0001227025-18-000113.txt : 20181105 0001227025-18-000113.hdr.sgml : 20181105 20181105172114 ACCESSION NUMBER: 0001227025-18-000113 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 89 CONFORMED PERIOD OF REPORT: 20180930 FILED AS OF DATE: 20181105 DATE AS OF CHANGE: 20181105 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NEOPHOTONICS CORP CENTRAL INDEX KEY: 0001227025 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 943253730 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-35061 FILM NUMBER: 181160806 BUSINESS ADDRESS: STREET 1: 2911 ZANKER ROAD CITY: SAN JOSE STATE: CA ZIP: 951342125 BUSINESS PHONE: 4082329200 MAIL ADDRESS: STREET 1: 2911 ZANKER ROAD CITY: SAN JOSE STATE: CA ZIP: 95134 10-Q 1 nptn-09302018x10q.htm 10-Q Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 

(Mark One)
☒        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
OR
☐        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from        to        
Commission File Number: 001-35061
 
NeoPhotonics Corporation
(Exact name of registrant as specified in its charter)
 
 
 
 
 
Delaware
 
94-3253730
(State or other jurisdiction
of incorporation or organization)
 
(I.R.S. Employer
Identification No.)
2911 Zanker Road
San Jose, California 95134
(Address of principal executive offices, zip code)
(408) 232-9200
(Registrant’s telephone number, including area code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  ☒     No   ☐     
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes  ☒     No   ☐ 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
Accelerated filer
Non-accelerated filer
 
Smaller reporting company
Emerging growth company
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ☐     No   ☒ 
 
As of October 31, 2018, there were approximately 46,049,277 shares of the registrant’s Common Stock outstanding. 




NEOPHOTONICS CORPORATION
For the Quarter Ended September 30, 2018
Table of Contents
 
 
Page
 
 
 
 
 
 
 
 
 
 
 




PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 
 
As of
 
September 30, 2018
 
December 31, 2017
(In thousands, except par data)
 
ASSETS
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
52,099

 
$
78,906

Short-term investments
7,441

 
12,311

Restricted cash
5,195

 
2,658

Accounts receivable, net of allowance for doubtful accounts
66,620

 
67,229

Inventories
57,124

 
67,301

Assets held for sale
3,192

 

Prepaid expenses and other current assets
28,659

 
36,235

Total current assets
220,330

 
264,640

Property, plant and equipment, net
104,965

 
127,565

Purchased intangible assets, net
3,320

 
4,294

Goodwill
1,115

 
1,115

Other long-term assets
3,080

 
5,339

Total assets
$
332,810

 
$
402,953

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
54,603

 
$
69,017

Notes payable and short-term borrowing
3,634

 
35,607

Current portion of long-term debt
2,798

 
6,005

Accrued and other current liabilities
46,857

 
43,242

Total current liabilities
107,892

 
153,871

Long-term debt, net of current portion
50,356

 
40,556

Other noncurrent liabilities
13,388

 
14,075

Total liabilities
171,636

 
208,502

Commitments and contingencies (Note 11)


 


Stockholders’ equity:
 

 
 

Preferred stock, $0.0025 par value, 10,000 shares authorized, no shares issued or outstanding

 

Common stock, $0.0025 par value, 100,000 shares authorized
 

 
 

As of September 30, 2018, 45,840 shares issued and outstanding; as of December 31, 2017, 44,219 shares issued and outstanding
115

 
111

Additional paid-in capital
559,371

 
545,953

Accumulated other comprehensive income (loss)
(7,569
)
 
398

Accumulated deficit
(390,743
)
 
(352,011
)
Total stockholders’ equity
161,174

 
194,451

Total liabilities and stockholders’ equity
$
332,810

 
$
402,953



See accompanying Notes to Condensed Consolidated Financial Statements.


3


NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
(In thousands, except per share data)
2018
 
2017
 
2018
 
2017
Revenue
$
81,748

 
$
71,121

 
$
231,436

 
$
216,023

Cost of goods sold
62,815

 
60,608

 
187,849

 
170,230

Gross profit
18,933

 
10,513

 
43,587

 
45,793

Operating expenses:
 
 
 
 
 
 
 
Research and development
13,177

 
14,662

 
40,308

 
44,412

Sales and marketing
4,351

 
4,071

 
12,366

 
12,913

General and administrative
8,592

 
7,637

 
23,509

 
26,792

Amortization of purchased intangible assets
118

 
119

 
357

 
355

Asset sale related costs
251

 
78

 
344

 
229

Restructuring charges
1,133

 
2,829

 
1,786

 
3,550

Gain on asset sale

 

 

 
(2,000
)
Total operating expenses
27,622

 
29,396

 
78,670

 
86,251

Loss from operations
(8,689
)
 
(18,883
)
 
(35,083
)
 
(40,458
)
Interest income
85

 
37

 
300

 
141

Interest expense
(540
)
 
(495
)
 
(2,007
)
 
(743
)
Other income (expense), net
1,310

 
(41
)
 
1,891

 
197

Total interest and other income (expense), net
855

 
(499
)
 
184

 
(405
)
Loss before income taxes
(7,834
)
 
(19,382
)
 
(34,899
)
 
(40,863
)
Income tax (provision) benefit
(291
)
 
1,195

 
(2,009
)
 
1,813

Net loss
$
(8,125
)
 
$
(18,187
)
 
$
(36,908
)
 
$
(39,050
)
 
 
 
 
 
 
 
 
Basic net loss per share
$
(0.18
)
 
$
(0.42
)
 
$
(0.82
)
 
$
(0.90
)
Diluted net loss per share
$
(0.18
)
 
$
(0.42
)
 
$
(0.82
)
 
$
(0.90
)
Weighted average shares used to compute basic net loss per share
45,476

 
43,790

 
44,804

 
43,212

Weighted average shares used to compute diluted net loss per share
45,476

 
43,790

 
44,804

 
43,212

 


See accompanying Notes to Condensed Consolidated Financial Statements.

4


 
NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
(in thousands)
2018
 
2017
 
2018
 
2017
Net loss
$
(8,125
)
 
$
(18,187
)
 
$
(36,908
)
 
$
(39,050
)
Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments, net of zero tax
(5,588
)
 
2,177

 
(7,968
)
 
6,090

Unrealized gains on available-for-sale securities, net of zero tax

 
1

 
1

 
17

Total other comprehensive income (loss)
(5,588
)
 
2,178

 
(7,967
)
 
6,107

Comprehensive loss
$
(13,713
)
 
$
(16,009
)
 
$
(44,875
)
 
$
(32,943
)
 


See accompanying Notes to Condensed Consolidated Financial Statements.

5


NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  
(Unaudited)
 
 
Nine Months Ended
September 30,
 
(In thousands)
2018
 
2017
Cash flows from operating activities
 
 
 
Net loss
$
(36,908
)
 
$
(39,050
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
Depreciation and amortization
23,551

 
20,630

Stock-based compensation expense
10,527

 
5,692

Deferred taxes
(42
)
 
673

Others
327

 
158

Loss (gain) on sale of assets and other write-offs
304

 
(1,623
)
Loss (gain) on foreign currency hedges
2,220

 
(1,501
)
Allowance for doubtful accounts
(144
)
 
76

Write-down of inventories
3,200

 
7,083

Asset impairment charge

 
275

Foreign currency remeasurement
(4,192
)
 
1,576

Change in assets and liabilities, net of effects of asset sale:
 
 
 
Accounts receivable
519

 
13,755

Inventories
5,482

 
(36,466
)
Prepaid expenses and other assets
5,957

 
(12,002
)
Accounts payable
(4,958
)
 
(9,424
)
Accrued and other liabilities
3,154

 
8,937

Net cash provided by (used in) operating activities
8,997

 
(41,211
)
Cash flows from investing activities
 
 
 
Purchase of property, plant and equipment
(14,377
)
 
(41,461
)
Proceeds from sale of property, plant and equipment and other assets
32

 
21,806

Purchase of marketable securities
(880
)
 
(52,031
)
Proceeds from sale of marketable securities
5,000

 
52,272

Proceeds from maturity of marketable securities
750

 
6,458

Settlement of foreign currency hedges
(1,776
)
 
1,553

Net cash used in investing activities
(11,251
)
 
(11,403
)
Cash flows from financing activities
 
 
 
Proceeds from exercise of stock options and issuance of stock under ESPP
3,801

 
3,568

Tax withholding on restricted stock units
(747
)
 
(973
)
Payments for public stock offering

 
(117
)
Proceeds from bank loans, net of debt issuance costs
29,358

 
96,039

Repayment of bank loans
(57,323
)
 
(68,270
)
Proceeds from issuance of notes payable
4,795

 
5,842

Repayment of notes payable
(2,568
)
 
(9,789
)
Proceeds from government grants
1,228

 

Net cash (used in) provided by financing activities
(21,456
)
 
26,300

Effect of exchange rates on cash, cash equivalents and restricted cash
(560
)
 
1,174

Net decrease in cash, cash equivalents and restricted cash
(24,270
)
 
(25,140
)
Cash, cash equivalents and restricted cash at the beginning of the period
81,564

 
86,585

Cash, cash equivalents and restricted cash at the end of the period
$
57,294

 
$
61,445

Supplemental disclosure of non-cash investing and financing activities:
 
 
 
Decrease in unpaid property, plant and equipment
$
8,916

 
$
6,430

Asset retirement obligations
$

 
$
2,146

 


See accompanying Notes to Condensed Consolidated Financial Statements.
 

6


NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements
(Unaudited)


 
Note 1. Basis of presentation and significant accounting policies
Basis of Presentation and Consolidation
The condensed consolidated financial statements of NeoPhotonics Corporation (“NeoPhotonics” or the “Company”) as of September 30, 2018 and for the three and nine months ended September 30, 2018 and 2017, have been prepared in accordance with the instructions on Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In accordance with those rules and regulations, the Company has omitted certain information and notes normally provided in the Company’s annual consolidated financial statements. In the opinion of management, the condensed consolidated financial statements contain all adjustments, consisting only of normal recurring items, except as otherwise noted, necessary for the fair presentation of the Company’s financial position and results of operations for the interim periods. The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by U.S. generally accepted accounting principles (“U.S. GAAP”). These condensed consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017. The results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the results expected for the entire fiscal year. All intercompany accounts and transactions have been eliminated.
Going Concern
Accounting Standards Update (“ASU”) No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, requires an entity to disclose information about its potential inability to continue as a going concern when conditions and events indicate that it is probable that the entity may be unable to meet its obligations as they become due within one year. Management has assessed the Company’s ability to continue as a going concern within one year of the filing date of this Quarterly Report on Form 10-Q with the SEC in November 2018. The accompanying unaudited condensed financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.
As of September 30, 2018, the Company’s working capital was $112.4 million, including available cash, cash equivalents, short-term investments and restricted cash of approximately $64.7 million. In the first nine months of 2018, the Company had operating losses of $35.1 million and cash from operations of $9.0 million. It had an accumulated deficit of approximately $390.7 million as of September 30, 2018.
Through 2017 and the early part of 2018, the Company's operating results and cash flows were negatively affected by demand that was lower than customer estimates that were used to put capacity in place over the last two years.  In the three months ended June 30, 2018, demand continued to be strong, primarily due to volume growth in the Americas and the result of increased domestic deployments in China plus exports for international deployments. In the three months ended September 30, 2018, demand was in line with the increased demand experienced during the three months ended June 30, 2018.
To adjust to the demand that was less than estimates used for capacity decisions, the Company implemented restructuring plans in May and September 2017 that included a reduction in force and consolidation of facilities, in order to reduce expenses. The Company has also reduced or delayed certain product development projects and capital expenditures, aggressively pursued collections of accounts and notes receivable and continued to closely manage production and inventory levels.
In September 2017, the Company entered into a revolving line of credit agreement with Wells Fargo Bank, National Association ("Wells Fargo") which provides for borrowings under an accounts receivable based formula up to a maximum of $50.0 million. As of September 30, 2018, $35.6 million was outstanding under this line. The remaining borrowing capacity as of September 30, 2018 was $14.4 million, of which $5.0 million is required to be maintained as unused borrowing capacity. Borrowings under the Wells Fargo line are not due until June 30, 2022 as long as the borrowing base is not less than the outstanding amount (See Note 9). Additionally, the Company had $3.6 million of notes payable and $2.8 million of current portion of long-term debt as of September 30, 2018, which it plans to pay out of its existing available cash.
The Company currently believes it will have sufficient resources to fund its currently planned operations and expenditures over the next twelve months without additional financing or other actions.  In addition, the Company believes there are a number of ongoing and potential actions that may further strengthen its projected cash and projected financial position.
The Company operates in an industry in which it is difficult to evaluate its prospects with certainty. Future declines in China market demand or other changes to the Company’s forecasts could adversely affect the Company’s results of operations, financial position and cash flows. As a result, the Company may need to raise additional debt or equity capital to fund its operations.  Any

