NeoPhotonics Corporation

This call is being webcast live on the company's website at www.neophotonic.com on the events page of the investor section. This call is the property of Neophotonic and any recording, reproduction, or transmission of this call without the express written consent of Neophotonic is prohibited. I will now turn the call over to Erica Mannion at Sapphire Investor Relations.

Good afternoon. Thank you for joining us to discuss Neophotonics operating results for the first quarter of 2021 and outlook for the second quarter of 2021. On the call today are Tim Jenks, Chairman and CEO, Wu-Pen Yen, Chief Product Officer, and Beth Eby, Chief Financial Officer. Tim will begin with a review of the company's business results in the first quarter and a discussion of relevant market issues and trends. Wu-Pen will provide a summary of products, technologies, and growth drivers, for our highest speed product. Beth will then provide financial results for the first quarter and provide the outlook for the second quarter of 2021. The operator will then open the call for questions. The company's press release and management statements during this call will include discussions of certain non-GAAP financial measures and information, including all income statement and balance sheet amounts and percentages other than revenue, unless otherwise noted. These non-GAAP financial measures are not prepared in accordance with GAAP and are not a substitute for or superior to measures of financial performance prepared in accordance with GAAP. These financial measures and a reconciliation of GAAP to non-GAAP results are provided in the company's press release and related Form 8K being filed today with the SEC and can be found in the investor relations section of Neophotonics' website. Material contained in the webcast is a sole property and copyright of Neophotonics, with all rights reserved. Certain statements in this conference call, which are not historical facts, may be considered forward-looking statements that involve risks and uncertainties, and include statements regarding future business results, product and technology development, customer demand, inventory levels, economic and industry projections, or subsequent events. Various factors could cause actual results to differ materially. Some of these factors have been set forth in our press release dated April 29, 2021, and are described at length in our annual and quarterly SEC filings. Now, I will turn the call over to CEO, Tim Jenks.

Thank you, Erica, and good afternoon. Neophytonics again delivered strong results in the first quarter with revenue of $61 million, which was in the upper half of our guidance range. Gross margin and operating margins were in the high end of the range as well. These results were driven by the more than doubling of 400 gigabit and above product revenue, which grew 134% on a year-over-year basis and comprised 52% of total revenue in the quarter. Demand for Neophytonics' highest speed products, including ultra-pure light tunable lasers and 64 gigabaud modulators and receivers, remains strong, with accelerating market adoption and deployments and related market share gains at 400 gigabits per second and beyond, especially for links requiring the highest speed over distance. These highest speed deployments are among the fastest areas of growth in the industry. And driven by cloud and data center demand, they continue to drive our growth in addition to expanding our customer base. With our high-speed product growth, we had four 10% customers in the first quarter. These customers ranged from 12% to 26% of revenue, and together comprised 74% of revenue. We believe the growth in demand for our 400 gig and above components for chassis-based communication systems is in early innings. As the market continues to move to higher and higher speeds, including 600 gig and 800 gig, we are increasingly well positioned to capture this next wave of growth. Our 400 ZR DDQSFP and OSFP coherent modules for data center interconnect applications and our CFP2 DCO modules for telecom networks at 400 gig and 200 gig long haul applications continue to make progress as Wu-Pen Yen will detail in a few minutes. Demand strengthened for our multi-rate CFP2-DCO coherent modules within China in the first quarter. These modules use our leading 64-gigawatt component suite, as well as our C++ laser and other extended tuning range products to increase total fiber capacity up to 50%. In the customer network trade-off between speed and distance, network equipment manufacturers within China are utilizing our 64 gigawatt high-performance components for long-haul applications to achieve 200 gigabits over a single wavelength. Our multi-rate 400 gig CFP2 DCO module is tailored to regional and metro distances combined with our C++ laser product we believe our module solutions deliver the same, if not better, performance as chassis-based systems while consuming less power in a smaller form factor and lowering cost per bit. We see expanding activity in the Western 400 ZR market, which initially targeted hyperscale data center interconnects, and then 400 ZR plus modules targeted at regional and metro applications. Beyond hyperscale data center operators, we now see more interest in 400 gig module solutions from network equipment manufacturers. This is important as it supports and validates our view that 400 ZR and its architectures is a large market opportunity delivering significant savings to network operators. We are conducting qualifications with multiple potential customers. Based on current schedules, we expect to increase production to hundreds of units this quarter and to initial deployments in the second half. Near-term demand in Western carrier markets is muted. Our customers tell us that they are seeing modest deployment rates at this point in the pandemic, as well as pauses in spending by large carriers following the US 5G wireless spectrum auctions. The muted demand is exacerbated by semiconductor shortages. These shortages did not impact us in Q1, but we are seeing some impact in Q2. We expect that this will limit upside in our near term due to the inability to pull in IC chip deliveries. Currently, the China telecom market, too, is muted in regional and metro deployments with just modest tenders by China telecom underway. That is, China mobile business levels currently have been very light. In Q1, we began shipping a subset of our legacy products that comply with the AR to Huawei, and we now expect that they could become a moderate-sized customer in the near term. We do sell to each of the China network equipment manufacturers, so we would expect to benefit as new carrier tenders materialize later this year. in the current period is soft overall. We anticipate this will change in the second half as major global carriers increase their deployment rates as the pandemic subsides and as hyperscalers begin to roll out initial 400 ZR installations. Looking beyond 2021, we are excited about the applications for our high performance optical components and as we continue to have multiple engagements in adjacent markets, as Wu-Pen Yen, our Chief Product Officer, will discuss next. Wu-Pen?

