certain defined cash balances and unused borrowing capacity under the Credit Facility of at least$20.0 million , of which at least$5.0 million must be unused borrowing capacity. Borrowings under the Credit Facility are collateralized by substantially all of our assets. OnJune 14, 2019 , we entered into a First Amendment to the Credit Facility (the "Amended Credit Facility"). The Amendment removesHuawei from the list of "Eligible Accounts" as a basis for our borrowing whileHuawei is on the Entity List. During the period of time whileHuawei remains on the Entity List, the concentration limits of certain other customers are increased to partially offset the removal ofHuawei . Additionally, untilHuawei is no longer on the Entity List, we are required to maintain a temporary combination of certain defined unrestricted cash and unused borrowing capacity under the credit facility of at least$30.0 million in theU.S. and$40.0 million world-wide, of which at least$5.0 million shall include unused borrowing capacity. InJune 2020 , Fiberhome was added to the Entity List and was also removed from the Borrowing Base. We were in compliance with the covenants of this Credit Facility as ofSeptember 30, 2020 . As ofSeptember 30, 2020 , the outstanding balance under the Credit Facility was$21.9 million and the weighted average rate under the LIBOR option was 2.02%. The remaining borrowing capacity as ofSeptember 30, 2020 was$6.6 million , of which$5.0 million is required to be maintained as unused borrowing capacity. We regularly issue short-term notes payable to our suppliers inChina in exchange for accounts payable. These notes are supported by non-interest bearing bank acceptance drafts and are due three to six months after issuance. As a condition of the notes payable arrangements, we are required to keep a compensating balance at the issuing banks that is a percentage of the total notes payable balance until the amounts are settled. As ofSeptember 30, 2020 , our subsidiary inChina had two line of credit facilities with banking institutions. Under these line of credit facilities, the non-interest bearing bank acceptance drafts issued in connection with our notes payable to our suppliers inChina , had no outstanding balance atSeptember 30, 2020 andDecember 31, 2019 . Compensating balances relating to these credit facilities totaled$2.6 million and$2.5 million as ofSeptember 30, 2020 andDecember 31, 2019 , respectively. Compensating balances are classified as restricted cash on our condensed consolidated balance sheets. 40 -------------------------------------------------------------------------------- Table of Contents As ofSeptember 30, 2020 , we had two loan arrangements withMUFG Bank, Ltd. (collectively the "Mitsubishi Bank Term Loans") and a third loan arrangement with theMUFG Bank, Ltd. and The Yamanashi Chuo Bank, Ltd. One of Mitsubishi Bank Term Loans requires equal monthly payments of principal equal to8.3 million JPY (approximately$0.1 million ) until the maturity date ofFebruary 25, 2025 , with a lump sum payment of the balance of8.4 million JPY (approximately$0.1 million ) on the maturity date. Interest on this loan accrues and is paid monthly based upon the annual rate of the monthly Tokyo Interbank Offer Rate (TIBOR) plus 1.40% and is secured by manufacturing equipment owned by our subsidiary inJapan . The second term loan of690.0 million JPY (approximately$6.5 million ) (the "2017 Mitsubishi Bank Loan") was entered into inMarch 2017 to acquire manufacturing equipment for our Japanese subsidiary and has an annual interest rate of the monthly TIBOR rate plus 1.00%. The 2017Mitsubishi Bank Loan requires monthly interest and principal payments over 72 months commencing inApril 2018 . This loan was available fromMarch 31, 2017 toMarch 30, 2018 and690.0 million JPY (approximately$6.5 million ) under this loan was fully drawn inMarch 2017 . InJanuary 2018 , we entered into a term loan agreement withMUFG Bank, Ltd. and The Yamanashi Chuo Bank, Ltd. for a term loan in the aggregate principal amount of850.0 million JPY (approximately$8.1 million ) (the "Mitsubishi-Yamanashi Term Loan"). The Mitsubishi-Yamanashi Term Loan was available fromJanuary 29, 2018 toJanuary 29, 2025 . The full amount of the Mitsubishi-Yamanashi Term Loan was drawn onJanuary 29, 2018 . Interest on the Mitsubishi-Yamanashi Term Loan is based upon the annual rate of the three months TIBOR rate plus 1.00%. The Mitsubishi-Yamanashi Term Loan requires quarterly interest payments, along with the principal payments, over 82 months commencing inApril 2018 . As ofSeptember 30, 2020 , our aggregate outstanding principal balance under Mitsubishi Bank Term Loans and Mitsubishi-Yamanashi Term Loan was1.4 billion JPY (approximately$13.2 million ). Refer to Note 9 of Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report for further details. From time to time we accept notes receivable in exchange for accounts receivable from certain of our customers inChina . These notes receivable are non-interest bearing and are generally due within six months. Historically, we have collected on the notes receivable in full at the time of maturity. In the first nine months of 2020, we generated operating income of$11.4 million and cash from operations was$49.5 million . We had an accumulated deficit of$407.4 million as ofSeptember 30, 