7

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

additional debt arrangements may likely require regular interest and principal payments which could adversely affect the Company’s operations. There can be no assurance that additional debt or equity capital will be available on acceptable terms, or at all.
Certain Significant Risks and Uncertainties
The Company operates in a dynamic industry and, accordingly, can be affected by a variety of factors.  For example, any of the following areas could have a negative effect on the Company in terms of its future financial position, results of operations or cash flows: the general state of the U.S., China and world economies; the highly cyclical nature of the industries the Company serves; the loss of any of a small number of its larger customers; ability to obtain additional financing; inability to meet certain debt covenants; fundamental changes in the technology underlying the Company’s products; the hiring, training and retention of key employees; successful and timely completion of product design efforts; and new product design introductions by competitors.
Concentration
In the three months ended September 30, 2018, Huawei Technologies Co. Ltd. and its affiliate HiSilicon Technologies (together with Huawei Technologies Co. Ltd., "Huawei") accounted for approximately 47% of the Company's total revenue. One other customer accounted for approximately 28% of the Company’s total revenue and the Company’s top five customers represented approximately 89% of the Company’s total revenue. In the three months ended September 30, 2017, Huawei accounted for approximately 39% of the Company's total revenue. Two other customers accounted for approximately 14% and 11% of the Company’s total revenue and the Company’s top five customers represented approximately 79% of the Company’s total revenue. In the nine months ended September 30, 2018, Huawei accounted for approximately 47% of the Company's total revenue. One other customer accounted for approximately 25% of the Company's total revenue and the Company's top five customers represented approximately 89% of its total revenue. In the nine months ended September 30, 2017, Huawei accounted for approximately 39% of the Company's total revenue. One other customer accounted for approximately 16% of the Company's total revenue and the Company's top five customers represented approximately 76% of the Company's total revenue.
As of September 30, 2018, three customers accounted for approximately 41%, 20% and 12% of the Company’s accounts receivable. As of December 31, 2017, three customers accounted for approximately 36%, 14% and 10%, respectively, of the Company’s accounts receivable.
Use of Estimates
The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported revenue and expenses during the reporting period. Significant estimates made by management include: the useful lives of property, plant and equipment and intangible assets as well as future cash flows to be generated by those assets; fair values of identifiable assets acquired and liabilities assumed in business combinations; allowances for doubtful accounts; valuation allowances for deferred tax assets; valuation of excess and obsolete inventories; warranty reserves; litigation accrual and recognition of stock-based compensation, among others. Actual results could differ from these estimates.
Accounting Standards Update Recently Adopted
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-9, Revenue from Contracts with Customers (“ASU 2014-9”). The standard, along with the amendments issued in 2016 and 2015, provides companies with a single model for use in accounting for revenue arising from contracts with customers and supersedes current revenue recognition guidance, including industry-specific revenue guidance. The core principle of the model is to recognize revenue when control of the goods or services transfers to the customer, as opposed to recognizing revenue when the risks and rewards transfer to the customer under the existing revenue guidance. ASU 2014-9 is required to be adopted, using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-9; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-9 recognized at the date of initial application and providing certain additional disclosures. This standard, as amended, is effective for annual and interim periods beginning after December 15, 2017 and permits entities to early adopt for annual and interim reporting periods beginning after December 15, 2016. The Company adopted this standard as of January 1, 2018, using the full retrospective transition method. See Note 2 for further details.

In May 2017, the FASB issued ASU No. 2017-9, Compensation—Stock Compensation (718)—Scope of Modification Accounting (ASU 2017-9”). This guidance redefines which changes to the terms and conditions of a share-based payment

8

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

award require an entity to apply modification accounting for a share-based payment. ASU 2017-9 is effective for interim and annual periods after December 15, 2017 and early adoption is permitted in any interim period. The Company adopted this standard effective January 1, 2018. The impact on the Company's consolidated financial statements upon the adoption of this standard was immaterial.

In January 2017, the FASB issued ASU 2017-1, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-1”). This standard provides a framework in determining when a set of assets and activities is a business. ASU 2017-1 is effective for interim and annual periods beginning after December 15, 2017 on a prospective basis. The Company adopted this standard effective January 1, 2018. The impact on the Company's consolidated financial statements upon the adoption of this standard was immaterial.

In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (“ASC 2016-18”). This standard provides guidance on the classification and presentation of restricted cash in the statement of cash flows and must be applied retrospectively. ASU 2016-18 is effective for fiscal years beginning after December 15, 2017. The Company adopted this standard effective January 1, 2018. The reclassified restricted cash balances from investing activities to changes in cash, cash equivalents and restricted cash on the condensed consolidated statements of cash flows were not material for all periods presented.

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”). This standard provides guidance on the tax accounting for the transferring and receiving entities upon transfer of an asset. ASU 2016-16 is effective for the Company’s interim and annual periods beginning after December 15, 2017 and should be applied on a modified retrospective basis. Upon adoption of this standard on January 1, 2018, the Company recorded $1.8 million to accumulated deficit balance for intra-entity transfer of an asset other than inventory in prior years.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). This standard provides guidance on the classification of certain cash receipts and payments in the statement of cash flows. It is effective, retrospectively, for the Company’s annual and interim reporting periods beginning after December 15, 2017 or prospectively from the earliest date practicable if retrospective application is impracticable. The Company adopted this standard effective January 1, 2018, using the retrospective transition method. The impact on the Company's consolidated financial statements upon the adoption of this standard was immaterial.

In January 2016, the FASB issued ASU 2016-1, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-1”).  ASU 2016-1 revises an entity’s accounting related to (1) the classification and measurement of investments in equity securities and (2) the presentation of certain fair value changes for financial liabilities measured at fair value. It also amends certain disclosure requirements associated with the fair value of financial instruments and is effective for the Company’s annual and interim reporting periods beginning after December 15, 2017. The Company adopted this standard effective January 1, 2018. The impact on the Company's consolidated financial statements upon the adoption of this standard was immaterial.

In March 2017, the FASB issued ASU No. 2017-7, Compensation-Retirement Benefits (Topic 715)-Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU 2017-7”). This guidance revises the presentation of employer-sponsored defined benefit pension and other postretirement plans for the net periodic benefit cost in the statement of operations and requires that the service cost component of net periodic benefit be presented in the same income statement line items as other employee compensation costs for services rendered during the period. The other components of the net benefit costs are required to be presented in the statement of operations separately from the service cost component and outside the subtotal of income from operations. This guidance allows only the service cost component of net periodic benefit costs to be eligible for capitalization. ASU 2017-7 is effective for interim and annual periods after December 15, 2017. The Company adopted this standard effective January 1, 2018. The impact on the Company's consolidated financial statements upon the adoption of this standard was immaterial.
There have been no other changes in the Company’s significant accounting policies in the nine months ended September 30, 2018, as compared to the significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2017
Recent Accounting Standards Update Not Yet Effective 
In January 2017, the FASB issued ASU 2017-4, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-4”). This standard amends the goodwill impairment test to compare the fair value of a

9

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, up to the total amount of goodwill allocated to that reporting unit. ASU 2017-4 is effective prospectively for interim and annual periods beginning after December 15, 2019. Early adoption is permitted for interim and annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company has not determined whether it will elect early adoption and is currently evaluating the impact of the adoption of this standard on its consolidated financial statements and related disclosures.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 amends existing guidance on the impairment of financial assets and adds an impairment model that is based on expected losses rather than incurred losses and requires an entity to recognize as an allowance its estimate of expected credit losses for its financial assets. An entity will apply this guidance through a cumulative-effect adjustment to retained earnings upon adoption (a modified-retrospective approach) while a prospective transition approach is required for debt securities for which an other-than-temporary impairment had been recognized before the effective date. It is effective for the Company’s annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted. The Company is in the process of evaluating the impact of the adoption on its consolidated financial statements and related disclosure.
In February 2016, the FASB issued ASU 2016-2, Leases (Topic 842) (“ASU 2016-2”).  ASU 2016-2 introduces a lessee model that requires recognition of assets and liabilities arising from qualified leases on the consolidated balance sheets and consolidated statements of operations and to disclose qualitative and quantitative information about lease transactions. It is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. Certain optional practical expedients are allowed. The Company is in the process of evaluating the impact of the adoption on its consolidated financial statements and related disclosure.
 
Note 2. Revenue

Adoption of ASC Topic 606, “Revenue from Contracts with Customers”

On January 1, 2018, the Company adopted Topic 606 using the full retrospective method which required it to restate each prior reporting period presented. The adoption did not have a material impact on the Company's consolidated financial statements and as a result, no changes were made to prior reporting periods presented.

Product revenue
The Company develops, manufactures and sells optoelectronic products that transmit, receive, modify and switch high speed digital optical signals for communications networks. Revenue is derived primarily from the sale of hardware products. The Company sells its products worldwide, primarily to leading network equipment manufacturers.

Revenue recognition
Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company generally bears all costs, risk of loss or damage and retains title to the goods up to the point of transfer of control of promised products to customer. Revenue related to the sale of consignment inventories at customer vendor managed locations is not recognized until the products are pulled from consignment inventories by customers. In instances where acceptance of the product or solutions is specified by the customer, revenue is deferred until such required acceptance criteria have been met. Shipping and handling costs are included in the cost of goods sold. The Company presents revenue net of sales taxes and any similar assessments.

