424B4 1 d424b4.htm FILED PURSUANT TO RULE 424(B)(4) Filed Pursuant to Rule 424(b)(4)
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Filed Pursuant to Rule 424(b)(4)
Registration No. 333-166096

PROSPECTUS

7,500,000 Shares

LOGO

Common Stock

 

 

This is NeoPhotonics Corporation’s initial public offering. We are selling 7,500,000 shares of our common stock.

Currently, no public market exists for the shares. The shares have been approved for listing on the New York Stock Exchange, subject to notice of issuance, under the symbol ‘‘NPTN.’’

Investing in the common stock involves risks that are described in the “Risk Factors” section beginning on page 11 of this prospectus.

 

 

 

   

Per Share

         

Total

 

Public offering price

    $11.00          $82,500,000   

Underwriting discount

    $.77              $5,775,000     

Proceeds, before expenses, to us

    $10.23          $76,725,000   

The underwriters may also exercise their option to purchase up to an additional 1,125,000 shares from us, at the public offering price, less the underwriting discount, for 30 days after the date of this prospectus to cover overallotments, if any.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The shares will be ready for delivery on or about February 7, 2011.

 

 

 

BofA Merrill Lynch   Deutsche Bank Securities

 

 

 

Piper Jaffray   
Morgan Keegan     ThinkEquity LLC   

 

 

The date of this prospectus is February 1, 2011.


Table of Contents

LOGO


Table of Contents

TABLE OF CONTENTS

 

     Page  

Conventions that Apply in this Prospectus

     ii   

Prospectus Summary

     1   

Risk Factors

     11   

Special Note Regarding Forward-looking Statements and Industry Data

     38   

Use of Proceeds

     40   

Dividend Policy

     40   

Capitalization

     41   

Dilution

     43   

Selected Consolidated Financial Data

     45   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     48   

Business

     80   

Management

     98   

Compensation Discussion and Analysis

     110   

Executive Compensation

     122   

Certain Relationships and Related Party Transactions

     145   

Principal Stockholders

     148   

Description of Capital Stock

     152   

Shares Eligible for Future Sale

     156   

Material U.S. Federal Income and Estate Tax Consequences to Non-U.S. Holders

     159   

Underwriting

     162   

Legal Matters

     168   

Experts

     168   

Where You Can Find More Information

     168   

Index to Consolidated Financial Statements

     F-1   

 

 

You should rely only on the information contained in this prospectus or in any free writing prospectus prepared by or on behalf of us and delivered or made available to you. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock.

No action is being taken in any jurisdiction outside the United States to permit a public offering of the common stock or possession or distribution of this prospectus in that jurisdiction. Persons who come into possession of this prospectus in jurisdictions outside the United States are required to inform themselves about and to observe any restrictions as to this offering and the distribution of this prospectus applicable to that jurisdiction.

 

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CONVENTIONS THAT APPLY IN THIS PROSPECTUS

Unless otherwise indicated, references in this prospectus to:

 

   

“3D” refer to three dimensional or other multiview technology;

 

   

“3G” refer to third generation wireless architecture;

 

   

“AWG” refer to arrayed waveguide grating;

 

   

“China” or “Chinese” refer to the People’s Republic of China, excluding, for the purpose of this prospectus only, Hong Kong, Macau and Taiwan;

 

   

“design win” refer to a confirmation by a customer that a product or group of products may be used as part of a customer’s solution and we have a purchase order for such products;

 

   

“doping” refer to altering the physical properties of a material by adding a different element to the material;

 

   

“DQPSK” refer to dual quadrature phase shift keying;

 

   

“exabytes” refer to one billion billion bytes;

 

   

“Gbps” refer to gigabits per second;

 

   

“HD” refer to high definition;

 

   

“IP” refer to Internet protocol;

 

   

“LTE” refer to long-term evolution wireless architecture;

 

   

“MEMS” refer to micro electro-mechanical systems;

 

   

“OADM” refer to optical add drop multiplexer;

 

   

“PIC” refer to photonic integrated circuit;

 

   

“PON” refer to a passive optical network;

 

   

“product family” refer to one or more of our products with similar functionality deployed in similar optical network segments;

 

   

“RMB” refer to the legal currency of the People’s Republic of China;

 

   

“ROADM” refer to reconfigurable optical add drop multiplexer;

 

   

“service provider” refer to companies that maintain networks to provide communications services to businesses and consumers;

 

   

“Tier 1 customers” refer to a list of our key network equipment customers first set forth in “Prospectus Summary—Overview;”

 

   

“U.S. dollars,” “$,” and “dollars” refer to the legal currency of the United States;

 

   

“U.S. GAAP” refer to accounting principles generally accepted in the United States;

 

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“VMUX” refer to a variable optical attenuator multiplexer;

 

   

“WDM-PON” refer to a wavelength division multiplexing passive optical network; and

 

   

“well-characterized” refer to our ability to predict the outcome of our manufacturing processes based upon known statistics of various manufacturing inputs.

Unless the context indicates otherwise, we use the terms “NeoPhotonics,” “we,” “us” and “our” in this prospectus to refer to NeoPhotonics Corporation and, where appropriate, its subsidiaries.

 

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PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus and does not contain all of the information that you should consider in making your investment decision. Before investing in our common stock, you should carefully read this entire prospectus, including our consolidated financial statements and the related notes thereto and the information set forth under the sections “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in each case appearing elsewhere in this prospectus.

Overview

We are a leading designer and manufacturer of photonic integrated circuit, or PIC, based modules and subsystems for bandwidth-intensive, high-speed communications networks. The rapid growth of bandwidth-intensive content, including HD and 3D video, music, social networking, video conferencing and other multimedia, is driving the demand for high-bandwidth products. The demand for bandwidth capacity is further intensified by the proliferation of network-attached devices, such as smartphones, laptops, netbooks, tablet computers, PCs, e-readers, televisions and gaming devices, that are enabling consumers to access bandwidth-intensive content anytime and anywhere over fixed and wireless networks, including 3G, and increasingly, LTE networks.

Our products enable cost-effective, high-speed data transmission and efficient allocation of bandwidth over communications networks. We have a broad portfolio of over 300 products, including high-speed products that enable data transmission at 10Gbps, 40Gbps and 100Gbps, agility products such as ROADMs that dynamically allocate bandwidth to adjust for volatile traffic patterns, and access products that provide high-bandwidth connections to more devices and people over fixed and wireless networks.

Our innovative PIC technology utilizes proprietary design elements that provide optical functionality on a silicon chip. PIC devices integrate many more functional elements than discretely packaged components, enabling increased functionality in a small form factor while reducing packaging and interconnection costs. In addition, the cost advantages of PIC-based components are driven by the economics of semiconductor wafer mass manufacturing, where the marginal cost of producing an incremental chip is much less than that of a discrete component.

We sell our products to the leading network equipment vendors globally, including ADVA AG Optical Networking Ltd., Alcatel-Lucent SA, Ciena Corporation (including its recent acquisition of Nortel’s Metro Ethernet Networks business), Cisco Systems, Inc., FiberHome Technologies Group, ECI Telecom Ltd., Telefonaktiebolaget LM Ericsson, Fujitsu Limited, Harmonic, Inc., Huawei Technologies Co., Ltd., Mitsubishi Electric Corporation, NEC Corporation, Nokia Siemens Networks B.V. and ZTE Corporation. We refer to these companies as our Tier 1 customers. According to Infonetics Research, or Infonetics, an independent research firm, the top 12 optical network hardware vendors supplied over 90% of the worldwide market for optical network hardware in 2009. Each of these vendors is one of our Tier 1 customers. In 2009, we had revenue of $155.1 million and a net loss of $6.8 million. In the nine months ended September 30, 2010, we had revenue of $132.9 million and a net income of $2.9 million. We have grown our revenue at a 45.1% compound annual growth rate, or CAGR, from 2005 to 2009 due to organic growth and acquisitions.

Industry background

Network traffic is continuing to experience rapid growth driven primarily by bandwidth-intensive content, such as HD and 3D video, music, social networking, video conferencing and other multimedia. This growth is intensified by the proliferation of fixed and wireless network-attached devices, and the widespread and growing use of Cloud-based services, IP-based video, including user-generated video, IPTV, streaming web

 

 

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video, video conferencing and mobile video, enabled by 3G and increasingly by LTE networks. These factors have accelerated and are expected to continue to accelerate growth in network traffic and place significant strains on existing communications networks. According to Cisco’s Visual Networking Index, global IP traffic grew 45% during 2009 to reach an annual run rate of 176 exabytes per year or 15 exabytes per month and, in 2014, global IP traffic will reach 767 exabytes per year or 64 exabytes per month, representing a 34% CAGR.

Service providers are increasingly moving beyond their traditional markets to deliver a broad suite of converged services, including voice, video, broadband and mobile offerings. As a result, competition has increased, placing pressure on revenues, driving consolidation and creating increasingly complex networks with multiple bottlenecks. Consequently, service providers are seeking solutions that improve profitability by increasingly utilizing and investing in scalable, low-cost, high-bandwidth network architectures that deploy increased bandwidth capacity closer to the rapidly expanding base of fixed and mobile end users.

Optical networking has emerged as a key technology to support the increasing demand for bandwidth capacity due to its ability to provide the speed, agility and access required by service providers. The market for high-bandwidth solutions presents a compelling opportunity for optical technology providers. For example, optical network technologies help enable the migration to high-speed 40Gbps and 100Gbps networks, provide network agility through cost-effective ROADM equipment and enable network access in outside plant PON installations and wireless backhaul deployments. According to Infonetics, global optical network hardware revenue is projected to increase from $12.9 billion in 2010 to $15.0 billion in 2014. Further, Infonetics projects that from 2010 to 2014, globally, revenue from 40Gbps and 100Gbps ports will reach $3.4 billion, revenue from ROADM equipment will reach $4.9 billion and revenue from PON equipment, including fiber to the home and fiber to the building, will reach $3.8 billion, representing CAGRs of 42%, 16% and 15%, respectively.

Existing communications networks face many challenges. Most currently available solutions consist of multiple discrete components which result in a high degree of complexity, creating challenges to cost-effectively operate with the precision and performance necessary to deliver high-speed data transmission. In addition, approaches to increase bandwidth capacity that cannot efficiently leverage existing infrastructure, or are not otherwise backward compatible, are less attractive to service providers.

Given these challenges, we believe that existing discrete optical solutions and certain alternative PIC-based solutions are sub-optimal and do not allow service providers to cost-effectively deliver scalable bandwidth capacity to their customers. We believe this provides multiple opportunities for vendors that provide PIC-based modules and subsystems that address these challenges.

Our solutions

The key benefits of our solutions include:

 

   

Enabling service providers to cost-effectively deploy and rapidly scale high-bandwidth capacity networks. Our solutions are compatible with existing network architectures and enable incremental system upgrades, allowing service providers to rapidly scale network capacity and cost-effectively deploy enhanced services to their customers over existing optical fiber infrastructure.

 

   

Simplifying communications networks implementation through large scale integration. We are able to simplify communications networks deployments by delivering high levels of functional integration through our PIC solutions, which combine multiple discrete elements, in some cases over 100 elements on a single silicon chip.

 

   

Enabling acceleration of time-to-market for network equipment vendors. We believe our technology is attractive to leading service providers and network equipment vendors because it

 

 

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enables them to implement new features and scale network capacity rapidly, cost-effectively and predictably to meet demanding time-to-market requirements.

 

   

Satisfying our customers’ quality and volume requirements. We believe we are one of the highest volume PIC manufacturers in the world and have the ability to grow our capacity to meet increasing customer demand. Our Silicon Valley and China-based manufacturing facilities utilize semiconductor manufacturing techniques, such as statistical processing control and wafer scale fabrication, which enable us to provide repeatable, well-characterized performance at nanoscale tolerances with high yields.

Our strengths

Our key competitive strengths include the following:

 

   

Leading provider of PIC technology. Our differentiated PIC technology is a key enabler for delivering the speed, agility and access necessary to meet the increasing performance requirements of high-speed communications networks, including 100Gbps, at low costs.

 

   

Tier 1 global customer base and leading supplier to fast growing Asian markets. We are focused on serving our global Tier 1 customer base of network equipment vendors in the United States, Europe and Asia. In addition, we are a leading global supplier of PIC-based and other communications products to the largest markets in Asia, and we sell to each of the leading optical network hardware vendors, including Huawei Technologies. According to Infonetics, Huawei Technologies had the leading market share with 22.0% of the optical network hardware market in 2009.

 

   

Broad portfolio of products that address bandwidth bottlenecks across various network segments. Our products range from single function devices to modules and subsystems that enable speed, agility and access across communications networks, such as wireless backhaul, fiber-to-the-home, cable and transport.

 

   

Global, vertically integrated volume manufacturing platform. Our vertically integrated design and manufacturing process in the United States and China encompasses all steps from wafer design and fabrication to module and subsystem assembly and test, and allows for rapid iterations in the development cycle and shorter time-to-market for our products.

 

   

Strong knowledge base and extensive intellectual property portfolio. We have a significant intellectual property portfolio relating to PIC design and fabrication, methods for assembly and packaging and other product designs and technologies. In addition, we currently employ over 300 people in our research and development departments, with over 100 additional technically qualified engineering staff in manufacturing, process and product support functions, including over 45 professionals with Ph.D. degrees.

Our strategy

Our goal is to become the leading global supplier of high-performance optical technologies that enable the speed, agility and access required to support the rapid growth in traffic over communications networks. Key elements of our strategy include:

 

   

Extending our leadership in photonic integration technologies. We plan to strengthen our technology leadership and leading product performance by enhancing and extending our PIC capabilities across multiple product lines, including 40Gbps, 100Gbps, ROADM and PON products.

 

 

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Strengthening our relationships with our Tier 1 customers and penetrating new customers and geographies. We intend to deepen our relationships with our Tier 1 customers by increasing design wins in their systems, and by further collaborating to create new solutions with superior features and capabilities. Additionally, we intend to penetrate new high-growth network equipment vendors, particularly in emerging markets.

 

   

Expanding our product development and vertically integrated volume manufacturing capabilities. We plan to continue innovating in our design and manufacturing process to shorten our product development cycles and enhance our ability to provide highly integrated PIC-based and other communications solutions.

 

   

Extending our product portfolio into additional segments of the network. Given the demonstrated performance and reliability of our PIC-based products, we intend to leverage our technology to take advantage of new opportunities within communications networks.

 

   

Pursuing opportunistic acquisitions. We intend to opportunistically pursue acquisitions that we believe provide complementary technology and can help accelerate our growth and strengthen our market position.

Risk factors

Our business is subject to numerous risks and uncertainties, such as those highlighted in the section titled “Risk factors” immediately following this prospectus summary, including:

 

   

our history of losses that may continue in the future;

 

   

the overall condition of the highly cyclical communications network industry, including the impact of any future downturn;

 

   

the loss of, or a significant reduction in orders from, our key customers, including Huawei Technologies;

 

   

our ability to continually achieve new design wins and enhance our existing products; and

 

   

our ability to anticipate and respond to rapidly changing technologies and customer requirements.

Corporate information

We changed our name to NeoPhotonics Corporation in 2002 after having been incorporated as NanoGram Corporation in October 1996 in the State of Delaware. Our principal executive offices are located at 2911 Zanker Road, San Jose, California 95134, USA, and our telephone number is +1 (408) 232-9200. Our website address is www.neophotonics.com. Information contained on our website is not incorporated by reference into this prospectus, and you should not consider information contained on our website to be part of this prospectus or in deciding whether to purchase shares of our common stock.

Our name is a registered trademark of NeoPhotonics Corporation. This prospectus contains additional trade names and trademarks of ours and of other companies.

 

 

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THE OFFERING

 

Common stock offered by NeoPhotonics Corporation

7,500,000 shares

 

Over-allotment option

1,125,000 shares

 

Common stock to be outstanding after this offering

23,474,619 shares

 

Use of proceeds

We intend to use our net proceeds from this offering for working capital, to continue to expand our existing business and general corporate purposes. Accordingly, our management will have broad discretion in the application of our net proceeds from this offering, and investors will be relying on management’s judgment regarding the application of these net proceeds. We also may use a portion of our net proceeds from this offering to acquire complementary businesses, products, services or technologies, but we currently have no agreements or commitments relating to any material acquisitions. We may also use a portion of our net proceeds to repay a portion of our outstanding indebtedness, but we currently have no commitments or specific plans to repay any particular indebtedness in advance of its maturity date. As of September 30, 2010, our outstanding short-term loans and long-term debt totaled $15.1 million with interest rates ranging from 3.01% to 5.31% and maturity dates ranging from November 2010 through December 2012.

 

NYSE symbol

NPTN

The number of shares of our common stock to be outstanding after this offering is based on shares of our common stock outstanding, on a pro forma basis as of September 30, 2010, assuming the conversion of all outstanding shares of our preferred stock (other than our Series X preferred stock) into an aggregate of 6,639,513 shares of common stock on a 1-for-1 basis and, in the case of our Series X preferred stock, into an aggregate of 7,398,976 shares of common stock on a 400-for-1 basis, and excludes:

 

   

1,795,220 stock options with a weighted average exercise price of $5.61 per share outstanding as of September 30, 2010, exercisable into an equal number of shares of common stock;

 

   

4,482 stock warrants with an exercise price of $29.00 per share outstanding as of September 30, 2010, exercisable into an equal number of shares of common stock;

 

   

283,317 stock options granted on December 13, 2010 with a weighted average exercise price of $7.50 per share, exercisable into an equal number of shares of common stock; and

 

   

1,207,988 shares of common stock reserved for future issuance under our 2010 equity incentive plan and 2010 employee stock purchase plan, which will become effective in connection with this offering, and shares that become available under the plans pursuant to provisions thereof that automatically increase the share reserves under the plans each year, as more fully described in “Executive Compensation—Employee benefit plans.”

Unless otherwise indicated, all information in this prospectus assumes:

 

   

the automatic conversion of all outstanding shares of our preferred stock into shares of our common stock effective immediately prior to the closing of this offering;

 

 

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the amendment and restatement of our certificate of incorporation and the amendment and restatement of our bylaws upon the closing of this offering; and

 

   

no exercise by the underwriters of their right to purchase up to an additional 1,125,000 shares of common stock from us.

Unless otherwise noted, all of the information contained in this prospectus has been adjusted to reflect a 1-for-25 reverse stock split that we effected on November 30, 2010.

 

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

The following summary consolidated financial data should be read together with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus. The actual consolidated statements of operations data for the years ended December 31, 2007, 2008 and 2009 are derived from our consolidated financial statements appearing elsewhere in this prospectus. The unaudited consolidated financial statement data as of September 30, 2010 and for the nine months ended September 30, 2009 and 2010 is derived from our unaudited financial statements appearing elsewhere in this prospectus. We have prepared the unaudited consolidated financial statement data on a basis consistent with our audited consolidated financial statements and, in the opinion of our management, the unaudited consolidated financial data reflect all adjustments, consisting of only normal recurring adjustments, necessary for a fair statement of such data. Our historical results are not necessarily indicative of our future results.

