NEOPHOTONICS CORPORA

NPTN
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NEOPHOTONICS : MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (form 10-Q)

11/02/2020 | 05:30pm


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, 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 ended December 31, 2019 included in our Annual Report on
Form 10-K/A. 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, 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 ended September 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 ended December 31, 2019, as filed with the SEC on March 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.
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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 to Department of Commerce BIS restrictions on
Huawei, in the Company's outlook for the fourth quarter of 2020, there is no
revenue from Huawei.

Our High Speed Products for data rates of 100G, 200G and 400G were 92% of our
revenues for the three months ended September 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.
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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 our China-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
of NeoPhotonics, 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 in San Jose
and Fremont, California and in Tokyo, Japan that coordinate with our research
and development and manufacturing facilities in Dongguan, Shenzhen and Wuhan,
China
and Ottawa, 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.
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Demand for certain of our High Speed Products that are used in metro and data
center interconnect (DCI) applications in North America and Europe is increasing
rapidly. DCI deployments in North 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.
On May 16, 2019, the U.S. Commerce Department's Bureau of Industry and Security
("BIS") added Huawei and certain affiliates to the BIS Entity List ("Entity
List"), with an effective date of May 21, 2019. This denies Huawei the ability
to purchase products, software and technology that are subject to U.S. Export
Administration Regulations ("EAR").
In May 2020, BIS added Fiberhome Technologies Group to the Entity List, with an
effective date of June 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 to Huawei and/or
Fiberhome. During 2018, prior to the denial order, non-EAR products were over
half of our Huawei revenue and shipments to Huawei 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 of U.S.-manufactured lasers to Huawei.
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.

On August 17, 2020 BIS in the Department of Commerce increased restrictions on
Huawei and its affiliates on the Entity List related to items produced
domestically and abroad that use U.S. technology or software and imposed
additional requirements for items subject to Commerce export control. On October
5, 2020
the Company announced that it will manage the business without relying
on future revenue contributions from Huawei. There is no revenue from Huawei 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 for Huawei-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 $2 million in quarterly operating expense reductions
when fully implemented by the second quarter of 2021.




Revenue was $102.4 million in the three months ended September 30, 2020,
compared to $92.4 million in the three months ended September 30, 2019 primarily
due to volume growth in China and from continued strength from the U.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 ended
September 30, 2020 compared to 28.4% of revenue in three months ended September
30, 2019
. The decline in gross margin was due to the restructuring charges for
actions taken in response to the new restrictions placed on Huawei by the U.S.
Department of Commerce
.

In the three months ended September 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 ended September 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 ended September 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 ended
December 31, 2019.
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Results of Operations
Revenue
Our business is focused on the highest speed digital optics and signal
processing communications applications. In the three months ended September 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 in China. 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 in U.S. dollars,
with small portions in Chinese Renminbi ("RMB") or Japanese Yen ("JPY").
When BIS added Huawei 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. In August 2020, BIS
added additional restrictions on Huawei imposing new export control requirements
for items that use U.S. technology or software. As a result of the August 2020
restrictions, we will manage the business without relying on future revenue
contributions from Huawei. We expect this Entity List to continue to affect our
revenue and operations. There is no revenue from Huawei 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 ended September 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
ended September 30, 2019.

In addition to Huawei, 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 ended September 30, 2020 and one
other customer was greater than 10% for the three months ended September 30,
2019
. After Huawei, our next four largest customers accounted for 39% and 48% of
our revenue in the three months ended September 30, 2020 and 2019, respectively.


Three Months Ended September 30, 2020 Compared With Three Months Ended September
30, 2019




Revenue increased by $10.0 million, or 11%, in the three months ended September
30, 2020
, compared to the same period in 2019, reflecting strong customer demand
in China, as well as Metro and DCI markets in the west, including their offshore
contract manufacturers. In the three months ended September 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 ended September 30,
2020
and the three months ended September 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 Ended September 30, 2020 Compared With Nine Months Ended September
30, 2019


Revenue increased by $49.5 million, or 20%, in the nine months ended September
30, 2020
, compared to the same period in 2019, reflecting both strong customer
demand in China, 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
ended September 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
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September 30, 2020, compared to approximately 10% of total revenue in the nine
months ended September 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 to Huawei's
placement on the Entity List.