Nature of products
Revenue from sale of hardware products is recognized upon transfer of control to the customer. The performance obligation for the sale of hardware products is satisfied at a point in time. The Company has aligned its products in two groups - High Speed Products and Network Products and Solutions. The following presents revenue by product group (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
2018
 
2017
 
2018
 
2017
High Speed Products
$
68,519

 
$
59,426

 
$
197,362

 
$
177,488

Network Products and Solutions
13,229

 
11,695

 
34,074

 
38,535

    Total revenue
$
81,748

 
$
71,121

 
$
231,436

 
$
216,023


10

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)


The following table presents the Company's revenue information by geographical region. Revenue is classified based on the ship to location requested by the customer. Such classification recognizes that for many customers, including those in North America or in Europe, designated shipping points are often in China or elsewhere in Asia (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
2018
 
2017
 
2018
 
2017
China
$
46,134

 
$
40,513

 
$
133,917

 
$
117,599

Americas
22,369

 
13,487

 
52,270

 
36,853

Rest of world
13,245

 
17,121

 
45,249

 
61,571

  Total revenue
$
81,748

 
$
71,121

 
$
231,436

 
$
216,023

Certain prior period amounts have been reclassified to conform to the current period presentation.

Deferred revenue

The Company records deferred revenue when cash payments are received or due in advance of our performance. Refer to Note 7 for disclosure of deferred revenue balances. The increase in the deferred revenue balances during the three and nine months ended September 30, 2018 was immaterial, offset by approximately $0.2 million and $0.8 million of revenue recognized during the three and nine months ended September 30, 2018 that was included in the deferred revenue balance as of December 31, 2017. The increase in the deferred revenue balances during the three and nine months ended September 30, 2017 was $0.1 million and $1.7 million, respectively, offset by approximately $0.2 million and $0.7 million of revenue recognized during the three and nine months ended September 30, 2017, respectively, that was included in the deferred revenue balance as of December 31, 2016.

Contract assets
The Company records contract assets when the revenue is recognized but the customer payment is contingent on a future event. The balance of contract assets as of September 30, 2018 and December 31, 2017 was immaterial.

Refund liabilities
The Company records refund liabilities when the contract permits the customer to return the product if certain circumstances arise. The balance of refund liabilities as of September 30, 2018 and December 31, 2017 was immaterial.

Note 3. Net loss per share
 
The following table sets forth the computation of the basic and diluted net loss per share for the periods indicated (in thousands, except per share amounts): 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2018
 
2017
 
2018
 
2017
Numerator:
    
 
 
 
    
 
 
Net loss
$
(8,125
)
 
$
(18,187
)
 
$
(36,908
)
 
$
(39,050
)
Denominator:
 

 
 

 
 
 
 
Weighted average shares used to compute per share amount:
 

 
 

 
 
 
 
Basic
45,476

 
43,790

 
44,804

 
43,212

Diluted
45,476

 
43,790

 
44,804

 
43,212

 
 
 
 
 
 
 
 
Basic net loss per share
$
(0.18
)
 
$
(0.42
)
 
$
(0.82
)
 
$
(0.90
)
Diluted net loss per share
$
(0.18
)
 
$
(0.42
)
 
$
(0.82
)
 
$
(0.90
)
 
 
 
 
 
 
 
 
 

11

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

The Company has excluded the impact of the following outstanding employee stock options and restricted stock units as well as the shares expected to be issued under its employee stock purchase plan from the computation of diluted net loss per share, as their effect would have been antidilutive (in thousands): 
 
September 30, 2018
 
September 30, 2017
Employee stock options
3,405

 
4,227

Restricted stock units
2,630

 
2,504

Market-based restricted stock units
665

 

Employee stock purchase plan
174

 
245

 
6,874

 
6,976

 
Note 4. Cash, cash equivalents, short-term investments, and restricted cash
 
The following table summarizes the Company’s cash, cash equivalents, short-term investments and restricted cash (in thousands): 
 
September 30,
2018
 
December 31,
2017
 
 
Cash and cash equivalents:
 
 
 
Cash
$
52,099

 
$
78,906

Cash equivalents

 

Cash and cash equivalents
$
52,099

 
$
78,906

Short-term investments
$
7,441

 
$
12,311

Restricted cash
$
5,195

 
$
2,658


 
September 30,
2018
 
December 31,
2017
 
 
Cash and cash equivalents
$
52,099

 
$
78,906

Restricted cash
5,195

 
2,658

Total cash, cash equivalents and restricted cash shown in the statement of cash flows
$
57,294

 
$
81,564


As of September 30, 2018 restricted cash primarily included approximately $2.1 million pursuant to an asset purchase agreement with APAT Optoelectronics Components Co., Ltd. (“APAT OE”) relating to the asset sale closed in January 2017, approximately $1.2 million relating to government grants received in advance and approximately $1.9 million for the compensating balances relating to the Company’s notes payable issued under its line of credit facilities in China (see Note 9). As of December 31, 2017, restricted cash primarily included approximately $2.1 million pursuant to an asset purchase agreement with APAT OE. The following table summarizes the Company’s unrealized gains and losses related to its cash equivalents and short-term investments in marketable securities designated as available-for-sale (in thousands): 
 
As of September 30, 2018
 
As of December 31, 2017
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Loss
 
Fair Value
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Loss
 
Fair Value
Marketable securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
$
7,441

 
$

 
$

 
$
7,441

 
$
11,561

 
$

 
$

 
$
11,561

U.S. government securities

 

 

 

 
751

 

 
(1
)
 
750

Total
$
7,441

 
$

 
$

 
$
7,441

 
$
12,312

 
$

 
$
(1
)
 
$
12,311

Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Short-term investments
7,441

 

 

 
7,441

 
12,312

 

 
(1
)
 
12,311

Total
$
7,441

 
$

 
$

 
$
7,441

 
$
12,312

 
$

 
$
(1
)
 
$
12,311

 

12

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

As of September 30, 2018 and December 31, 2017, maturities of marketable securities were as follows (in thousands): 
 
September 30,
2018
 
December 31,
2017
 
 
Less than 1 year
$
7,441

 
$
12,311

Due in 1 to 2 years

 

Due in 3 to 5 years

 

Total
$
7,441

 
$
12,311


Realized gains and losses on the sale of marketable securities during the three and nine months ended September 30, 2018 and 2017 were insignificant. The Company did not recognize any impairment losses on its marketable securities during the three and nine months ended September 30, 2018 or 2017. As of September 30, 2018, the Company did not have any investments in marketable securities that were in an unrealized loss position for a period in excess of 12 months.
 
Note 5.  Fair value disclosures
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table presents the Company's assets that are measured at fair value on a recurring basis (in thousands):  
 
As of September 30, 2018
 
As of December 31, 2017
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents and short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
$
7,441

 
$

 
$

 
$
7,441

 
$
11,561

 
$

 
$

 
$
11,561

U.S. government securities

 

 

 

 
750

 

 

 
750

Total
$
7,441

 
$

 
$

 
$
7,441

 
$
12,311

 
$

 
$

 
$
12,311

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts*
$

 
$

 
$

 
$

 
$

 
$

 
$

 
$

Mutual funds held in Rabbi Trust, recorded in other long-term assets
$
569

 
$

 
$

 
$
569

 
$
523

 
$

 
$

 
$
523

________________________________________________________

*The fair value of the Company’s foreign currency forward contract was immaterial as of December 31, 2017.
 
The Company offers a Non-Qualified Deferred Compensation Plan (“NQDC Plan”) to a select group of its highly compensated employees.  The NQDC Plan provides participants the opportunity to defer payment of certain compensation as defined in the NQDC Plan. A Rabbi Trust has been established to fund the NQDC Plan obligation, which was fully funded at September 30, 2018. The assets held by the Rabbi Trust are substantially in the form of exchange traded mutual funds and are included in the Company’s other long-term assets on its condensed consolidated balance sheets as of September 30, 2018 and December 31, 2017.
Effective July 1, 2016, the Company maintains a hedging program using forward exchange contracts as economic hedges, to protect against volatility of foreign exchange rate exposure when it is deemed economical to do so, based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The forward contracts are not designated for hedge accounting.
Under the hedging program, the Company enters into monthly forward exchange contracts, that have average maturities of one month, to offset the effects of exchange rate exposures for its net intercompany activities denominated in Chinese Renminbi, or RMB, by buying and selling the underlying foreign currency in the future at fixed exchange rates, to offset the consequences of changes in foreign exchange on the balance sheet. Accordingly, fair value changes in the forward contracts help mitigate the changes in the value of the re-measurement of the hedged assets and liabilities attributable to changes in foreign currency exchange rates, except to the extent of the spot-forward differences. The net effect of fair value changes is reported in other income (expense), net. The Company temporarily discontinued entering into forward exchange contracts in the quarter ended September 30, 2018, as it was uneconomical for the Company to enter into forward exchange contracts.
The following table presents the Company's liabilities that are measured at fair value on a recurring basis (in thousands): 

13

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

 
As of September 30, 2018
 
As of December 31, 2017
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Rusnano payment derivative
$

 
$

 
$
2,000

 
$
2,000

 
$

 
$

 
$
389

 
$
389

Foreign currency forward contracts

 

 

 

 

 
43

 

 
43

 
$

 
$

 
$
2,000

 
$
2,000

 
$

 
$
43

 
$
389

 
$
432

 
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

As of September 30, 2018 and December 31, 2017 the Company had no assets or liabilities required to be measured at fair value on a nonrecurring basis. In the three months ended March 31, 2017, the Company recorded a $6.7 million contingent liability within accrued and other current liabilities on its balance sheet in connection with the contingent indemnification commitments pursuant to an asset sale closed in January 2017. See Note 6. This liability was measured using the Company's best estimate of the likelihood of payment based on circumstances the Company identified as having a significant impact on its fair value during the period, which is considered to be a level 3 fair value measurement.
 
Assets and Liabilities Not Measured at Fair Value
 
The carrying values of accounts receivable, accounts payable, notes payable and short-term borrowings approximate their fair values due to the short-term nature and liquidity of these financial instruments.

The estimated fair value of the Company's long-term debt approximated its carrying value as of September 30, 2018 and December 31, 2017, as the interest rates approximated rates currently available to the Company on the issuance of liabilities with a similar maturity. This estimate is considered to be a level 2 fair value measurement.

 
Note 6. Asset sale
In January 2017, the Company completed the sale of its Low Speed Transceiver Products’ assets to APAT OE pursuant to an asset purchase agreement dated December 14, 2016 for consideration of approximately $25.0 million (in RMB equivalent) plus approximately $1.4 million (in RMB equivalent) for post-closing transaction service fees under a transition services agreement with APAT OE in which the Company provided short-term manufacturing and other specific services pursuant to such agreement. The related supply chain purchase commitments and value-added tax obligations have been assumed by APAT OE. The receivable and payable balances related to the transition service arrangement were $12.1 million and $11.8 million, respectively, as of September 30, 2018. See Note 11 for litigation and arbitration matters with APAT OE.
As of December 31, 2016, the balance in assets held for sale was $13.9 million, consisting of $13.1 million in inventories and $0.8 million in property, plant and equipment. As a result of post-closing adjustments, total consideration was reduced by approximately $3.4 million for inventory. In addition, an immaterial amount of property, plant and equipment was reclassified from assets held for sale. Upon closing, assets sold to APAT OE were approximately $12.8 million, including approximately $12.1 million in inventories and $0.7 million in property, plant and equipment. The adjusted consideration received of approximately $21.6 million is subject to further reduction of up to $10.0 million for any indemnification claims. As of September 30, 2018, the Company has a reserve of $6.8 million within accrued and other current liabilities for warranty claims. The indemnification warranties expired on June 30, 2017. The Company recognized a $2.2 million gain on the sale of these assets within the operating loss in 2017.
All of the Low Speed Transceiver Products were part of the Company’s Network Products and Solution product group and included the low speed optical network (PON) products for which the end-of-life plan was announced in mid-2016. 
 