 

    Years ended December 31,     Nine months ended
September 30,
 
(in thousands, except percentages, share and per share data)   2007     2008     2009     2009     2010  

Consolidated statements of operations data:

         

Revenue

  $ 95,825      $ 133,989      $ 155,062      $ 112,014      $ 132,888   

Cost of goods sold(1)

    83,475        109,439        114,572        86,142        91,079   
                                       

Gross profit

    12,350        24,550        40,490        25,872        41,809   
                                       

Gross margin

    12.9     18.3     26.1     23.1     31.5

Operating expenses

         

Research and development(1)

    23,076        21,480        17,266        12,431        16,049   

Sales and marketing(1)

    10,123        10,435        9,587        7,330        7,502   

General and administrative(1)

    13,142        14,581        15,448        11,230        12,397   

Amortization of purchased intangible assets

    1,826        1,665        1,136        852        855   

Asset impairment charges

    6,138        4,047        1,233        —          —     

Restructuring charges

    —          1,383        —          —          —     
                                       

Total operating expenses

    54,305        53,591        44,670        31,843        36,803   
                                       

Income (loss) from operations

    (41,955     (29,041     (4,180     (5,971     5,006   

Interest and other income (expense), net

    566        (812     (765     (451     (360
                                       

Income (loss) before income taxes

    (41,389     (29,853     (4,945     (6,422     4,646   

Benefit from (provision for) income taxes

    (86     1,812        (1,902     (1,211     (1,725
                                       

Net income (loss)

    (41,475     (28,041     (6,847     (7,633     2,921   

Net (income) loss attributable to noncontrolling interests

    8        (13     (116     (63     (80
                                       

Net income (loss) attributable to NeoPhotonics Corporation

    (41,467     (28,054     (6,963     (7,696     2,841   

Accretion of redeemable convertible preferred stock

    —          (428     (153     (122     (91
                                       

Net income (loss) attributable to NeoPhotonics Corporation common stockholders

  $ (41,467   $ (28,482   $ (7,116   $ (7,818   $ 2,750   
                                       

Net income (loss) per share attributable to NeoPhotonics Corporation common stockholders:

         

Basic

  $ (22.34   $ (14.80   $ (3.72   $ (4.09   $ 0.00   
                                       

Diluted

  $ (22.34   $ (14.80   $ (3.72   $ (4.09   $ 0.00   
                                       

Weighted average shares used to compute net income (loss) per share attributable to NeoPhotonics Corporation common stockholders:

         

Basic

    1,856,215        1,924,141        1,913,117        1,912,095        1,932,998   
                                       

Diluted

    1,856,215        1,924,141        1,913,117        1,912,095        3,036,756   
                                       

 

 

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    Year ended
December 31,
2009
    Nine months ended
September 30,
2010
 

Pro forma net income (loss) per share attributable to NeoPhotonics Corporation common stockholders(2):

   

Basic

  $ (0.51   $ 0.18   
               

Diluted

  $ (0.51   $ 0.17   
               

Weighted average shares used to compute pro forma net income (loss) per share attributable to NeoPhotonics Corporation common stockholders(2):

   

Basic

    13,599,967        15,883,606   
               

Diluted

    13,599,967        16,987,364   
               

 

    September 30, 2010  
(in thousands)   Actual     Pro  forma(3)     Pro forma  as
adjusted(4)
 

Consolidated summary balance sheet data:

     

Cash and cash equivalents

  $ 25,353      $ 25,353      $ 101,702   

Working capital(5)

    43,833        42,759        116,814   

Total assets

    167,753        167,753        241,807   

Total debt(6)

    27,350        27,350        27,350   

Redeemable convertible preferred stock

    211,519                 

Common stock and additional paid-in capital

    92,928        304,447        378,501   

Total stockholders’ equity (deficit)

    (115,633     94,812        168,866   

 

(1) These expenses include stock-based compensation expense. Stock-based compensation expense for employee stock options granted on or before December 31, 2005 was accounted for as the difference, if any, between the exercise price and the fair value of the common stock on the date of grant. Stock-based compensation expense for employee stock options granted on or after January 1, 2006 is accounted for at fair value, using the Black-Scholes option pricing model. Stock-based compensation expense is recognized over the vesting period of the stock options and was included in cost of goods sold and operating expenses as follows:

 

     Years ended
December 31,
     Nine months ended
September 30,
 
(in thousands)    2007      2008        2009          2009          2010    

Cost of goods sold

   $ 130       $ 125       $ 53       $ 53       $ 93   

Research and development

     435         314         228         174         283   

Sales and marketing

     226         177         180         131         292   

General and administrative

     545         512         520         381         572   
                                            

Total stock-based compensation expense

   $ 1,336       $ 1,128       $ 981       $ 739       $ 1,240   
                                            

 

(2) The pro forma basic and diluted net loss per share attributable to NeoPhotonics Corporation common stockholders calculations assume the conversion of all outstanding shares of preferred stock into shares of common stock using the as-if-converted method as though the conversion had occurred at the beginning of the period presented, or the date of issuance, if later, and a 1-for-25 reverse stock split that we effected on November 30, 2010. Pro forma net income (loss) per share attributable to NeoPhotonics Corporation common stockholders has not been adjusted for a potential charge upon completion of this offering which is triggered by the conversion of the Series X preferred stock, related to a beneficial conversion feature, which is described in Note 10 to our consolidated financial statements appearing elsewhere in this prospectus.
(3) Pro forma basis reflects the conversion of all outstanding shares of our preferred stock, other than our Series X preferred stock, into an aggregate of 6,639,513 shares of common stock on a 1-for-1 basis and, in the case of our Series X preferred stock, into an aggregate of 7,398,976 shares of common stock on a 400-for-1 basis and reflects the recognition of a liability of $1,073,778 and the related impact to accumulated deficit for the portion of the 263,020 stock appreciation units that were vested at September 30, 2010 and become exercisable upon the expiration of the lock-up period associated with this offering, based on the initial public offering price of $11.00 per share.
(4) Pro forma as adjusted basis reflects the pro forma adjustments described above in footnote (3) and further reflects the sale by us of 7,500,000 shares of common stock in this offering at the initial public offering price of $11.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses.

 

 

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(5) Working capital is defined as total current assets less total current liabilities.
(6) Total debt is defined as short-term loans, notes payable and total long-term debt.

Non-GAAP financial measures

 

     Years ended December 31,      Nine months  ended
September 30,
 
(in thousands)    2007     2008     2009          2009             2010      

Non-GAAP income (loss) from operations

   $ (28,980   $ (16,547   $ 3,254       $ (1,165   $ 9,032   

Non-GAAP net income (loss)

     (28,492     (15,560     140         (3,098     6,846   

Adjusted EBITDA

     (21,636     (8,521     11,428         5,025        15,473   

The following table reflects the reconciliation of U.S. GAAP financial measures to non-GAAP financial measures:

 

     Years ended December 31,     Nine months ended
September 30,
 
(in thousands)    2007     2008     2009       2009          2010    

Income (loss) from operations

   $ (41,955   $ (29,041   $ (4,180   $ (5,971    $ 5,006   

Non-GAAP adjustments:

           

Amortization of purchased intangibles(1)

     5,501        5,936        5,220        4,067         2,786   

Stock-based compensation expense

     1,336        1,128        981        739         1,240   

Asset impairment charges

     6,138        4,047        1,233        —           —     

Restructuring charges

     —          1,383        —          —           —     
                                         

Non-GAAP income (loss) from operations

   $ (28,980   $ (16,547   $ 3,254      $ (1,165    $ 9,032   
                                         

Net income (loss) attributable to NeoPhotonics Corporation

   $ (41,467   $ (28,054   $ (6,963   $ (7,696    $ 2,841   

Non-GAAP adjustments:

           

Amortization of purchased intangibles(1)

     5,501        5,936        5,220        4,067         2,786   

Stock-based compensation expense

     1,336        1,128        981        739         1,240   

Asset impairment charges

     6,138        4,047        1,233        —           —     

Restructuring charges

     —          1,383        —          —           —     

Share of loss of unconsolidated investee

     —          —          —          —           176   

Tax effect of non-GAAP adjustments

     —          —          (331     (208      (197
                                         

Non-GAAP net income (loss)

   $ (28,492   $ (15,560   $ 140      $ (3,098    $ 6,846   
                                         

Net income (loss) attributable to NeoPhotonics Corporation

   $ (41,467   $ (28,054   $ (6,963   $ (7,696    $ 2,841   

Non-GAAP adjustments:

           

Amortization of purchased intangibles(1)

     5,501        5,936        5,220        4,067         2,786   

Stock-based compensation expense

     1,336        1,128        981        739         1,240   

Asset impairment charges

     6,138        4,047        1,233        —           —     

Restructuring charges

     —          1,383        —          —           —     

Share of loss of unconsolidated investee

     —          —          —          —           176   

Interest (income) expense, net

     (247     1,244        701        506         402   

Provision for (benefit from) income taxes

     86        (1,812     1,902        1,211         1,725   

Depreciation expense

     7,017        7,607        8,354        6,198         6,303   
                                         

Adjusted EBITDA

   $ (21,636   $ (8,521   $ 11,428      $ 5,025       $ 15,473   
                                         

 

(1) Reflects amortization of purchased intangible assets included in cost of goods sold and operating expenses.

 

 

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We believe that the use of non-GAAP income (loss) from operations, non-GAAP net income (loss) and adjusted earnings before interest, taxes, depreciation and amortization, or adjusted EBITDA, is helpful for an investor in determining whether to invest in our common stock. In computing our non-GAAP financial measures, we exclude certain items included under U.S. GAAP. Non-GAAP income (loss) from operations excludes the amortization of purchased intangible assets, stock-based compensation expense, asset impairment charges and restructuring charges. Non-GAAP net income (loss) excludes these same items and, additionally, it excludes our share of loss of unconsolidated investee. Adjusted EBITDA excludes these same items and, additionally, it excludes interest (income) expense, net, provision for (benefit from) income taxes and depreciation expense.

We believe that excluding amortization of purchased intangible assets, stock-based compensation expense, asset impairment charges, restructuring charges and share of loss of unconsolidated investee helps investors compare our operating performance with our results in prior periods. We believe that it is appropriate to exclude these items as they are not necessarily indicative of ongoing operating performance and, therefore, limit comparability between periods and between us and similar companies. We believe adjusted EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. In addition, we believe that adjusted EBITDA is useful in evaluating our operating performance compared to that of other companies in our industry because the calculation of adjusted EBITDA generally eliminates the effects of financing and income taxes and the accounting effects of capital spending and acquisitions, which items may vary for different companies for reasons unrelated to overall operating performance. We use these non-GAAP financial measures to evaluate the operating performance of our business and aid in the period-to-period comparability. We also use the non-GAAP financial measures for planning and forecasting and measuring results against the forecast and in certain cases for bonus targets for certain of our employees. Using several measures to evaluate the business allows us and investors to (1) assess our relative performance against our competitors and (2) ultimately monitor our capacity to generate returns for our stockholders. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Key metrics.”

 

 

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RISK FACTORS

You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our common stock. Investing in our common stock involves a high degree of risk. If any of the following risks actually occur, we may be unable to conduct our business as currently planned and our financial condition and results of operations could be seriously harmed. In addition, the trading price of our common stock could decline due to the occurrence of any of these risks, and you may lose all or part of your investment. See “Special Note Regarding Forward-looking Statements and Industry Data” beginning on page 38.

Risks related to our business

We have a history of losses which may continue in the future.

We have a history of losses and we may incur additional losses in future periods. We experienced a net loss of $6.8 million for the year ended December 31, 2009. As of September 30, 2010, our accumulated deficit was $216.1 million. We also expect to continue to make significant expenditures related to the development of our business. These include expenditures to hire additional personnel related to the sales, marketing and development of our products and to maintain and expand our manufacturing facilities and research and development operations.

We are subject to the cyclical nature of the markets in which we compete and any future downturn may reduce demand for our products and revenue.

The markets in which we compete are tied to the aggregate capital expenditures of service providers as they build out and upgrade their network infrastructure. These markets are highly cyclical and characterized by constant and rapid technological change, price erosion, evolving standards and wide fluctuations in product supply and demand. In the past, these markets have experienced significant downturns, often connected with, or in anticipation of, the maturation of product cycles—for both manufacturers’ and their customers’ products—and with declining general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices.

Our historical results of operations have been subject to substantial fluctuations, and we may experience substantial period-to-period fluctuations in future results of operations. Any future downturn in the markets in which we compete could significantly reduce the demand for our products and therefore may result in a significant reduction in revenue. It may also increase the volatility of the price of our common stock. Our revenue and results of operations may be materially and adversely affected in the future due to changes in demand from individual customers or cyclical changes in the markets utilizing our products.

In addition, the communications networks industry from time to time has experienced and may again experience a pronounced downturn. To respond to a downturn, many service providers may slow their capital expenditures, cancel or delay new developments, reduce their workforces and inventories and take a cautious approach to acquiring new equipment and technologies from original equipment manufacturers, which would have a negative impact on our business. Weakness in the global economy or a future downturn in the communications networks industry may cause our results of operations to fluctuate from year-to-year, harm our business, and may increase the volatility of the price of our common stock.

If spending for communications networks does not continue to grow as expected, our business may suffer.

Our future success as a provider of modules and subsystems to leading network equipment vendors depends on their continued capital spending on global communications networks. Network traffic has experienced rapid growth driven primarily by bandwidth-intensive content, including HD and 3D video, music, social networking, video conferencing and other multimedia. This growth is intensified by the proliferation of

 

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fixed and wireless network-attached devices, including smartphones, laptops, netbooks, tablet computers, PCs, e-readers, televisions and gaming devices, that are enabling consumers to access content at increasing data rates anytime and anywhere. Our future success depends on continued demand for high-bandwidth, high-speed communications networks and the ability of network equipment vendors to meet this demand. Growth in demand for communications networks is limited by several factors, including an evolving regulatory environment and uncertainty regarding long-term sustainable business models. We cannot be certain that demand for bandwidth-intensive content will continue to grow in the future. If expectations for growth of communications networks and bandwidth consumption are not realized and investment in communications networks does not grow as anticipated, our business could be harmed.

We are dependent on Huawei Technologies and our key customers for a significant portion of our revenue and the loss of, or a significant reduction in orders from, Huawei Technologies or any of our other key customers may reduce our revenue and adversely impact our results of operations.

Historically, we have generated most of our revenue from a limited number of customers. In 2009, our largest customer, Huawei Technologies, represented 52.9% of our total revenue and our top ten customers represented 82.9% of our total revenue. As a result, the loss of, or a significant reduction in orders from, Huawei Technologies or any of our other key customers would materially and adversely affect our revenue and results of operations. Adverse events affecting our customers could also adversely affect our revenue and results of operations (for instance, in 2009, the filing of a voluntary petition for bankruptcy protection by one of our customers, Nortel Networks Limited, has prevented us from timely collection of our accounts receivable from that customer). In addition, network equipment vendors serving the communications networks industry may continue to consolidate, and we may not be able to offset any potential decline in revenue arising from consolidation of our existing customers with revenue from new customers.

We have a limited history operating on a global basis, making it difficult to predict our future results of operations.

We have a limited history operating on a global basis, which makes it difficult to evaluate our business and financial prospects. While our operations began in 1996, we did not begin commercial shipments of our PIC products until the second quarter of 2003 and we did not acquire our subsidiaries in China until 2005. Since then, our revenue, gross margin and results of operations have varied significantly and are likely to continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. For instance, changes in gross margin may result from various factors, such as changes in pricing, changes in our fixed costs, changes in the mix of our products sold and changes in the amount of product manufactured versus the amount of product sold over time. In making an investment decision, you should evaluate our business in light of the risks, expenses and difficulties frequently encountered by companies operating on a global platform, particularly companies in the rapidly changing communications networks industry. It is difficult for us to accurately forecast our future revenue and gross margin and plan expenses accordingly and, therefore, it is difficult for us to predict our future results of operations.

We must continually achieve new design wins and enhance existing products or our business may be harmed.

The markets for our products are characterized by frequent new product introductions, changes in customer requirements and evolving industry standards, all with an underlying pressure to reduce cost and meet stringent reliability and qualification requirements. Our future performance will depend on our successful development, introduction and market acceptance of new and enhanced products that address these challenges. The anticipated or actual introduction of new and enhanced products by us and by our competitors may cause our customers to defer or cancel orders for our existing products. In addition, the introduction of new products by us or our competitors could result in a slowdown in demand for our existing products and could result in a write-down in the value of inventory. We have in the past experienced a slowdown in demand for existing products and delays in new product development, and such delays may occur in the future. To the extent customers defer or cancel orders for our products for any reason or we fail to achieve new design wins, our competitive position would be adversely affected and our ability to grow revenue would be impaired.

 

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Product development delays may result from numerous factors, including:

 

   

changing product specifications and customer requirements;

 

   

unanticipated engineering complexities;

 

   

difficulties in reallocating engineering resources and overcoming resource limitations; and

 

   

changing market or competitive product requirements.

Furthermore, fast time-to-market with new products can be critical to success in our markets. It is difficult to displace an existing supplier for a particular type of product once a network equipment vendor has chosen a supplier, even if a later-to-market product provides superior performance or cost efficiency. If we are unable to make our new or enhanced products commercially available on a timely basis, we may lose existing and potential customers and our financial results would suffer.

The development of new, technologically-advanced products is a complex and uncertain process requiring frequent innovation, highly-skilled engineering and development personnel and significant capital, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product introductions by competitors, technological changes or emerging industry standards. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements, license these technologies from third parties, or remain competitive in our markets.

Our success will depend on our ability to anticipate and quickly respond to rapidly changing technologies and customer requirements.

The communications networks industry is characterized by substantial investment in new technology and the development of diverse and changing technologies and industry standards. For example, new technologies are required to satisfy the emerging standards for 40Gbps and 100Gbps data transmission in communications networks.

Our ability to anticipate and respond to rapid changes in technology, industry standards, customer requirements and product offerings, and to develop and introduce new and enhanced products and technologies, will be critical factors in our ability to succeed. If we are unable to anticipate and respond to such changes in the future, our competitive position could be adversely affected. In addition, the introduction of new products by other companies embodying new technologies, or the emergence of new industry standards, could render our existing products uncompetitive from a pricing standpoint, obsolete or otherwise unmarketable.

If our customers do not qualify our products for use, then our results of operations may suffer.

Prior to placing volume purchase orders with us, most of our customers require us to obtain their approval—called qualification in our industry—of our new and existing products, and our customers often audit our manufacturing facilities and perform other vendor evaluations during this process. The qualification process involves product sampling and reliability testing and collaboration with our product management and engineering teams in the design and manufacturing stages. If we are unable to qualify our products with customers, then our revenue would be lower than expected and we may not be able to recover the costs associated with the qualification process which would have an adverse effect on our results of operations.

In addition, due to rapid technological changes in our markets, a customer may cancel or modify a design project before we have qualified our product or begun volume manufacturing of a qualified product. It is

 

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unlikely that we would be able to recover the expenses for cancelled or unutilized custom design projects. It is difficult to predict with any certainty whether our customers will delay or terminate product qualification or the frequency with which customers will cancel or modify their projects, but any such delay, cancellation or modification would have a negative effect on our results of operations.

In particular, we have developed new technologies and products that are key components in our customers’ systems for 40Gbps and 100Gbps data transmission. While we are shipping certain products for 40Gbps and 100Gbps system designs today, many of our products for these systems are currently being qualified for use by our customers. Our ability to successfully qualify and scale capacity for these new technologies and products is important to our ability to grow our business and market presence. If we are unable to qualify and sell any of these products in volume on time, or at all, our results of operations may be adversely affected.

We are under continuous pressure to reduce the prices of our products.

The communications networks industry has been characterized by declining product prices over time. We have reduced the prices of some of our products in the past and we expect to experience pricing pressure for our products in the future. When seeking to maintain or increase their market share, our competitors may also reduce the prices of their products. In addition, our customers may have the ability to internally develop and manufacture competing products at a lower cost than we would otherwise charge, which would add additional pressure on us to lower our selling prices. If we are unable to offset any future reductions in our average selling prices by increasing our sales volume, reducing our costs and expenses or introducing new products, our gross margin would suffer.

Customer demand is difficult to accurately forecast and, as a result, we may be unable to optimally match production with customer demand.

We make planning and spending decisions, including determining the levels of business that we will seek and accept, production schedules, component procurement commitments, personnel needs and other resource requirements, based on our estimates of customer requirements. The short-term nature of commitments by many of our customers and the possibility of unexpected changes in demand for their products reduce our ability to accurately estimate future customer requirements. On occasion, customers may require rapid increases in production, which can strain our resources, cause our manufacturing to be negatively impacted by materials shortages, necessitate higher or more restrictive procurement commitments and reduce our gross margin. We may not have sufficient capacity at any given time to meet the volume demands of our customers, or one or more of our suppliers may not have sufficient capacity at any given time to meet our volume demands. Conversely, a downturn in the markets in which our customers compete can cause, and in the past have caused, our customers to significantly reduce the amount of products ordered from us or to cancel existing orders, leading to lower utilization of our facilities. Because many of our costs and operating expenses are relatively fixed, reduction in customer demand would have an adverse effect on our gross margin, operating income and cash flow. During an industry downturn, there is also a higher risk that our trade receivables would be uncollectible.

The majority of our products are purchased pursuant to individual purchase orders. While our customers generally provide us with their demand forecasts and may give us a promised market share award, they are typically not contractually committed to buy any quantity of products beyond firm purchase orders. Many of our customers may increase, decrease, cancel or delay purchase orders already in place. If any of our major customers decrease, stop or delay purchasing our products for any reason, our business and results of operations would be harmed. Cancellation or delays of such orders may cause us to fail to achieve our short and long-term financial and operating goals.

We face intense competition which could negatively impact our results of operations and market share.

The communications networks industry is highly competitive. Our competitors range from large, international companies offering a wide range of products to smaller companies specializing in niche markets. In

 

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addition, we believe that a number of companies have developed or are developing planar lightwave or MEMS-based, PIC devices and other products that compete directly with our products. Current and potential competitors may have substantially greater financial, marketing, research and manufacturing resources than we possess, and there can be no assurance that our current and future competitors will not be more successful than us in specific product lines or as a whole.

Some of our competitors have substantially greater name recognition, technical, financial, and marketing resources, and greater manufacturing capacity, as well as better-established relationships with customers, than we do. Some of our competitors have more resources to develop or acquire, and more experience in developing or acquiring, new products and technologies and in creating market awareness for these products and technologies. Some of our competitors may be able to develop new products more quickly than us and may be able to develop products that are more reliable or which provide more functionality than ours. In addition, some of our competitors have the financial resources to offer competitive products at below-market pricing levels that could prevent us from competing effectively and result in a loss of sales or market share or cause us to lower prices for our products.

We also face competition from some of our customers who evaluate our capabilities against the merits of manufacturing products internally. Due to the fact that such customers are not seeking to make a profit directly from the manufacture of these products, they may have the ability to manufacture competitive products at a lower cost than we would charge such customers. As a result, these customers may purchase less of our products and there would be additional pressure to lower our selling prices which, accordingly, would negatively impact our revenue and gross margin.

In particular we have developed new technologies and products that are key components in our customers’ system designs for 40Gbps and 100Gbps data transmission. The emergence of technologies and products from our competitors and their success in competing against our technologies and products for 40Gbps and 100Gbps data transmission could render our existing products uncompetitive from a pricing standpoint, obsolete or otherwise unmarketable.

Intense competition in our markets could result in aggressive business tactics by our competitors, including aggressively pricing their products or selling older inventory at a discount. If our current or future competitors utilize aggressive business tactics, including those described above, demand for our products could decline, we could experience delays or cancellations of customer orders, or we could be required to reduce our sales prices.

The communications networks industry has long product development cycles requiring us to incur product development costs without assurances of an acceptable investment return.

