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NEOPHOTONICS CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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, 2014 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, 2013 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, 2014 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, 2014 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, 2013, as filed with the SEC on June 4, 2014. 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 are a leading designer and manufacturer of photonic integrated circuit, or PIC-based optoelectronic modules and subsystems for bandwidth-intensive, high-speed communications networks. Our products are designed to enable high-speed transmission rates and efficient allocation of bandwidth over optical networks with high quality and low costs. Our PIC technology utilizes proprietary design elements that provide optical functionality on a silicon or indium phosphide or hybrid chip. PIC devices can integrate many more functional elements than discretely packaged components, enabling increased functionality in a small form factor while reducing packaging and interconnection costs. In addition, the cost advantages of PIC-based components are similar to the economics of semiconductor wafer mass manufacturing, where the marginal cost of producing an incremental chip is much less than that of a discrete component. We have research and development and wafer fabrication facilities in San Jose and Fremont, California and in Tokyo, Japan which coordinate with our research and development and manufacturing facilities in Shenzhen and Wuhan, China and Ottawa, Canada. We utilize proprietary design tools and design-for-manufacturing techniques to align our design process with our precision nanoscale, vertically integrated manufacturing and testing capabilities. We sell our products to the leading network equipment vendors globally, including ADVA AG Optical Networking Ltd., Alcatel-Lucent SA, Ciena Corporation, Cisco Systems, Inc., Coriant Gmbh & Co. KG (formerly Nokia Siemens Networks B.V.), ECI Telecom, Ltd., FiberHome Technologies Group, Fujitsu Limited, Huawei Technologies Co., Ltd, Juniper Networks, Inc., Mitsubishi Electric Corporation, NEC Corporation, Telefonaktiebolaget LM Ericsson and ZTE Corporation. We refer to these companies as our Tier 1 customers. On March 29, 2013, we acquired the optical semiconductor business unit of LAPIS Semiconductor Co., Ltd., now known as NeoPhotonics Semiconductor Godo Keisha ("NeoPhotonics Semiconductor"). NeoPhotonics Semiconductor is a leading provider of lasers, drivers, and detectors for high speed 100Gbps applications and is located in Japan. We believe the acquisition of NeoPhotonics Semiconductor enhances our competitive position in 100Gbps products. In the three months ended September 30, 2014, our revenue growth of 6% over the three months ended September 30, 2013 was primarily due to the demand for our High Speed products, including our 100Gbps Speed products, as carriers continued to accelerate deployments of 100Gpbs high capacity optical transport networks worldwide. 21 -------------------------------------------------------------------------------- We expect continued volume growth for our 100Gbps products, although quarter-to-quarter results may show considerable variability as is usual in a rapid initial ramp-up for a new technology. Similar to revenue, our gross margins can fluctuate materially depending on a variety of factors including average selling price changes, product mix, volume, manufacturing utilization and ongoing manufacturing process improvements. In October 2014, we entered into an Asset Purchase Agreement (the "Purchase Agreement"), with EMCORE Corporation ("EMCORE"). Consummation of the Purchase Agreement is subject to customary closing conditions and is expected to close by early January 2015. Under the Purchase Agreement, we agreed to purchase certain assets and assume certain liabilities of EMCORE's tunable laser and transceiver product lines for $17.5 million in total consideration, which is subject to certain adjustments for inventory, net accounts receivable, pre-closing revenues and the principal amount due under the promissory note will be increased and decreased, as applicable, by an amount corresponding to any such adjustment. Purchase consideration would consist of $1.5 million in cash at closing with the balance to be paid pursuant to a promissory note with a two-year term. In July 2014, we initiated a restructuring plan (the "2014 Restructuring Plan") to improve our operating costs, reduce our workforce and to better align our resources for our needs in the changing market. As a result, we have recorded $0.8 million in restructuring expenses in the three and nine months ended September 30, 2014 for severance and related charges. We expect to complete the 2014 Restructuring Plan in the remainder of 2014 as part of our effort to reorganize our business structure to address operational and profitability challenges while continuing our focus on key growth markets. Critical accounting policies and estimates In the three and nine months ended September 30, 2014, there have been no material changes to our critical accounting policies and estimates 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, 2013. Results of operations Revenue We sell substantially all of our products to original equipment manufacturers, or OEMs. Revenue is recognized when