Note 7. Balance sheet components
 
Accounts receivable, net
 
Accounts receivable, net, consists of the following (in thousands):

14

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

 
September 30, 2018
 
December 31, 2017
Accounts receivable
$
66,264

 
$
65,499

Trade notes receivable
476

 
2,356

Allowance for doubtful accounts
(120
)
 
(626
)
 
$
66,620

 
$
67,229

 
Inventories, net 

Inventories, net consist of the following (in thousands): 
 
September 30, 2018
 
December 31, 2017
Raw materials
$
26,904

 
$
33,400

Work in process
11,755

 
13,246

Finished goods(1)
18,465

 
20,655

 
$
57,124

 
$
67,301

________________________________________________________

(1)
Finished goods inventory at customer vendor managed inventory locations was $6.8 million and $7.1 million as of September 30, 2018 and December 31, 2017, respectively.

Assets held for sale

In September 2018, the Company received a non binding term sheet from Joint Stock Company Rusnano, a related party, for Joint Stock Company Rusnano group to purchase the 100% interest in the operations of NeoPhotonics Corporation, LLC, the Company's manufacturing operations in Russia. In the three and nine months ended September 30, 2018, the Company recorded additional restructuring expense of $1.0 million and $1.6 million, respectively for the Rusnano payment derivative related to these operations.

As of September 30, 2018, the Company reclassified assets with carrying value of $3.2 million as held for sale primarily consisting of $2.6 million of property, plant and equipment and $0.6 million of prepaid expenses and other current assets. The estimated fair value less direct costs of sale approximates the related carrying value. The balance for liabilities held for sale as of September 30, 2018 was immaterial and was primarily included in accrued and other current liabilities.

Prepaid expenses and other current assets
 
Prepaid expenses and other current assets consist of the following (in thousands):
 
September 30, 2018
 
December 31, 2017
Prepaid taxes and taxes receivable
$
7,167

 
$
15,162

Transition services agreement receivable (Note 6)
12,120

 
12,817

Deposits and other prepaid expenses
3,975

 
4,138

Other receivable
5,397

 
4,118

 
$
28,659

 
$
36,235


Property, plant and equipment, net

Purchases of property, plant and equipment unpaid as of September 30, 2018 and September 30, 2017 was $1.1 million and $9.7 million, respectively.

15

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)


Purchased intangible assets
 
Purchased intangible assets consist of the following (in thousands): 
 
September 30, 2018
 
December 31, 2017
 
Gross
Assets
 
Accumulated
Amortization
 
Net
Assets
 
Gross
Assets
 
Accumulated
Amortization
 
Net
Assets
 
 
 
 
 
 
Technology and patents
$
37,045

 
$
(34,833
)
 
$
2,212

 
$
37,684

 
$
(34,923
)
 
$
2,761

Customer relationships
15,123

 
(14,888
)
 
235

 
15,425

 
(14,835
)
 
590

Leasehold interest
1,240

 
(367
)
 
873

 
1,309

 
(366
)
 
943

 
$
53,408

 
$
(50,088
)
 
$
3,320

 
$
54,418

 
$
(50,124
)
 
$
4,294

 
Amortization expense relating to technology and patents and the leasehold interest intangible assets is included within cost of goods sold and customer relationships within operating expenses. The following table presents details of the amortization expense of the Company’s purchased intangible assets as reported in the condensed consolidated statements of operations (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2018
 
2017
 
2018
 
2017
Cost of goods sold
$
185

 
$
202

 
$
572

 
$
667

Operating expenses
118

 
119

 
357

 
355

Total
$
303

 
$
321

 
$
929

 
$
1,022

 
The estimated future amortization expense of purchased intangible assets as of September 30, 2018, is as follows (in thousands): 
2018 (remaining three months)
$
302

2019
855

2020
737

2021
645

2022
28

Thereafter
753

 
$
3,320

 
Accrued and other current liabilities
 
Accrued and other current liabilities consist of the following (in thousands): 
 
September 30, 2018
 
December 31, 2017
Transition services agreement payables (Note 6)
$
11,769

 
$
11,222

Employee-related
14,742

 
12,990

Asset sale related contingent liabilities (Note 6)
6,760

 
7,135

Accrued warranty
1,199

 
1,334

Deferred revenue, current
704

 
939

Income and other taxes payable
2,376

 
542

Rusnano payment derivative
2,000

 

Other accrued expenses
7,307

 
9,080

 
$
46,857

 
$
43,242

 

16

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Warranty Accrual
 
The table below summarizes the movement in the warranty accrual, which is included in accrued and other current liabilities (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2018
 
2017
 
2018
 
2017
Beginning balance
$
1,592

 
$
528

 
$
1,334

 
$
678

Warranty accruals
(42
)
 
1,047

 
487

 
1,019

Settlements
(351
)
 
(173
)
 
(622
)
 
(295
)
Ending balance
$
1,199

 
$
1,402

 
$
1,199

 
$
1,402

 
Other noncurrent liabilities
 
Other noncurrent liabilities consist of the following (in thousands): 
 
September 30, 2018
 
December 31, 2017
Pension and other employee-related
$
4,651

 
$
4,675

Deferred rent
3,023

 
2,908

Deferred revenue
112

 
617

Government grant
1,912

 
1,095

Rusnano payment derivative

 
389

Deferred income tax liabilities
63

 
106

Asset retirement obligations and other
3,627

 
4,285

 
$
13,388

 
$
14,075

 

Note 8. Restructuring
 
In 2017, the Company initiated restructuring actions in order to focus on key growth initiatives and to move towards a lower break even revenue level through lower operating expenses and manufacturing cost reductions. Actions included a reduction in force, facilities consolidation and certain asset-related adjustments. The Company recorded $0.1 million and $0.2 million in restructuring charges within cost of goods sold in the three and nine months ended September 30, 2018, respectively, and $1.1 million and $1.8 million in restructuring charges within operating expenses in the three and nine months ended September 30, 2018, respectively. The Company recorded $3.1 million and $4.1 million in restructuring charges within cost of goods sold and operating expenses in the three and nine months ended September 30, 2017. Restructuring activities for the nine months ended September 30, 2018 were as follows (in thousands):
 
Employee Severance
 
Facilities Consolidation
 
Others
 
Total
Restructuring obligations December 31, 2017
$

 
$
1,580

 
$
43

 
$
1,623

Charges
269

 

 
1,704

 
1,973

Cash payments
(147
)
 
(640
)
 
(43
)
 
(830
)
Non-cash settlements and others

 

 
(94
)
 
(94
)
Restructuring obligations September 30, 2018
$
122

 
$
940

 
$
1,610

 
$
2,672

The current restructuring liability reported in Accrued and other current liabilities in the Condensed Consolidated Balance Sheets as of September 30, 2018 was $2.6 million. The non-current restructuring liability reported in other noncurrent liabilities in the Condensed Consolidated Balance Sheets as of September 30, 2018 was $0.1 million.


17

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 9. Debt
 
The table below summarizes the carrying amount and weighted average interest rate of the Company’s debt (in thousands, except percentages):  
 
September 30, 2018
 
December 31, 2017
 
Carrying
Amount
 
Interest
Rate
 
Carrying
Amount
 
Interest
Rate
 
 
 
 
Note payable to Shanghai Pudong Development Bank
$

 


 
$
17,000

 
4.10
%
Note payable to China CITIC Bank

 


 
17,000

 
4.00
%
Notes payable to suppliers
3,634

 

 
1,607

 
 
Total notes payable and short-term borrowing
$
3,634

 
 

 
$
35,607

 
 

 
 
 
 
 
 
 
 
Long-term debt, current and non-current:
 

 
 

 
 

 
 

Borrowing under Wells Fargo Credit Facility
$
35,630

 
4.51
%
 
$
30,018

 
3.29
%
Mitsubishi Bank loans
11,206

 
1.05% -1.45%

 
16,924

 
1.05% -1.45%

Mitsubishi Bank and Yamanashi Chou Bank loan
6,942

 
1.1
%
 

 
 
Unaccreted discount and issuance costs within current portion of long-term debt
(161
)
 
 

 
(86
)
 
 

Unaccreted discount and issuance costs within long-term debt, net of current portion
(463
)
 
 

 
(295
)
 
 

Total long-term debt, net of unaccreted discount and issuance costs
$
53,154

 
 

 
$
46,561

 
 

 
 
 
 
 
 
 
 
Reported as:
 

 
 

 
 

 
 

Current portion of long-term debt
$
2,798

 
 

 
$
6,005

 
 

Long-term debt, net of current portion
50,356

 
 

 
40,556

 
 

Total long-term debt, net of unaccreted discount and issuance costs
$
53,154

 
 

 
$
46,561

 
 

 
Notes payable and short-term borrowing
 
The Company regularly issues notes payable to its suppliers in China. These notes are supported by non-interest bearing bank acceptance drafts issued under the Company’s existing line of credit facilities and are due three to six months after issuance. As a condition of the notes payable arrangements, the Company is required to keep a compensating balance at the issuing banks that is a percentage of the total notes payable balance until the amounts are settled. As of September 30, 2018, the Company’s subsidiary in China had three line of credit facilities with the following banking institutions:

Under the first line of credit facility with Shanghai Pudong Development Bank, the Company can borrow up to RMB 120.0 million ($17.5 million) for short-term loans at varying interest rates, or up to approximately RMB 240.0 million ($34.9 million) for bank acceptance drafts (with up to 50% compensating balance requirement). This line of credit facility expires in July 2019. In November 2017, the Company borrowed $17.0 million under this line which bore interest at 4.1%. The amount of $17.0 million under this line was repaid in May 2018.

Under the second line of credit facility with Shanghai Pudong Development Bank, which expires in July 2019, the Company can borrow up to RMB 30.0 million ($4.4 million) for short-term loans at varying interest rates, or up to approximately RMB 60.0 million ($8.7 million) for bank acceptance drafts (with up to 50% compensating balance requirement).

In December 2017, the Company's subsidiary in China entered into a third line of credit facility with China CITIC Bank in China, which expires in November 2018. The purpose of the credit facility is to provide short-term borrowings, bank acceptance drafts and letters of credits. Under this credit facility, the Company can borrow up to approximately RMB 250 million ($36.4 million) at varying interest rates, or up to approximately RMB 390.6 million ($56.9 million) for bank acceptance drafts (with up to 36% compensating balance requirement). In February 2018, the Company borrowed $17.0 million under this line which bore interest at 4.7%. The amount of $17.0 million under this line was repaid in August 2018.

18

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

The Company had a line of credit facility previously with China CITIC Bank in China which expired during September 2017. In July 2017, the Company borrowed $17.0 million under this line which bears interest at LIBOR plus 2.55%. The amount of $17.0 million under this line was repaid to CITIC Bank in January 2018.
Under these line of credit facilities, the non-interest bearing bank acceptance drafts issued in connection with the Company’s notes payable to its suppliers in China, had an outstanding balance of $3.6 million and $1.6 million as of September 30, 2018 and December 31, 2017, respectively. In addition to the outstanding notes payable, three letters of credit totaling $1.6 million were issued to its suppliers in 2016 for equipment purchases delivered by December 2016. These letters of credit required a 30% compensating balance. As of December 31, 2016, the outstanding balance of these letters of credit was immaterial and was fully repaid as of December 31, 2017.
As of September 30, 2018 and December 31, 2017, compensating balances relating to these bank acceptance drafts and letters of credit issued to suppliers and the Company’s subsidiaries totaled $1.9 million and $0.5 million, respectively. Compensating balances are classified as restricted cash on the Company’s condensed consolidated balance sheets.
In China, when there is a case pending in judicial court, banks may choose to limit borrowing against existing credit lines, regardless of the legitimacy of the case. The Company has a dispute pending with APAT OE in judicial court (See Note 11). The Company does not expect to make any additional draws against its credit facilities in China until this matter is resolved. 
 
