Basis of Presentation and Significant Accounting Policies (Policies)

9 Months Ended

Sep. 30, 2013

The condensed consolidated financial statements of NeoPhotonics Corporation (“NeoPhotonics” or the “Company”) as of September 30, 2013 and December 31, 2012 and for the three and nine months ended September 30, 2013 and 2012, 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 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, 2012. The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the results expected for the entire fiscal year. All significant intercompany accounts and transactions have been eliminated.

The condensed consolidated financial statements are prepared in accordance with U.S. GAAP and include the consolidated accounts of the Company and its majority owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.

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; write off of excess and obsolete inventories and the valuations and recognition of stock-based compensation, among others. Actual results could differ from these estimates.

Revision of Prior Period Balance Sheet

As further described in Note 9, the Company may be required to pay a $5.0 million penalty if it does not achieve certain performance obligations agreed to in connection with the sale of its common stock in a private placement transaction on April 27, 2012. The penalty payment was originally classified outside of equity as redeemable common stock at December 31, 2012 since, while the Company intends to meet its performance obligations, it determined the ability to satisfy some of the obligations may be outside of the Company’s control. The Company has since determined that the $5.0 million penalty payment is an embedded derivative instrument, with the underlying being the performance or nonperformance of meeting its performance obligations by the deadline, and has thus classified $4.9 million of the $5.0 million to additional paid-in capital and the remaining $0.1 million, representing the estimated fair value of the penalty payment derivative, to other noncurrent liabilities at December 31, 2012. The effect on the Company’s balance sheet at December 31, 2012 for this matter was as follows:



	December 31, 2012
(in thousands)	Previously Reported			As Revised
Other noncurrent liabilities	$	2,377	⁽¹⁾	$	2,515	⁽¹⁾
Redeemable common stock		5,000			—
Additional paid-in capital		433,996			438,858

⁽¹⁾	Includes long-term deferred tax liabilities of $653 to conform to the September 30, 2013 presentation.

Recent Accounting Pronouncements

Recent accounting pronouncements

In February 2013, the Financial Accounting Standard Board (“FASB”) issued amendments to the FASB Accounting Standard Codification to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments require new disclosures for items reclassified out of accumulated other comprehensive income (“AOCI”), including (1) changes in AOCI balances by component and (2) significant items reclassified out of AOCI. The guidance does not amend any existing requirements for reporting net income or OCI in the financial statements. As this guidance only requires expanded disclosures, the adoption of this guidance did not have a material effect on the Company’s consolidated financial statements.

In March 2013, the FASB issued amendments to the FASB Accounting Standard Codification, which indicates that the entire amount of a cumulative translation adjustment related to an entity’s investment in a foreign entity should be released when there has been a (i) sale of a subsidiary or group of net assets within a foreign entity and the sale represents the substantially complete liquidation of the investment in the foreign entity, (ii) loss of a controlling financial interest in an investment in a foreign entity, or (iii) step acquisition for a foreign entity. The amendments are effective prospectively for fiscal years beginning after December 15, 2013. Early adoption is permitted. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

In July 2013, the FASB issued amendments to the FASB Accounting Standard Codification on Income Taxes, to improve the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. This guidance is expected to reduce diversity in practice and is expected to better reflect the manner in which an entity would settle at the reporting date any additional income taxes that would result from the disallowance of a tax position when net operating loss carryforwards, similar tax losses, or tax credit carryforwards exists. This guidance is effective for reporting periods beginning after December 15, 2013. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

Earnings Per Share

Shares of common stock subject to repurchase resulting from the early exercise of employee stock options are not considered participating securities and are therefore excluded from the basic weighted average common shares outstanding.

Cash and Cash Equivalents and Short-term Investments

The Company may sell its marketable securities in the future to fund future operating needs. As a result, the Company recorded all of its marketable securities as short-term as of September 30, 2013 and December 31, 2012, regardless of the contractual maturity date of the securities.

Realized gains and losses on the sale of marketable securities during the three and nine months ended September 30, 2013 and 2012 were immaterial. The Company did not recognize any impairment losses on its marketable securities during the three and nine months ended September 30, 2013 and 2012. As of September 30, 2013, 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.

Business Combination Policy

The Company accounted for its acquisition of the NeoPhotonics Semiconductor assets and assumed liabilities as a business combination. NeoPhotonics Semiconductor’s tangible and identifiable intangible assets acquired and liabilities assumed were recorded based upon their estimated fair values as of the closing date of the acquisition. The estimated fair values of the identifiable assets acquired and liabilities assumed approximated the purchase price; therefore, no goodwill was recorded.