The communications networks industry is highly capital-intensive. Large volumes of equipment and support structures are installed with considerable expenditures of funds and other resources, and long investment return period expectations. At the component supplier level, this reluctance creates considerable, typically multi-year, gaps between the commencement of new product development and volume purchases. Accordingly, we and our competitors often incur significant research and development and sales and marketing costs for products that, at the earliest, will be purchased by our customers long after much of the cost is incurred and, in some cases, may never be purchased due to changes in industry or customer requirements in the interim.

Due to changing industry and customer requirements, we are constantly developing new products, including seeking to further integrate functions on PICs and developing and using new technologies in our products. These development activities can and are expected to necessitate significant investment of capital. Our new products often require a long time to develop because of their complexity and rigorous testing and qualification requirements. Additionally, developing a manufacturing approach with an acceptable cost structure and yield for new products can be expensive and time-consuming. Due to the costs and length of research and

 

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development and manufacturing process cycles, we may not recognize revenue from new products until long after such expenditures are incurred, if at all, and our gross margin may decrease if our costs are higher than expected.

Manufacturing problems could result in delays in product shipments to customers and could adversely affect our revenue, competitive position and reputation.

We may experience delays, disruptions or quality control problems in our manufacturing operations. For instance, we could experience a disruption in our fabrication facility for our PIC products due to any number of reasons, such as equipment failure, contaminated materials or process deviations, which could adversely impact manufacturing yields or delay product shipments. As a result, we could incur additional costs that would adversely affect our gross margin, and product shipments to our customers could be delayed beyond the shipment schedules requested by our customers, which would negatively affect our revenue, competitive position and reputation.

Additionally, manufacturing yields depend on a number of factors, including the stability and manufacturability of the product design, manufacturing improvements gained over cumulative production volumes, the quality and consistency of component parts and the nature and extent of customization requirements by customers. Capacity constraints, raw materials shortages, logistics issues, labor shortages, the introduction of new product lines and changes in customer requirements, manufacturing facilities or processes, or those of some third party contract manufacturers and suppliers of raw materials and components have historically caused, and may in the future cause, reduced manufacturing yields, negatively impacting the gross margin on, and our production capacity for, those products. Moreover, an increase in the rejection and rework rate of products during the quality control process before, during or after manufacture would result in our experiencing lower yields, gross margin and production capacity.

Our ability to maintain sufficient manufacturing yields is particularly challenging with respect to PICs due to the complexity and required precision of a large number of unique manufacturing process steps. Manufacturing yields for PICs can also suffer if contaminated materials or materials that do not meet highly precise composition requirements are inadvertently utilized. Because a large portion of our PIC manufacturing costs are fixed, PIC manufacturing yields have a substantial effect on our gross margin. Lower than expected manufacturing yields could also delay product shipments and decrease our revenue.

While we rely on many suppliers, there are a few which, if they stopped, decreased or delayed shipments to us, it could have an adverse effect on our business.

We depend on a limited number of suppliers for certain components we have qualified to use in the manufacture of certain of our products. Some of these suppliers could disrupt our business if they stop, decrease or delay shipments or if the components they ship have quality or consistency issues. Some of these components are available only from a sole source or have been qualified only from a single supplier. Furthermore, other than our current suppliers, there are a limited number of entities from whom we could obtain certain of these supplies. We may also face component shortages if we experience increased demand for components beyond what our qualified suppliers can deliver. We have recently experienced component shortages from certain key suppliers, which has resulted and may continue to result in an inability to meet customer demand, higher purchasing costs, or both. Although we engage in various actions to mitigate the impact of these shortages, any inability on our part to obtain sufficient quantities of critical components at reasonable costs could adversely affect our ability to meet demand for our products, which could cause our revenue, results of operations, or both to suffer.

Our customers generally restrict our ability to change the component parts in our modules without their approval. For more critical components, such as PICs, lasers and photodetectors, any changes may require repeating the entire qualification process. We typically have not entered into long-term agreements with our suppliers and, therefore, our suppliers could stop supplying materials and equipment at any time or fail to supply

 

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adequate quantities of component parts on a timely basis. It is difficult, costly, time consuming and, on short notice, sometimes impossible for us to identify and qualify new component suppliers. The reliance on a sole supplier, single qualified vendor or limited number of suppliers could result in delivery and quality problems, reduced control over product pricing, reliability and performance and an inability to identify and qualify another supplier in a timely manner. We have in the past had to change suppliers, which has, in some instances, resulted in delays in product development and manufacturing and loss of revenue. Any such delays in the future may limit our ability to respond to changes in customer and market demands. Any supply deficiencies relating to the quality or quantities of components that we use to manufacture our products could adversely affect our ability to fulfill our customer orders and our results of operations.

Rapidly changing standards and regulations could make our products obsolete, which would cause our revenue and results of operations to suffer.

We design our products to conform to regulations established by governments and to standards set by industry standards bodies worldwide, such as The American National Standards Institute, the European Telecommunications Standards Institute, the International Telecommunications Union and the Institute of Electrical and Electronics Engineers, Inc. Various industry organizations are currently considering whether and to what extent to create standards for elements used in 100Gbps systems. Because certain of our products are designed to conform to current specific industry standards, if competing or new standards emerge that are preferred by our customers, we would have to make significant expenditures to develop new products. If our customers adopt new or competing industry standards with which our products are not compatible, or the industry groups adopt standards or governments issue regulations with which our products are not compatible, our existing products would become less desirable to our customers and our revenue and results of operations would suffer.

If we fail to retain our key personnel or if we fail to attract additional qualified personnel, we may not be able to achieve our anticipated level of growth and our business could suffer.

Our success and ability to implement our business strategy depends upon the continued contributions of our senior management team and others, including our technical employees. Our future success depends, in part, on our ability to attract and retain key personnel, including our senior management and others, and on the continued contributions of members of our senior management team and key technical personnel, each of whom would be difficult to replace. The loss of services of members of our senior management team or key personnel or the inability to continue to attract and retain qualified personnel could have a material adverse effect on our business. Competition for highly skilled technical people, both in the United States and China, is extremely intense, and we continue to face challenges identifying, hiring and retaining qualified personnel in many areas of our business. If we fail to retain our senior management and other key personnel or if we fail to attract additional qualified personnel, our business could suffer.

If we fail to protect, or incur significant costs in defending, our intellectual property and other proprietary rights, our business and results of operations could be materially harmed.

Our success depends to a significant degree on our ability to protect our intellectual property and other proprietary rights. We rely on a combination of patent, trademark, copyright, trade secret and unfair competition laws, as well as license agreements and other contractual provisions, to establish and protect our intellectual property and other proprietary rights. We have applied for patent registrations in the United States and in other foreign countries, some of which have been issued. In addition, we have registered the trademark “NeoPhotonics” in the United States. We cannot guarantee that our pending applications will be approved by the applicable governmental authorities. Moreover, our existing and future patents and trademarks may not be sufficiently broad to protect our proprietary rights or may be held invalid or unenforceable in court. A failure to obtain patents or trademark registrations or a successful challenge to our registrations in the United States or other foreign countries may limit our ability to protect the intellectual property rights that these applications and registrations intended to cover.

 

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Policing unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent the misappropriation, unauthorized use or other infringement of our intellectual property rights. Further, we may not be able to effectively protect our intellectual property rights from misappropriation or other infringement in foreign countries where we have not applied for patent protections, and where effective patent, trademark, trade secret and other intellectual property laws may be unavailable, or may not protect our proprietary rights as fully as U.S. law. Particularly, our U.S. patents do not afford any intellectual property protection in China, where we have substantial operations. We seek to secure, to the extent possible, comparable intellectual property protections in China. However, while we have issued patents and pending patent applications in China, portions of our intellectual property portfolio are not yet protected by patents in China. Moreover, the level of protection afforded by patent and other laws in China may not be comparable to that afforded in the United States.

We attempt to protect our intellectual property, including our trade secrets and know-how, through the use of trade secret and other intellectual property laws, and contractual provisions. We enter into confidentiality and invention assignment agreements with our employees and independent consultants. We also use non-disclosure agreements with other third parties who may have access to our proprietary technologies and information. Such measures, however, provide only limited protection, and there can be no assurance that our confidentiality and non-disclosure agreements will not be breached, especially after our employees or those of our third-party contract manufacturers end their employment or engagement, and that our trade secrets will not otherwise become known by competitors or that we will have adequate remedies in the event of unauthorized use or disclosure of proprietary information. Unauthorized third parties may try to copy or reverse engineer our products or portions of our products, otherwise obtain and use our intellectual property, or may independently develop similar or equivalent trade secrets or know-how. If we fail to protect our intellectual property and other proprietary rights, or if such intellectual property and proprietary rights are infringed or misappropriated, our business, results of operations or financial condition could be materially harmed.

In the future, we may need to take legal actions to prevent third parties from infringing upon or misappropriating our intellectual property or from otherwise gaining access to our technology. Protecting and enforcing our intellectual property rights and determining their validity and scope could result in significant litigation costs and require significant time and attention from our technical and management personnel, which could significantly harm our business. In addition, we may not prevail in such proceedings. An adverse outcome of such proceedings may reduce our competitive advantage or otherwise harm our financial condition and our business.

We may be involved in intellectual property disputes in the future, which could divert management’s attention, cause us to incur significant costs and prevent us from selling or using the challenged technology.

Participants in the markets in which we sell our products have experienced frequent litigation regarding patent and other intellectual property rights. Numerous patents in these industries are held by others, including our competitors. In addition, from time to time, we have been notified that we may be infringing certain patents or other intellectual property rights of others. Regardless of their merit, responding to such claims can be time consuming, divert management’s attention and resources and may cause us to incur significant expenses. In addition, there can be no assurance that third parties will not assert infringement claims against us. While we believe that our products do not infringe in any material respect upon intellectual property rights of other parties and/or meritorious defense would exist with respect to any assertions to the contrary, we cannot be certain that our products would not be found infringing the intellectual property rights of others. Intellectual property claims against us could invalidate our proprietary rights and force us to do one or more of the following:

 

   

obtain from a third party claiming infringement a license to sell or use the relevant technology, which may not be available on reasonable terms, or at all;

 

   

stop manufacturing, selling, incorporating or using our products that use the challenged intellectual property;

 

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pay substantial monetary damages; or

 

   

expend significant resources to redesign the products that use the technology and to develop non-infringing technology.

Any of these actions could result in a substantial reduction in our revenue and could result in losses over an extended period of time.

On January 5, 2010, Finisar Corporation, or Finisar, filed a complaint in the United States District Court for the Northern District of California against Source Photonics, Inc., MRV Communications, Inc., Oplink Communications, Inc. and us, or collectively, the co-defendants. In the complaint, Finisar alleged infringement of certain of its U.S. patents arising from the co-defendants’ respective manufacture, importation, use, sale of or offer to sell certain optical transceiver products in the United States. Finisar sought to recover unspecified damages, up to treble the amount of actual damages, together with attorneys’ fees, interest and costs. Finisar alleged that at least some of the patents asserted are a part of certain digital diagnostic standards for optoelectronics transceivers and, therefore, are being utilized in such digital diagnostic standards. On March 23, 2010, we filed an answer to the complaint and counterclaims, asserting two claims of patent infringement and additional claims asserting that Finisar has violated state and federal competition laws and violated its obligations to license on reasonable and non-discriminatory terms. On May 5, 2010, the court dismissed without prejudice all co-defendants (including us) except Source Photonics, Inc., on grounds that such claims should have been asserted in four separate lawsuits, one against each co-defendant. This dismissal without prejudice does not prevent Finisar from bringing a new similar lawsuit against us. We and Finisar had agreed to a 90 day tolling of our respective claims and not to refile the originally asserted claims against each other until one or more specified events occur resulting in the partial or complete resolution of the litigation between Source Photonics and Finisar. On September 10, 2010, Source Photonics and Finisar settled their lawsuit, commencing the tolling period, which expired in early December 2010.

On January 18, 2011, we and Finisar again agreed to toll our respective claims and not to refile the originally asserted claims against each other until at least 90 days after one or more specified events occur resulting in the partial or complete resolution of litigation involving the same Finisar patents between Oplink Communications, Inc. and Finisar. At that time, Finisar will be permitted to bring a new lawsuit against us if they choose to do so. If we are unsuccessful in our defense of the Finisar patent infringement claims, a license to use the allegedly infringing technology may not be available to us at all, and if it is, it may not be available on commercially reasonable terms and therefore may limit or preclude us from competing in the market for optical transceivers in the United States, which may have a material adverse effect on our results of operations and financial condition, and otherwise materially harm our business.

Although we believe that we would have meritorious defenses to the infringement allegations and intend to defend any new similar lawsuit vigorously, there can be no assurance that we will be successful in our defense. Even if we are successful, we may incur substantial legal fees and other costs in defending the lawsuit. Further, a new lawsuit, if brought, would be likely to divert the efforts and attention of our management and technical personnel, which could harm our business.

If we fail to obtain the right to use the intellectual property rights of others which are necessary to operate our business, and to protect their intellectual property, our ability to succeed will be adversely affected.

From time to time we may choose to or be required to license technology or intellectual property from third parties in connection with the development of our products. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. Generally, a license, if granted, would include payments of up-front fees, ongoing royalties or both. These payments or other terms could have a significant adverse impact on our results of operations. The inability to obtain a necessary third-party license required for our product offerings or to develop new products and product enhancements could require us to substitute technology of lower quality or performance standards, or of greater cost, either of which could adversely affect

 

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our business. If we are not able to obtain licenses from third parties, if necessary, then we may also be subject to litigation to defend against infringement claims from these third parties. Our competitors may be able to obtain licenses or cross-license their technology on better terms than we can, which could put us at a competitive disadvantage. Also, we typically enter into confidentiality agreements with such third parties in which we agree to protect and maintain their proprietary and confidential information, including requiring our employees to enter into agreements protecting such information. There can be no assurance that the confidentiality agreements will not be breached by any of our employees or that such third parties will not make claims that their proprietary information has been disclosed.

Any potential dispute involving our patents or other intellectual property could also include our customers using our products, which could trigger our indemnification obligations to them and result in substantial expenses to us.

In any potential dispute involving our patents or other intellectual property, our customers could also become the target of litigation. Because we often indemnify our customers for intellectual property claims made against them for products incorporating our technology, any claims against our customers could trigger indemnification obligations in some of our supply agreements, which could result in substantial expenses such as increased legal expenses, damages for past infringement or royalties for future use. While we have not incurred any indemnification expenses to date, any future indemnity claim could adversely affect our relationships with our customers and result in substantial costs to us. Our insurance does not cover intellectual property infringement.

It could be discovered that our products contain defects that may cause us to incur significant costs, divert our attention, result in a loss of customers and result in product liability claims.

Our products are complex and undergo quality testing as well as formal qualification by our customers and us. However, defects may occur from time to time. Our customers’ testing procedures are limited to evaluating our products under likely and foreseeable failure scenarios and over varying amounts of time. For various reasons, such as the occurrence of performance problems that are unforeseeable in testing or that are detected only when products age or are operated under peak stress conditions, our products may fail to perform as expected long after customer acceptance. Failures could result from faulty components or design, problems in manufacturing or other unforeseen reasons. As a result, we could incur significant costs to repair or replace defective products under warranty, particularly when such failures occur in installed systems. We have experienced such failures in the past and will continue to face this risk going forward, as our products are widely deployed throughout the world in multiple demanding environments and applications. In addition, we may in certain circumstances honor warranty claims after the warranty has expired or for problems not covered by warranty in order to maintain customer relationships. Any significant product failure could result in lost future sales of the affected product and other products, as well as customer relations problems, litigation and damage to our reputation.

In addition, our products are typically embedded in, or deployed in conjunction with, our customers’ products, which incorporate a variety of components, modules and subsystems and may be expected to interoperate with modules produced by third parties. As a result, not all defects are immediately detectable and when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significant damages or warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems or loss of customers, all of which would harm our business.

The occurrence of any defects in our products could give rise to liability for damages caused by such defects. They could, moreover, impair our customers’ acceptance of our products. Both could have a material adverse effect on our business and financial condition. Although we carry product liability insurance which covers this risk, this insurance may not adequately cover our costs arising from defects in our products or otherwise.

 

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If we fail to adequately manage our long-term growth and expansion requirements, our business will suffer.

In recent years, we have experienced significant growth through, among other things, internal expansion programs, product development and acquisitions of other companies. We expect to continue to grow, which could require us to expand our manufacturing operations, including hiring new personnel, purchasing additional equipment, leasing or purchasing additional facilities, developing the management infrastructure and developing our suppliers to manage any such expansion. If we fail to secure these expansion requirements or manage our future growth effectively, our business could suffer.

Potential future acquisitions could be difficult to integrate, divert the attention of key personnel, disrupt our business, dilute stockholder value and impair our financial results.

As part of our business strategy, we have pursued and intend to continue to pursue acquisitions of complementary businesses, products, services or technologies that we believe could accelerate our ability to compete in our existing markets or allow us to enter new markets.

Acquisitions involve numerous risks, any of which could harm our business, including:

 

   

difficulties in integrating the operations, technologies, products, existing contracts, accounting and personnel of the target company and realizing the anticipated synergies of the combined businesses;

 

   

difficulties in supporting and transitioning customers, if any, of the target company;

 

   

diversion of financial and management resources from existing operations;

 

   

the price we pay or other resources that we devote may exceed the value we realize, or the value we could have realized if we had allocated the purchase price or other resources to another opportunity;

 

   

risks of entering new markets in which we have limited or no experience;

 

   

potential loss of key employees, customers and strategic alliances from either our current business or the target company’s business;

 

   

assumption of unanticipated problems or latent liabilities, such as problems with the quality of the target company’s products;

 

   

inability to generate sufficient revenue to offset acquisition costs;

 

   

dilutive effect on our stock as a result of any equity-based acquisitions;

 

   

inability to successfully complete transactions with a suitable acquisition candidate; and

 

   

in the event of international acquisitions, risks associated with accounting and business practices that are different from applicable U.S. practices and requirements.

Acquisitions also frequently result in the recording of goodwill and other intangible assets which are subject to potential impairments which have occurred in the past and which, were they to occur in the future, could harm our financial results. As a result, if we fail to properly evaluate acquisitions or investments, we may not achieve the anticipated benefits of any such acquisitions, and we may incur costs in excess of what we anticipate. The failure to successfully evaluate and execute acquisitions or investments or otherwise adequately address these risks could materially harm our business and financial results.

 

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Covenants in our credit facilities may limit our flexibility in responding to business opportunities and competitive developments and increase our vulnerability to adverse economic or industry conditions.

We have lending arrangements with several financial institutions, including a loan and security agreement with Comerica Bank in the United States, and our subsidiaries in China have several line of credit arrangements. Our U.S. loan and security agreement requires us to maintain certain financial covenants, including a liquidity ratio, and restricts our ability to take certain actions such as incurring additional debt, paying dividends, or engaging in certain transactions like mergers and acquisitions, investments and asset sales. These restrictions may limit our flexibility in responding to business opportunities, competitive developments and adverse economic or industry conditions. In addition, our obligations under our U.S. loan and security agreement with Comerica Bank are secured by substantially all of our U.S. assets other than intellectual property assets, which limits our ability to provide collateral for additional financing. A breach of any of these covenants, or a failure to pay interest or indebtedness when due under any of our credit facilities, could result in a variety of adverse consequences, including the acceleration of our indebtedness.

Our future results of operations may be subject to volatility as a result of exposure to fluctuations in foreign exchange rates, primarily the RMB/U.S. dollar exchange rate.

We are exposed to foreign exchange risks. Foreign currency fluctuations may adversely affect our revenue and our costs and expenses, and hence our results of operations. A substantial portion of our business is conducted through our subsidiaries based in China, whose functional currency is the RMB. The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. Since July 21, 2005, the RMB has no longer been pegged solely to the value of the U.S. dollar. Instead, the RMB is now pegged against a basket of currencies, determined by the People’s Bank of China, against which it can rise or fall by as much as 0.5% each day. This change in policy has resulted in approximately 19% appreciation of the RMB against the U.S. dollar between July 21, 2005 and September 30, 2010. While the international reaction to the RMB revaluation has generally been positive, there remains significant international pressure on the Chinese government to adopt an even more flexible currency policy, which may result in a further and more significant appreciation of the RMB against the U.S. dollar. In the long term, the RMB may appreciate or depreciate significantly in value against the U.S. dollar, depending upon the fluctuation of the basket of currencies against which it is currently valued, or it may be permitted to enter into a full float, which may also result in a significant appreciation or depreciation of the RMB against the U.S. dollar.

Foreign currency exchange rates are subject to fluctuation and may cause us to recognize transaction gains and losses in our statements of operations. To the extent that transactions by our subsidiaries in China are denominated in currencies other than the RMB, we bear the risk that fluctuations in the exchange rates of the RMB in relation to other currencies could decrease our revenue or increase our costs and expenses, therefore having an adverse effect on our future results of operations.

While we generate the majority of our revenue in RMB, conversely, a majority of our operating expenses are in U.S. dollars. Therefore, depreciation in the RMB against the U.S. dollar would adversely impact our revenue upon translation to U.S. dollars, but the positive impact on operating expenses would be less. This would result in an overall adverse effect on our results of operations and financial position.

To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedging transactions may be limited and we may not be able to successfully hedge our exposure. In addition, our currency exchange variations may be magnified by Chinese exchange control regulations that restrict our ability to convert RMB into foreign currency.

 

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We face a variety of risks associated with international sales and operations.