Credit facilities
The Company had a credit agreement, as amended, with Comerica Bank as lead bank in the U.S. (the “Comerica Bank Credit Facility”) with a borrowing capacity of up to $30.0 million. In January 2017, the Company amended the Comerica Bank Credit Facility to extend the maturity to April 30, 2017 and to remove the covenant related to EBITDA. In April 2017, the Company amended the Comerica Bank Credit Facility to extend the maturity date to July 31, 2017 and to add a financial covenant that required maintenance of a modified EBITDA. In June 2017, the Company amended the Comerica Bank Credit Facility to extend the maturity to August 31, 2017, to allow NeoPhotonics China to borrow up to $17.0 million, to limit the indebtedness under the facility to $20.0 million and to modify the EBITDA requirement. In August 2017, the Credit Facility was further amended to extend the maturity to September 30, 2017. Borrowings under the Comerica Bank Credit Facility bore interest at an interest rate option of a base rate as defined in the agreement plus 1.75% or LIBOR plus 2.75%. The base rate was the greater of (a) the effective prime rate, (b) the Federal Funds effective rate plus one percent, and (c) the daily adjusting LIBOR rate plus one percent.
In September 2017, the Company entered into a revolving line of credit agreement with Wells Fargo Bank, National Association ("Wells Fargo") as the administrative agent for a lender group (the "Wells Fargo Credit Facility" or "Credit Facility"), and the amount outstanding under the Comerica Bank Credit Facility was paid in full.
The Wells Fargo Credit Facility provides for borrowings equal to the lower of (a) a maximum revolver amount of $50.0 million, or (b) an amount equal to 80% - 85% of eligible accounts receivable plus 100% of qualified cash balances up to $15.0 million, less certain discretionary adjustments ("Borrowing Base"). The maximum revolver amount may be increased by up to $25.0 million, subject to certain conditions. At closing, $50.0 million was available, of which $30.0 million was drawn. The Company used $20.0 million of this amount to pay the principal and interest due under the Comerica Bank Credit Facility, which has since been terminated.
The Credit Facility matures on June 30, 2022 and borrowings bear interest at an interest rate option of either (a) the LIBOR rate, plus an applicable margin ranging from 1.50% to 1.75% per annum, or (b) the prime lending rate, plus an applicable margin ranging from 0.50% to 0.75% per annum.  The Company is also required to pay a commitment fee equal to 0.25% of the unused portion of the Credit Facility.

19

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

The Credit Facility agreement ("Agreement") requires prepayment of the borrowings to the extent the outstanding balance is greater than the lesser of (a) the most recently calculated Borrowing Base, or (b) the maximum revolver amount. The Company is required to maintain a combination of certain defined cash balances and unused borrowing capacity under the Credit Facility of at least $20.0 million, of which at least $5.0 million shall include unused borrowing capacity. The Agreement also restricts the Company's ability to dispose of assets, permit change in control, merge or consolidate, make acquisitions, incur indebtedness, grant liens, make investments and make certain restricted payments. Borrowings under the Credit Facility are collateralized by substantially all of the Company's assets. The Company was in compliance with the covenants of this Credit Facility as of September 30, 2018. As of September 30, 2018, the outstanding balance under the Credit Facility was $35.6 million and the weighted average rate under the LIBOR option was 4.51%. The remaining borrowing capacity as of September 30, 2018 was $14.4 million, of which $5.0 million is required to be maintained as unused borrowing capacity. The Company repaid $5.0 million in October 2018, which was borrowed in September 2018.
  
Mitsubishi Bank loans
On February 25, 2015, the Company entered into certain loan agreements and related agreements with the Bank of Tokyo-Mitsubishi UFJ, Ltd. (the “Mitsubishi Bank”) that provided for (i) a term loan in the aggregate principal amount of 500 million JPY ($4.4 million) (the “Term Loan A”) and (ii) a term loan in the aggregate principal amount of one billion JPY ($8.8 million) (the “Term Loan B” and together with the Term Loan A, the “2015 Mitsubishi Bank Loans”). The Mitsubishi Bank Loans are secured by a mortgage on certain real property and buildings owned by the Company’s Japanese subsidiary. Interest on the 2015 Mitsubishi Bank Loans accrues and is paid monthly based upon the annual rate of the monthly Tokyo Interbank Offer Rate (TIBOR) plus 1.40%. The Term Loan A required interest only payments until the maturity date of February 23, 2018, with a lump sum payment of the aggregate principal amount on the maturity date. The Term Loan B requires equal monthly payments of principal equal to 8,333,000 JPY until the maturity date of February 25, 2025, with a lump sum payment of the balance of 8,373,000 JPY on the maturity date. Interest on the Term Loan B is accrued based upon monthly TIBOR plus 1.40% and is secured by real estate collateral. In conjunction with the execution of the Bank Loans, the Company paid a loan structuring fee, including consumption tax, of 40,500,000 JPY ($0.4 million). The Term Loan A of 500 million JPY (approximately $4.4 million) was repaid to the Mitsubishi Bank in January 2018.

The 2015 Mitsubishi Bank Loans contain customary representations and warranties and customary affirmative and negative covenants applicable to the Company’s Japanese subsidiary, including, among other things, restrictions on cessation in business, management, mergers or acquisitions. The 2015 Mitsubishi Bank Loans contain financial covenants relating to minimum net assets, maximum ordinary loss and a dividends covenant. Outstanding principal balance for Term Loan B and unamortized debt issuance costs were approximately 641.7 million JPY (approximately $5.6 million) and 71.0 million JPY (approximately $0.6 million), respectively, as of September 30, 2018. The Company was in compliance with the related covenants as of September 30, 2018 and December 31, 2017.
 
In March 2017, the Company entered into a loan agreement and related agreements with the Mitsubishi Bank for a term loan of 690 million JPY (approximately $6.1 million) (the “2017 Mitsubishi Bank Loan”) to acquire manufacturing equipment for its Japanese subsidiary. This loan is secured by the manufacturing equipment acquired from the loan proceeds. Interest on the 2017 Mitsubishi Bank Loan is based on the annual rate of the monthly TIBOR rate plus 1.00%. The 2017 Mitsubishi Bank Loan matures on March 29, 2024 and requires monthly interest and principal payments over 72 months commencing in April 2018. The loan contains customary covenants relating to minimum net assets, maximum ordinary loss and a dividends covenant. The Company was in compliance with these covenants as of September 30, 2018. The loan was available from March 31, 2017 to March 30, 2018 and 690 million JPY (approximately $6.1 million) under this loan was fully drawn in March 2017.

Mitsubishi Bank and Yamanashi Chou Bank loan

In January 2018, the Company entered into a term loan agreement with Mitsubishi Bank and The Yamanashi Chou Bank, Ltd. for a term loan in the aggregate principal amount of 850 million JPY (approximately $7.5 million) (the “Term Loan C”).  The purpose of the Term Loan C is to obtain machinery for the core parts of the manufacturing line and payments for related expenses by the Company's subsidiary in Japan. The Term Loan C is secured by the assets owned by the Company's subsidiary in Japan. The Term Loan C was available from January 29, 2018 to January 29, 2025.  The full amount of the Term Loan C was drawn in January 2018. Interest on the Term Loan C is based upon the annual rate of the three months TIBOR rate plus 1.00%. The Term Loan C requires quarterly interest payments, along with the principal payments, over 82 months commencing in April 2018. The Term Loan C loan agreement contains customary representations and warranties and customary affirmative and negative covenants applicable to the Japanese Subsidiary, including, among other things, restrictions on

20

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

cessation in business, management, mergers or acquisitions. The Term Loan C loan agreement contains financial covenants relating to minimum net assets and maximum ordinary loss. The Company was in compliance with these covenants as of September 30, 2018.
 
As of September 30, 2018, maturities of total long-term debt were as follows (in thousands):
2018 (remaining three months)
$
740

2019
2,959

2020
2,959

2021
2,959

2022
38,589

Thereafter
5,572

 
$
53,778


Note 10. Japan pension plan
 
The pension liability related to the Company’s Retirement Allowance Plan (“RAP”) in Japan as of September 30, 2018 was $4.1 million which was recorded in other noncurrent liabilities on the Company’s condensed consolidated balance sheet. The pension liability related to the Company’s RAP in Japan as of December 31, 2017 was $4.6 million, of which $0.5 million, was recorded in accrued and other current liabilities and the remainder in other noncurrent liabilities on the Company’s condensed consolidated balance sheet.
 
Net periodic pension cost associated with this plan was immaterial in the three and nine months ended September 30, 2018 and 2017.  

Note 11. Commitments and contingencies
Litigation
From time to time, the Company is subject to various claims and legal proceedings, either asserted or unasserted, that arise in the ordinary course of business. The Company accrues for legal contingencies if the Company can estimate the potential liability and if the Company believes it is probable that the case will be ruled against it. If a legal claim for which the Company did not accrue is resolved against it, the Company would record the expense in the period in which the ruling was made. The Company believes that the likelihood of an ultimate amount of liability, if any, for any pending claims of any type (alone or combined) that will materially affect the Company’s financial position, results of operations or cash flows is remote. The ultimate outcome of any litigation is uncertain, however, and unfavorable outcomes could have a material negative impact on the Company’s financial condition and operating results. Regardless of outcome, litigation can have an adverse impact on the Company because of defense costs, negative publicity, diversion of management resources and other factors.
On January 5, 2010, Finisar Corporation, or Finisar, filed a complaint in the U.S. District Court for the Northern District of California, or the Court, against Source Photonics, Inc., MRV Communications, Inc., Oplink Communications, Inc. and the Company, or collectively, the co-defendants. In the complaint Finisar alleged infringement of certain of its U.S. patents. In 2010 the Company filed an answer to the complaint and counterclaims, asserting two claims of patent infringement and additional claims. The Court dismissed without prejudice all co-defendants (including the Company) except Source Photonics, Inc., on grounds that such claims should have been asserted in four separate lawsuits, one against each defendant. This dismissal does not prevent Finisar from bringing a new similar lawsuit against the Company. In 2011 the Company and Finisar agreed to suspend their respective claims and in 2012 the Company and Finisar further agreed to toll their respective claims. While there has been no action on this matter since 2012, the Company is currently unable to predict the outcome of this dispute and therefore cannot determine the likelihood of loss nor estimate a range of possible loss.
On December 27, 2016 the Company was served with a lawsuit filed by Lestina International Ltd. (“Lestina”), in Santa Clara County, CA. The lawsuit is regarding a dispute of approximately $3.0 million related to purchase orders for the Company’s Low Speed Transceiver Products that was soon thereafter sold by the Company to APAT OE in January 2017. The purchase orders in question were included in the asset sale and were assumed liabilities by the purchaser of the business. The Company is unable to predict with certainty the outcome of this matter, but is seeking to resolve the matter either through a court dismissal of the action or a resolution with the plaintiff and/or the purchaser of the Low Speed Transceiver Products’

21

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

assets. Discovery is currently in process. Because the purchase orders in question were an assumed liability of the Low Speed Transceiver Products’ assets that were transferred to the purchaser, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations or cash flows. A trial date is currently scheduled for January 14, 2019.