The following table summarizes the acquisition accounting and the tangible and intangible assets acquired as of the date of acquisition and subsequent adjustments (in thousands):

Total purchase consideration:
Cash paid	$	13,128
Notes payable		11,130
	$	24,258
Liabilities assumed:
Pension and retirement obligations	$	6,471
Other compensation-related liabilities		1,083
Other current liabilities		1,265
	$	8,819
Fair value of assets acquired:
Inventory	$	13,309
Other current assets		35
Land, property, plant and equipment⁽¹⁾		14,433
Intangible assets acquired:
Developed technology		2,120
Customer relationships		3,180
	$	33,077

⁽¹⁾	Includes land of $3.5 million, buildings of $3.9 million and machinery, equipment, furniture and fixtures of $7.0 million.

The approach for measuring the fair value of the assets acquired and liabilities assumed is described below:

Net Tangible Assets

NeoPhotonics Semiconductor’s tangible assets acquired and liabilities assumed as of March 29, 2013 were recorded at estimated fair value. The Company estimated fair value by adjusting NeoPhotonics Semiconductor’s historical value of property, plant and equipment to an estimate of depreciated replacement cost, adjusted for economic obsolescence. The Company depreciates property, plant and equipment over estimated lives of 2 to 10 years, and records the expense to cost of goods sold and operating expense. The fair value of inventory acquired was determined using a net realizable value approach based upon the expected sales value of the inventory, less any costs to complete and selling costs along with a reasonable profit margin based on historical and expected results.

Intangible Assets

Developed technology represents products that have reached technological feasibility. NeoPhotonics Semiconductor’s current product offerings include high speed semiconductor and high speed laser and photodetector devices for communication networks. The fair value of developed technology intangibles acquired was determined by using a royalty-avoidance method. The share of future revenue relating to current technology was forecasted, using an estimate for obsolescence such that the share declines over time. A royalty rate of two percent was used to calculate royalty savings on that revenue that are avoided since the Company owns the technology and does not need to license it from other parties. The after-tax royalty savings was then discounted to present value using the Company’s discount rate. The Company amortizes the developed technology intangible assets over estimated lives of 4 to 5 years, and amortization expense is recorded to cost of goods sold.

The customer relationships asset represents the value of the ability to sell existing, in-process, and future versions of the technology to the NeoPhotonics Semiconductor existing customer base. The Company utilized the excess earnings method, estimating future cash flows that will result from existing customers given assumed retention rates, and then discounting those flows to their present value using the Company’s discount rate. The Company amortizes the customer relationships intangible asset over an average estimated life of 6 years, and amortization expense is recorded to operating expenses.

The weighted average amortization period for the total amount of intangible assets acquired is 5.4 years.

Standard Product Warranty, Policy

Warranty Accrual

The Company provides warranties to cover defects in workmanship, materials and manufacturing for a period of one to two years to meet the stated functionality as agreed to in each sales arrangement. The Company accrues for estimated warranty costs based upon historical experience, and for specific items, at the time their existence is known and the amounts are estimable.

Debt

The Company records debt at its carrying amount. The Company uses a market approach to determine fair value, which results in a Level 2 fair value measurement. As of September 30, 2013 the carrying value of the Company’s debt approximated its fair value.

Share-based Compensation, Option and Incentive Plans Policy

Private Sale of Common Stock

On April 27, 2012, the Company issued and sold approximately 4.97 million shares of its common stock in a private placement transaction at a price of $8.00 per share for a gross amount of approximately $39.8 million.

The shares of common stock are restricted from transfer pursuant to a lockup agreement for up to two years, at the end of which the Company is obligated to file one or more registration statements covering the potential resale of the shares of common stock.

In connection with this private placement transaction, the Company agreed to certain performance obligations including establishing a wholly-owned subsidiary in the Russian Federation and making a $30.0 million investment commitment (the ‘Investment Obligation’) towards the Company’s Russian operations. The Investment Obligation can be partially satisfied by investment outside of the Russian Federation and/or by way of non-cash asset transfers, including but not limited to capital equipment, small tools, intellectual property, and other intangibles. A minimum of $15.0 million of the Investment Obligation is required to be satisfied by making capital expenditures and the remaining $15.0 million can be satisfied through general working capital and research and development expenditures. All of the amount for general working capital can be spent either inside or outside of Russia. However, at least 80% of the amount expended for research and development expenditure must be spent inside Russia. General working capital can include acquisition of other businesses or portions thereof to be owned by the Russian subsidiary.