We currently derive, and expect to continue to derive, a significant portion of our revenue from international sales in various markets. In addition, a major portion of our operations is based in Shenzhen, China. Our international revenue and operations are subject to a number of material risks, including, but not limited to:

 

   

difficulties in staffing, managing and supporting operations in more than one country;

 

   

difficulties in enforcing agreements and collecting receivables through foreign legal systems;

 

   

fewer legal protections for intellectual property in foreign jurisdictions;

 

   

foreign and U.S. taxation issues and international trade barriers;

 

   

general economic and political conditions in the markets in which we operate;

 

   

difficulties in obtaining any necessary governmental authorizations for the export of our products to certain foreign jurisdictions;

 

   

fluctuations in foreign economies;

 

   

fluctuations in the value of foreign currencies and interest rates;

 

   

trade and travel restrictions;

 

   

outbreaks of avian flu, Severe Acute Respiratory Syndrome, or SARS, H1N1 swine flu or other contagious diseases;

 

   

domestic and international economic or political changes, hostilities and other disruptions in regions where we currently operate or may operate in the future;

 

   

difficulties and increased expenses in complying with a variety of U.S. and foreign laws, regulations and trade standards, including the Foreign Corrupt Practices Act; and

 

   

different and changing legal and regulatory requirements in the jurisdictions in which we currently operate or may operate in the future.

Negative developments in any of these areas in China or other countries could result in a reduction in demand for our products, the cancellation or delay of orders already placed, difficulties in producing and delivering our products, threats to our intellectual property, difficulty in collecting receivables, and a higher cost of doing business. In addition, although we maintain an anti-corruption compliance program throughout the company, violations of our compliance program may result in criminal or civil sanctions, including material monetary fines, penalties and other costs against us or our employees, and may have a material adverse effect on our business.

We are subject to governmental export and import controls that could subject us to liability or impair our ability to compete in international markets.

We are subject to export control laws, regulations and requirements that limit which products we sell and where and to whom we sell our products, especially laser-dependent products. In some cases, it is possible that export licenses would be required from U.S. government agencies for some of our products in accordance with various statutory authorities, including but not limited to the International Traffic in Arms Regulations, the

 

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Export Administration Act of 1979, the International Emergency Economic Powers Act of 1977, the Trading with the Enemy Act of 1917 and the Arms Export Control Act of 1976 and various country-specific trade sanctions legislation. In addition, various countries regulate the import of certain technologies and have enacted laws that could limit our ability to distribute our products. We may not be successful in obtaining the necessary export and import licenses. Failure to comply with these and similar laws on a timely basis, or at all, or any limitation on our ability to export or sell our products would adversely affect our business, financial condition and results of operations.

Changes in our products or changes in export and import laws and implementing regulations may create delays in the introduction of new products in international markets, prevent our customers from deploying our products internationally or, in some cases, prevent the export or import of our products to certain countries altogether. Any change in export or import regulations or related legislation, shift in approach to the enforcement or scope of existing regulations, or change in the countries, persons or technologies targeted by such regulations, could result in decreased use of our products by, or in our decreased ability to export or sell our products to, existing or potential customers with international operations. In such event, our business and results of operations could be adversely affected.

We are subject to government regulations that could adversely impact our business.

The Federal Communications Commission, or FCC, has jurisdiction over the entire U.S. telecommunications industry and, as a result, our products and our U.S. customers are subject to FCC rules and regulations. Current and future FCC regulations affecting communications services, our products or our customers’ businesses could negatively affect our business. In addition, international regulatory standards could impair our ability to develop products for international customers in the future. Delays caused by our compliance with regulatory requirements could result in postponements or cancellations of product orders. Further, we may not be successful in obtaining or maintaining any regulatory approvals that may, in the future, be required to operate our business. Any failure to obtain such approvals could harm our business and results of operations.

If we fail to maintain effective internal control over financial reporting in the future, the accuracy and timing of our financial reporting may be adversely affected.

Preparing our consolidated financial statements involves a number of complex manual and automated processes, which are dependent upon individual data input or review and require significant management judgment. One or more of these elements may result in errors that may not be detected and could result in a material misstatement of our consolidated financial statements. In 2007, we implemented Oracle eBusiness suite software to automate certain business operations and internal reporting activities. While automation is intended to decrease the likelihood for error and enhance our ability to detect errors that could arise, we expect that for the foreseeable future we will have procedures that are manually intensive.

The Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act, requires, among other things, that as a publicly traded company we maintain effective internal control over financial reporting and disclosure controls and procedures. During 2009, we determined we had a significant deficiency related to policies, procedures and controls over maintaining adequate third party evidence of product shipment or delivery to support revenue recognition. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of a company’s financial reporting. For certain quarters, our subsidiaries in China did not retain shipping documentation adequate under U.S. GAAP to enable us to determine whether to recognize revenue for certain shipments at the end of such periods. Specifically, we noted that in certain instances shipping documentation was not retained or did not clearly indicate the date on which shipment or delivery had occurred. In the fourth quarter of 2009, we developed and implemented a remediation plan designed to address this deficiency. The remediation plan includes training of our logistics personnel with a focus on adequate documentation and procedures necessary for satisfying revenue recognition criteria under U.S. GAAP, additional

 

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training of our employees with regard to our code of business conduct and ethics and revenue recognition criteria, and other policies and procedures. Although we have not noted any additional exceptions in the fourth quarter of 2009 or the first nine months of 2010, until we have further experience with the results of the remediation plan, we will not know if it will be successful in helping us avoid such errors in the future.

If a material misstatement occurs in the future, we may fail to meet our future reporting obligations, we may need to restate our financial results and the price of our common stock may decline. Any failure of our internal controls could also adversely affect the results of the periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that will be required when the rules of the Securities and Exchange Commission, or the SEC, under Section 404 of the Sarbanes-Oxley Act, become applicable to us beginning with the filing of our Annual Report on Form 10-K for the year ending December 31, 2011. Effective internal controls are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and results of operations could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.

Potential changes in our effective tax rate could harm our future results.

We are subject to income taxes in the United States and various foreign jurisdictions, and our domestic and international tax liabilities are subject to the allocation of expenses in differing jurisdictions. Our tax rate is affected by changes in the mix of earnings and losses in countries with differing statutory tax rates, certain non-deductible expenses arising from the requirement to expense stock options and the valuation of deferred tax assets and liabilities, including our ability to utilize our net operating losses. Increases in our effective tax rate could harm our results of operations.

We may be unable to utilize our net operating loss carryforwards to reduce our income taxes.

As of December 31, 2009, we had net operating loss, or NOL, carryforwards for U.S. federal and state tax purposes of $130.8 million and $85.4 million, respectively, which are subject to valuation allowance. If not utilized, these NOL carryforwards expire, beginning in 2010. The utilization of the NOL and tax credit carryfowards are subject to a substantial limitation imposed by Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, and similar state provisions. We recorded deferred tax assets net of valuation allowance for the NOL carryforwards currently available after considering the existing Section 382 limitation. If we incur an additional limitation under Section 382, then the NOL carryforwards, as disclosed, could be reduced by the impact of any future limitation that would result in existing NOL carryforwards and tax credit carryforwards expiring unutilized.

We will incur increased costs as a result of operating as a public company, and our management will be required to devote substantial time to new compliance initiatives.

As a public company, we will incur legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act, as well as rules subsequently implemented by the SEC and the New York Stock Exchange, imposes additional requirements on public companies, including specific corporate governance practices. For example, the listing requirements of the New York Stock Exchange require that we satisfy certain corporate governance requirements relating to independent directors, audit and compensation committees, distribution of annual and interim reports, stockholder meetings, stockholder approvals, solicitation of proxies, conflicts of interest, stockholder voting rights and codes of conduct. Our management and other personnel will need to devote a substantial amount of time to these compliance initiatives. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly. For example, we expect these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to

 

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accept reduced policy limits and coverage or incur substantial additional costs to maintain the same or similar coverage. These rules and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers.

We may not be able to obtain capital when desired on favorable terms, if at all, or without dilution to our stockholders.

We believe that our existing cash and 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. We operate in an industry, however, that makes our prospects difficult to evaluate. It is possible that we may not generate sufficient cash flow from operations or otherwise have the capital resources to meet our future capital needs. If this occurs, we may need additional financing to execute on our current or future business strategies, including to:

 

   

invest in our research and development efforts by hiring additional technical and other personnel;

 

   

expand our operating or manufacturing infrastructure;

 

   

acquire complementary businesses, products, services or technologies; or

 

   

otherwise pursue our strategic plans and respond to competitive pressures.

If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders could be significantly diluted, and these newly-issued securities may have rights, preferences or privileges senior to those of existing stockholders, including those acquiring shares in this offering. We cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, if and when needed, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance our products, or otherwise respond to competitive pressures could be significantly limited.

In some instances, we rely on third-party sales representatives and distributors to assist in selling our products, and the failure of these representatives and distributors to perform as expected could reduce our future revenue.

Although we primarily sell our products through direct sales to systems vendors, we also sell our products to some of our customers through third-party sales representatives and distributors. Many of our third-party sales representatives and distributors also market and sell competing products from our competitors. Our third-party sales representatives and distributors may terminate their relationships with us at any time, or with short notice. Our future performance will also depend, in part, on our ability to attract additional third-party sales representatives and distributors that will be able to market and support our products effectively, especially in markets in which we have not previously distributed our products. If our current third-party sales representatives and distributors fail to perform as expected, our revenue and results of operations could be harmed.

Natural disasters, terrorist attacks or other catastrophic events could harm our operations.

Our worldwide operations could be subject to natural disasters and other business disruptions, which could harm our future revenue and financial condition and increase our costs and expenses. For example, our corporate headquarters and wafer fabrication facility in Silicon Valley, California are located near major earthquake fault lines. In addition, our manufacturing facilities are located in Shenzhen, China, an area that is susceptible to typhoons. Further, a terrorist attack, including one aimed at energy or communications infrastructure suppliers, could hinder or delay the development and sale of our products. In the event that an earthquake, typhoon, terrorist attack or other natural or manmade catastrophe were to destroy any part of our facilities, destroy or disrupt vital infrastructure systems or interrupt our operations for any extended period of time, our business, financial condition and results of operations would be materially adversely affected.

 

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We are subject to environmental, health and safety laws and regulations, which could subject us to liabilities, increase our costs, or restrict our business or operations in the future.

Our manufacturing operations and our products are subject to a variety of federal, state, local and international environmental, health and safety laws and regulations in each of the jurisdictions in which we operate or sell our products. These laws and regulations govern, among other things, air emissions, wastewater discharges, the handling and disposal of hazardous substances and wastes, soil and groundwater contamination, employee health and safety, and the use of hazardous materials in, and the recycling of, our products. Our failure to comply with present and future environmental, health or safety requirements, or the identification of contamination, could cause us to incur substantial costs, including cleanup costs, monetary fines, civil or criminal penalties, or curtailment of operations. In addition, these laws and regulations have increasingly become more stringent over time. The identification of presently unidentified environmental conditions, more vigorous enforcement of current environmental, health and safety requirements by regulatory agencies, the enactment of more stringent laws and regulations, or other unanticipated events could restrict our ability to expand our facilities, require us to install costly pollution control equipment or incur other additional expenses, or require us to modify our manufacturing processes or the contents of our products, which could have a material adverse effect on our business, financial condition and results of operations.

Our manufacturing facilities use, store and dispose of hazardous substances in connection with their processes. In addition, our operations have grown through acquisitions, and it is possible that businesses that we have acquired may expose us to environmental liabilities that have not yet been discovered associated with historical site conditions or offsite locations. Some environmental laws impose liability for contamination on current and former owners and operators of affected sites, or on parties that generated wastes disposed of at off-site locations, regardless of fault. In the event we are found liable for any such contamination in the future, there can be no assurance that remediation costs, or potential claims for personal injury or property or natural resource damages resulting from contamination, will not be material.

Additionally, increasing efforts to control emissions of greenhouse gases, or GHG, may also impact us. For example California’s recently enacted Global Warming Solutions Act will require us to design and install additional pollution control equipment at our San Jose, California, manufacturing plant. Additional climate change or GHG control requirements are under consideration at the federal level in the United States and in China. Additional restrictions, limits, taxes, or other controls on GHG emissions could increase our operating costs and, while it is not possible to estimate the specific impact any final GHG regulations will have on our operations, there can be no assurance that these measures will not have significant additional impact on us.

Risks related to our operations in China

Our business operations conducted in China are critical to our success. $105.6 million, or 68.1%, of our revenue in 2009 was recognized from customers located in China. Additionally, a substantial portion of our property, plant and equipment, 78.0% as of December 31, 2009, is located in China. We expect to make further investments in China in the foreseeable future. Therefore, our business, financial condition, results of operations and prospects are to a significant degree subject to economic, political, legal, and social events and developments in China.

Adverse changes in economic and political policies in China, or Chinese laws or regulations could have a material adverse effect on business conditions and the overall economic growth of China, which could adversely affect our business.

The Chinese economy differs from the economies of most developed countries in many respects, including the level of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. The Chinese economy has been transitioning from a planned economy to a more market-oriented economy. Despite reforms, the government continues to exercise significant control over

 

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China’s economic growth by way of the allocation of resources, control over foreign currency-denominated obligations and monetary policy and provision of preferential treatment to particular industries or companies. Moreover, the laws, regulations and legal requirements in China, including the laws that apply to foreign-invested enterprises are relatively new and are subject to frequent changes. The interpretation and enforcement of such laws is uncertain. Any adverse changes to these laws, regulations and legal requirements, including tax laws, or their interpretation or enforcement could have a material adverse effect on our business.

Furthermore, while China’s economy has experienced rapid growth in the past 20 years, growth has been uneven across different regions, among various economic sectors and over time. China has also in the past and may in the future experience economic downturns due to, for example, government austerity measures, changes in government policies relating to capital spending, limitations placed on the ability of commercial banks to make loans, reduced levels of exports and international trade, inflation, lack of financial liquidity, stock market volatility and global economic conditions. Any of these developments could contribute to a decline in business and consumer spending in addition to other adverse market conditions, which could adversely affect our business.

The termination and expiration or unavailability of our preferential income tax treatments in China may have a material adverse effect on our operating results.

Prior to January 1, 2008, entities established in China were generally subject to a 30% state and 3% local enterprise income tax rate. In accordance with the China Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises, effective through December 31, 2007, our subsidiaries in China enjoyed preferential income tax rates. Effective January 1, 2008, the China Enterprise Income Tax Law, or the EIT law, imposes a single uniform income tax rate of 25% on all Chinese enterprises, including foreign-invested enterprises, and eliminates or modifies most of the tax exemptions, reductions and preferential treatment available under the previous tax laws and regulations. As a result, our subsidiaries in China may be subject to the uniform income tax rate of 25% unless we are able to qualify for preferential status. Currently, we have qualified for a preferential 15% tax rate that is available for new and high technology enterprises. The preferential rate applies to 2008, 2009 and 2010. We realized benefits from this 10% reduction in tax rate of $0.2 million, $1.0 million and $1.3 million for 2008, 2009, and the nine months ended September 30, 2010, respectively. We intend to reapply for the preferential rate for 2011. If approved, the income tax rate will remain at 15%, otherwise, the income tax rate will be 24% for 2011 and 25% thereafter.

Our subsidiaries in China are subject to restrictions on dividend payments, on making other payments to us or any other affiliated company, and on borrowing or allocating tax losses among our subsidiaries.

Current Chinese regulations permit our subsidiaries in China to pay dividends only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations, which are different than U.S. accounting standards and regulations. In addition, our subsidiaries in China are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund their statutory common reserves until such reserves have reached at least 50% of their respective registered capital. As of September 30, 2010, our Chinese subsidiaries’ common reserves had not reached this threshold and, accordingly, these entities are required to continue funding such reserves with accumulated net profits. The statutory common reserves are not distributable as cash dividends except in the event of liquidation. In addition, current Chinese regulations prohibit inter-company borrowings or allocation of tax losses among subsidiaries in China. Further, if our subsidiaries in China incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other payments to us. Accordingly, we may not be able to move our capital easily, which could harm our business.

Restrictions on currency exchange may limit our ability to receive and use our revenue and cash effectively.

Because a substantial portion of our revenue is denominated in RMB, any restrictions on currency exchange may limit our ability to use revenue generated in RMB to fund any business activities we may have

 

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outside China or to make dividend payments in U.S. dollars. Under relevant Chinese rules and regulations, the RMB is currently convertible under the “current account,” which includes dividends, trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment and loans, without the prior approval of the State Administration of Foreign Exchange, or SAFE. Currently, our subsidiaries in China may purchase foreign exchange for settlement of “current account transactions,” including the payment of dividends to us, without the approval of SAFE. Although Chinese government regulations now allow greater convertibility of the RMB for current account transactions, significant restrictions remain. For example, foreign exchange transactions under our primary Chinese subsidiary’s capital account, including principal payments in respect of foreign currency-denominated obligations, remain subject to significant foreign exchange controls and the approval of SAFE. These limitations could affect the ability of our subsidiaries in China to obtain foreign exchange for capital expenditures through debt or equity financing, including by means of loans or capital contributions from us. We cannot be certain that Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB, especially with respect to foreign exchange transactions. If such restrictions are imposed, our ability to adjust our capital structure or engage in foreign exchange transactions may be limited.

In August 2008, SAFE promulgated the Circular on the Relevant Operating Issues Concerning the Improvement of the Administration of Payment and Settlement of Foreign Currency Capital of Foreign-invested Enterprises, or Circular 142, a notice regulating the conversion by foreign-invested enterprises of foreign currency into RMB by restricting how the converted RMB may be used. Circular 142 requires that RMB converted from the foreign currency-dominated capital of a FIE may only be used for purposes within the business scope approved by the applicable government authority and may not be used for equity investments within China unless specifically provided for otherwise. In addition, SAFE strengthened its oversight over the flow and use of RMB funds converted from the foreign currency-dominated capital of a FIE. The use of such RMB may not be changed without approval from SAFE. As a result of Circular 142, our subsidiaries in China that are considered foreign-invested enterprises may not be able to convert our capital contributions to them into RMB for equity investments or acquisitions in China.

Uncertainties with respect to China’s legal system could adversely affect the legal protection available to us.

Our operations in China are governed by Chinese laws and regulations. Our subsidiaries in China are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to wholly foreign-owned enterprises. China’s legal system is a civil law system based on written statutes. Unlike common law systems, it is a legal system where decided legal cases have limited value as precedents. Since 1979, Chinese legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, China has not developed a fully-integrated legal system, and recently-enacted laws and regulations may not sufficiently cover all aspects of economic activities in China. In particular, because these laws and regulations are relatively new, the interpretation and enforcement of these laws and regulations involve uncertainties. For example, we may have to resort to administrative and court proceedings to enforce the legal protection under contracts or law. However, since Chinese administrative and court authorities have significant discretion in interpreting and implementing statutory and contract terms, it may be more difficult to evaluate the outcome of administrative and court proceedings and the level of legal protection we would receive compared to more developed legal systems. In addition, protections of intellectual property rights and confidentiality in China may not be as effective as in the United States or other countries or regions with more developed legal systems. Furthermore, the legal system in China is based in part on government policies and internal rules (some of which are not published on a timely basis or at all) that may have a retroactive effect. As a result, we may not be aware of our violation of these policies and rules until sometime after the violation. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention. All the uncertainties described above could limit the legal protections available to us.

 

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Chinese regulations relating to offshore investment activities by Chinese residents and employee stock options granted by overseas-listed companies may increase our administrative burden, restrict our overseas and cross-border investment activity or otherwise adversely affect the implementation of our acquisition strategy. If our stockholders who are Chinese residents, or our Chinese employees who are granted or exercise stock options, fail to make any required registrations or filings under such regulations, we may be unable to distribute profits and may become subject to liability under Chinese laws.

Chinese foreign exchange regulations require Chinese residents and corporate entities to register with local branches of SAFE in connection with their direct or indirect offshore investment activities. These regulations apply to our stockholders who are Chinese residents and may apply to any offshore acquisitions that we make in the future. Pursuant to these foreign exchange regulations, Chinese residents who make, or have previously made, direct or indirect investments in offshore companies, will be required to register those investments. In addition, any Chinese resident who is a direct or indirect stockholder of an offshore company is required to file or update the registration with the local branch of SAFE, with respect to that offshore company, any material change involving its round-trip investment, capital variation, such as an increase or decrease in capital, transfer or swap of shares, merger, division, long-term equity or debt investment or creation of any security interest. If any Chinese stockholder fails to make the required SAFE registration or file or update the registration, subsidiaries in China of that offshore parent company may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation, to their offshore parent company, and the offshore parent company may also be prohibited from injecting additional capital into their subsidiaries in China. Moreover, failure to comply with the various foreign exchange registration requirements described above could result in liability under Chinese laws for evasion of applicable foreign exchange restrictions. We cannot provide any assurances that all of our stockholders who are Chinese residents have made or obtained, or will make or obtain, any applicable registrations or approvals required by these foreign exchange regulations. The failure or inability of our stockholders in China to comply with the required registration procedures may subject us to fines and legal sanctions, restrict our cross-border investment activities, or limit our Chinese subsidiaries’ ability to distribute dividends or obtain foreign-exchange-dominated loans. Moreover, because of the uncertainties in the interpretation and implementation of these foreign exchange regulations, we cannot predict how they will affect our business operations or future strategy. For example, we may be subject to a more stringent review and approval process with respect to our foreign exchange activities, such as remittance of dividends and foreign-currency-denominated borrowings, which may adversely affect our results of operations and financial condition. In addition, if we decide to acquire a domestic company in China, we cannot assure you that we or the owners of such company, as the case may be, will be able to obtain the necessary approvals or complete the necessary filings and registrations required by these foreign exchange regulations. This may restrict our ability to implement our acquisition strategy and could adversely affect our business and prospects.