Thank you, Tim, and good afternoon. During previous calls, we have talked about the three legs of our coherent product suite for the highest speed over distance applications. These are, first, our coherent components, including our industry-leading ultra-pure light tunable lasers, which we provide to network equipment manufacturers for their line card and chassis-based systems operating at 400 gig to 800 gig. We also integrate these high-performance and high-volume components into phone-to-VR pluggable modules, such as our QSP-DD for use in data center interconnect applications, with reaches of around 100 kilometers. And finally, we extend the performance of these pluggable modules to achieve longer reaches in Formula ZR Plus versions covering metro and even long-haul distances. Our Formula ZR modules are designed to comply with the Optical Inter-Networking Forums Implementation Agreement and have been successfully tested at multiple hyperscale data center customers, demonstrating interoperability with other vendors' 400ZR modules. We believe that our 400ZR modules are industry-leading in performance and in maturity. We recently demonstrated the successful operation of 36 of our QSPDD modules in a fully populated Ethernet switch. These 400ZR QHPDD modules utilize our vertically integrated silicon photonics coherent optical subassembly, or COSA, and our low power consumption, ultra narrow line width, nano ITLA tunable laser. Each of these components can be operated over temperatures ranging up to 80 degrees Celsius. For extended temperature data center environments, that reduce cooling requirements. Our QCVDD 400ZR modules have passed 2,000 hours of high temperature operating life, HTOL, and other critical testing, and are in qualification at multiple hyperscalers and other customers. We'd expect deployment in the second half of 2021. Our ultra-pure light lasers and high-performance coherent components, when coupled with the latest generation of 790-meter DSPs, increased the reach of our QSP-DD modules far beyond DCI distances, performed the ZR+, metro, and long-haul reaches, significantly expanding our served market. We successfully demonstrated our formed ZR+, QSP-DD coherent pluggable transceivers transmitting 400 gigabits per second over a distance of 800 kilometers in a 75 gigahertz space DWDM system, maximizing total fiber capacity for IP over DWDM. We believe such 400 ZR plus QSP DD modules will serve the cloud-based metro infrastructure capable of supporting 5G network services with a common platform. For more stringent applications, we have integrated our Indian phosphide coherent modulator and receiver with our nano-trimmable laser into a CFP2-DCO module for advanced applications, matching performance of chassis-based systems operating at 400 gig, but at a fraction of the size and power consumption. We have demonstrated our multi-rate CFP2-DCO coherent pluggable transceiver transmitting at a 400 gigabits per second data rate over a distance of 1,000 kilometers in a 75 gigahertz space DWDM channel plan with a performance margin that we expect will allow transmission up to 2,000 kilometers. Of course, ultra-long-haul and submarine applications will continue to require the higher performance that can be achieved in chassis-based systems with higher costs and higher power consumption. Alternable laser, receiver, and modulator products have high market share in these uses due to their performance, quality, reliability, and availability. We have continued to expand the capabilities of these products and are now sampling 96 gigabit versions for 800 gigabits per second systems. And we are developing 130 gigabit versions for 1 terabits per second and beyond. With increasing data rates and extending distances, the use cases for 400ZR are growing. As a result, we are engaged with an expanding target customer group beyond the leading hyperscalers and traditional AEMs, including content providers, data center, and other private high-performance network operators. Communications is just one application area for our coherent technology. Our coherent abilities in coherent optics open further opportunities for us in adjacent markets. Coherent technology improves sensitivity and performance for such applications as inter-satellite communication links, including for low Earth orbit LEO satellites, sensing for industrial applications, and LiDAR for autonomous vehicle navigation. We're investigating such applications and will provide additional information as they mature. With that, I will turn the call over to our CFO, Beth Eby.