The purchaser of the common stock has non-transferable veto rights over the Company’s Russian subsidiary’s annual budget during the investment period and must approve non-cash asset transfers to be made in satisfaction of the Investment Obligation. Spending and/or commitments to spend for general working capital and research and development do not require approval by the purchaser. There are no legal restrictions on the specific usage of the $39.8 million received in the private placement transaction or on withdrawal from the Company’s bank accounts for use in general corporate purposes.

The Company is required to satisfy the Investment Obligation by July 31, 2014 or, in the event the Company has not recorded aggregate revenue from sales of its products in the Russian Federation of at least $26.8 million during the period beginning July 1, 2012 and ending June 30, 2014, then will be automatically extended from July 31, 2014 to March 31, 2015. The Company expects the date for achievement of the Investment Obligation will be extended to March 31, 2015. Therefore, the Company intends to meet its Investment Obligation by March 31, 2015. If the Company fails to meet the Investment Obligation by the deadline, including failure to meet the Investment Obligation because the purchaser of the common stock does not approve the transfer of non-cash assets, the Company will be required to pay a $5.0 million penalty (the ‘Penalty Payment’) as the sole and exclusive remedy for damages and monetary relief available to the purchaser for failure to meet the Investment Obligation.

The Company has accounted for the $5.0 million Penalty Payment as an embedded derivative instrument, with the underlying being the performance or nonperformance of meeting the Investment Obligation by the extended deadline of March 31, 2015 and has classified $4.9 million of the $5.0 million as additional paid-in capital and the remaining $0.1 million, representing the estimated fair value of the Penalty Payment derivative, as other noncurrent liabilities.

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 Obligation and a discount rate that approximates the Company’s incremental borrowing rate. After the initial measurement, changes in the fair value of this derivative were recorded in other income (expense). The estimated fair value of this derivative was $0.2 million and $0.1 million at September 30, 2013 and December 31, 2012, respectively.

Accumulated Deficit

Approximately $6.3 million of the Company’s accumulated deficit at December 31, 2012 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 to fund statutory common reserves as well as allocate a discretional portion of their after-tax profits to their staff welfare and bonus fund.

Stock Options

The Company granted 369,900 and 1,534,030 stock options during the third quarter and first nine months of 2013, respectively, with weighted-average grant-date fair values per share of $7.78 and $5.82, respectively. The Company granted 107,770 and 251,475 stock options during the third quarter and first nine months of 2012, respectively, with weighted-average grant-date fair values per share of $5.00 and $4.90, respectively.

The fair values of option awards were estimated at each grant date using the Black-Scholes option valuation model. The Black-Scholes model requires the input of assumptions, including the expected stock-price volatility and estimated option life. The expected volatilities utilized were based on the actual volatility of similar entities due to the limited history of the trading of the Company’s common stock since the initial public offering in February 2011. The expected lives of options granted were estimated using the Company’s historical and expected future exercise behavior. The risk-free interest rates utilized were based on the U.S. Treasury yield in effect at each grant date. No dividends were assumed in estimated option values. Assumptions used in the Black-Scholes model are presented below:

	Three Months Ended September 30,						Nine Months Ended September 30,
Stock Options	2013			2012			2013			2012
Weighted-average expected term (years)		6.55			6.78			6.48			6.77
Weighted-average volatility		71	%		71	%		72	%		71	%
Risk-free interest rate		1.82-1.82	%		1.07-1.07	%		1.08-1.82	%		1.07-1.83	%
Expected dividends		0	%		0	%		0	%		0	%

On December 12, 2012, the Company granted 1,060,000 shares of stock options to key employees subject to an increase in the shares available to be granted which was approved by our stockholders at our Annual Meeting on June 11, 2013. The Company determined that the grant date for these performance options was June 11, 2013 for accounting purposes. During the three months ended September 30, 2013, the Company granted an additional 110,000 shares of performance-based stock options. These shares will vest during the term if the average closing price of the Company’s common stock over a period of 20 consecutive trading days is equal to or greater than $15.00 per share and the recipient remains in continuous service with the Company through such period, or fully accelerate and vest on the seventh anniversary of the grant date. The Company estimated the fair value of its performance options as $5.68 for the three months ended September 30, 2013 using a Monte Carlo simulation model on the date of grant with the assumptions discussed above. The Company recorded $0.2 million and $0.2 million of compensation expense for these options for the three months and nine months ended September 30, 2013, respectively.

As of September 30, 2013, there were 3,979,813 unexercised stock options outstanding.