On March 28, 2007, SAFE promulgated the Application Procedure of Foreign Exchange Administration for Domestic Individuals Participating in Employee Stock Holding Plan or Stock Option Plan of Overseas-Listed Company, or the Stock Option Rule. Under the Stock Option Rule, Chinese residents who are granted stock options by an overseas publicly-listed company are required, through a Chinese agent or Chinese subsidiary of such overseas publicly-listed company, to register with SAFE and complete certain other procedures. We and our Chinese employees who have been granted stock options will be subject to the Stock Option Rule when we become an overseas publicly-listed company. If we or our optionees in China fail to comply with these regulations, we or our optionees in China may be subject to fines and legal sanctions. Several of our employees in China have exercised their stock options prior to our becoming an overseas publicly-listed company. Since there is not yet a clear regulation on how and whether Chinese employees can exercise their stock options granted by overseas private companies, it is unclear whether such exercises are permissible by Chinese laws and it is uncertain how SAFE or other government authorities will interpret or administer such regulations. Therefore, we cannot predict how such exercises will affect our business or operations. For example, we may be subject to more stringent review and approval processes with respect to our foreign exchange activities, such as remittance of dividends and foreign-currency-denominated borrowings, which may affect our results of operations and financial condition.

 

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We may be obligated to withhold and pay individual income tax in China on behalf of our employees who are subject to individual income tax in China arising from the exercise of stock options. If we fail to withhold or pay such individual income tax in accordance with applicable Chinese regulations, we may be subject to certain sanctions and other penalties and may become subject to liability under Chinese laws.

The State Administration of Taxation has issued several circulars concerning employee stock options. Under these circulars, our Chinese employees (which could include both employees in China and expatriate employees subject to individual income tax in China) who exercise stock options will be subject to individual income tax in China. Our subsidiaries in China have obligations to file documents related to employee stock options with relevant tax authorities and withhold and pay individual income taxes for those employees who exercise their stock options. However, since there is not yet a clear regulation on how and whether Chinese employees can exercise stock options granted by overseas private companies and how Chinese employers shall withhold and pay individual taxes, the relevant tax authority has verbally advised us that due to the difficulty in determining the fair market value of our shares as a private company, we need not withhold and pay the individual income tax for the exercises until after the completion of this offering. Thus, we have not withheld and paid the individual income tax for the option exercises. However, we cannot assure you that the Chinese tax authorities will not act otherwise and request us to withhold and pay the individual income tax immediately and impose sanctions on us.

If the Chinese government determines that we failed to obtain approvals of, or registrations with, the requisite Chinese government with respect to our current and past import and export of technologies, we could be subject to sanctions.

China imposes controls on technology import and export. The term “technology import and export” is broadly defined to include, without limitation, the transfer or license of patents, software and know-how, and the provision of services in relation to technology. Depending on the nature of the relevant technology, the import and export of technology to or from China requires either approval by, or registration with, the relevant Chinese governmental authorities.

If we are found to be, or to have been, in violation of Chinese laws or regulations, the relevant regulatory authorities have broad discretion in dealing with such violation, including, but not limited to, issuing a warning, levying fines, restricting us from benefiting from these technologies inside or outside of China, confiscating our earnings generated from the import or export of such technology or even restricting our future export and import of any technology. If the Chinese government determines that our past import and export of technology were inconsistent with, or insufficient for, the proper operation of our business, we could be subject to similar sanctions. Any of these or similar sanctions could cause significant disruption to our business operations or render us unable to conduct a substantial portion of our business operations and may adversely affect our business and result of operations.

China regulation of loans and direct investment by offshore holding companies to China entities may delay or prevent us from using the proceeds we receive from this offering to make loans or additional capital contributions to our China subsidiaries.

In utilizing the proceeds we receive from this offering, we may make loans or additional capital contributions to our China subsidiaries. Any loans to our China subsidiaries are subject to China regulations and approvals. For example, any loans to our China subsidiaries to finance their activities cannot exceed statutory limits, must be registered with SAFE, or its local counterpart, and must be approved by the relevant government authorities. Any capital contributions to our China subsidiaries must be approved by the Ministry of Commerce or its local counterpart. In addition, under Circular 142, our China subsidiaries, as foreign-invested enterprises, may not be able to convert our capital contributions to them into RMB for equity investments or acquisitions in China.

 

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We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all, with respect to our future loans or capital contributions to our China subsidiaries. If we fail to receive such registrations or approvals, our ability to use the proceeds of this offering and to capitalize our China subsidiaries may be negatively affected, which could materially and adversely affect our liquidity and ability to fund and expand our business.

Dividends paid to us by our Chinese subsidiaries may be subject to Chinese withholding tax.

The EIT Law and the implementation regulations provide that a 10% withholding tax may apply to dividends payable to investors that are “non-resident enterprises,” to the extent such dividends are derived from sources within China. The comprehensive Double Taxation Arrangement between China and Hong Kong generally reduces the withholding tax on dividends paid from a Chinese company to a Hong Kong company to 5%. Dividends paid to us by our Chinese subsidiaries will be subject to Chinese withholding tax if, as expected, we are considered a “non-resident enterprise” under the EIT Law. If dividends from our Chinese subsidiaries are subject to Chinese withholding tax, our financial condition may be adversely impacted to the extent of such tax.

Our worldwide income may be subject to Chinese tax under the EIT Law.

The EIT Law provides that enterprises established outside of China whose “de facto management bodies” are located in China are considered “resident enterprises” and are generally subject to the uniform 25% enterprise income tax on their worldwide income. Under the implementation regulations for the EIT Law issued by the State Council, a “de facto management body” is defined as a body that has material and overall management and control over the manufacturing and business operations, personnel and human resources, finances and treasury, and acquisition and disposition of properties and other assets of an enterprise. If we are deemed to be a resident enterprise for Chinese tax purposes, we will be subject to Chinese tax on our worldwide income at the 25% uniform tax rate, which could have an impact on our effective tax rate and an adverse effect on our net income (loss), however, dividends paid to us by our Chinese subsidiaries may not be subject to withholding if we are deemed to be a resident enterprise.

Dividends payable by us to our investors and gains on the sale of our common stock by our foreign investors may be subject to tax under Chinese law.

Under the EIT Law and implementation regulations issued by the State Council, a 10% withholding tax is applicable to dividends payable to investors that are “non-resident enterprises.” Similarly, any gain realized on the transfer of common stock by such investors is also subject to a 10% withholding tax if such gain is regarded as income derived from sources within China. If we are determined to be a “resident enterprise,” dividends we pay on our common stock, or the gain you may realize from the transfer of our common stock, would be treated as income derived from sources within China. If we are required under the EIT Law to withhold tax from dividends payable to investors that are “non-resident enterprises,” or if a gain realized on the transfer of our common stock is subject to withholding, the value of your investment in our common stock may be materially and adversely affected.

Because a substantial portion of our business is located in China, we may have difficulty establishing adequate management, legal and financial controls, which we are required to do in order to comply with Section 404 of the Sarbanes-Oxley Act and securities laws, and which could cause a material adverse impact on our consolidated financial statements, the trading price of our common stock and our business.

Chinese companies have historically not adopted a western style of management and financial reporting concepts and practices, which includes strong corporate governance, internal controls and computer, financial and other control systems. Most of our middle and top management staff in China are not educated and trained in the western system, and we may have difficulty hiring new employees in China with experience and expertise relating to accounting principles generally accepted in the United States and U.S. public-company reporting

 

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requirements. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet U.S. public-company reporting requirements. We may, in turn, experience difficulties in implementing and maintaining adequate internal controls as required under Section 404 of the Sarbanes-Oxley Act. This may result in material weaknesses in our internal controls which could impact the reliability of our consolidated financial statements and prevent us from complying with SEC rules and regulations and the requirements of the Sarbanes-Oxley Act. Any such material weaknesses or lack of compliance with SEC rules and regulations could result in restatements of our historical consolidated financial statements, cause investors to lose confidence in our reported financial information, have an adverse impact on the trading price of our common stock, adversely affect our ability to access the capital markets and our ability to recruit personnel, lead to the delisting of our securities from the stock exchange on which they are traded. This could lead to litigation claims, thereby diverting management’s attention and resources, and which may lead to the payment of damages to the extent such claims are not resolved in our favor, lead to regulatory proceedings, which may result in sanctions, monetary or otherwise, and have a material adverse effect on our reputation and business.

See also “Risk Factors—Risks related to our business—If we fail to maintain effective internal control over financial reporting in the future, the accuracy and timing of our financial reporting may be adversely affected.”

Our subsidiaries in China are subject to Chinese labor laws and regulations. Recently enacted Chinese labor laws may increase our operation costs in China.

China Labor Contract Law, effective January 1, 2008, together with its implementing rules, effective September 18, 2008, provides more protection to Chinese employees. Previously, an employer had discretionary power in deciding the probation period, not to exceed six months. Additionally, the employment contract could only be terminated for cause. Under the new rules, the probation period varies depending on contract terms and the employment contract can only be terminated during the probation period for cause upon three days notice. Additionally, an employer may not be able to terminate a contract during the probation period on the grounds of a material change of circumstances or a mass layoff. The new law also has specific provisions on conditions when an employer has to sign an employment contract with open-ended terms. If an employer fails to enter into an open-ended contract in certain circumstances, the employer must pay the employee twice their monthly wage beginning from the time the employer should have executed an open-ended contract. Additionally an employer must pay severance for nearly all terminations, including when an employer decides not to renew a fixed-term contract.

On January 1, 2008, the Regulations on Paid Annual Leaves of Staff and Workers also took effect, followed by its implementing measures effective September 18, 2008. These regulations provide that employees who have worked consecutively for one year or more are entitled to paid annual leave. An employer must guarantee that employees receive the same wage income during the annual leave period as that for the normal working period. Where an employer cannot arrange annual leave for an employee due to production needs, upon agreement with the employee, the employer must pay daily wages equal to 300% of the employee’s daily salary for each day of annual leave forfeited by such employee. These newly introduced laws and regulations may materially increase the costs of our operations in China.

The turnover of direct labor in manufacturing industries in China is high, which could adversely affect our production, shipments, and results of operations.

Employee turnover of direct labor in the manufacturing sector in China is high and retention of such personnel is a challenge to companies located in or with operations in China. Although direct labor cost does not represent a high proportion of our overall manufacturing costs, direct labor is required for the manufacture of our products. If our direct labor turnover rates are higher than we expect, or we otherwise fail to adequately manage our direct labor turnover rates, then our results of operations could be adversely affected.

 

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Adoption of international labor standards may increase our direct labor costs.

International standards of corporate social responsibility include strict requirements on labor work practices and overtime. As global service providers and their network equipment vendors adopt these standards, we may be required to incur additional direct labor costs associated with our compliance with these standards.

If any of our subsidiaries in China becomes the subject of a bankruptcy or liquidation procedures, we may lose the ability to use its assets.

Because a substantial portion of our business and revenue are derived from China, if any of our subsidiaries in China goes bankrupt and all or part of its assets become subject to liens or rights of third-party creditors, we may be unable to continue some or all of our operations in China. Any delay, interruption or cessation of all or a part of our operations in China would negatively impact our ability to generate revenue and otherwise adversely affect our business.

We face risks related to health epidemics and outbreaks of contagious diseases.

Over the past several years, there have been recent reports of outbreaks of avian flu, SARS and H1N1 swine flu in Asia. Since a large portion of our operations and our customers’ and suppliers’ operations are currently based in Asia (mainly China), an outbreak of avian flu, SARS, H1N1 swine flu or other contagious diseases in Asia or elsewhere, or the perception that such outbreak could occur, and the measures taken by the governments of countries affected, including China, may result in material disruptions in our operations.

Risks related to this offering and our common stock

There is no existing market for our common stock and we do not know if one will develop to provide our stockholders adequate liquidity.

There has not been a public trading market for shares of our common stock prior to this offering. An active trading market may not develop or be sustained after this offering. The initial public offering price for the shares of common stock sold in this offering will be determined by negotiations between us and representatives of the underwriters. This price may not be indicative of the price at which our common stock will trade after this offering.

Our financial results may vary significantly from quarter-to-quarter due to a number of factors, which may lead to volatility in our stock price.

Our quarterly revenue and results of operations have varied in the past and may continue to vary significantly from quarter to quarter. This variability may lead to volatility in our stock price as research analysts and investors respond to these quarterly fluctuations. These fluctuations are due to numerous factors, including:

 

   

fluctuations in demand for our products;

 

   

the timing, size and product mix of sales of our products;

 

   

changes in our pricing and sales policies or the pricing and sales policies of our competitors;

 

   

our ability to design, manufacture and deliver products to our customers in a timely and cost-effective manner and that meet customer requirements;

 

   

quality control or yield problems in our manufacturing operations;

 

   

our ability to timely obtain adequate quantities of the components used in our products;

 

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length and variability of the sales cycles of our products;

 

   

new product introductions and enhancements by our competitors and ourselves;

 

   

unanticipated increases in costs or expenses; and

 

   

fluctuations in foreign currency exchange rates.

The foregoing factors are difficult to forecast, and these, as well as other factors, could materially adversely affect our quarterly and annual results of operations. In addition, a significant amount of our operating expenses is relatively fixed in nature due to our internal manufacturing, research and development, sales and general administrative efforts. Any failure to adjust spending quickly enough to compensate for a revenue shortfall could magnify the adverse impact of such revenue shortfall on our results of operations. Moreover, our results of operations may not meet our announced guidance or the expectations of research analysts or investors, in which case the price of our common stock could decrease significantly. There can be no assurance that we will be able to successfully address these risks.

Our stock price may be volatile and you may be unable to sell your shares at or above the offering price.

The market price of our common stock could be subject to wide fluctuations in response to, among other things, the risk factors described in this section of this prospectus, and other factors beyond our control, such as fluctuations in the valuation of companies perceived by investors to be comparable to us.

Furthermore, the stock markets have experienced price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock.

In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may become the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

If research analysts do not publish research about our business or if they issue unfavorable commentary or downgrade our common stock, our stock price and trading volume could decline.

The trading market for our common stock will depend in part on the research and reports that research analysts publish about us and our business. The price of our common stock could decline if one or more research analysts downgrade our stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business. If one or more of the research analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our common stock could decrease, which could cause our stock price or trading volume to decline.

Our principal stockholders, executive officers and directors own a significant percentage of our stock and will continue to have significant control of our management and affairs after the offering, and they can take actions that may be against your best interests.

Following the completion of this offering, our executive officers and directors, and entities that are affiliated with them, will beneficially own an aggregate of approximately 59% of our outstanding common stock, on an as-converted basis. This significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. Also, as a result, these stockholders, acting together, may be able to control our management and affairs and matters requiring stockholder approval, including the election of directors and

 

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approval of significant corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets. Consequently, this concentration of ownership may have the effect of delaying or preventing a change in control, including a merger, consolidation or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control, even if such a change in control would benefit our other stockholders.

Our stock price could decline due to the large number of outstanding shares of our common stock eligible for future sale.

Sales of substantial amounts of our common stock in the public market following this offering, or the perception that these sales could occur, could cause the market price of our common stock to decline. These sales could also make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate.

Assuming completion of this offering, as of September 30, 2010, we would have had an aggregate of 23,474,619 shares of common stock outstanding, assuming no exercise of the underwriters’ over-allotment option, no exercise of outstanding options or warrants. The 7,500,000 shares sold pursuant to this offering will be immediately tradable without restriction. Of the remaining shares:

 

   

no shares will be eligible for sale immediately upon completion of this offering;

 

   

799,619 shares will be eligible for sale 90 days after the date of this offering;

 

   

15,168,335 shares will be eligible for sale upon the expiration of lock-up agreements, subject in some cases to volume and other restrictions of Rule 144 and Rule 701 under the Securities Act of 1933, as amended, or the Securities Act; and

 

   

6,665 shares will be eligible for sale in the public market from time to time thereafter upon the lapse of our right of repurchase with respect to any unvested shares.

The number of shares eligible for sale upon expiration of lock-up agreements assumes the conversion of all outstanding shares of our preferred stock (other than our Series X preferred stock) into an aggregate of 6,639,513 shares of common stock on a 1-for-1 basis and, in the case of our Series X preferred stock, into an aggregate of 7,398,976 shares of common stock on a 400-for-1 basis.

The lock-up agreements expire 180 days after the date of this prospectus, subject to potential extension in the event we release earning results or material news or a material event relating to us occurs near the end of the lock-up period. Merrill Lynch, Pierce, Fenner & Smith Incorporated, as a representative of the underwriters, may, in its discretion and at any time without notice, release all or any portion of the securities subject to lock-up agreements. Merrill Lynch, Pierce, Fenner & Smith Incorporated has agreed not to release any of the lock-up agreements with our directors and executive officers and substantially all of our stockholders without the prior written consent of Deutsche Bank Securities Inc. After the completion of this offering, we intend to register approximately 3,619,791 shares of our common stock that have been issued or reserved for future issuance under our stock incentive plans.

Because our initial public offering price is substantially higher than the pro forma as adjusted net tangible book value per share of our outstanding common stock, new investors will incur immediate and substantial dilution.

The initial public offering price is substantially higher than the pro forma as adjusted net tangible book value per share of our common stock based on the expected total value of our total assets, less our goodwill and other intangible assets, less our total liabilities immediately following this offering. Therefore, if you purchase shares of our common stock in this offering, you will experience immediate and substantial dilution of $4.11 per share in the price you pay for our common stock as compared to the pro forma as adjusted net tangible book

 

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value as of September 30, 2010. To the extent outstanding options or warrants to purchase common stock are exercised, there will be further dilution. For a further description of the dilution that you will experience immediately after this offering, see the section titled “Dilution.”

Our management has broad discretion in the use of the net proceeds from this offering and may not use the net proceeds effectively.

Our management will have broad discretion in the application of the net proceeds of this offering. We cannot specify with certainty the uses to which we will apply the net proceeds we will receive from this offering. The failure by our management to apply these funds effectively could adversely affect our ability to continue to maintain and expand our business.

We currently do not intend to pay dividends on our common stock and, consequently, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates.

We currently do not plan to declare dividends on shares of our common stock in the foreseeable future. In addition, the terms of our loan and security agreement with Comerica Bank restrict our ability to pay dividends. See “Dividend policy” for more information. Consequently, your only opportunity to achieve a return on your investment in our company will be if the market price of our common stock appreciates and you sell your shares at a profit. There is no guarantee that the price of our common stock that will prevail in the market after this offering will ever exceed the price that you pay.

Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.

Our amended and restated certificate of incorporation and our amended and restated bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:

 

   

providing for a classified board of directors with staggered, three-year terms;

 

   

not providing for cumulative voting in the election of directors;

 

   

authorizing our board of directors to issue, without stockholder approval, preferred stock rights senior to those of common stock;

 

   

prohibiting stockholder action by written consent;

 

   

limiting the persons who may call special meetings of stockholders; and

 

   

requiring advance notification of stockholder nominations and proposals.

In addition, the provisions of Section 203 of the Delaware General Corporate Law will govern us upon completion of this offering. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding common stock, from engaging in certain business combinations without approval of substantially all of our stockholders for a certain period of time.

These and other provisions in our amended and restated certificate of incorporation, our amended and restated bylaws and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions. See “Description of capital stock—Preferred stock” and “Description of capital stock—Anti-takeover effects of provisions of our amended and restated certificate of incorporation, our bylaws and Delaware law.”

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS AND INDUSTRY DATA

This prospectus contains forward-looking statements that are based on our management’s beliefs and assumptions and on information currently available to our management. The forward-looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and “Compensation Discussion and Analysis.” Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, industry environment, potential growth opportunities and the effects of competition. Forward-looking statements include statements that are not historical facts and can be identified by terms such as “anticipates,” “believes,” “could,” “seeks,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts, “projects,” “should,” “will,” “would” or similar expressions and the negatives of those terms.

Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this prospectus. You should read this prospectus and the documents that we have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect.

Important factors that could cause actual results to differ materially from our expectations are disclosed under “Risk factors” and elsewhere in this prospectus, including, without limitation, in conjunction with the forward-looking statements appearing elsewhere in this prospectus. Some of the factors that we believe could affect our results include:

 

   

our history of losses which may continue in the future;

 

   

the overall condition of the highly cyclical communications networks industry, including the impact of any future downturn;

 

   

overall capital spending for global information networks and adverse economic conditions;

 

   

the loss of, or a significant reduction in orders from, our key customers, including Huawei Technologies;

 

   

our limited operating history on a global basis;

 

   

our ability to continually achieve new design wins and enhance our existing products;

 

   

our ability to anticipate and quickly respond to rapidly changing technologies and customer requirements;

 

   

our customers’ qualification of our products;

 

   

potential future price reductions for our products;

 

   

our ability to optimally match production with customer demand;

 

   

competition in the markets we serve;

 

   

long product development cycles in our industry;

 

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manufacturing problems, including future potential product defects;

 

   

dependence on a limited number of suppliers of certain components used in our products;

 

   

rapidly changing standards and regulations in our industry;

 

   

our ability to retain key personnel and attract additional qualified personnel;

 

   

our ability to protect and defend our intellectual property, as well as our involvement in current or future intellectual property disputes;

 

   

our ability to manage our long-term growth and expansion requirements;

 

   

the impact of future potential acquisitions;

 

   

limitations resulting from covenants in our credit facilities;

 

   

currency fluctuations and foreign exchange risks;

 

   

risks associated with international sales and operations, including a number of specific risks related to our substantial operations in China; and

 

   

the other factors set forth under “Risk Factors.”