On April 21, 2018, APAT OE filed a lawsuit in the Qianhai Court in Shenzhen, China against NeoPhotonics (China) Co., Ltd. ("NeoChina"), NeoPhotonics Corporation and NeoPhotonics Dongguan Co. Ltd. The lawsuit is in reference to the sale of the low speed transceiver business to APAT OE from NeoChina. APAT OE claims that the business has been losing money and that APAT OE was not given all of the information about the business they purchased prior to signing the Asset Purchase Agreement. On May 28, 2018, counsel on behalf of NeoChina filed a motion objecting to the jurisdiction, claiming that the proper jurisdiction for any dispute between these parties is the Shenzhen Court of International Arbitration and the proper parties to this dispute are NeoChina and APAT OE, pursuant to the Asset Purchase Agreement signed by APAT OE and NeoChina. On June 20, 2018 a hearing was held in the Qianhai Court in Shenzhen, China. The Court ruled in favor of APAT OE. NeoChina has filed an appeal which will be heard in the Intermediate Court of Shenzhen; however, a court date has not yet been scheduled. On October 10, 2018, a hearing was held in the Intermediate Court of Shenzhen which was filed by NeoChina. At that hearing arguments were heard regarding the proper jurisdiction for all disputes between NeoChina and APAT OE. NeoChina argued that all disputes between the parties should be decided in the Shenzhen Court of Arbitration per the Asset Purchase Agreement between the parties. APAT OE argued that the Qianhai Court is the appropriate jurisdiction. The Company is unable to predict the outcome of this matter.
APAT Arbitration
On June 16, 2017, APAT OE filed an arbitration claim against NeoChina (the Company’s China subsidiary), claiming that approximately $1.5 million of the inventory that was sold to APAT OE by NeoChina in an Asset Purchase Agreement executed between the parties on December 14, 2016 was aged inventory and of no value. The arbitration was heard in the Shenzhen Court of International Arbitration on August 2, 2017.  On October 25, 2017, NeoChina was informed that it was successful in the defense of the dispute and was also successful in its counterclaim against APAT OE.  NeoChina was awarded approximately RMB700,000 (approximately USD $110,000) in compensatory damages and attorney fees as well as having the approximately $1.5 million claim against it rejected in its entirety.
On or about May 1, 2018, APAT OE filed a Notice of Judicial Review of the arbitration judgment in the Shenzhen Intermediate Court in Shenzhen, China.  The case was heard on May 29, 2018, and NeoChina was successful in disputing the Judicial Review, which means that the arbitration judgment against APAT OE and in favor of NeoChina stands. Although APAT OE continues to dispute this matter through the lawsuit as described in the above litigation section, the Company and its affiliates continue to argue that the proper jurisdiction for any dispute in reference to the low speed transceiver business purchased by APAT OE is the Shenzhen Court of International Arbitration.
Indemnifications
In the normal course of business, the Company enters into agreements that contain a variety of representations and warranties and provide for general indemnification. The Company’s exposure under these agreements is unknown because it involves claims that may be made against the Company in the future, but have not yet been made. To date, the Company has not paid any claims or been required to defend any action related to its indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.
In November 2016, Oyster Communications, Inc. filed nine patent lawsuits against several defendants in the U.S. District Court for the Eastern District of Texas, including one against Cisco Systems, Inc. ("Cisco"). One defendant successfully transferred their case to the U.S. District Court for the Northern District of California. Additional defendants requested venue changes are still pending. The Company was not named as a defendant in any of the lawsuits. In July 2017, Cisco notified the Company that it would be seeking indemnification from the Company for claims against Cisco arising from the lawsuits and the parties engaged in discussions and negotiations. In September 2018, the Company and Cisco signed a settlement agreement under which the Company agreed to pay to Cisco $300,000 to be paid by January 31, 2019 and $150,000 in product credits to be applied during calendar year 2019. This settlement resolves Cisco's indemnification claims against the Company in this matter.
Leases
The Company leases various facilities under non-cancelable operating leases expiring through 2027. As of September 30, 2018, future minimum payments under these operating leases totaled approximately $27.8 million and future minimum

22

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

sublease receipts were approximately $1.4 million. Rent expense was $1.1 million and $3.2 million in the three and nine months ended September 30, 2018 and $1.3 million and $3.5 million in the three and nine months ended September 30, 2017.
On June 13, 2017, the Company entered into an office lease for approximately 39,000 square feet for the Company’s current headquarters in San Jose, California (the “2017 Lease”) with a commencement date of June 1, 2017. The Company’s existing office lease for the facility was terminated and replaced by the 2017 Lease. Upon commencement, the 2017 Lease had an initial term of one hundred and twenty-three (123) months, ending September 30, 2027, (the “02017 Lease Initial Term”) with a monthly rental rate of $41,388, escalating annually to a maximum monthly rental rate of approximately $72,525 in the last year of the 2017 Lease Initial Term. Upon termination of the 2017 Lease, the Company anticipates a restoration cost of approximately $0.7 million
In September 2016, the Company entered into an office lease for approximately 64,000 square feet of office and laboratory space located adjacent to the Company’s current headquarters in San Jose, California (the “2016 Lease”). The term of the 2016 Lease commenced on January 1, 2017. Upon commencement, the 2016 Lease has an initial term of one hundred and twenty-nine (129) months, ending on September 30, 2027 (the “2016 Lease Initial Term”), with a monthly rental rate of $144,000, escalating annually to a maximum monthly rental rate of approximately $194,000 in the last year of the 2016 Lease Initial Term. The Landlord has agreed to provide the office and laboratory space to the Company free of charge for the first nine months of the 2016 Lease Initial Term through September 30, 2017. Upon termination of the 2016 Lease, the Company anticipates a restoration cost of approximately $3.1 million.
Penalty Payment Derivative
In connection with a private placement transaction with Joint Stock Company “Rusnano” (formerly Open Joint Stock Company “RUSNANO”), or Rusnano, in 2012, the Company agreed to certain performance obligations including establishing a wholly-owned subsidiary in Russia and making a $30.0 million investment commitment (the “Investment Commitment’) towards the Company’s Russian operations, which could be partially satisfied by cash and/or non-cash investment inside or outside of Russia and/or by way of non-cash asset transfers.
The Rights Agreement, as amended in 2015 (the “Amended Rights Agreement”) limits the maximum amount of penalties and/or exit fee (the “Rusnano Payment”) to be paid by the Company to $5.0 million in the aggregate and allows such payment to be reduced when certain milestones are met over time.  The Amended Rights Agreement also provides for an updated investment plan for the Company’s Russian subsidiaries that includes non-cash transfer of licensing rights to intellectual property, non-cash transfers of existing equipment and commitments to complete the remaining investment milestones through 2019. The Company fulfilled its investment commitment required by 2016 and had contributed over $21.0 million in cash and assets to its subsidiaries in Russia as of December 31, 2016.

As of September 30, 2018, the remaining Investment Commitment was approximately $7.5 million to be invested at any time on or before December 31, 2019. At any point between September 30, 2018 and December 31, 2019, the Company may elect to pay a $2.0 million exit fee to terminate any remaining obligations associated with the Investment Commitment.

In August 2016, the Company entered into a letter of agreement with Rusnano to agree to transfer a 10G SFP+ transceiver product line and incur expected costs of approximately $0.1 million, by July 30, 2017, which will not be counted toward the Company’s overall Investment Commitment. Since the asset sale of the Company’s Low Speed Transceiver Products was completed in January 2017, the Company may undertake an alternative path for spending such amount to be discussed and agreed between the parties.
Rusnano has non-transferable veto rights over the Company’s Russian subsidiaries’ annual budget during the investment period and must approve non-cash asset transfers to be made in satisfaction of the Investment Commitment.  The Company accounted for the Rusnano Payment as an embedded derivative instrument.  The fair value of the Penalty Payment derivative has been estimated at the date of the original common stock sale (April 27, 2012) and at each subsequent balance sheet date using a probability-weighted discounted future cash flow approach using unobservable inputs, which are classified as Level 3 within the fair value hierarchy. The primary inputs for this approach include the probability of achieving the Investment Commitment and a discount rate that approximates the Company’s incremental borrowing rate. After the initial measurement, changes in the fair value of this derivative are recorded in other income (expense), net. The estimated fair value of this derivative was $2.0 million as of September 30, 2018 and $0.4 million as of December 31, 2017. As of September 30, 2018, and December 31, 2017, the derivative was reported within Accrued and other current liabilities and other noncurrent liabilities, respectively on the Company’s condensed consolidated balance sheets. See Note 7.
 

23

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 12. Stockholders’ equity
 
Common Stock
 
As of September 30, 2018, the Company had reserved 7,857,810 common stock for issuance under its equity incentive plans and 644,187 common stock shares for issuance under its employee stock purchase plan.
Accumulated Other Comprehensive Income (loss)
The components of accumulated other comprehensive income (loss), net of related taxes, were as follows (in thousands):
 
Foreign Currency Translation Adjustments
 
Unrealized Gain (Loss) on Available-For-Sale Securities
 
Defined Benefit Pension Plan Adjustment
 
Total Accumulated Other Comprehensive Income (loss)
Balance as of December 31, 2017
$
567

 
$
(1
)
 
$
(168
)
 
$
398

Other comprehensive income (loss), net of taxes of zero and reclassifications
(7,968
)
 
1

 

 
(7,967
)
Balance as of September 30, 2018
$
(7,401
)
 
$

 
$
(168
)
 
$
(7,569
)
 
No material amounts were reclassified out of accumulated other comprehensive income during the three and nine months ended September 30, 2018 and 2017 for realized gains or losses on available-for-sale securities.
  
Accumulated Deficit
Approximately $8.8 million of the Company’s retained earnings within its total accumulated deficit as of December 31, 2017 was subject to restriction due to the fact that the Company’s subsidiaries in China are required to set aside at least 10% of their respective accumulated profits each year end to fund statutory common reserves as well as allocate a discretional portion of their after-tax profits to their staff welfare and bonus fund.