In the three and nine months ended September 30, 2020 and 2019, respectively,
revenue from China, Americas and rest of the world, based on the ship to
location requested by the customer was as follows:



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 to China during the three months
ended September 30, 2020, when compared to the three months ended September 30,
2019
, was mainly the result of strong demand and strategic inventory build at
Huawei. The same reason for the increase from 51% of revenue in the nine months
ended September 30, 2019 to 59% in the same period in 2020. Shipments to China
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 the Americas
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 ended September 30, 2020. The restructuring charge, including
severance, inventory and equipment accelerated depreciation, largely explains
the 4% gross margin decrease in the three months ended September 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 ended September 30, 2020, as compared to the same period
in 2019, despite the $9.3 million restructuring charge. For the nine months
ended September 30, 2019, there was $3.6 million, 1% of revenue, for Huawei
special inventory reserves, and $2.3 million, 1% of revenue, of accelerated
depreciation for end-of-line products.

The China government has imposed tariffs affecting products manufactured in the
United States
. Certain products manufactured in our U.S. operations have been
included in the tariffs imposed on imports into China from the United States.
These tariffs were $0.7 million and $1.5 million for the three months and for
the nine months ended September 30, 2019, respectively. Starting in March 2020,
tariffs on most of the products we imported into China have been eliminated and
these tariffs were $0.9 million for the nine months ended September 30, 2020.



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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 Ended September 30, 2020 Compared With Three Months Ended September
30, 2019

Gross profit decreased by $1.8 million, or 7%, to $24.4 million in the three
months ended September 30, 2020, compared to $26.2 million in the same period in
2019. Gross margin decreased to 24% in the three months ended September 30,
2020
, compared to 28% in the three months ended September 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 September 30, 2020 Compared With Nine Months Ended September
30, 2019




Gross profit increased by $30.0 million, or 52%, to $87.6 million in the nine
months ended September 30, 2020, compared to $57.6 million in the same period in
2019. Gross margin increased to 29% in the nine months ended September 30, 2020,
compared to 23% in the nine months ended September 30, 2019. $9.3 million of
restructuring charge, 3% of revenue, was included in the nine months ended
September 30, 2020, without which the gross margin would be 32%. Included in the
nine months ended September 30, 2019 were a special $3.6 million, or 1% of
revenue, Huawei EAR special reserve in June 2019, and $2.3 million, 1% of
revenue, accelerated depreciation for end-of-line products ended by June 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.


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Three Months Ended September 30, 2020 Compared With Three Months Ended September
30, 2019


Research and development expense increased by $1.6 million, or 12%, in the three
months ended September 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 Ended September 30, 2020 Compared With Nine Months Ended September
30, 2019

Research and development expense decreased by $1.3 million, or 3%, in the nine
months ended September 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 September 30, 2020 Compared With Three Months Ended September
30, 2019




Sales and marketing expense remained flat in the three months ended September
30, 2020
and decreased by $0.1 million, or 4%, compared to the same period in
2019.

Nine Months Ended September 30, 2020 Compared With Nine Months Ended September
30, 2019

Sales and marketing expense decreased by $0.4 million, or 4%, in the nine months
ended September 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 September 30, 2020 Compared With Three Months Ended September
30, 2019




General and administrative expense increased by $0.4 million or 5%, in the three
months ended September 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 Ended September 30, 2020 Compared With Nine Months Ended September
30, 2019

General and administrative expense increased by $1.0 million or 5%, in the nine
months ended September 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 of December 31, 2019.
Asset sale related costs
We incurred $0.1 million and $0.2 million in the three and nine months ended
September 30, 2020, respectively, and less than $0.1 million and $0.4 million in
the three and nine months ended September 30, 2019, respectively, in asset sale
related costs for legal and other professional services.


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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 in China is the RMB and of our subsidiary in Japan is the JPY. The
foreign currency transaction gains and losses of our subsidiaries in China and
Japan primarily result from transactions in U.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 ended September 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 from September 30, 2019 to September 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 ended September 30, 2020, as compared to the same period in
2019, with $6.0 million exchange loss from U.S. dollar depreciation against both
the Chinese Renminbi and Japanese Yen and $0.3 million less China government
subsidy granted.

Interest expense included in interest and other income (expense) net decreased
by $0.5 million in the nine months ended September 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 from September 30, 2019 to September 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 ended September 30, 2020, as compared to the same period in
2019, primarily due to $4.4 million exchange loss from U.S. dollar appreciation
against the Chinese Renminbi in the nine months period year on year and $0.3
million
less China government subsidy granted.
Income taxes
We conduct our business globally and our operating income is subject to varying
rates of tax in the U.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 ended September 30, 2020
and 2019 was primarily related to updating the projected forecast for the tax
provision for the U.S. and non-U.S. operations. We projected a pre-tax loss for
our U.S. operations and a higher effective tax rate based on our non-U.S.
operations for the period ended September 30, 2020.