Except as required by law, we assume no obligation to update these forward-looking statements, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

This prospectus also contains estimates and other information concerning our industry and the communications networks industry, including market size and growth rates that we obtained from industry publications, surveys and forecasts, including the “Optical Network Hardware Quarterly Worldwide and Regional Market Share, Size, and Forecasts: 3Q10” generated by Infonetics Research, dated November 19, 2010, the “PON and FTTH Equipment and Subscribers Quarterly Worldwide and Regional Market Share, Size, and Forecasts: 3Q10” generated by Infonetics Research, dated November 24, 2010, and the “Cisco Visual Networking Index: Forecast and Methodology, 2009-2014” generated by Cisco Systems, Inc. in June 2010. This information involves a number of assumptions and limitations, and you are cautioned not to give undue weight to these estimates. Although we believe the information in these industry publications, surveys and forecasts is reliable, we have not independently verified the accuracy or completeness of the information.

 

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USE OF PROCEEDS

We estimate that the net proceeds from our sale of 7,500,000 shares of common stock in this offering at the initial public offering price of $11.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses, will be $74,054,300, or $85,563,050 if the underwriters’ option to purchase additional shares is exercised in full.

We intend to use the net proceeds to us from this offering for working capital, to continue to expand our existing business and general corporate purposes. Accordingly, our management will have broad discretion in the application of our net proceeds from this offering, and investors will be relying on the judgment of our management regarding the application of these proceeds. We may also use a portion of the net proceeds to us for repayment of a portion of our outstanding indebtedness, but we currently have no commitments or specific plans to repay any particular indebtedness in advance of its maturity date. As of September 30, 2010, our outstanding short-term loans and long-term debt totaled $15.1 million with interest rates ranging from 3.01% to 5.31% and maturity dates ranging from November 2010 through December 2012. The repayment of our outstanding indebtedness may depend on the availability of future credit and the returns of alternative uses of the net proceeds compared to the interest rate charged by our lenders. We may also use a portion of the net proceeds to us to acquire complementary businesses, products, services or technologies, but we currently have no agreements or commitments relating to any material acquisitions. We do not have any agreements or commitments which would require us to use the net proceeds from this offering in a specific manner.

Pending their use, we plan to invest the net proceeds to us from this offering in short term, interest bearing obligations, investment grade instruments, certificates of deposit or direct or guaranteed obligations of the U.S. government.

DIVIDEND POLICY

To date, no dividends have been declared, accrued, paid or otherwise earned on our common stock or preferred stock and we do not expect to pay dividends on our common stock or preferred stock in the foreseeable future. Instead, we anticipate that all of our earnings in the foreseeable future will be used for the operation and growth of our business. Any future determination to pay dividends on our common stock or preferred stock would be subject to the discretion of our board of directors and would depend upon various factors, including our results of operations, financial condition, liquidity requirements, restrictions that may be imposed by applicable law and our contracts and other factors deemed relevant by our board of directors. In addition, our loan and security agreement with Comerica Bank limits our ability to pay dividends.

 

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CAPITALIZATION

The following table sets forth our consolidated cash and cash equivalents and capitalization as of September 30, 2010 on:

 

   

an actual basis;

 

   

a pro forma basis to reflect (i) the conversion of all outstanding shares of our preferred stock (other than our Series X preferred stock) into an aggregate of 6,639,513 shares of common stock on a 1-for-1 basis and, in the case of our Series X preferred stock, into an aggregate of 7,398,976 shares of common stock on a 400-for-1 basis, (ii) the recognition of a liability of $1,073,778 and the related impact to accumulated deficit for the portion of the 263,020 stock appreciation units that were vested at September 30, 2010 and become exercisable upon the expiration of the lock-up period associated with this offering, based on the initial public offering price of $11.00 per share, and (iii) the filing and effectiveness of our amended and restated certificate of incorporation immediately upon the closing of this offering; and

 

   

a pro forma as adjusted basis to reflect the pro forma adjustments described above and the sale by us of 7,500,000 shares of common stock in this offering, at the initial public offering price of $11.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses.

The information below is illustrative only and our capitalization following the completion of this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing. You should read the information in this table together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the accompanying notes appearing elsewhere in this prospectus.

 

    September 30, 2010  

(in thousands, except share and per share data)

  Actual     Pro forma     Pro forma
as adjusted
 

Cash and cash equivalents

  $ 25,353      $ 25,353      $ 101,702   
                       

Long-term debt (including current portion)

  $ 6,377      $ 6,377      $ 6,377   
                       

Series X redeemable convertible preferred stock, $0.0025 par value

     

Authorized 20,000 shares; Issued and outstanding 18,497.44 shares; Maximum liquidation preference $92,487 actual; No shares outstanding pro forma and pro forma as adjusted

    46,165        —          —     

Series 1, 2 and 3 redeemable convertible preferred stock, $0.0025 par value

     

Authorized 7,400,000 shares; Issued and outstanding 6,639,513 shares; Liquidation preference $177,960 actual; Authorized 10,000,000 shares; No shares outstanding pro forma and pro forma as adjusted

    165,354        —          —     
                       
    211,519        —          —     

Stockholders’ equity (deficit):

     

Common stock, $0.0025 par value

     

Authorized 14,000,000 shares; Issued and outstanding 1,936,130 shares actual; Authorized 100,000,000 shares; Issued and outstanding 15,974,619 shares pro forma; and issued and outstanding 23,474,619 shares pro forma as adjusted

    5        40        59   

Additional paid-in capital

    92,923        304,407        378,442   

Accumulated other comprehensive income

    7,588        7,588        7,588   

Accumulated deficit

    (216,149     (217,223     (217,223
                       

Total stockholders’ equity (deficit)

    (115,633     94,812        168,866   
                       

Total capitalization

  $ 102,263      $ 101,189      $ 175,244   
                       

 

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The number of shares of common stock shown as issued and outstanding in the above table excludes:

 

   

1,795,220 stock options with a weighted average exercise price of $5.61 per share outstanding as of September 30, 2010, exercisable into an equal number of shares of common stock;

 

   

4,482 stock warrants with an exercise price of $29.00 per share outstanding as of September 30, 2010, exercisable into an equal number of shares of common stock;

 

   

283,317 stock options granted on December 13, 2010 with a weighted average exercise price of $7.50 per share, exercisable into an equal number of shares of common stock; and

 

   

1,207,988 shares of common stock reserved for future issuance under our 2010 equity incentive plan and 2010 employee stock purchase plan, which will become effective in connection with this offering, and shares that become available under the plans pursuant to provisions that automatically increase the share reserves under the plans each year, as more fully described in “Executive Compensation—Employee benefit plans.”

If the underwriters exercise their over-allotment option in full, there would be an increase of $11.5 million in each of pro forma as adjusted cash and cash equivalents, total stockholders’ equity, and total capitalization.

 

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DILUTION

At September 30, 2010, we had net tangible book value of $88.8 million. Net tangible book value represents the amount of our total assets, less our goodwill and other intangible assets, less our total liabilities. At September 30, 2010, our pro forma net tangible book value was $87.8 million, or $5.49 per share of common stock. Pro forma net tangible book value per share represents the amount of our net tangible book value adjusted for the recognition of a liability of $1.1 million for the portion of the 263,020 stock appreciation units that were vested at September 30, 2010 and become exercisable upon the expiration of the lock-up period associated with this offering, based on the initial public offering price of $11.00 per share, divided by the shares of common stock outstanding at September 30, 2010, assuming the conversion of all outstanding shares of our preferred stock (other than our Series X preferred stock) into an aggregate of 6,639,513 shares of common stock on a 1-for-1 basis and, in the case of our Series X preferred stock, into an aggregate of 7,398,976 shares of common stock on a 400-for-1 basis.

After giving effect to our sale of 7,500,000 shares of common stock in this offering at the initial public offering price of $11.00, and after deducting underwriting discounts and commissions and estimated offering expenses, our pro forma as adjusted net tangible book value at September 30, 2010 would have been $161.8 million, or $6.89 per share of common stock. This represents an immediate increase in pro forma net tangible book value of $1.40 per share to existing stockholders and an immediate dilution of $4.11 per share to new investors.

The following table illustrates this dilution:

 

Initial public offering price per share

      $ 11.00   

Pro forma net tangible book value per share as of September 30, 2010 before giving effect to this offering

   $ 5.49      

Increase in pro forma net tangible book value per share attributable to new investors purchasing shares in this offering

     1.40      
           

Pro forma as adjusted net tangible book value per share after this offering

        6.89   
           

Dilution per share to new investors in this offering

      $ 4.11   
           

If all our outstanding options had been exercised, the pro forma net tangible book value as of September 30, 2010 would have been $97.8 million, or $5.51 per share, and the pro forma as adjusted net tangible book value after this offering would have been $171.9 million, or $6.80 per share, resulting in dilution to new investors of $4.20 per share.

The following table summarizes, on a pro forma as adjusted basis as of September 30, 2010, the total number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid to us by existing stockholders and by new investors purchasing shares in this offering at the initial public offering price of $11.00, before deducting underwriting discounts and commissions and estimated offering expenses:

 

     Shares purchased     Total consideration     Average
price

per share
 
     Number      Percent     Amount      Percent    

Existing stockholders

     15,974,619         68   $ 223,470,327         73   $ 13.99   

New investors

     7,500,000         32        82,500,000         27        11.00   
                                          

Total

     23,474,619         100   $ 305,970,327         100   $ 13.03   
                                          

 

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If the underwriters exercise their over-allotment option in full, the number of shares held by existing stockholders will be 15,974,619, or 65% of the total shares outstanding, and the number of shares held by new investors will be 8,625,000, or 35% of the total shares outstanding.

The foregoing dilution calculations exclude:

 

   

1,795,220 stock options with a weighted average exercise price of $5.61 per share outstanding as of September 30, 2010, exercisable into an equal number of shares of common stock;

 

   

4,482 stock warrants with an exercise price of $29.00 per share outstanding as of September 30, 2010, exercisable into an equal number of shares of common stock;

 

   

283,317 stock options granted on December 13, 2010 with a weighted average exercise price of $7.50 per share, exercisable into an equal number of shares of common stock; and

 

   

1,207,988 shares of common stock reserved for future issuance under our 2010 equity incentive plan and 2010 employee stock purchase plan, which will become effective in connection with this offering, and shares that become available under the plans pursuant to provisions that automatically increase the share reserves under the plans each year, as more fully described in “Executive Compensation—Employee benefit plans.”

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data should be read together with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus. The selected consolidated financial data in this section is not intended to replace our consolidated financial statements and the related notes.

We derived the consolidated statements of operations data for the years ended December 31, 2007, 2008 and 2009 and the consolidated balance sheet data as of December 31, 2008 and 2009 from our consolidated financial statements appearing elsewhere in this prospectus. The consolidated statements of operations data for the years ended December 31, 2005 and 2006 and the consolidated balance sheet data as of December 31, 2005, 2006 and 2007 are derived from our consolidated financial statements, which do not appear elsewhere in this prospectus and have been revised to reflect the adoption of revised authoritative guidance relating to accounting and reporting for the noncontrolling interest in a subsidiary. The consolidated statements of operations data for the nine months ended September 30, 2009 and 2010 and the consolidated balance sheet data as of September 30, 2010 are derived from our unaudited interim consolidated financial statements included in this prospectus. In the opinion of our management, the unaudited interim consolidated financial statements reflect all adjustments, consisting of only normal recurring adjustments, necessary for a fair statement of such data. Our historical results are not necessarily indicative of our future results.

 

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    Years ended December 31,     Nine months ended
September 30,
 
(in thousands, except share and per share data)   2005     2006     2007     2008     2009           2009           2010  

Consolidated statement of operations data:

             

Revenue

  $ 35,021      $ 83,357      $ 95,825      $ 133,989      $ 155,062      $ 112,014      $ 132,888   

Cost of goods sold(1)(2)

    33,552        71,453        83,475        109,439        114,572        86,142        91,079   
                                                       

Gross profit

    1,469        11,904        12,350        24,550        40,490        25,872        41,809   

Operating expenses:

             

Research and development(1)

    12,475        20,315        23,076        21,480        17,266        12,431        16,049   

Sales and marketing(1)

    4,126        7,753        10,123        10,435        9,587        7,330        7,502   

General and administrative(1)

    5,078        10,995        13,142        14,581        15,448        11,230        12,397   

Acquired in—process research and development(2)

    1,341        8,736        —          —          —          —          —     

Amortization of purchased intangible assets(2)

    346        922        1,826        1,665        1,136        852        855   

Asset impairment charges(3)

    —          —          6,138        4,047        1,233        —          —     

Restructuring charges

    —          —          —          1,383        —          —          —     
                                                       

Total operating expenses

    23,366        48,721        54,305        53,591        44,670        31,843        36,803   
                                                       

Income (loss) from operations

    (21,897)        (36,817)        (41,955)        (29,041)        (4,180)        (5,971)        5,006   

Interest and other income (expense), net

             

Interest income

    285        1,755        1,496        448        345        295        163   

Interest expense

    (144)        (747)        (1,249)        (1,692)        (1,046)        (801)        (565)   

Other income (expense), net

    (1,230)        (157)        319        432        (64)        55        42   
                                                       

Total interest and other income (expense), net

    (1,089)        851        566        (812)        (765)        (451)        (360)   
                                                       

Income (loss) before income taxes

    (22,986)        (35,966)        (41,389)        (29,853)        (4,945)        (6,422)        4,646   

Benefit from (provision for) income taxes

    (71)        241        (86)        1,812        (1,902)        (1,211)        (1,725)   
                                                       

Net income (loss)

    (23,057)        (35,725)        (41,475)        (28,041)        (6,847)        (7,633)        2,921   

Net (income) loss attributable to noncontrolling interests(4)

    132        22        8        (13)        (116)        (63)        (80)   
                                                       

Net income (loss) attributable to NeoPhotonics Corporation

    (22,925)        (35,703)        (41,467)        (28,054)        (6,963)        (7,696)        2,841   

Accretion of redeemable convertible preferred stock

    —          —          —          (428)        (153)        (122)        (91)   
                                                       

Net income (loss) attributable to NeoPhotonics Corporation common stockholders

  $ (22,925)      $ (35,703)      $ (41,467)      $ (28,482)      $ (7,116)      $ (7,818)      $ 2,750   
                                                       

Net income (loss) per share attributable to NeoPhotonics Corporation common stockholders:

             

Basic

  $ (31.09)      $ (21.19)      $ (22.34)      $ (14.80)      $ (3.72)      $ (4.09)      $ 0.00   
                                                       

Diluted

  $ (31.09)      $ (21.19)      $ (22.34)      $ (14.80)      $ (3.72)      $ (4.09)      $ 0.00   
                                                       

Weighted average shares used to compute net income (loss) per share attributable to NeoPhotonics Corporation common stockholders:

             

Basic

    737,361        1,684,599        1,856,215        1,924,141        1,913,117        1,912,095        1,932,998   
                                                       

Diluted

    737,361        1,684,599        1,856,215        1,924,141        1,913,117        1,912,095        3,036,756   
                                                       

Pro forma net income (loss) per share attributable to NeoPhotonics Corporation common stockholders(5):

             

Basic

          $ (0.51)        $ 0.18   
                         

Diluted

          $ (0.51)        $ 0.17   
                         

Weighted average shares used to compute pro forma net income (loss) per share attributable to NeoPhotonics Corporation common stockholders(5):

             

Basic

            13,599,967          15,883,606   
                         

Diluted

            13,599,967          16,987,364   
                         

 

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     December 31,     September  30,
2010
 
(in thousands)    2005     2006     2007     2008     2009    

Consolidated balance sheet data:

            

Cash and cash equivalents

   $ 18,958      $ 50,629      $ 13,663      $ 28,741      $ 43,420      $ 25,353   

Restricted cash

     —          1,269        1,652        1,516        3,286        3,006   

Short-term investments

     —          6,006        4,112        —          —          —     

Working capital(6)

     14,855        51,417        26,012        30,583        44,167        43,833   

Total assets

     85,703        138,896        167,116        154,776        162,248        167,753   

Long-term debt (including current portion)

     —          2,724        13,970        17,470        8,147        6,377   

Redeemable convertible preferred stock

     65,226        164,789        164,789        196,430        205,450        211,519   

Common stock and additional paid-in-capital

     86,815        89,390        90,714        91,281        91,899        92,928   

Total deficit

     (15,264     (50,756     (88,285     (113,023     (119,582     (115,633

 

(1) These expenses include stock-based compensation expense. Stock-based compensation expense for employee stock options granted on or before December 31, 2005 was accounted for as the difference, if any, between the exercise price and the fair value of the common stock on the date of grant. Stock-based compensation expense for employee stock options granted on or after January 1, 2006 is accounted for at fair value, using the Black-Scholes option pricing model. Stock-based compensation expense is recognized over the vesting period of the stock options and was included in cost of goods sold and operating expenses as follows:

 

     Years ended December 31,      Nine months  ended
September 30,
 
(in thousands)    2005      2006      2007      2008      2009      2009      2010  

Cost of goods sold

   $ 75       $ 128       $ 130       $ 125       $ 53       $ 53       $ 93   

Research and development

     215         409         435         314         228         174         283   

Sales and marketing

     94         200         226         177         180         131         292   

General and administrative

     216         371         545         512         520         381         572   
                                                              

Total

   $ 600       $ 1,108       $ 1,336       $ 1,128       $ 981       $ 739       $ 1,240   
                                                              

 

(2) In 2005, we acquired approximately 81.5% of Shenzhen Photon Technology Co., Ltd., in 2006 we acquired another 18.1% interest and in April 2010 we acquired the remaining 0.4% of outstanding shares. Also in 2005, we invested in 7.7% of the outstanding shares of BeamExpress, Inc. and, in 2006, we acquired BeamExpress, Inc. by purchasing the remaining shares. In 2006, we acquired Optun, Inc., Lightconnect, Inc. and the assets and liabilities of Paxera Corporation. These acquisitions were accounted for using the purchase method of accounting. Consideration was allocated to the assets acquired and liabilities assumed based on their fair values, including intangible assets and in-process research and development, and the residual was recorded to goodwill. In-process research and development was expensed at the date of acquisition and the intangible assets are being amortized in cost of goods sold and in operating expenses over their respective useful lives. The results of operations for these acquired businesses are included in our consolidated results of operations from the date of acquisition.
(3) In 2007, we recorded asset impairment charges relating to goodwill of $5.9 million and intangible assets of $0.2 million, both relating to our acquisition of BeamExpress Inc. in 2006. In 2008, we recorded asset impairment charges relating to intangible assets of $3.3 million and property and equipment of $0.7 million, both triggered by our decision to discontinue development of a product relating to our acquisition of Paxera Corporation in 2006. In 2009, we entered into an agreement to sell our ownership interest in Shenzhen Archcom Technology Co., Ltd, or Archcom, for less than our share of the net assets of Archcom and, as a result, we recognized an impairment charge of $0.8 million. In 2009, we also recorded an asset impairment charge of $0.4 million resulting from the write-off of machinery and equipment no longer in use. For further information, see Note 5 to our consolidated financial statements appearing elsewhere in this prospectus.
(4) Net income (loss) attributable to noncontrolling interests represents the noncontrolling shareholders’ proportionate share of the results of operations of our majority-owned subsidiaries. For further information, see Note 14 to our consolidated financial statements appearing elsewhere in this prospectus.
(5) The pro forma basic and diluted net loss per share attributable to NeoPhotonics Corporation common stockholders calculations assume the conversion of all outstanding shares of preferred stock into shares of common stock using the as-if-converted method as though the conversion had occurred at the beginning of the period presented, or the date of issuance, if later, and a 1-for-25 reverse stock split that we effected on November 30, 2010. These calculations have not been adjusted for a potential charge upon completion of this offering which is triggered by the conversion of the Series X preferred stock, related to a beneficial conversion feature, which is described in Note 10 to our consolidated financial statements appearing elsewhere in this prospectus.
(6) Working capital is defined as total current assets less total current liabilities.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis by our management of our financial condition and results of operations in conjunction with our consolidated financial statements and the accompanying notes appearing elsewhere in this prospectus. This discussion and other parts of this prospectus contain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Risk Factors.”

Business overview

We are a leading designer and manufacturer of PIC-based modules and subsystems for bandwidth-intensive, high-speed communications networks. Our products enable high-speed transmission rates and efficient allocation of bandwidth over optical networks with high quality and low costs. Our innovative PIC technology utilizes a set of proprietary design elements that provide optical functionality on a silicon chip. PIC devices integrate many more functional elements than discretely packaged components, enabling increased functionality in a small form factor while reducing packaging and interconnection costs. In addition, the cost advantages of PIC-based components are driven by the economics of semiconductor wafer mass manufacturing, where the marginal cost of producing an incremental chip is much less than that of a discrete component.

We have research and development and wafer fabrication facilities in Silicon Valley, California which are closely aligned with our research and development and manufacturing facilities in Shenzhen, China. We utilize proprietary design tools and design-for-manufacturing techniques to closely align our design process with our precision nanoscale, vertically integrated manufacturing and testing capabilities. Our technology and manufacturing expertise enables us to deliver repeatable, well-characterized products at high yields.