Thank you, Wu-Pen, and good afternoon. Neophytonics continued to execute well in Q1. Increased demand for our highest speed products resulted in slightly better than expected revenue and gross margin above our range. As Tim mentioned, revenue was $60.9 million on strong demand for our 400G and above products, which comprised 52% of Q1 revenue. As expected, we did ship an immaterial volume of U.S. EAR-compliant products to Huawei. Non-GAAP gross margin of 22.4% was just above our range as a result of favorable product mix and good execution of cost reductions. Product margin of 40.5% was offset by the expected high levels of excess capacity charges. Non-GAAP operating expense for the first quarter was 21.5 million, down 2.2 million from Q4, and lower than expected as some expenses pushed to Q2. Non-GAAP operating loss for the quarter was 7.8 million. Interest and other charges were offset by 1.1 million of FX gains. Tax expense was 0.6 million on full year losses as opposed to the effective tax rate benefit we had expected. This resulted in a non-GAAP net loss of 7.5 million and a loss per share of 15 cents. This is at the midpoint of our estimate as the consistent good news in the operations and operating profit were offset by the change in tax estimate methodology. I will close out my discussion of the first quarter income statement with a review of our GAAP results. First quarter gross margin was 21.9%, down slightly from Q4, but higher than expected given the higher product margins and the use of previously reserved materials for production. Operating expense was 24.4 million, up 1.1 million from Q4, as the prior quarter included one-time gains. Those gains were mostly the settlement of litigation. Operating loss for the first quarter was $11.1 million, and net loss was $10.7 million, which included expenses of $3.3 million of stock-based compensation and $0.5 million of accelerated depreciation, amortization, and other costs, offset by the materials reserve release of $0.6 million. Turning to the balance sheet, we finished the quarter with $111 million in cash investments and restricted cash, down $12 million as we held inventory levels flat and made payments on previously settled litigation. Net inventory was $46 million flat versus last quarter. The inventory reductions related to the lower revenue have been offset by an inventory build for critical components given the IC shortages. and new product ramps. Days of inventory increased to 88 days. We remain in a good position to continue to drive the growth of neophotonics, even while we increase inventories on key chips to buffer supply shortages. As Tim mentioned, the annual demand forecast for neophotonics' highest speed products remains strong. We are seeing softness in Q2 and have spot shortages that are constraining our ability to satisfy all of the opportunities we see in the quarter. These shortages could impact future quarters, though we have a history of working through supply chain challenges. As a result, while there is increased risk, we remain committed to our growth target of 25% to 35% for the year, excluding Huawei. Our revenue ramp in the second half to meet that target is substantial. We expect the ramp will be in the following areas. First, unsatisfied demand from Q2 and customer second half ramp of 400G and above components based on their forecasts. Second, coherent module ramps, both telecom and datacom. And third, stronger China revenue in the second half compared to the first half. Q2 revenue is impacted by low to mid single digits of supply chain constraints. Those supply constraints disproportionately impact the high-end products. Because of this, our gross margin is down quarter over quarter on less favorable product mix plus the expected underutilization charges. Operating expense is higher due to the expenses that pushed from Q1 and the startup expenses for 400 ZR modules. As a result, the company's expectations for the June 2021 quarter are revenue in the range of $59 million to $65 million, gap gross margin in the range of 15% to 19%, non-gap gross margin in the range of 17% to 21%, gap diluted earnings per share in the range of a $0.35 loss to a $0.25 loss, and non-GAAP diluted earnings per share in the range of a $0.30 loss to a $0.20 loss. These numbers are reflective of approximately 51.6 million basic shares. In summary, for 2021, we are focused on driving growth in our 400G and above product lines, moving into the hyperscale market with added customers for our 400ZR and 400ZR Plus modules, and a return to profitability still expected in Q3 on a non-GAAP basis. Our strong cash position allows us to invest for that growth while positioning us for even higher levels of growth and profit in 2022. This concludes our formal comments, and now I would like to ask the operator to open up the line for questions.

Thank you.

If you would like to ask a question, please signal by pressing star 1 on your telephone keypad. If you were using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star 1 to ask a question. Each participant will be allowed one initial question and one follow-up question. We'll pause for just a moment to allow everyone an opportunity to signal for questions.

We'll take our first question from Tim Savageau with Northland Capital Markets.