24

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 13. Stock-based compensation
 
The following table summarizes the stock-based compensation expense recognized in the three and nine months ended September 30, 2018 and 2017 (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2018
 
2017
 
2018
 
2017
Cost of goods sold
$
553

 
$
340

 
$
1,832

 
$
811

Research and development
1,016

 
606

 
2,618

 
1,779

Sales and marketing
931

 
393

 
2,511

 
1,170

General and administrative
1,541

 
595

 
3,566

 
1,932

 
$
4,041

 
$
1,934

 
$
10,527

 
$
5,692

 
Determining Fair Value 
The Company estimated the fair value of certain stock-based awards using a Black-Scholes-Merton valuation model with the following assumptions:  
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
Stock options
2018
 
2017
 
2018
 
2017
Weighted-average expected term (years)
0.00
 
6.00
 
6.02
 
6.00
Weighted-average volatility
—%
 
65%
 
65%
 
65%
Risk-free interest rate
—%
 
2.02%
 
2.27%-2.62%
 
2.02%-2.08%
Expected dividends
—%
 
—%
 
—%
 
—%
Stock appreciation units
 
 
 
 
 
 
 
Weighted-average expected term (years)
1.87
 
2.20
 
1.99
 
2.30
Weighted-average volatility
65%
 
71%
 
66%
 
71%
Risk-free interest rate
1.73%-2.52%
 
1.03%-1.55%
 
1.03%-2.52%
 
0.51%-1.55%
Expected dividends
—%
 
—%
 
—%
 
—%
ESPP
 
 
 
 
 
 
 
Weighted-average expected term (years)
0.00
 
0.00
 
0.71
 
0.67
Weighted-average volatility
—%
 
—%
 
61%
 
55%
Risk-free interest rate
—%
 
—%
 
1.20%-1.93%
 
0.45%-0.91%
Expected dividends
—%
 
—%
 
—%
 
—%
  
Stock Options and Restricted Stock Units (RSUs)
 
The following table summarizes the Company’s stock option and RSU activity, excluding market-based RSUs, during the nine months ended September 30, 2018:
 
 
Stock Options
 
Restricted Stock Units
 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Number of
Units
 
Weighted
Average
Grant Date
Fair Value
 
 
 
 
Balance as of December 31, 2017
3,933,529

 
$
5.55

 
2,404,637

 
$
9.02

Granted
158,116

 
6.64

 
1,355,262

 
6.80

Exercised/Converted
(591,322
)
 
4.33

 
(915,713
)
 
9.02

Cancelled/Forfeited
(95,251
)
 
10.24

 
(214,048
)
 
8.80

Balance as of September 30, 2018
3,405,072

 
5.68

 
2,630,138

 
7.89


25

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Market-based Restricted Stock Units

In July 2018, the Company granted 665,000 shares of market-based RSUs to certain employees. These RSUs will vest if the 30-day weighted average closing price of the Company's common stock is equal to or greater than certain price targets per share and the recipients remain in continuous service with the Company through such service period. No market-based RSUs were vested/cancelled during 2018.

The weighted average grant-date fair value per share of market-based RSUs granted during 2018 was approximately $5.82 per share. The fair value of market-based RSUs was measured on the grant date using Monte Carlo simulation model with the following assumptions:

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
Market-based restricted stock units
2018
 
2017
 
2018
 
2017
Weighted-average volatility
66%
 
—%
 
66%
 
—%
Risk-free interest rate
2.79%
 
—%
 
2.79%
 
—%
Expected dividends
—%
 
—%
 
—%
 
—%

Stock Appreciation Units (SAU)
 
SAUs are liability classified share-based awards. Outstanding SAUs are re-measured each reporting period at fair value until settlement.  The Company did not grant any SAUs during the three and nine months ended September 30, 2018 or 2017. As of September 30, 2018 and December 31, 2017, there were 213,205 and 239,824 SAUs outstanding, respectively, and related SAU liabilities were $1.0 million and $0.8 million, respectively.  

Employee Stock Purchase Plan (ESPP)
As of September 30, 2018, there was $0.1 million of unrecognized stock-based compensation expense for employee stock purchase rights that will be recognized over the remaining offering period through November 2018.  
 
Note 14. Income taxes
The income tax (provision) benefit for income taxes in the periods presented is based upon the income (loss) before income taxes (in thousands):   
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2018
 
2017
 
2018
 
2017
Income tax (provision) benefit
$
(291
)
 
$
1,195

 
$
(2,009
)
 
$
1,813

 
The Company’s income tax (provision) benefit in the three and nine months ended September 30, 2018 and 2017 was primarily related to income taxes of the Company’s non-U.S. operations.
 
The Company conducts its business globally and its operating income is subject to varying rates of tax in the U.S., China and Japan. Consequently, the Company’s effective tax rate is dependent upon the geographic distribution of its earnings or losses and the tax laws and regulations in each geographical region. Historically, the Company has experienced net losses in the U.S. and in the short term, expects this trend to continue.
 
Due to historical losses in the U.S., the Company has a full valuation allowance on its U.S. federal and state deferred tax assets. Management continues to evaluate the realizability of deferred tax assets and the related valuation allowance. If management's assessment of the deferred tax assets or the corresponding valuation allowance were to change, the Company would record the related adjustment to income during the period in which management makes the determination.

On December 22, 2017, the U.S. President signed into U.S. law the Tax Cuts and Jobs Act of 2017 ("Tax Reform"). The new legislation, among other provisions, lowered the corporate tax rate from 35% to 21%. The SEC staff issued Staff Accounting Bulletin 118 (“SAB 118”) which provides guidance on accounting for the tax effects of the Tax Reform. SAB 118

26

NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

provides a measurement period that should not extend beyond one year from the Tax Reform enactment date for companies to complete the accounting under ASC 740, Income Taxes. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Reform for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Reform is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Reform. The Company expects to complete its analysis within the measurement period in accordance with SAB 118.

The Company adopted ASU 2016-16 on a modified retrospective basis effective January 1, 2018. Upon adoption of this standard on January 1, 2018, the Company recorded $1.8 million to accumulated deficit balance for intra-entity transfer of an asset other than inventory in prior years.

As of September 30, 2018, there were no material changes to either the nature or the amounts of the uncertain tax positions previously determined for the year ended December 31, 2017.
Note 15. Subsequent events
In October 2018, the Company repaid $5.0 million to Wells Fargo under the Credit Facility.


27


ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q for the period ended September 30, 2018 and the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2017 included in our Annual Report on Form 10-K. References to “NeoPhotonics,” “we,” “our,” and “us” are to NeoPhotonics Corporation unless otherwise specified or the context otherwise requires.
This Quarterly Report on Form 10-Q for the period ended September 30, 2018 contains “forward-looking statements” that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. The statements contained in this Quarterly Report on Form 10-Q for the period ended September 30, 2018 that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Terminology such as “believe,” “may,” “might,” “objective,” “estimate,” “continue,” “anticipate,” “intend,” “should,” “plan,” “expect,” “predict,” “potential,” or the negative of these terms or other similar expressions is intended to identify forward-looking statements.
We have based these forward-looking statements largely on our current expectations and projections about future events and industry and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified in “Part II —Item 1A. Risk Factors” below, and those discussed in the sections titled “Special Note Regarding Forward-Looking Statements” and “Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the SEC on March 9, 2018.  Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
Business Overview
 
We develop, manufacture and sell optoelectronic products that transmit, receive, modify and switch high speed digital optical signals for communications networks and related applications. Our products address the highest speed over distance applications and are designed for 100G and beyond data rates, such as at 200G, 400G, 600G and coming Terabit per second rates for telecom and hyper-scale data center, or content provider, networks. We sell our products to the world’s leading network equipment manufacturers, including Ciena Corporation ("Ciena"), Cisco Systems, Inc., Fiberhome Technologies, Ltd. ("Fiberhome"), Huawei Technologies Co., Ltd. and its affiliate HiSilicon Technologies, Ltd. (collectively “Huawei”) and Nokia (formerly Alcatel-Lucent, which was acquired by Nokia in January 2016). These companies are among our largest customers and a focus of our strategy due to their leading market positions.

Over the last decade we have been a consistent technology innovator in high speed digital optics products and applications, steadily introducing new capabilities and solutions that enable leading market positions for our customers and for our products that they use.
 
We have research and development and wafer fabrication facilities in San Jose and Fremont, California and in Tokyo, Japan that coordinate with our research and development and manufacturing facilities in Dongguan, Shenzhen and Wuhan, China and Ottawa, Canada. We use proprietary design tools and design-for-manufacturing techniques to align our design process with our precision nanoscale, vertically integrated manufacturing and testing. Today, we believe we are one of the highest volume photonic integrated circuit ("PIC") manufacturers in the world.

Our High Speed Products for data rates of 100G, 200G, 400G and beyond use our Advanced Hybrid Photonic Integration technology. These products using our advanced technology are the core focus of our strategy, and we believe that they are an important competitive differentiator. Our strategic focus on high speed components and coherent solutions recognizes the explosion of optics in converged edge network applications and we are expanding to new markets ranging from data centers to cable television to autonomous vehicle navigation. We align our product group reporting to “High Speed Products”, which includes products designed for 100G and beyond communications applications, and “Network Products and Solutions,” which comprises all products designed for applications that do not have data rates at or above 100G.

28



For coherent transport from data center interconnect through long-haul, we are a vertically integrated designer and manufacturer of the highest speed optical components which we sell to the merchant market and which we incorporate into our own module level products. For applications inside the data center, we are focused on supplying the highest value laser, receiver and optical IC solutions to the merchant market. As disaggregation of optical equipment continues to gain momentum, we believe that high performance merchant components capability will be an increasingly important differentiator.

We recently introduced a number of new products for 400G and 600G systems. We see strength in our design wins, most notably across all three of our leading coherent components, including our ultra-narrow linewidth tunable laser, 400G and 600G micro coherent driver-modulator and coherent receiver. Our ultra-narrow linewidth lasers are a critical element in achieving these speeds because they have the narrowest linewidth and minimal phase noise for the higher order modulation schemes - or data coding methods - that are required. Our laser, receiver and modulator work together to enable the highest performance solutions and we offer them as both a full solution and as discrete elements to customers who demand the highest performance and whose systems operate at the highest data rates. We are currently shipping these products to customers to meet their system development needs and we are now ramping manufacturing volumes as 400G and 600G demands grow.

Our coherent module solutions leverage our high performance and high speed components. Our CFP-DCO 100G coherent module is shipping to customers deploying links in metro networks and switch/router connection applications where high signal clarity is key. We further demonstrated at OFC in March 2018 our 400G coherent OSFP module for 400G point to point links over 80 km data center interconnect distances.

Our new client side and data center product offerings are focused on 400G applications. Our 53GBaud Linear Optical Component product family includes PAM4 capable optical components for 100G and 400G cloud data center and other client applications, including drivers and EML lasers for transmitters plus photodetectors and trans-impedance amplifiers for receivers. These provide the optical content necessary for single wavelength 100G PAM4 and four wavelength 400G PAM4 transceivers for 2-10km distances inside data centers, such as DD-QSFP and OSFP. We have also introduced high-power, non-hermetic laser optical sources for shorter reach 100G and 400G Silicon Photonics based transceivers for data center applications.

While supporting our customers' current needs with these advanced components, we are also preparing for their next generation needs by taking steps to integrate and reduce the size of the optics by approximately a factor of two while maintaining the high performance necessary for 400G, 600G and 800G per wavelength. We recently introduced and demonstrated our Coherent Optical Subassembly, or COSA, which integrates our 64GBaud coherent driver-modulator and our coherent receiver in a compact package that occupies less than half the space of the equivalent discrete components. Alongside this, we introduced and demonstrated our “Nano” ultra-narrow linewidth external cavity tunable laser, which combined with ASIC control circuitry similarly reduces the size in half or more while featuring the industry leading linewidth and power consumption of our external cavity laser.

Long Haul, Metro and high density data center interconnect networks also leverage our multi-cast switches to boost network capacity while supporting bandwidth-hungry services. These switches enable contentionless reconfiguration to maximize fiber utilization and capacity growth.

Finally, we are deploying a range of both passive module solutions and long reach laser solutions for 5G network applications, for which network deployments are expected to ramp in 2019.