We sell our products to the leading network equipment vendors globally, including ADVA AG Optical Networking Ltd., Alcatel-Lucent SA, Ciena Corporation (including its recent acquisition of Nortel’s Metro Ethernet Networks business), Cisco Systems, Inc., FiberHome Technologies Group, ECI Telecom Ltd., Telefonaktiebolaget LM Ericsson, Fujitsu Limited, Harmonic, Inc., Huawei Technologies Co., Ltd., Mitsubishi Electric Corporation, NEC Corporation, Nokia Siemens Networks B.V. and ZTE Corporation. We refer to these companies as our Tier 1 customers.

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

We changed our name to NeoPhotonics Corporation in 2002 after having been incorporated as NanoGram Corporation in October 1996 in the State of Delaware. During 2002 and 2003, we spun out two new companies, NanoGram Devices Corporation, a medical device battery company, and NanoGram Corporation, a nanomaterials applications company. NanoGram Devices was subsequently acquired by Greatbatch Inc. NanoGram Corporation was acquired by Teijin Limited in July 2010. In November 2003, we filed a petition for relief under Chapter 11 of the federal bankruptcy laws in the United States Bankruptcy Court for the Northern District of California. Our plan of reorganization was substantially consummated in March 2004, at which point we emerged from bankruptcy. In addition, we have completed several acquisitions as follows:

 

   

In March 2003, we acquired Lightwave Microsystems Corporation, a developer and fabricator of photonic integrated circuits;

 

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In March 2006, we completed the acquisition of Photon Technology Co., Ltd. (now named NeoPhotonics (China) Co., Ltd.), a manufacturer of active optoelectronics, transceivers and modules;

 

   

In June 2006, we acquired Lightconnect, Inc., which expanded our product portfolio by adding a line of micro-electromechanical systems based optical components and modules;

 

   

In June 2006, we acquired OpTun, Inc., a developer of ROADM technology;

 

   

In August 2006, we completed an acquisition of BeamExpress, Inc., an integrator of active indium phosphide telecommunications devices in parallel optics high-speed transceivers;

 

   

In November 2006, we acquired Paxera Corporation, a developer of tunable technology for dynamically reconfigurable networks; and

 

   

In February 2008, we acquired certain assets and intellectual property from Mitsubishi Electric Corporation relating to the manufacture of high-speed transceivers.

The amortization of intangible assets relative to these acquisitions is expected to be $3.3 million, $0.8 million and $0.3 million for the years ending December 31, 2010, 2011 and 2012, respectively, and will continue to decline until fully amortized.

Key components of operating results

Revenue

We sell substantially all of our products to original equipment manufacturers, or OEMs. Revenue is recognized upon delivery of our product to the OEM. We price our products based on market and competitive conditions and may periodically reduce the price of our products as market and competitive conditions change and as manufacturing costs are reduced. Our sales transactions to customers are denominated primarily in RMB or U.S. dollars. For the year ended December 31, 2009, 83.5% of our sales were derived from our China-based subsidiaries, the majority of which were denominated in RMB. We expect a significant portion of our sales to be denominated in foreign currencies in the future. Revenue is driven by the volume of shipments and may be impacted by pricing pressures. We expect that our revenue for the three months ended December 31, 2010 will be higher than our revenue for the three months ended September 30, 2010. We have generated most of our revenue from a limited number of customers. Given the high concentration of network equipment vendors in our industry, our top ten customers represented 82.9% and 86.6% of our revenue in 2009 and the nine months ended September 30, 2010, respectively. We expect that our top ten customers will represent more than 90% of our revenue for the three months ended December 31, 2010, as a result of growth in purchases by our key U.S. and European customers. We also expect that a significant portion of our revenue will continue to be derived from a limited number of customers.

Cost of goods sold and gross margin

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

 

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Gross profit as a percentage of total revenue, or gross margin, has been and is expected to continue to be affected by a variety of factors, including the introduction of new products, production volume, production volume compared to sales over time, the mix of products sold, changes in the cost and volumes of materials purchased from our suppliers, changes in labor costs, changes in overhead costs or requirements, any reserves for excess and obsolete inventories and changes in the average selling prices of our products. Our newer and more advanced products typically have higher average selling prices and higher gross margins. Average selling prices by product typically decline as a result of periodic negotiations with our customers and competitive pressures. We strive to increase our gross margin as we seek to manage the costs of our supply chain and increase productivity in our manufacturing processes. In addition, our gross margin for the three months ended December 31, 2010 will be negatively impacted by reserves for excess and obsolete inventory during this period, as well as the imposition in December 2010 of a new housing tax on wages in China. As a result, we expect our gross margin for such period to be lower than it was for the three months ended September 30, 2010. We expect that our gross margins are likely to continue to fluctuate from quarter to quarter due to a number of factors, including those mentioned in this paragraph.

Operating expenses

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

Research and development. Research and development expense consists of personnel costs, including stock-based compensation, for our research and development personnel, and product development costs, including engineering services, development software and hardware tools, depreciation of capital equipment and facility costs. We record all research and development expense as incurred. Research and development expense has declined over the past two years primarily due to the integration of acquired companies and the termination of certain projects in response to a general decline in the global economy. In the future, we expect research and development expense to increase as we enhance and expand our product offerings. As a percentage of revenue, our research and development expense may vary as our revenue changes over time.

Sales and marketing. Sales and marketing expense consists primarily of personnel costs, including stock-based compensation and sales commissions, costs related to sales and marketing programs and services and facility costs. We expect sales and marketing expense to increase as we increase the number of sales and marketing professionals and expand our marketing activities. As a percentage of revenue, our sales and marketing expense may vary as our revenue changes over time.

General and administrative. General and administrative expense consists primarily of personnel costs, including stock-based compensation, for our finance, human resources and information technology personnel and certain executive officers, as well as professional services costs related to accounting, tax, banking, legal and information technology services, depreciation of capital equipment and facility costs. We expect general and administrative expense to increase in the short term, as we develop infrastructure necessary to operate as a public company, including increased audit and legal fees, costs to comply with the Sarbanes-Oxley Act and the rules and regulations applicable to companies listed on a national stock exchange, as well as investor relations expense and higher insurance premiums. As a percentage of revenue, our general and administrative expense may vary as our revenue changes over time.

Amortization of purchased intangible assets. We completed a series of business acquisitions in 2005 and 2006, which included the acquisition of intangible assets. These intangible assets are being amortized over their estimated useful lives.

Asset impairment charges. We record asset impairment charges when it is determined that the carrying value of our assets is not recoverable.

 

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In 2007, we discovered a defect in the main product acquired through a previous business acquisition, and we discontinued sales and production activities of this product. Given this event, we performed an impairment review of goodwill and the related long-lived intangible assets. The results of our review indicated that certain assets were impaired and an asset impairment charge of $6.1 million was recognized in the year ended December 31, 2007, of which $5.9 million was related to goodwill and $0.2 million was related to purchased intangible assets.

In 2008, we discontinued the development of a tunable laser product based on recognized operating losses and the projection of future losses relative to that product. As a result of the discontinuance, we concluded that certain asset groups associated with the product were impaired and an asset impairment charge of $4.0 million was recognized in the year ended December 31, 2008, of which $3.3 million was related to purchased intangible assets and $0.7 million was related to tangible fixed assets.

In 2009, we entered into an agreement to sell our 55% ownership interest in Shenzhen Archcom Technology Co., Ltd., or Archcom, for $1.1 million, which was less than our share of the value in the net assets of Archcom. This transaction was completed as of March 31, 2010. As a result, we recognized an impairment charge of $0.8 million in the year ended December 31, 2009, of which $0.2 million was related to tangible fixed assets and the remaining $0.6 million was recorded as an accrual for the expected loss on sale.

In addition, in 2009, we recorded an impairment charge of $0.4 million resulting from the write-off of machinery and equipment no longer in use.

Asset impairment charges are based on individual facts and circumstances and are not otherwise considered a recurring expense. Although we have recognized impairment charges in each of the three years presented, this is not necessarily indicative of future periods.

Restructuring charges. During the third quarter of 2008, we initiated a restructuring plan as part of a companywide cost saving initiative aimed to reduce operating costs by moving manufacturing operations from the United States to our primary subsidiary in China. As a result, we recorded $1.4 million of restructuring expense in 2008, primarily related to severance costs resulting from the involuntary termination of employees located in the United States and China. Personnel expenses decreased $2.9 million in 2009 as compared to 2008. This decrease was primarily due to the restructuring plan. However, we do not anticipate any incremental cost savings in 2010 or thereafter.

Interest and other income (expense), net

Interest income consists of income earned on our cash, cash equivalents and short-term investments.

Interest expense consists of amounts paid for interest on our short-term and long-term debt borrowings.

Other income (expense), net is primarily made up of foreign currency transaction gains and losses. The functional currency of our subsidiaries in China is the RMB and the foreign currency transaction gains and losses of our subsidiaries in China primarily result from their transactions in U.S. dollars.

Income taxes

We conduct our business globally. However, our operating income is subject to varying rates of tax in the United States and China. 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. We expect that our income taxes will vary in relation to our profitability and the geographic distribution of our profits. Historically, we have experienced net losses in the United States and in the short term, we expect this trend to continue. In China, one of our subsidiaries has qualified for a preferential 15% tax rate available for high technology enterprises. The

 

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preferential rate applies to 2008, 2009 and 2010. We realized benefits from this 10% reduction in tax rate of $0.2 million, $1.0 million, and $1.3 million for 2008, 2009, and the nine months ended September 30, 2010, respectively. We intend to reapply for the preferential rate for 2011. If approved, the rate will remain at 15%, otherwise, the rate will be 24% for 2011 and 25% thereafter. In 2009, our cash tax liability in China was partially offset by the utilization of NOL carryforwards. In future periods, we expect that our operations in China will not have sufficient NOL carryforwards to offset any future cash tax obligation in China.

Key metrics

We monitor key financial metrics on a quarterly basis, as set forth below, to help us evaluate future growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. We discuss revenue, cost of goods sold and gross margin recognized in accordance with U.S. GAAP under “Key components of operating results.” Non-GAAP financial measures are discussed immediately below this table.

 

    Three months ended  
(in thousands, except percentages)   Dec. 31,
2008
    Mar. 31,
2009
    Jun. 30,
2009
    Sep. 30,
2009
    Dec. 31,
2009
    Mar. 31,
2010
    Jun. 30,
2010
    Sep. 30,
2010
 

Revenue

  $ 32,790      $ 32,085      $ 36,579      $ 43,350      $ 43,048      $ 40,208      $ 45,554      $ 47,126   

Cost of goods sold

    27,137        27,042        28,016        31,084        28,430        27,510        30,656        32,913   

Gross margin

    17.2     15.7     23.4     28.3     34.0     31.6     32.7     30.2

Income (loss) from operations

    (7,966     (4,824     (1,684     537        1,791        697        3,590        719   

Non-GAAP income (loss) from operations

    (4,001     (3,176     11        2,000        4,419        2,271        5,036        1,725   

Net income (loss) attributable to NeoPhotonics Corporation

    (8,224     (5,001     (2,525     (170     733        (19     2,782        78   

Non-GAAP net income (loss)

    (4,259     (3,424     (906     1,232        3,238        1,463        4,164        1,219   

Adjusted EBITDA

    (2,263     (708     1,681        4,052        6,403        4,323        7,103        4,047   

Non-GAAP financial measures. We believe that the use of non-GAAP income (loss) from operations, non-GAAP net income (loss) and adjusted earnings before interest, taxes, depreciation and amortization, or adjusted EBITDA, is helpful for an investor in determining whether to invest in our common stock. In computing our non-GAAP financial measures, we exclude certain items included under U.S. GAAP. Non-GAAP income (loss) from operations excludes the amortization of purchased intangible assets, stock-based compensation expense, asset impairment charges and restructuring charges. Non-GAAP net income (loss) excludes these same items and, additionally, it excludes our share of loss of unconsolidated investee. Adjusted EBITDA excludes these same items and, additionally, it excludes interest (income) expense, net, provision for (benefit from) income taxes and depreciation expense.

We believe that excluding amortization of purchased intangible assets, stock-based compensation expense, asset impairment charges, restructuring charges and share of loss of unconsolidated investee helps investors compare our operating performance with our results in prior periods. We believe that it is appropriate to exclude these items as they limit comparability between periods and between us and similar companies. We believe adjusted EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. In addition, we believe that adjusted EBITDA is useful in evaluating our operating performance compared to that of other companies in our industry because the calculation of adjusted EBITDA generally eliminates the effects of financing and income taxes and the accounting effects of capital spending and acquisitions, which items may vary for different companies for reasons unrelated to overall operating performance. We use these non-GAAP financial measures to evaluate the operating performance of our business and aid in the period-to-period comparability. We also use the non-GAAP financial measures for planning and forecasting and measuring results against the forecast and in certain cases for performance-based cash bonus targets for certain of our employees. Using several measures to evaluate the

 

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business allows us and investors to (1) assess our relative performance against our competitors and (2) ultimately monitor our capacity to generate returns for our stockholders. Further explanation of the excluded items is provided below:

 

   

Amortization of purchased intangible assets. Included in our U.S. GAAP financial results is the amortization of purchased intangible assets associated with prior acquisitions and which is non-cash in nature. We exclude these expenses from our non-GAAP financial measures because we believe they are not indicative of our core operating performance.

 

   

Stock-based compensation expense. Included in our U.S. GAAP financial results are non-cash charges for the fair value of stock options granted to employees. While this is a recurring item, we believe that excluding these charges from our non-GAAP financial measures provides for more accurate comparisons of our historical and current operating results to those of similar companies because various valuation methodologies with subjective assumptions may be used to calculate stock-based compensation expense.

 

   

Asset impairment charges. Included in our U.S. GAAP financial results in 2008 are non-cash asset impairment charges related to the discontinuation of a product and in 2009 related to the pending sale of our interest in Archcom and fixed assets no longer in use. We exclude asset impairment charges from our non-GAAP financial measures because they are unique to the specific events and circumstances and we do not believe they are indicative of our core operating performance.

 

   

Restructuring charges. Included in our U.S. GAAP financial results are restructuring charges related to severance and other costs associated with the move of our U.S. manufacturing operations to China. We exclude restructuring charges from our non-GAAP financial measures, because we believe they are not indicative of our core operating performance.

 

   

Share of loss of unconsolidated investee. Included in our U.S. GAAP financial results is our share of loss of unconsolidated investee related to our investment in Ignis ASA. We exclude our share of loss of unconsolidated investee from our non-GAAP financial measures because we believe it is not indicative of our core operating performance.

 

   

Interest expense, net. Included in our U.S. GAAP financial results is interest income and interest expense. Although our investing and borrowing activities are elements of our cost structure and provide us the ability to generate revenue and returns for our owners, we exclude interest income and interest expense from our adjusted EBITDA financial measure to provide period-to-period comparability of our core operating results unassociated with our investing and borrowing activities.

 

   

Provision for (benefit from) income taxes. Included in our U.S. GAAP financial results is income tax expense (benefit). While we are subject to various state and foreign taxes and the payment of such taxes is a necessary element of our operations, we exclude income tax expense (benefit) from our adjusted EBITDA financial measure to provide period-to-period comparability of our core operating results unassociated with the varying effective tax rates to which we are subject.

 

   

Depreciation expense. Included in our U.S. GAAP financial results is depreciation expense associated with our capital expenditures. While the use of the capital equipment enables us to generate revenue for our business, we exclude depreciation expense from our adjusted EBITDA financial measure as the depreciation expense enables us to compare our financial results with other companies in our industry.

 

   

Income tax effect of non-GAAP adjustments. This amount adjusts the provision for (benefit from) income taxes to reflect the effect of the non-GAAP adjustments on non-GAAP net income. The adjustments were calculated by applying the effective tax rate of the entity where each non-GAAP adjustment was recorded.

 

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These non-GAAP financial measures may not provide information that is directly comparable to that provided by other companies in our industry, as other companies in our industry may calculate such financial results differently, particularly related to nonrecurring, unusual items. Our non-GAAP financial measures are not measurements of financial performance under U.S. GAAP, and should not be considered as alternatives to income (loss) from operations and net income (loss) attributable to NeoPhotonics Corporation or as indications of operating performance or any other measure of performance derived in accordance with U.S. GAAP. We do not consider these non-GAAP financial measures to be a substitute for, or superior to, the information provided by U.S. GAAP financial results.

The following table reflects the reconciliation of U.S. GAAP financial measures to our non-GAAP financial measures.

 

    Three months ended  
(in thousands)   Dec.  31,
2008
    Mar. 31,
2009
    Jun. 30,
2009
    Sep. 30,
2009
    Dec. 31,
2009
    Mar. 31,
2010
    Jun. 30,
2010
    Sep. 30,
2010
 

Income (loss) from operations

  $ (7,966   $ (4,824   $ (1,684   $ 537      $ 1,791      $ 697      $ 3,590      $ 719   

Non-GAAP adjustments:

               

Amortization of purchased intangibles(1)

    1,607        1,413        1,414        1,240        1,153        1,154        1,023        609   

Stock-based compensation expense

    336        235        281        223        242        420        423        397   

Asset impairment charges

    869        —            —          1,233        —          —          —     

Restructuring charges

    1,153        —          —          —          —          —          —          —     
                                                               

Non-GAAP income (loss) from operations

  $ (4,001   $ (3,176   $ 11      $ 2,000      $ 4,419      $ 2,271      $ 5,036      $ 1,725   
                                                               

Net income (loss) attributable to NeoPhotonics Corporation

  $ (8,224   $ (5,001   $ (2,525   $ (170   $ 733      $ (19   $ 2,782      $ 78   

Non-GAAP adjustments:

               

Amortization of purchased intangibles(1)

    1,607        1,413        1,414        1,240        1,153        1,154        1,023        609   

Stock-based compensation expense

    336        235        281        223        242        420        423        397   

Asset impairment charges

    869        —          —          —          1,233        —          —          —     

Restructuring charges

    1,153        —          —          —          —          —          —          —     

Share of loss of unconsolidated investee

    —          —          —          —          —          —          —          176   

Income tax effect of non-GAAP adjustments

    —          (71     (76     (61     (123     (92     (64  

 

(41

                                                               

Non-GAAP net income (loss)

  $ (4,259   $ (3,424   $ (906   $ 1,232      $ 3,238      $ 1,463      $ 4,164      $ 1,219   
                                                               

Net income (loss) attributable to NeoPhotonics Corporation

  $ (8,224   $ (5,001   $ (2,525   $ (170   $ 733      $ (19   $ 2,782      $ 78   

Non-GAAP adjustments:

               

Amortization of purchased intangibles(1)

    1,607        1,413        1,414        1,240        1,153        1,154        1,023        609   

Stock-based compensation expense

    336        235        281        223        242        420        423        397   

Asset impairment charges

    869        —          —          —          1,233        —          —          —     

Restructuring charges

    1,153        —          —          —          —          —          —          —     

Share of loss of unconsolidated investee

    —          —          —          —          —          —          —          176   

Interest (income) expense, net

    258        244        63        199        195        155        115        132   

Provision for (benefit from) income taxes

    (384     267        405        539        691        610        710        405   

Depreciation expense

    2,122        2,134        2,043        2,021        2,156        2,003        2,050        2,250   
                                                               

Adjusted EBITDA

  $ (2,263   $ (708   $ 1,681      $ 4,052      $ 6,403      $ 4,323      $ 7,103      $ 4,047   
                                                               

 

(1) Reflects amortization of purchased intangible assets included in cost of goods sold and operating expenses.

 

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Critical accounting policies and estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses and cash flow, and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, stock-based compensation expense, impairment analysis of goodwill and long-lived assets, valuation of inventory, warranty liabilities and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

We believe that of our significant accounting policies, which are described in Note 2 to our consolidated financial statements appearing elsewhere in this prospectus, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe these are the most critical to fully understand and evaluate our financial condition and results of operations.

Revenue recognition

We recognize revenue from the sale of our products provided that persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable and collectability is reasonably assured. Contracts and/or customer purchase orders are used to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based primarily on the creditworthiness of the customer as determined by credit checks and the customer’s payment history.

Revenue is recognized when the product is shipped and title has transferred to the buyer. We bear all costs and risks of loss or damage to the goods up to that point. On most orders, our terms of sale provide that title passes to the buyer upon shipment by us. In certain cases, our terms of sale may provide that title passes to the buyer upon delivery of the goods to the buyer. We determine payments made to third-party sales representatives are appropriately recorded to sales and marketing expense and not a reduction of revenue as the sales agent services they provide have an identifiable benefit and are made at similar rates of other sales agent service providers. Shipping and handling costs are included in the cost of goods sold. We present revenue net of sales taxes and any similar assessments.

We recognize revenue on sales to distributors, using the “sell in” method (i.e., when product is sold to the distributor) at the time of shipment or delivery, as our distributors do not have extended rights of return or subsequent price discounts or price protections.

Stock-based compensation expense

Our stock-based compensation expense was recorded as follows:

 

     Years ended December 31,      Nine months ended
September 30,
 
(in thousands)        2007          2008          2009          2009          2010  

Cost of goods sold

   $ 130       $ 125       $ 53       $ 53       $ 93   

Research and development

     435         314         228         174         283   

Sales and marketing

     226         177         180         131         292   

General and administrative

     545         512         520         381         572   
                                            
   $ 1,336       $ 1,128       $ 981       $ 739       $ 1,240   
                                            

 

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For awards granted on or before December 31, 2005, we applied the intrinsic value method of accounting for our employee stock option awards. Under the intrinsic value method, compensation expense for employees was based on the difference, if any, between the fair value of our common stock and the exercise price of the option on the measurement date, the date of grant. As of December 31, 2005, we had $1.7 million of deferred stock-based compensation expense, which was amortized over the vesting period of the applicable options on a straight-line basis through December 31, 2009.