Hi, good afternoon. Tim? My question, you made a comment about sort of initial volumes of 400 ZR, I guess, in the current quarter, second calendar quarter. Being in the hundreds, as we get closer to your kind of expectation for volume production, of ZR, I guess I want to maybe try and get a little color on your definition of volume production. That thousands of units, or what sort of visibility do you have at this point to those type of unit volumes? And would you say that would be the predominant factor of the three that you enumerated in kind of making up for this, some weakness in Q2?

Yeah, Tim, thanks for the question. You know, I think the most important thing would be, you know, moving into, I'll just say, four digits, you know, four digits in terms of production. And by four digits, you know, what I'm really referring to is, you know, whether it's, you know, 1,000-plus units a month or in that order, I think – you know, that would be volume production.

And then the second part of your question, those three areas that we enumerated are roughly in the same order of magnitude.

Sorry. Quick follow-up was muted there.

And also in your guidance for Q2, what are you factoring in for Huawei there? I imagine, I'm not sure of the timing, but you said you had immaterial revenues in Q1. Would you get up to some level of materiality in Q2?

Yeah, I would expect to have a level of materiality, but I still think there'll be a modest-sized customer just because it's very few of the legacy products that are involved. And so, you know, it would still be a modest number. We're not going to give, you know, specific numerical guidance on individual customers, but... You know, our point really is just to point out that they are there, but they're still modest size.

Okay, thanks. Thank you.

We'll take our next question from Dave Kang with B. Reilly Securities.

Yeah, good afternoon. Thank you. My first question is, Beth, you're still targeting third quarter to be profitable or at least break-even. Just wondering if you can, I'm not asking for guidance, but at least maybe just how should we think about, you know, like metrics, you know, top-line margins and all that?

You know our break-even model, Dave. It runs 80, 85 in revenue. are going to hit average for the year of 22.5%, which kind of backs into a 28%, 29% gross margin. So break even is going to be a profit positive in Q3 is going to be somewhere in that range.

Got it. And then regarding chip shortages, I mean, can you tell us which chips are really impacting this current quarter?

I think that, uh, you know, one of the things with, uh, chip shortages is, uh, you know, sometimes it surprises that, you know, there, there, there are, uh, two, two really, um, uh, issues is, is, you know, trying is we're seeing the lead times extend. And I think several companies have, uh, talked about that, that started, you know, a number of months ago. And, uh, uh, Essentially, for us, as Beth said in the prepared remarks, one of the issues is that to the extent that there are chip shortages, sometimes they affect the newest products and that often have a flow-through effect on margin. But I don't think I'll say more about which specific chips

Got it. So is it fair to sort of summarize that? Sounds like sort of a double whammy for you. I mean, 400 gig and above, demand is strong, but then chip shortages is impacting that negatively, whereas 100 gig and below, it seems like demand is soft due to various factors that you mentioned about US and China slowing down. Is that a fair summary?

Yeah, I think it's a good observation. I think the supply chain, we do expect the supply chain will work through. And the comments about overall demand, we did see 134% growth year over year on 400 gig and above products. And then for products that were shipping to customers other than Huawei on a year-on-year basis, we were up 28%. And so the underlying business... is certainly doing well, but we think it would be doing better if we didn't have a semiconductor chip issue.

Okay. Thank you. Thanks, babe.

Thank you. We'll take our next question from Alex Henderson with Needham & Company.

Hi, Alex. Thank you. Hi. It's good to hear your voices. And I'm hoping to see you guys at some point this year now that things are starting to improve in the broader economy. So I was hoping you could talk a little bit about the mechanics around the assumptions here. Is it at the high end of the band you still have some visibility to the components that you need for the current quarter? And At the lower end of the band, it's a mixed shift between products that causes maybe a little less visibility. How do we think about the supply constraints relative to the top and the bottom of the band?

Well, what we see in the highest-speed products is we see good rates of growth, and in a number of cases, we see some acceleration. the ability for less mature components to be accelerated, you know, through foundries that already are full and have long lead times. That's pretty tough. And we think we have reasonably good visibility to the things that we need. But, you know, essentially if, you know, we give the example of, you know, customer winning a new order or a significant deployment that is above and beyond their prior forecast, it can be hard in some cases to respond on the upside, you know, unless we've buffered that inventory. So, you know, for example, you know, we've seen some impact in international deployments of 400 gig and above systems where under the pandemic deployments may slow. in a region. Well, by the same token, if there's an opportunity to accelerate, if it's not already in the forecast, you have limited ability to pull in and accelerate. And so what we have done is we've worked to buffer our inventory. We've tried to protect that where we can, and we're working with suppliers where we have some concern or limited visibility, but these are the things that we see as, if you will, risks near term. I hope that helps.