In 2017, decreased market demand in China for 100G and above product deployments materially affected our operating results. Demand was very strong in 2016 from our China-based customers, who at that time provided optimistic forecasts for 2017 in anticipation of new tenders for provincial and metro 100G system deployments from the leading Chinese telecom carriers. However, tender awards from the China telecom carriers were slower than expected in 2017, which caused a significant drop in demand beginning in the first quarter of 2017. We believe one or more of our leading customers in China had accumulated significant inventory prior to the end of the quarter ended March 31, 2017. We also believe they and other customers rapidly moved to adjust their inventory by reducing their purchases of our products, beginning in the first quarter of 2017 and continuing in successive quarters, to align with the slowing market demand and their own production levels.

Beginning in the quarter ended December 31, 2017 and continuing into the quarter ended September 30, 2018, we saw a steady demand environment emerge in China and inventories of our products stabilize at our Chinese customers, primarily as a result of provincial deployments in China. We believe there remains uncertainty in the market in China, such that accurately anticipating the timing and volume of provincial deployments is difficult. Therefore, we and our customers have limited visibility into the timing and volumes of such tender awards. These market conditions in China adversely affected our revenues, operating results and financial condition throughout 2017 and in early 2018.

29



On April 15, 2018, the United States Department of Commerce issued a Denial Order which prohibited Chinese telecom equipment maker ZTE Corporation ("ZTE") from receiving items subject to U. S. Export Administration Regulations. This order effectively banned U.S. companies from selling, exporting or re-exporting components, software and technology to ZTE.

Our direct revenue from ZTE during the quarter ended March 31, 2018 was approximately 1% of total revenue, the same as for the entire fiscal year 2017. In addition, we provide component products to certain ZTE supply chain partners, which was estimated to be approximately 2% of total revenue in the quarter ended March 31, 2018, compared to approximately 3% for the entire fiscal year 2017. In addition, in the quarter ended March 31, 2018, we took a reserve for products held in inventory designated for ZTE valued at approximately $1.2 million.

In July 2018, the U.S. Department of Commerce removed the ban as a result of a settlement agreement with ZTE.
Revenue was $81.7 million in the three months ended September 30, 2018, compared to $71.1 million in the same period in 2017 primarily due to volume growth in the Americas, including through off-shore contract manufacturers, and in China due continued domestic deployments plus exports for international deployments. Our gross profit was 23% of revenue in the three months ended September 30, 2018, compared to 15% of revenue in the three months ended September 30, 2017, primarily attributable to improved factory utilization on higher volumes and improved product mix to higher data rates.
In the three months ended September 30, 2018, High Speed Products represented approximately 84% of total revenue, or $68.5 million and Network Products and Solutions represented approximately 16% of total revenue, or $13.2 million.  In the three months ended September 30, 2017, High Speed Products were 84% of total revenue, or $59.4 million and Network Products and Solutions represented approximately 16% of total revenue, or $11.7 million.
In September 2017, we initiated certain restructuring actions to improve near-term profitability while focusing our investment and developments on key growth opportunities within and between data centers, front and backhaul for 5G, traditional metro and long haul telecommunications, plus emerging cable TV and edge network applications.
In December 2016, we entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”) with APAT Optoelectronics Components Co., Ltd. (the “Purchaser”) for the sale of certain assets of our access and low speed transceiver product lines (the “Low Speed Transceiver Products”) which was completed in January 2017.  All of these products were part of our Network Products and Solutions group and included low speed passive optical network ("PON") products for which an end-of-life plan was announced in mid-2016. In 2017 and 2016, such Low Speed Transceiver Products generated approximately1% and 15% of our total revenue, respectively.
The asset sale consisted of approximately $25.0 million in cash consideration plus approximately $1.4 million post-closing transition services under a transition services agreement ("TSA") with the Purchaser. We recognized a $2.2 million gain on the sale of these assets within our operating loss in 2017. See Note 6 and Note 11 in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report.
Critical accounting policies and estimates
Other than the policy changes disclosed in Note 1 in Notes to Condensed Consolidated Financial Statements in Item 1, Part I of this Report, there have been no material changes to our critical accounting policies and estimates during the three and nine months ended September 30, 2018 from those disclosed in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2017.
Results of Operations
 
Revenue
Our business is focused on the highest speed digital optics and signal processing communications applications. In the three months ended September 30, 2018, our High Speed Products for data rates of 100G and beyond comprised 84% of our revenues.

30


We sell substantially all of our products to original equipment manufacturers ("OEMs") and their contract manufacturers. Revenue is recognized upon transfer of control of the product to the buyer. We price our products based on market and competitive conditions and may periodically reduce the price of our products as market and competitive conditions change or as manufacturing costs are reduced. Our first quarter revenue is typically seasonally lower than the rest of the year primarily due to the impact of annual price negotiations with customers that occur at the end of the prior year and lower capacity utilization during the holidays in China. However, this historical pattern should not be considered a reliable indicator of our future revenue or financial performance. Our sales transactions to customers are denominated primarily in U.S. dollars, with some portions in Chinese Renminbi (“RMB”) or Japanese Yen (“JPY”).
 
 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
2018
 
2017
 
$ Change
 
% Change
 
2018
 
2017
 
$ Change
 
% Change
Total revenue
$
81,748

 
$
71,121

 
$10,627
 
15%
 
$
231,436

 
$
216,023

 
$15,413
 
7%
 
We generate most of our revenue from a limited number of customers. Huawei has consistently been our largest customer, which was again the case in the three months ended September 30, 2018, as it accounted for approximately 47% of our revenue. One other customer accounted for an additional 28% of our revenue for the three months ended September 30, 2018. In the three months ended September 30, 2017, Huawei and one other customer accounted for approximately 39% and 14% of our revenue, respectively.

In addition to Huawei, we have several large customers which may or may not exceed 10% of revenue in any given quarter. After Huawei, our next four largest customers accounted for an additional 42% and 40% of our revenue in the three months ended September 30, 2018 and 2017, respectively.
We expect that a significant portion of our revenue will continue to be derived from a limited number of customers. As a result, the loss of, or a significant reduction in, orders from any of our key customers would materially affect our revenue and results of operations. Similarly, our accounts receivable are from a limited number of customers. As of September 30, 2018, three customers accounted for 41%, 20% and 12% of total accounts receivable and as of December 31, 2017, three customers accounted for 36%, 14% and 10% of total accounts receivable.
Three Months Ended September 30, 2018 Compared With Three Months Ended September 30, 2017
 
Revenue increased $10.6 million, or 15%, in the three months ended September 30, 2018, compared to the same period in 2017, as described in "Business Overview" above. In the three months ended September 30, 2018, High Speed Products represented approximately 84% of total revenue, compared to 84% of total revenue in the same period in 2017, while Network Products and Solutions represented approximately 16% of total revenue in the three months ended September 30, 2018, compared to approximately 16% of total revenue in the same period a year ago. In the three months ended September 30, 2018, revenue from China, Americas and rest of the world, based on the ship to location requested by the customer, was 56%, 28% and 16% of total revenue, respectively, compared to 57%, 19% and 24% of total revenue, respectively, in the same period in 2017.
Nine Months Ended September 30, 2018 Compared With Nine Months Ended September 30, 2017

Revenue increased $15.4 million or 7%, in the nine months ended September 30, 2018, compared to the same period in 2017, primarily due to volume growth in the Americas, including through off-shore contract manufacturers, and in China for domestic deployments plus exports for international deployments. In the nine months ended September 30, 2018, High Speed Products represented approximately 85% of total revenue, compared to 82% of total revenue in the same period in 2017, while Network Products and Solutions represented approximately 15% of total revenue in the nine months ended September 30, 2018, compared to approximately 18% of total revenue in the same period a year ago, which included revenue from Low Speed Transceiver Products for a portion of the first quarter. In the nine months ended September 30, 2018, revenue from China, Americas and rest of the world, based on the ship to location requested by the customer, was 58%, 23% and 19% of total revenue, respectively, compared to 54%, 17% and 29% of total revenue, respectively, in the same period in 2017.
 

31


Cost of Goods Sold and Gross Profit
Our cost of goods sold consists primarily of the cost to produce wafers and to manufacture and test our products. Additionally, our cost of goods sold generally includes stock-based compensation, write-downs of excess and obsolete inventory, amortization of certain purchased intangible assets, depreciation, acquisition-related fair value adjustments, restructuring charges, warranty costs, royalty payments, logistics and allocated facilities costs. 
Gross profit as a percentage of total revenue, or gross margin, has been and is expected to continue to be affected by a variety of factors including the introduction of new products, production volume, production volume compared to sales over time, the mix of products sold, inventory changes, changes in the average selling prices of our products, changes in the cost and volumes of materials purchased from our suppliers, changes in labor costs, changes in overhead costs or requirements, stock-based compensation, write-downs of excess and obsolete inventories and warranty costs. In addition, we periodically negotiate pricing with certain customers which can cause our gross margins to fluctuate, particularly in the quarters in which the negotiations occurred. Our first quarter gross margins are typically seasonally lower than the fourth quarter of the prior year due to annual price negotiations with customers that occur the end of the prior year as well as lower manufacturing capacity utilization during the holidays in China.   
As a manufacturing company, our margins are sensitive to changes in volume and factory utilization. Increasing strength in demand with increasing volume growth across various product lines contributed to the increase in our gross profit in the three months ended September 30, 2018.
The China government has recently imposed tariffs affecting products manufactured in the U.S. Certain of our products manufactured in our U.S. operations have been included in the tariffs imposed on imports into China from the United States. Going forward, we expect these tariffs, as currently applied, will increase our cost of goods sold by about one percentage point for as long as the tariffs remain in place.

 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands, except percentages)
2018
 
2017
 
$ Change
 
% Change
 
2018
 
2017
 
$ Change
 
% Change
Cost of goods sold
62,815

 
60,608

 
$
2,207

 
4
%
 
187,849

 
170,230

 
$
17,619

 
10
 %
Gross profit
18,933

 
10,513

 
$
8,420

 
80
%
 
43,587

 
45,793

 
$
(2,206
)
 
(5
)%
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2018
 
2017
 
2018
 
2017
Gross profit as a % of revenue
23
%
 
15
%
 
19
%
 
21
%
Three Months Ended September 30, 2018 Compared With Three Months Ended September 30, 2017
Gross profit increased $8.4 million, or 80%, to $18.9 million in the three months ended September 30, 2018, compared to $10.5 million in the same period in 2017. Gross margin increased by approximately 8 percentage points to 23% in the three months ended September 30, 2018, compared to the same period in 2017. The improvement in gross margin was driven by approximately 6 percentage points of lower inventory write-downs and warranty costs and 2 percentage points of higher factory utilization and lower restructuring costs.
Nine Months Ended September 30, 2018 Compared With Nine Months Ended September 30, 2017
Gross profit decreased $2.2 million or 5%, to $43.6 million in the nine months ended September 30, 2018, compared to $45.8 million in the same period in 2017. Gross margin decreased by approximately 2 percentage points to 19% in the nine months ended September 30, 2018, compared to the same period in 2017. The decline in gross margin was driven by approximately 4 percentage points of annual price reductions, offset by approximately 2 percentage points of lower inventory write-downs and warranty costs.
Operating expenses

32


Personnel costs are the most significant component of operating expenses and consist of costs such as salaries, benefits, bonuses, stock-based compensation and, with regard to sales and marketing expense, other variable compensation. 
 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands, except percentages)
2018
 
2017
 
$ Change
 
% Change
 
2018
 
2017
 
$ Change
 
% Change
Research and development
$
13,177

 
$
14,662

 
$
(1,485
)