2020 . As ofSeptember 30, 2020 , the remaining borrowing capacity under our revolving line of credit agreement with Wells Fargo, was$6.6 million , of which$5.0 million is required to be maintained as unused borrowing capacity. Additionally, we had$3.2 million of current portion of long-term debt as ofSeptember 30, 2020 , which we plan to pay out from our existing available cash. InChina , when there is a case pending in judicial court, banks may choose to limit borrowing against existing credit lines, regardless of the legitimacy of the case. We had a dispute pending with APAT OE in judicial court. (Refer to Note 12 of Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report for further details.) We do not expect to make any additional draws against our credit facilities inChina until this matter is resolved, and onOctober 27, 2020 , the parties entered into a settlement agreement to settle all claims and release all property preservation orders. Nonetheless, we have sufficient cash and credit lines available in theU.S. , and believe this will not adversely impact our operations inChina . OnAugust 17, 2020 , BIS increased restrictions onHuawei related to items produced domestically and abroad that usesU.S. technology or software. As a result, we will manage the business without relying on and will not plan on future revenue contributions fromHuawei . AsHuawei has been our largest customer, this has a material impact on our forecasted revenue and profitability. To adjust to the revised forecast, we have adjusted capital expenditures, operating expenditures, project plans and reset incoming materials to adjust to changing demand levels. We continue to implement actions to improve cash flow and profitability. We believe that our existing cash, cash equivalents and cash flows from our operating activities will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products, the costs to increase our manufacturing capacity and our foreign operations and the continuing market acceptance of our products. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. Rusnano Rights Agreement Under our amended rights agreement, datedJune 30, 2015 , with Rusnano, one of our principal stockholders, we agreed to make a$30.0 million investment commitment (the "Investment Commitment") toward our Russian operations. If certain of the Investment Commitments were not achieved in the indicated time frames through 2019, we had the ability to exit our Russian operations by paying an exit fee of up to$2.0 million at that time. 41 -------------------------------------------------------------------------------- Table of Contents InApril 2019 , we completed the sale of 100% interest in the operations ofNeoPhotonics Corporation, LLC , our manufacturing operations inRussia , to Rusnano. In connection with the sale, we received$2.0 million in cash and settled the$2.0 million exit fee. Cash flow discussion The table below sets forth selected cash flow data for the periods presented: Nine Months Ended September 30, (in thousands) 2020 2019 Net cash provided by operating activities$ 49,514 $ 18,389 Net cash used in investing activities (28,765) (4,235) Net cash used in financing activities (7,416) (10,725)
Effect of exchange rates on cash, cash equivalents and restricted cash
502 (444) Net increase in cash, cash equivalents and restricted cash $
13,835
Operating activities Net cash provided by operating activities was$49.5 million in the nine months endedSeptember 30, 2020 , compared to$18.4 million net cash provided by operating activities in the same period in 2019. The net cash provided by operating activities increased by$31.1 million primarily due to the increase in net income of$26.3 million , a net increase of foreign currency remeasurement by$4.8 million , primarily due to depreciation inU.S. dollar against RMB. Investing activities Net cash used in investing activities was$28.8 million in the nine months endedSeptember 30, 2020 , compared to$4.2 million used in investing activities in the same period in 2019. The increase in cash flows used in investing activities was primarily due to an increase in purchases of marketable securities of$23.4 million , an increase in purchases property, plant and equipment of$3.0 million , an increase in proceeds from sales of marketable securities of$3.5 million and a decrease in proceeds from the sale of property, plant and equipment and other assets of$1.6 million , when compared to 2019. Financing activities Net cash used in financing activities was$7.4 million in the nine months endedSeptember 30, 2020 , compared to$10.7 million used in financing activities in the same period in 2019. The decrease in cash flows used in financing activities was primarily due to a decrease in net payments under our note payable and debt arrangements of$8.8 million , offset by a decrease in proceeds from bank loans of$5.0 million when compared to the same period in 2019. Off-balance Sheet Arrangements As ofSeptember 30, 2020 , we did not have any significant off-balance sheet arrangements. Recent Accounting Pronouncements Refer to Note 1 "Basis of presentation and significant accounting policies" in the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q for a description of recent accounting pronouncements and accounting changes.
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