The question really is, do you have in hand and supply and site to all of the inventory necessary to hit the high end of the band? And under what circumstances would you be at the low end of the band? I assume it's not a demand problem. The demand is stripping the supply capabilities. Is that not accurate?

I would say that's absolutely accurate in our coherent markets where it's definitely a supply chain constraint and there's opportunities in there. We continue to work the supply chain things. We're comfortable at the low end of the range, as you say. At the high end of the range, we have good visibility on getting to the materials. But it's some of the upside things that we could have been able to go after, but we don't have line of sight to be able to get. And as you know, Alex, a year ago, we kept highlighting, yeah, we're going to have about 10 million of risk on supply chain, and it didn't materialize. So we continue to work it, and we're pretty effective at working it.

So the second question is, do you have a line of sight to the products and components that you need in order to ramp the products that are driving the acceleration in the second half, or is the risk... in the second half as prevalent or even greater because it's further out? And is there any risk of decommissioning or decommitments?

I would say we do have good line of sight. We know what we need. We're working that with our suppliers. We've buffered parts where we think there are risks. We think we have good line of sight. That said, you don't know what you don't know. But I think at the moment, we feel pretty good about line of sight.

I'll get back in the queue. Thanks.

Thanks. Thank you. We'll take our next question from Richard Shannon with Craig Hellum Capital Group.

Hello. Good afternoon, guys. Thanks for taking my questions. Maybe I guess my first one is on the third quarter here, suggesting getting to a break-even level or above here. Pretty significant ramp from the second quarter guidance you just gave us. If we think about the bridge here in sales in terms of ZR and other products, how do we think about this? Tim, given what you suggested about unit volumes in the four figures here with prices I can probably guess at, it seems to suggest that ZR might be a majority of that bridge from second to third quarter. Is that the right way to think about that, or how would you have us think there?

Yeah, on an order of magnitude basis, I'll start and Tim can pile on, is those three areas that I mentioned, the unsatisfied demand from Q2 that we hope to satisfy in Q3, the ramp of the 400G and above components continues to be excellent. and that's part of the supply chain issues we're having. So that was one. And then you get coherent modules, and it's both the telecom module, the CFP2 DCO, and the Datacom module of 400ZR. And then China, because some of the, as Tim mentioned, some of the China customers have been pretty well trained not doing a great deal of 5G stuff in Q, the first half of the year. So between those three, I would say they're roughly equal, plus or minus 5 million or so. So 400 ZR itself is not a majority of it at all. Sam, you want to pile on?

Well, the only thing I'd add is, yeah, it's not the majority, but there is more upside to it. You know, we talked about the fact that the overall business, ex-Huawei, grew 28% year-on-year, and the fact that the 400 gig and above products, as they are, grew 134%, and that's without any real material 400 ZRs. So the ongoing 400 gig and above component business is more predictable. And the 400 ZR has start dates for the second half, but it's a little more unknown. So this is the view as we see it today. Okay.

Well, that's fair enough. I'm going to extend the question here, ZR specific, a little farther into the year. Kimber, this is on your fourth quarter caller of the year. tech trends, Kelly, you did in March. You talked about ZR. I think it was couched as a favorable environment getting to much as 10% of your sales this year. Do you see that bogey as achievable, or is that a stretch either due to deployment timeframes or component shortages or both?

You know, it's still in the cards, Richard, but, you know, this is in the category of predicting, you know, trying to be predicting in two significant digits where the ability to do so actually is limited. So I think it's still a possibility, but it's difficult to say specifically what percent of the forecast will be. You know, it's also worth saying that, you know, in 400ZR, we have two different levels of participation. You know, we, of course, have modules that we're supporting in both the QSFP DD and the OSFP, but we also sell our ultrapure light tunable lasers into other vendors' 400ZR modules. And so, you know, if... If we think about those two pieces, the sale of lasers actually is in the more predictable part because it's a component sale. But we will be supporting both of them on an ongoing basis.

Okay. Fair reminder there. Last quick question for me on ZR here is on the gross margin impact. Any more precise thoughts? I know this has been asked in past quarters, but any more precise thoughts on what you expect that relative to your current portfolio?

Relative to our current margins, higher, but our current margins are slightly depressed right now. But no, we don't have a good picture of what margins are going to be until we get a little farther along. And as we've discussed in the past, there are frequently startup yield issues that you have to work through. So it's a little early to be predicting margin on that.

Thanks. Okay, thanks for those thoughts. That's all for me.

Thanks. Thanks, Richard. Thank you. We'll take our next question from Paul Silverspeen with Cowan & Company.