Our income tax provision in the nine months ended September 30, 2020 and 2019
was primarily due to decreased earnings from our non-U.S. operations.



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Liquidity and capital resources
As of September 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 in China, of which $11.6 million was in
restricted cash, and approximately $8.0 million in accounts held by our
subsidiary in Japan. Cash, short-term investments and restricted cash held
outside of the U.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 of December 31, 2019 was subject to restrictions due to the fact that
our subsidiaries in China 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.
In September 2017 we entered into a revolving line of credit agreement with
Wells 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 on June 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.
On June 14, 2019, we entered into a First Amendment to the Credit Facility (the
"Amended Credit Facility"). The Amendment removes Huawei from the list of
"Eligible Accounts" as a basis for our borrowing while Huawei is on the Entity
List. During the period of time while Huawei remains on the Entity List, the
concentration limits of certain other customers are increased to partially
offset the removal of Huawei. Additionally, until Huawei 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 the U.S. and $40.0 million world-wide, of
which at least $5.0 million shall include unused borrowing capacity. In June
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 of September
30, 2020
. As of September 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 of September 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 in China 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 of September 30, 2020,
our subsidiary in China 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 in China,
had no outstanding balance at September 30, 2020 and December 31, 2019.
Compensating balances relating to these credit facilities totaled $2.6 million
and $2.5 million as of September 30, 2020 and December 31, 2019, respectively.
Compensating balances are classified as restricted cash on our condensed
consolidated balance sheets.
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As of September 30, 2020, we had two loan arrangements with MUFG Bank, Ltd.
(collectively the "Mitsubishi Bank Term Loans") and a third loan arrangement
with the MUFG Bank, Ltd. and The Yamanashi Chuo Bank, Ltd. One of Mitsubishi
Bank Term Loans requires equal monthly payments of principal equal to 8.3
million JPY
(approximately $0.1 million) until the maturity date of February 25,
2025
, with a lump sum payment of the balance of 8.4 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 in Japan. The second term loan of 690.0 million JPY (approximately
$6.5 million) (the "2017 Mitsubishi Bank Loan") was entered into in March 2017
to acquire manufacturing equipment for our Japanese subsidiary and has an annual
interest rate of the monthly TIBOR rate plus 1.00%. The 2017 Mitsubishi Bank
Loan requires monthly interest and principal payments over 72 months commencing
in April 2018. This loan was available from March 31, 2017 to March 30, 2018 and
690.0 million JPY (approximately $6.5 million) under this loan was fully drawn
in March 2017. In January 2018, we entered into a term loan agreement with MUFG
Bank, Ltd.
and The Yamanashi Chuo Bank, Ltd. for a term loan in the aggregate
principal amount of 850.0 million JPY (approximately $8.1 million) (the
"Mitsubishi-Yamanashi Term Loan"). The Mitsubishi-Yamanashi Term Loan was
available from January 29, 2018 to January 29, 2025. The full amount of the
Mitsubishi-Yamanashi Term Loan was drawn on January 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
in April 2018. As of September 30, 2020, our aggregate outstanding principal
balance under Mitsubishi Bank Term Loans and Mitsubishi-Yamanashi Term Loan was
1.4 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 in China. 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 of September 30, 2020. As of September 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 of September 30, 2020, which we plan to pay out from our
existing available cash.
In China, 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 in China until this matter is
resolved, and on October 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 the
U.S., and believe this will not adversely impact our operations in China.
On August 17, 2020, BIS increased restrictions on Huawei related to items
produced domestically and abroad that uses U.S. technology or software. As a
result, we will manage the business without relying on and will not plan on
future revenue contributions from Huawei. As Huawei 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, dated June 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.
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In April 2019, we completed the sale of 100% interest in the operations of
NeoPhotonics Corporation, LLC, our manufacturing operations in Russia, 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 $ 2,985





Operating activities
Net cash provided by operating activities was $49.5 million in the nine months
ended September 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 in U.S. dollar against RMB.
Investing activities
Net cash used in investing activities was $28.8 million in the nine months ended
September 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 ended
September 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 of September 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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