Restricted Stock Units (“RSUs”)

The Company granted 606,300 and 637,340 RSUs during the third quarter and first nine months of 2013, respectively, with weighted-average grant-date fair values per share of $6.98 and $6.98, respectively. The Company granted 428,000 and 615,609 RSUs during the third quarter and first nine months of 2012, respectively, with weighted-average grant-date fair values per share of $4.96 and $5.27, respectively. As of September 30, 2013, there were 1,135,929 RSUs outstanding.

Stock appreciation units (“SAUs”)

The Company granted 25,000 and 275,000 SAUs during the third quarter and first nine months of 2013, with weighted-average grant-date fair values per share of $8.33 and $5.40, respectively. The Company did not grant SAUs during the third quarter and first nine months of 2012. As of September 30, 2013, there were 433,708 SAUs outstanding. SAUs are liability classified share-based awards which are re-measured each reporting period at fair value.

The fair values of SAUs were estimated at each grant date using the Black-Scholes option valuation model. The expected volatilities utilized were based on the actual volatility of similar entities. Vested SAUs first become exercisable upon the expiration of the lock-up period associated with the initial public offering. Therefore, the Company estimated the term of the SAUs based on an average of the weighted-average exercise period and the remaining contractual term. The risk-free interest rates utilized were based on the U.S. Treasury yield in effect at each grant date. No dividends were assumed in estimated option values. Assumptions used in the Black-Scholes model are presented below:

	Three Months Ended September 30,						Nine Months Ended September 30,
Stock Appreciation Units	2013			2012			2013			2012
Weighted-average expected term (years)		1.92			3.10			2.29			3.27
Weighted-average volatility		52	%		65	%		57	%		68	%
Risk-free interest rate		0.15-0.66	%		0.30-0.57	%		0.14-0.66	%		0.30-1.04	%
Expected dividends		0	%		0	%		0	%		0	%

The Company granted 250,000 shares and 25,000 shares of stock appreciation units to key employees on June 11, 2013 and August 6, 2013, respectively. These performance shares will vest during the term of the average closing price of the Company’s common stock over a period of 20 consecutive trading days is equal to or greater than $15.00 per share and the recipient remains in continuous service with the Company through such period, or fully accelerate and vest on the seventh anniversary of the grant date. The Company estimated the fair value of performance shares of $5.41 and $4.81for June 11, 2013 and August 6, 2013, respectively, for the three months ended September 30, 2013 using a Monte Carlo simulation model on the date of grant with the assumptions discussed above. The Company recorded $49,000 and $62,000 of compensation expense for these stock appreciation units for the three and nine months ended September 30, 2013, respectively.

Employee Stock Purchase Plan (“ESPP”)

Employees purchased 262,860 shares in the first nine months of 2013 for $1.2 million and 257,335 shares in the first nine months of 2012 for $0.9 million under the ESPP. The value of the ESPP consists of: (1) the 15% discount on the purchase of the stock, (2) 85% of the call option and (3) 15% of the put option. The call option and put option were valued using the Black-Scholes option pricing model. The expected volatilities utilized were based on the actual volatility of similar entities. The expected term represents the period of time from the beginning of the offering period to the purchase date. The risk-free interest rates utilized were based on the U.S. Treasury yield in effect at each grant date. No dividends were assumed in estimated option values. Assumptions used in the Black-Scholes model are presented below:

	Three months ended September 30,						Nine months ended September 30,
ESPP	2013			2012			2013			2012
Weighted-average expected term (years)		0.73			0.75			0.73			0.75
Weighted-average volatility		48	%		71	%		48	%		71	%
Risk-free interest rate		0.09-0.16	%		0.04-0.15	%		0.09-0.16	%		0.04-0.15	%
Expected dividends		0	%		0	%		0	%		0	%

Income Taxes

The Company conducts its business globally and its operating income is subject to varying rates of tax in the United States, 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. The Company expects that its income taxes will vary in relation to its profitability and the geographic distribution of its profits. Historically, the Company has experienced net losses in the United States and in the short term, expects this trend to continue. One of the Company’s subsidiaries in China generates a cash tax liability. The subsidiary has qualified for a preferential 15% tax rate available for high technology enterprises as opposed to the statutory 25% tax rate. The preferential rate applies to 2012-2013, and has been benefited for years 2008-2011 as well and the Company intends to reapply for the preferential rate for 2014 to 2016.

Due to historic losses in the US, the Company has a full valuation allowance on the US federal and state deferred tax assets and also has a full valuation allowance on the deferred tax assets of its NeoPhotonics Semiconductor subsidiary. 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.