Thanks, guys. First off, Tim and Beth, can you tell us what the high-speed and 400-gig growth was as you did the last several quarters? Maybe I missed it.

I apologize if I did. The 400-gig and above growth? In total? Yep. Is that what you're asking? Yes, sir. Let's see. In the current quarter, we said that it was 52% of revenue, but actually... Compared to 46% last quarter. Yeah. What was the year-over-year growth rate? The year-over-year growth rate was 134%. So first quarter 21 over first quarter 20, 134%. And for high speed, Tim, what was the year of your press?

100 gig and above, I think is how you define your high speed. Yeah. Now 94% a year ago, it was 92. So it's actually going to be down because it had Huawei in it. Have you been disclosing that? I thought you all had been disclosing that ex-Huawei on a year of your, am I wrong? I thought you'd been disclosing that metric including Huawei.

We've been doing that for the 400 gig stuff. Have we been talking about 100? Not for the 100 gig.

Okay, my fault. I'll move on. Beth, I was confused. I'm sure the shortcoming is me, not you, but I was confused by your response on the question about demand versus supply. Let me ask the question directly. I thought I heard Tim and you talking about softness in the market, but then in response to a question, you said demand for coherent, strong, the issue of supply, if I understood you correctly. I've been under the impression... Go ahead.

There's two things going on. The bigger factor absolutely is supply, but There is also some softness in the market that we're seeing in the first half, both in the U.S. after their large spend on Spectrum and in China, where it's looking like the 5G rollout has slowed down a little bit. But the big The bigger factor is supply and supply of our highest speed products because of chip shortages. There's upside to the Q2 number that we would have been able to get.

All right. I'm not trying to trip you up, but I am trying to understand. When you responded that coherent demand was strong, is the reconciliation of that statement to your statement about some softness in the market, in particular post-US spectrum auctions and the China post-5G rollout. Is the reconciliation that coherent demand is strong other than in the US and other than in China? Or was it just a misstatement?

No, we weren't trying, Paul, to talk about geography. The point was about timing. So, you know, we're seeing overall demand. Customers are forecasting up. Customers are saying that they will be higher in the second half, and that reflects in the backlog and the ordering pattern. But in the near term, you know, how much of the delivery is in 2Q? And, you know, there's current softness for the reasons that we stated and that Beth articulated in North America and in China for backbone provincial long-haul networks It's soft right now. Tim, I appreciate the clarification. But it's stronger later in the year.

Yeah, my statement was a little more annual 18-month type of thing rather than Q2.

Got it. Just to be clear, I appreciate the clarification, but just to be clear, Tim, the softness with respect to the U.S., based on the rolling forecast you're receiving, that underlies your view that it's largely, if not entirely, a 2Q issue and not a second half issue, or are you saying something different? We think it's a Q2 issue. All right. And it's not just based on your hope. You have a basis for belief that it's a near-term 2Q issue, not a full-blown 2I21 issue.

This is based on what our customers are telling us, yes.

All right, just one or two quick more. Tim, I thought I heard you say that you're expecting 1,000 or multiple thousands of units on DR. Am I wrong that, from a revenue perspective, that would translate to a relatively low couple of million, maybe not much more than that, from a revenue impact, just to gauge the impact on the model? Am I in the ball? I know pricing's sensitive, but you're not talking about a ton of revenue if you're talking about low thousands of units, right?

Well, so let me first start with the premise. I didn't say what we're expecting. The question I was asked was, what would constitute volume production? And I said volume in four digits per month would be what we would call volume production, okay? And then we subsequently responded to another question that's saying, you know, it's not the majority of our second half ramp or revenue target. but there is potentially more upside with ZR just because of the units, the potential for units and volume. It remains to be seen. So I hope that clears up the assumption versus the forecast.

Yeah, that's fine. I appreciate it. I'll take the rest offline. Thanks. I appreciate the responses. Thank you. Thank you.

Thank you. We'll take our next question. We'll take our next question from Fahad Majam with MKM Partners. Hi, Fahad.

Hey, Tim. Thank you for taking my question. A couple for me as well. First, if you didn't have any component shortages, would it be safe to say that you would have met your Q2 guidance or maybe some over above that guidance range?

Yeah, we said low to mid single-digit millions. So I don't know where your guide was, Fahad.

Just trying to get a sense if you would have exceeded street consensus numbers.

Sorry?

Just trying to get a sense if you didn't have component shortages, would you have exceeded street consensus numbers? I think it was around 66.5 million for the quarter.

Low to mid-single digits of impact, so I think that would have been in the range. Maybe a little light.