Effective January 1, 2006, we adopted new authoritative accounting guidance for stock-based compensation expense, which requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant date fair value of the award. We adopted the new guidance using the prospective transition method. Under this transition method, beginning January 1, 2006, employee stock-based compensation expense includes: (1) compensation cost for all stock-based awards granted prior to, but not yet vested as of December 31, 2005, based on the intrinsic value method and (2) compensation cost for all stock-based awards granted or modified subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the new guidance.

Our determination of the fair value of stock-based payment awards on the measurement date utilizes the Black-Scholes option pricing model, and is impacted by our common stock price as well as changes in assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, expected common stock price volatility over the term of the option awards, projected employee option exercise behaviors (expected period between stock option vesting date and stock option exercise date), risk-free interest rates and expected dividends.

The fair value is recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period) on a straight-line basis. Stock-based compensation expense includes the impact of estimated forfeitures. We estimate future forfeitures at the date of grant and revise the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The Black-Scholes pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants. Existing valuation models, including the Black-Scholes model, may not provide reliable measures of the fair value of our stock-based awards. Consequently, there is a risk that our estimates of the fair value of our stock-based awards on the grant dates may bear little resemblance to the actual values realized upon exercise. Stock options may expire or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our consolidated financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our consolidated financial statements.

For the years ended December 31, 2007, 2008 and 2009, and the nine months ended September 30, 2009 and 2010, we calculated the fair value of stock options granted to employees using the Black-Scholes pricing model with the following assumptions:

 

    Years ended December 31,   Nine months ended September 30,
    2007   2008   2009   2009   2010

Weighted-average expected term (years)

  5.45   5.84   6.00   6.00   6.56

Weighted-average volatility

  97%   77%   79%   79%   75%

Risk-free interest rate

  4.50%-4.67%   2.81%-3.45%   2.15%-3.12%   2.15%-3.12%   2.96%-3.19%

Expected dividends

  0%   0%   0%   0%   0%

 

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The table below summarizes all stock option grants from January 1, 2009 through September 30, 2010:

 

Grant Date

   Options      Exercise
price
     Common
stock fair
value
     Intrinsic
value
     Stock
option fair
value
 

February 26, 2009

     22,000       $ 4.25       $ 4.25       $ —         $ 2.79   

May 28, 2009

     258,316       $ 4.25       $ 4.25       $ —         $ 2.96   

August 13, 2009

     4,160       $ 4.25       $ 4.25       $ —         $ 2.93   

January 27, 2010

     288,019       $ 12.00       $ 13.75       $ 1.75       $ 9.91   

March 30, 2010

     22,120       $ 14.00       $ 14.50       $ 0.50       $ 10.09   

April 8, 2010

     2,200       $ 17.50       $ 14.50       $ —         $ 9.60   

April 14, 2010

     8,264       $ 17.50       $ 14.50       $ —         $ 9.59   
                    
     605,079               
                    

In order to determine the fair value of our common stock underlying all option grants, we engaged third party independent appraisers to assist us and have considered contemporaneous valuations of our common stock. The valuations of our common stock were based on a weighted average of various income and market valuation models, including the discounted cash flow method, the comparable company method, and the comparable transaction method. As part of the comparable company method, we analyzed a population of possible comparable companies and selected those technology companies that we considered to be the most comparable to us in terms of revenue, margins and growth. The comparable transaction method considers private company transactions over the past four years within the same industry and uses the earnings and revenue multiples from those transactions to determine the implied value of the subject company. Once the total equity value was computed under the various approaches, we calculated a weighted average of the methods. We then allocated the total equity value between preferred and common stock using a probability-weighted expected return method. We considered four exit events: (1) initial public offering, (2) sale or merger of the company, (3) continuing as a private company and (4) dissolution of the company. We calculated the common stock value under each scenario and based on our estimate of the probability of each event occurring, calculated an estimated common stock value.

We applied a 20% discount for the minority interest relative to the comparable transaction method. In all valuations, we applied a 24% discount for lack of marketability.

While the comparable transaction method uses historical data, we used several key assumptions in the other valuation models. The significant input assumptions used in the other valuation models are based on subjective future expectations combined with the judgment of management and our board of directors, including:

Assumptions utilized in the discounted cash flow method include:

 

   

our expected revenue, operating performance, cash flow and adjusted EBITDA for the current and future years, determined as of the valuation date based on our estimates;

 

   

a discount rate, which is applied to discretely forecasted future cash flows in order to calculate the present value of those cash flows; and

 

   

a terminal value multiple, which is applied to our last year of discretely forecasted adjusted EBITDA to calculate the residual value of our future cash flows.

Assumptions utilized in the comparable company method include:

 

   

our expected revenue, operating performance, cash flow and adjusted EBITDA for the current and future years, determined as of the valuation date based on our estimates;

 

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multiples of market value to trailing twelve months revenue, determined as of the valuation date, based on a group of comparable public companies we identified; and

 

   

multiples of market value to expected future revenue, determined as of the valuation date, based on the same group of comparable public companies.

Our board of directors sets the exercise price of stock options based on a price per share no less than the fair market value of our common stock, as estimated on the date of grant, using the information available on the grant date. Our board of directors has taken into consideration numerous objective and subjective factors to determine the fair market value of our common stock on each grant date in order to be able to set exercise prices at or above the estimated fair market value. Such factors included, but were not limited to, (1) valuations using the methodologies described above, (2) our operating and financial performance, (3) the lack of liquidity of our capital stock, (4) the likelihood of achieving a liquidity event given then-current market conditions and trends in the broader communications markets and other similar technology stocks and (5) during the recent economic downturn, the benefits to us of preserving relative consistency of exercise prices during periods characterized by decreasing market values.

The assumptions around fair value that we have made represent our management’s best estimate, but they are highly subjective and inherently uncertain. If management had made different assumptions, our calculation of the options’ fair value and the resulting stock-based compensation expense could differ, perhaps materially, from the amounts recognized in our consolidated financial statements. For example, if we increased the assumption regarding our common stock’s volatility for options granted during the year ended December 31, 2009 and the nine months ended September 30, 2010 by 10%, our stock-based compensation expense would increase by $43,000 and $129,000, respectively, net of expected forfeitures. Likewise, if we increased our assumption of the expected lives of options granted during the year ended December 31, 2009 and the nine months ended September 30, 2010 by one year, our stock-based compensation expense would increase by $39,000 and $110,000, respectively, net of expected forfeitures. These increased expense amounts would be amortized over the options’ four year vesting period. In addition, future periods could result in a more significant difference if we were to grant additional stock options, the value of our common stock increases significantly and/or our estimated volatility is higher.

In addition to the assumptions used to calculate the fair value of our options, we are required to estimate the expected forfeiture rate of all stock-based awards and only recognize expense for those awards we expect to vest. Accordingly, the stock-based compensation expense recognized in our consolidated statement of operations for the year ended December 31, 2009 and the nine months ended September 30, 2010, has been reduced for estimated forfeitures. If we were to change our estimate of forfeiture rates, the amount of stock-based compensation expense could differ, materially under certain circumstances, from the amount recognized in our consolidated financial statements. For example, if we had decreased our estimate of expected forfeitures by 50%, our stock-based compensation expense for the year ended December 31, 2009 and the nine months ended September 30, 2010, net of expected forfeitures, would have increased by $67,000 and $195,000, respectively. This decrease in our estimate of expected forfeitures would increase the amount of expense for all unvested awards that have not yet been recognized by $92,000 and $289,000 as of December 31, 2009 and September 30, 2010, respectively, which would be amortized over a weighted-average period of 2.4 years and 3.2 years, respectively. In addition, if our stock-based compensation expense increases in the future, the impact of a change in the estimated forfeiture rate could be more significant.

As of December 31, 2009 and September 30, 2010, we had 197,000 and 263,020 stock appreciation units issued and outstanding, respectively. These stock appreciation units are not exercisable by any recipient until the earliest to occur of the following: (i) the expiration of the period of time agreed to between our underwriters and certain of our stockholders selected by the underwriters in connection with a public offering of the stock, or (ii) upon the consummation of a change in control, which means a sale of all or substantially all of our assets, or a merger, consolidation or other capital reorganization or business combination transaction with or

 

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into another corporation or entity. Because neither of these events has occurred and therefore recipients are not able to exercise their units, no compensation expense has been recognized to date relative to these awards. Upon the occurrence of either of the two events, we would recognize compensation expense and corresponding liability equal to the number of vested and outstanding stock appreciation units multiplied by the fair value, calculated using the Black-Scholes option pricing model, on that date. In future periods, we will remeasure the fair value (based on the market price of our common stock at the relevant period end) of all vested and outstanding stock appreciation units and adjust our compensation expense and corresponding liability accordingly. We will also recognize compensation expense for additional vested stock appreciation units.

Goodwill and long-lived assets

Goodwill is evaluated, at a minimum, on an annual basis and whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. Our annual goodwill impairment testing is performed on December 31 of each year. Goodwill is reviewed for impairment utilizing a two-step process. First, impairment of goodwill is tested at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit. The fair value of the reporting unit is estimated using a discounted cash flow approach. If the carrying amount of the reporting unit exceeds its fair value, a second step is performed to measure the amount of impairment loss, if any. In step two, the implied fair value of goodwill is calculated as the excess of the fair value of a reporting unit over the fair values assigned to its assets and liabilities. If the implied fair value of goodwill is less than the carrying value of the reporting unit’s goodwill, the difference is recognized as an impairment loss. During the year ended December 31, 2007, we recorded $5.9 million of goodwill impairment charges. We did not recognize any goodwill impairment charges during the years ended December 31, 2008 or 2009 and the nine months ended September 30, 2010.

Depreciation and amortization of the intangible assets and other long-lived assets is provided using the straight-line method over their respective estimated useful lives, reflecting the pattern of economic benefits associated with these assets. Changes in circumstances such as technological advances, changes to our business model, or changes in our capital strategy could cause the actual useful lives of intangible assets or other long-lived assets to differ from initial estimates. In those cases where we determine that the useful life of an asset should be revised, we depreciate the remaining net book value over the new estimated useful life. During the year ended December 31, 2008, we changed the estimated remaining useful life of acquired technology and patents related to ROADM products from 57 months to 28 months, which increased our amortization expense included within cost of goods sold by $0.2 million and $0.5 million for the years ended December 31, 2008 and 2009, respectively, and $0.4 million for each of the nine months ended September 30, 2009 and 2010.

These assets are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable based on their future cash flows. The estimated future cash flows are based upon, among other things, assumptions about expected future operating performance and may differ from actual cash flows. The assets evaluated for impairment are grouped, based on our judgment, with other assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. If the sum of the projected undiscounted cash flows (excluding interest) is less than the carrying value of the assets, the assets will be written down to the estimated fair value. During the years ended December 31, 2007, 2008 and 2009, we recorded asset impairment charges of $0.2 million, $4.0 million and $1.2 million, respectively, related to finite-lived assets. We did not record any asset impairment charges during each of the nine months ended September 30, 2009 and 2010.

Valuation of inventories

Inventories are recorded at the lower of cost (using the first-in, first-out method) or market, after we give appropriate consideration to obsolescence and inventories in excess of anticipated future demand. In assessing the ultimate recoverability of inventories, we are required to make estimates regarding future customer demand, the timing of new product introductions, economic trends and market conditions. If the actual product

 

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demand is significantly lower than forecasted, we could be required to record additional inventory write-downs which would be charged to cost of goods sold. Any write-downs would have an adverse impact on our gross margin. During the years ended December 31, 2007, 2008 and 2009, we recorded excess and obsolete inventory charges of $2.6 million, $0.0 million, and $1.1 million, respectively. During the nine months ended September 30, 2009 and 2010, we recorded excess and obsolete inventory charges of $0.9 million and $0.5 million, respectively.

Warranty liabilities

We provide warranties to cover defects in workmanship, materials and manufacturing of our products for a period of one to two years to meet stated functionality specifications. From time to time, we have agreed, and may agree, to warranty provisions providing for extended terms or with a greater scope. Products are tested against specified functionality requirements prior to delivery, but we nevertheless from time to time experience claims under our warranty guarantees. We accrue for estimated warranty costs under those guarantees based upon historical experience, and for specific items at the time their existence is known and the amounts are determinable. A provision for estimated future costs related to warranty activities is charged to cost of goods sold based upon historical product failure rates and historical costs incurred in correcting product failures. If we experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than expected, our gross margin and profitability would be adversely affected.

Accounting for income taxes

We record income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. In estimating future tax consequences, generally all expected future events, other than enactments or changes in tax law or rates, are considered. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized.

We operate in various tax jurisdictions and are subject to audit by various tax authorities. We provide for tax contingencies whenever it is deemed probable that a tax asset has been impaired or a tax liability has been incurred for events such as tax claims or changes in tax laws. Tax contingencies are based upon their technical merits, relevant tax law and the specific facts and circumstances as of each reporting period. Changes in facts and circumstances could result in material changes to the amounts recorded for such tax contingencies.

On January 1, 2007, we adopted revised authoritative guidance which clarified the accounting for uncertainty in tax positions. The guidance defines the confidence level that a tax position must meet in order to be recognized in the financial statements and requires that the tax effects of a position be recognized only if it is “more likely than not” to be sustained based solely on its technical merits as of the reporting date. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.

With the adoption of this new guidance, companies are required to adjust their financial statements to reflect only those tax positions that are more likely than not to be sustained. Any necessary adjustment would be recorded directly to retained earnings and reported as a change in accounting principle as of the date of adoption. The new guidance also prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The adoption of this statement did not have a material impact on our consolidated financial position, results of operations or disclosures.

As part of the process of preparing our consolidated financial statements, we are required to estimate our taxes in each of the jurisdictions in which we operate. We estimate actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as accruals and allowances not currently deductible for tax purposes. These differences result in deferred tax assets.

 

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At December 31, 2009, we had total net deferred tax assets of $57.1 million, primarily comprised of U.S. federal and state NOL carryforwards, and a related valuation allowance of $56.6 million, primarily against our U.S. net deferred tax assets, as we believe that sufficient uncertainty exists regarding the realizability of these deferred tax assets. Our net deferred tax assets consist primarily of NOL carryforwards generated in the United States. Realizability of deferred tax assets is deemed appropriate when realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and the recorded U.S. cumulative net losses, we have provided a full valuation allowance against our U.S. deferred tax assets. We intend to maintain valuation allowances until sufficient evidence exists to support the reversal of the valuation allowances. Under certain conditions related to our future profitability and other business factors, we believe it is possible our results will yield sufficient positive evidence to support the conclusion that it is more likely than not that we will realize the tax benefit of our NOL carryforwards. If that is the case, subject to review of other qualitative factors and uncertainties, we would reverse the remaining deferred tax asset valuation allowance as a reduction of tax expense. For the periods following the recognition of this tax benefit and to the extent we are profitable, we will record a tax provision for which the actual payment may be offset against our accumulated NOL carryforwards. However, our tax rate may significantly increase in future periods.

We make estimates and judgments about our future taxable income that are based on assumptions that are consistent with our plans and estimates. Should the actual amounts differ from our estimates, the amount of our valuation allowance could be materially impacted. Any adjustment to the deferred tax asset valuation allowance would be recorded in the consolidated statement of operations in the period that the adjustment is determined to be required.

Our income tax expense in 2009 includes $0.8 million of withholding taxes on royalty income from foreign sources. During the nine months ended September 30, 2010, our tax expense included a tax benefit of $0.1 million as a result of lower royalty income from foreign sources and a refund from a favorable tax ruling in China. Although there is a U.S. foreign tax credit for foreign income taxes paid, we do not record a benefit from these foreign tax credits, due to our full valuation allowance on our U.S. deferred tax assets.

 

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Results of operations

The following tables set forth our results of operations for the periods presented and as a percentage of our revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods.

 

    Years ended December 31,     Nine months ended September 30,  
    2007     2008     2009     2009     2010  
(in thousands, except
percentages)
  Amount     % of
revenue
    Amount     % of
revenue
    Amount     % of
revenue
    Amount     % of
revenue
    Amount     % of
revenue
 

Revenue

  $ 95,825        100   $ 133,989        100   $ 155,062        100   $ 112,014        100   $ 132,888        100

Cost of goods sold

    83,475        87        109,439        82        114,572        74        86,142        77        91,079        69   
                                                 

Gross profit

    12,350        13        24,550        18        40,490        26        25,872        23        41,809        31   
                                                 

Operating expenses:

                   

Research and development

    23,076        24        21,480        16        17,266        11        12,431        11        16,049        12   

Sales and marketing

    10,123        11        10,435        8        9,587        6        7,330        7        7,502        6   

General and administrative

    13,142        14        14,581        11        15,448        10        11,230        10        12,397        9   

Amortization of purchased intangible assets

    1,826        2        1,665        1        1,136        1        852        1        855        1   

Asset impairment charges

    6,138        6        4,047        3        1,233        1        —          —          —          —     

Restructuring charges

    —          —          1,383        1        —          —          —          —          —          —     
                                                 

Total operating expenses

    54,305        57        53,591        40        44,670        29        31,843        29        36,803        28   
                                                 

Income (loss) from operations

    (41,955     (44     (29,041     (22     (4,180     (3     (5,971     (6     5,006        3   
                                                 

Other income (expense), net

    566        1        (812     —          (765     —          (451     —          (360     —     

Benefit from (provision for) income taxes

    (86     —          1,812        1        (1,902     (1     (1,211     (1     (1,725     (1
                                                 

Net income (loss)

    (41,475     (43     (28,041     (21     (6,847     (4     (7,633     (7     2,921        2   

Net (income) loss attributable to noncontrolling interests

    8        —          (13     —          (116     —          (63     —          (80     —     
                                                 

Net income (loss) attributable to NeoPhotonics Corporation

  $ (41,467     (43 )%    $ (28,054     (21 )%    $ (6,963     (5 )%    $ (7,696     (7 )%    $ 2,841        2
                                                 

Nine months ended September 30, 2009 and 2010

Revenue

 

     Nine months ended September 30,               
     2009     2010     Change  
(in thousands, except percentages)    Amount      % of
revenue
    Amount      % of
revenue
    Amount      %  

Total revenue

   $ 112,014         100   $ 132,888         100   $ 20,874         19

Total revenue increased by $20.9 million from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, representing a 19% increase. The increase in revenue was primarily attributable to an

 

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increase in demand for our agility products, as customers began to deploy more sophisticated product offerings, plus additional design wins and overall market expansion. Although sales increased on a global basis, the increase was primarily realized in China and the United States.

Cost of goods sold and gross margin

 

     Nine months ended September 30,        
     2009     2010     Change  
(in thousands, except percentages)    Amount      % of
revenue
    Amount      % of
revenue
    Amount      %  

Cost of goods sold

   $ 86,142         77   $ 91,079         69   $ 4,937         6
     Nine months ended September 30,               
            2009            2010               

Gross margin

        23        31        62

Cost of goods sold increased by $4.9 million from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, representing a 6% increase. Cost of goods sold increased primarily from higher sales volumes and additional direct labor costs, offset by lower material costs and improved manufacturing utilization in the nine months ended September 30, 2010. Gross margin was 31% for the nine months ended September 30, 2010, compared to 23% for the nine months ended September 30, 2009. The improvement in gross margin primarily resulted from the increase in sales of our higher-margin agility products in the nine months ended September 30, 2010, combined with lower production overhead and lower material costs resulting from manufacturing cost reductions.

Operating expenses

 

     Nine months ended September 30,        
     2009     2010     Change  
(in thousands, except percentages)    Amount      % of
revenue
    Amount      % of
revenue
    Amount      %  

Research and development

   $ 12,431         11   $ 16,049         12   $ 3,618         29

Sales and marketing

     7,330         7        7,502         6        172         2   

General and administrative

     11,230         10        12,397         9        1,167         10   

Amortization of purchased intangible assets

     852         1        855         1        3         —     
                                             

Total operating expenses

   $ 31,843         29   $ 36,803         28   $ 4,960         16   
                                                   

Research and development expense

Research and development expense increased by $3.6 million from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, representing a 29% increase. This increase was primarily due to a $1.9 million increase in project management and design services and prototype expenses and incurred additional personnel costs during the nine months ended September 30, 2010 as we invested in additional resources to support future anticipated demand.

Sales and marketing expense

Sales and marketing expense increased by $0.2 million from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, representing a 2% increase. The increase was primarily due to a $0.7 million increase in employee-related costs and sales commissions, partially offset by a $0.5 million decrease in bad debt expense as a result of improved collections.

 

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General and administrative expense

General and administrative expense increased by $1.2 million from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, representing a 10% increase. This increase was primarily due to increases in legal costs of $0.3 million, increases in audit and tax related costs of $0.4 million, and increases in personnel costs, partially offset by lower facilities-related costs.

Amortization of purchased intangible assets

Amortization of purchased intangible assets remained flat from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, as we continue to amortize intangible assets associated with business acquisitions made prior to 2007.

Interest and other expense, net

 

     Nine months ended September 30,     Change  
     2009     2010    
(in thousands, except percentages)    Amount     % of
revenue
    Amount     % of
revenue
    Amount     %  

Interest income

   $ 295        0.3   $ 163        0.1   $ (132