Okay. Tim, the software is in China. If my checks are correct, I'm increasingly hearing from a number of your peers and others in the supply chain that there is an increasing China insourcing risk that the Chinese customers are now sourcing from within China. To what extent is the softness related to insourcing? Are you concerned about insourcing in China impacting your long-term outlook this year and maybe next year from China?

Well, insourcing in China is not new, and certainly with the U.S.-China trade tensions, it's heightened. The fact of the matter is, with our highest speed products, we have very significant growth rates, certainly on a year-on-year basis, but some of the legacy products or, as we call it, network products and systems, have not really been growing. Some of that is because of customers in China, you know, increasing their business with local partners, either with direct competitor products or with suitable alternative products. But, you know, essentially... what we're working on most aggressively is things that are 400 gig and above, where in fact we don't believe that they really have the alternative of using domestic suppliers in China for a lot of those products. So I think insourcing is continuing to be a relevant element of the forward look. However, it's not new. It's been with us for years. And we are continuing to fight the battle of competition through innovation. And I think that's what we're building our forward model on is those newer products.

Okay. I have a clarification question for Beth. Can you just remind us what 100 gig and beyond was in the quarter. You've in the past given that number, but I don't think you gave it this quarter.

Yeah, it was 94%.

94%, okay. Thank you. That will be all for me.

Thank you, Fahad.

Thank you. We'll take our next question from Sameek Chatterjee with JP Morgan. Hi, Sameek.

Hi. Thanks for the question, Tim. I guess I just want to start off with a simple one. I know you mentioned the expanding market for 400 CR with network operators as well, beyond just the hyperscale customers. And you mentioned, I think you were in qualifications as well. Just wanted to understand, like, when you get to that stage, have they already, the network operators kind of already decided there and shortlisted only modules at that point, or are they kind of still evaluating a chassis-based system vis-a-vis a 400 gig module and CR module and what does that indicate? Who are you generally competing against at that stage?

So, you know, the mechanics of a process are that when you're selling components or when you're selling modules, you're working through a qualification and and seeking design wins on systems or on applications that require that product. So, for example, if it's a chassis-based system at 600 gigabit per second, or if it's a chassis-based system that will run up at 800 gig per second, you know, you're competing for a socket win on that, and then as you win it, ideally, you would have an ongoing business for some period of time, such is the case with the ZR, 400 ZR module qualifications. It's you know, in the process of doing the module qualification, doing the design win and doing the potential first article sale, the purchasing decision of the customer, whether it's a data center operator, you know, or a carrier, you know, the purchasing decision of what their system level or architecture level tradeoffs, you know, is less clear. And so... We do know that ZR is new. We do know, therefore, that essentially all the incumbent installations are not ZR. They're all chassis-based systems. And so, really, the question goes down to, you know, is the customer looking at new architecture, a new way of doing business with their network, or are they going to... stick with the way they have been doing it on a legacy basis if it gives them appropriate economics. I think that probably varies by customer, but I think it would be a little bit more on the side of hope to say that, gee, if they qualify the module, then they'll make all systems decisions in favor of that system. I don't think that's the way it works. there's not a direct one-to-one correlation. So we expect that there will continue to be, for some time, there's going to be a mix. And as Wu-Tang said in his prepared remarks, you know, certainly the highest performance, the longest distance, the submarine networks where you really have to have the highest performance at the highest speed, you know, those are going to continue to be chassis-based. And so... I hope that addresses your question. Wu-Pen, do you want to chime in on this at all? Yes, Sameek, so go ahead.

That was clear, thank you. The second one, I was just going back to the ramp that you have in front of you in the second half and understand there's a supply component to it as well as a demand component, particularly when it comes to North America and China. demand, but just wanted to, like, I would have thought if there is very high confidence from those network operators in relation to demand and your customers seeing that demand from network operators in the second half, they would try to, knowing the component shortages, kind of try to pull some of the orders ahead in relation to coherent components. So I'm just wondering, like, what are you seeing in your order patterns? Because if there's high confidence in that second half, revenue ramp and knowing corporate shortages, wouldn't it be logical for small them to start moving orders around and pulling them in?

It would be logical, and they are. Okay.

That's clear, and thank you. Thanks for the clarification.

Thank you. We'll take our next question from Michael Genovese with West Park Capital.

Thanks a lot. First question, just quickly, I want to go back to the earlier question about the macro and just understand if the first quarter and the second quarter are the same, if there's any changes in the first quarter to the second quarter, because you very slightly beat the first quarter, and maybe adding back the components are very slightly missing the consensus for the second quarter. But is the macro the same in the two quarters? Is it actually worse? Are there more push-outs in the second quarter?

I think there are more push-outs in the second quarter, if you put it in that term. But there are other things that have happened. We talked a bit about China Telecom, China Mobile, and slowness in deployments, which really derive from the 5G overall. So those are slower in China now. And then additionally, in the North American market, We saw the completion of the wireless spectrum auctions so that the major carriers in North America completed that. Early in the quarter or late in the last quarter, they outlined some of their multi-year plans for deployments. Those take a bit of time to get rolling. I would describe it as a little bit of an air pocket while we're transitioning from what was the plan to what will be the plan, and that's more of an impact in the second quarter than the first quarter.

Okay, that makes sense. My follow-up on a different topic is number of potential ZR customers. I mean, are we just talking about the hyperscalers and the switch and router vendors, or so is it 10 potential customers, and And related to that, how many trials are you in, or is it many more potential customers than that?

Well, there's two ways to think about that, and that is that 400 ZR interconnects in the top level, the attractive point is it allows direct connection between switches and routers. you know, while hyperscalers are the leaders in terms of time, schedule, and deployment, anybody who uses, you know, switches and routers at 400 gig is a potential customer for 400 ZR. So, you know, if you will, there are those two broad categories, you know, of customers. And so... you know, when we first made our early 400 ZR module deliveries early last year, and we were, you know, we were, you know, among the earliest deliverers and certainly the earliest of all the different form factors here, you know, we've been working on it, therefore, for some period of time, but those, without a doubt, were focused on the biggest guys with the earliest schedules. And we're now, you know, we're now more than a year down the road, and so there are numerous other companies in different parts of the world and in different bits of business that, as Wu-Pen said in his prepared remarks, that are operators of high-performance networks that are now doing their own testing, trials, proofing of 400ZR. So there still will be a relatively small number of very large customers, but I think there will ultimately be a large number of customers in the traditional sense of a long tail.

Great. Thanks for that, Tim.

Thank you. We'll take our final question from Simon Leopold with Raymond James and Associates.

Great. Thank you for taking the question. How are you guys doing? Hope everybody's well. A couple of things I wanted to ask about. One was on the ZR opportunity, I think I believe you're among the three leaders with products actually being evaluated and trialed, but we've definitely heard about many participants expressing interest in coming into this market. I wanted to get your view on how many companies do you expect to be competing and how you think about what the margins could be like overall if it's a crowded space or if you expect It won't be crowded. What's your thought on industry structure of the ZR market? How many players will there be?

My crystal ball is not perfectly clear on this kind of question. I agree with you about the fact that, you know, there are, there are three companies who've been in the fray for all of the last year with the operating modules and multiple tests at different vendors? How many companies ultimately... You know, the way things have gone in the industry for years is that, you know, things start with complete module vendors and then over time, you know, some people who were able to build this component or that component but couldn't get the module business, then they start to be merchant vendors of the components. And that allows assemblers then to get into the business. Now, in this case, we're talking about pretty sophisticated capabilities to be doing this business, and the leading players with leading schedules are really demanding vertically integrated manufacturers to have the ability to stay with the program over the long term and then extend it from ZR to ZR Plus and then from 400 to 800. And so, you know, I think there will be additional entrants, but I think it will still be, you know, let's call it a large handful. I don't think it'll proliferate.

Great. Appreciate that. And then, In terms of the outlook for the second quarter gross margin, you're looking at revenue that's not that different than what you just reported, but a lower gross margin. And I'm imagining that some of the headwind has to do with higher input costs. And I'd like to see if you could help us unpack what aspect of the relative gross margin in Q2 versus the quarter you just reported is is related to input costs, might be related to things like air freight and shipping, or is related to just your own pricing. Could you help us understand the bridge between the two quarters?

So our costs of our major components, just like our customers, are pretty much negotiated annually. So we won't see any inflationary aspects until the annual contracts come up. What the real story is on the Q1 to Q2 gross margin is product mix. As you know well, we have done a great job on increasing our product margins over the last year. We're up five points year over year. So if we start to sell some of the older products, the less favorable mix that I talked about in the script, it's going to show up. And that's exactly what's happened. The 400G components get constrained where there is demand that can't wait until Q3. They're taking older products, and the older products have lower margins.

Great. No, I appreciate that insight. That's helpful. Thank you for taking the questions.

Thank you. And at this time, this concludes our question and answer session. I'll turn it back to Tim Jinks for closing remarks.

Thank you, Todd. Thank you for joining our call today and for your interest in neophotonics. The core trends of the industry play into our strengths in 2021 and subsequent years. I'm very proud of our team for what they've achieved, and we do look forward to updating you in the future. Have a good evening.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.