title of our products passes to the OEM. We price our products based on market and competitive conditions and may periodically reduce the price of our products as market and competitive conditions change and as manufacturing costs are reduced. Our sales transactions to customers are denominated primarily in Chinese Renminbi ("RMB"), Japanese Yen ("JPY") or U.S. dollars. Three Months Ended Nine Months Ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Total revenue $ 81,576 $ 76,814 $ 227,195 $ 207,867 We have generated most of our revenue from a limited number of customers. Customers accounting for more than 10% of our total revenue and revenue from our top ten customers for the three and nine months ended September 30, 2014 and 2013 were as follows: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Percent of revenue from customers accounting for 10% or more of total revenue: Huawei Technologies Co., Ltd 35 % 23 % 36 % 26 % Ciena Corporation 17 % 13 % 15 % 16 % Alcatel-Lucent SA 9 % 17 % 11 % 14 % Percent of revenue from top ten customers 88 % 85 % 88 % 85 % As of September 30, 2014, Huawei, ZTE Corporation and Sanmina-SCI Corporation accounted for 39%, 14% and 10% of our total accounts receivable, respectively. As of December 31, 2013, Huawei and ZTE Corporation accounted for 14% and 10% of our total accounts receivable, respectively. 22 --------------------------------------------------------------------------------Three Months Ended September 30, 2014 Compared With Three Months Ended September 30, 2013 Our revenue increased $4.8 million, or 6%, in the three months ended September 30, 2014, compared with the three months ended September 30, 2013 due to increases in revenue from our High Speed products, including our 100Gbps Speed products, as carriers continued to accelerate deployments of 100Gbps high capacity optical transport networks worldwide and deployments of 4G-LTE networks. Nine Months Ended September 30, 2014 Compared With Nine Months Ended September 30, 2013 Our revenue increased $19.3 million, or 9%, in the nine months ended September 30, 2014, compared with the nine months ended September 30, 2013 due to increases in revenue from our High Speed products, including our 100Gbps Speed products and High Speed Transceivers, as carriers continued to accelerate deployments of 100Gbps high capacity optical transport networks worldwide and deployments of 4G-LTE networks in China. NeoPhotonics Semiconductor, many of whose products are 100Gbps and are in our Speed and Agility category, was acquired on March 29, 2013 and only contributed to a portion of the revenue in the nine months ended September 30, 2013. Cost of goods sold and gross margin Our cost of goods sold consists primarily of the cost to produce wafers and to manufacture and test our products. Additionally, our cost of goods sold includes stock-based compensation, write-downs of excess and obsolete inventory, royalty payments, amortization of certain purchased intangible assets, depreciation, acquisition-related fair value adjustments, restructuring cost, warranty, shipping and allocated facilities and information technology costs. Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in thousands, except % of % of % of % of percentages) Amount Revenue Amount Revenue Amount Revenue Amount Revenue Cost of goods sold $ 61,512 75 % $ 58,635 76 % $ 178,763 79 % $ 162,330 78 % Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Gross margin 25 % 24 % 21 % 22 % 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, revaluation of stock appreciation unit awards that are impacted by our stock price, 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. Three and Nine Months Ended September 30, 2014 Compared With Three and Nine Months Ended September 30, 2013 Gross margin increased one percentage point in the three months ended September 30, 2014 compared with the same period in 2013 primarily due to product mix, lower manufacturing costs and customer mix. Restructuring charges included within cost of goods sold were $0.3 million and $0.6 million in the three months ended September 30, 2014 and 2013, respectively. Gross margin decreased one percentage point in the nine months ended September 30, 2014 compared with the same period in 2013 primarily due to product mix. Restructuring charges included within cost of goods sold were $0.3 million and $0.6 million in the nine months ended September 30, 2014 and 2013, respectively. 23 --------------------------------------------------------------------------------Operating expenses Personnel costs are the most significant component of operating expenses and consist of costs such as salaries, benefits, bonuses, stock-based compensation and, with regard to sales and marketing expense, sales commissions. Our operating expenses are denominated primarily in RMB, JPY and U.S. dollars. Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 (in thousands, % of % of % of % of except percentages) Amount Revenue Amount Revenue Amount Revenue Amount Revenue Research and development $ 11,842 15 % $ 12,227 16 % $ 35,983 16 % $ 33,021 16 % Sales and marketing 3,075 4 % 3,580 5 % 10,057 4 % 10,515 5 % General and administrative 6,712 8 % 8,905 12 % 23,892 11 % 21,853 10 % Restructuring charges 504 1 % 450 1 % 504 0 % 775 0 % Amortization of purchased intangible assets 378 0 % 381 0 % 1,136 1 % 1,128 1 % Adjustment to fair value of contingent consideration - - % 1,026 1 % - - % 1,026 0 % Escrow settlement gain - 0 % - 0 % (3,886 ) (2) % - 0 % Acquisition-related transaction costs - 0 % 126 0 % - 0 % 5,317 3 % Total operating expenses $ 22,511 28 % $ 26,695 35 % $ 67,686 30 % $ 73,635 35 % Research and development Research and development expense consists of personnel costs, including stock-based compensation, for our research and development personnel, and product development costs, including engineering services, development software and hardware tools, depreciation of equipment and facility costs. We record all research and development expense as incurred. Three Months Ended September 30, 2014 Compared With Three Months Ended September 30, 2013 Research and development expense decreased $0.4 million, or 3%, in the three months ended September 30, 2014 compared with the three months ended September 30, 2013 primarily due to a $0.5 million decrease in development expenses and a $0.2 million increase in depreciation expense, partially offset by a $0.2 million increase in bonus accrual. Nine Months Ended September 30, 2014 Compared With Nine Months Ended September 30, 2013 Research and development expense increased $3.0 million, or 9%, in the nine months ended September 30, 2014, compared with the nine months ended September 30, 2013, primarily attributable to a $1.3 million increase in development expenses for key projects, a $0.9 million increase in facility and equipment depreciation expenses to support our development initiatives and a $0.2 million increase due to the acquisition of NeoPhotonics Semiconductor in March 2013. We intend to continue to invest in research and development in line with our business strategy. As a percentage of total revenue, our research and development expense may vary with changes in our revenue. Sales and marketing Sales and marketing expense consists primarily of personnel costs, including stock-based compensation and sales commissions, costs related to sales and marketing programs, services costs and facility costs. Three Months Ended September 30, 2014 Compared With Three Months Ended September 30, 2013 Sales and marketing expense decreased $0.5 million, or 14%, in the three months ended September 30, 2014 compared with the three months ended September 30, 2013 primarily due to a $0.4 million decrease in provision for doubtful accounts and a $0.2 million decrease in payroll expense resulting from past restructuring efforts, partially offset by a $0.1 million increase in allocated service costs. 24 --------------------------------------------------------------------------------Nine Months Ended September 30, 2014 Compared With Nine Months Ended September 30, 2013 Sales and marketing expense decreased $0.5 million, or 4%, in the nine months ended September 30, 2014 compared with the nine months ended September 30, 2013 primarily attributable to a $0.4 million decrease in payroll expense resulting from past restructuring efforts, a $0.3 million decrease in provision for doubtful accounts and a $0.2 million reduction in commission expense, partially offset by a $0.4 million increase in allocated service costs and a $0.1 million increase in employee related expenses. General and administrative General and administrative expense consists primarily of personnel costs, including stock-based compensation, for our finance, legal, human resources and information technology personnel and certain executive officers, as well as professional services costs related to accounting, tax, banking, legal and information technology services, depreciation and facility costs. Three Months Ended September 30, 2014 Compared With Three Months Ended September 30, 2013 General and administrative expense decreased $2.2 million, or 25%, in the three months ended September 30, 2014 compared with the three months ended September 30, 2013 primarily due to a $1.7 million decrease in consulting services, a $0.3 million decrease in accounting and legal fees, a $0.3 million decrease in maintenance costs, a $0.2 million decrease in equipment expense and a $0.2 million decrease in facility expenses, partially offset by a $0.3 million increase in depreciation expense and a $0.2 million increase in recruiting, bonus and employee related expenses. Nine Months Ended September 30, 2014 Compared With Nine Months Ended September 30, 2013 General and administrative expense increased $2.0 million, or 9%, in the nine months ended September 30, 2014, compared with the nine months ended September 30, 2013, primarily due to a $1.3 million increase in accounting and consulting fees related to the restatement of our Quarterly Reports on Form 10-Q for the quarters ended March 31 and June 30, 2013 and resources to assist us in the process of strengthening our internal controls. Employee costs increased $0.6 million as NeoPhotonics Semiconductor was acquired on March 29, 2013 and incurred related expenses for only a portion of 2013. In addition, depreciation expense increased $0.6 million due to past capital expenditures, partially offset by a $0.5 million decrease in maintenance costs. Amortization of purchased intangible assets Our intangible assets are being amortized over their estimated useful lives. Amortization expense relating to technology, patents and leasehold interests are included within cost of goods sold, and expense from amortization of customer relationships is recorded within operating expenses. Amortization of purchased intangibles included in operating expenses was relatively consistent in the three and nine months ended September 30, 2014 compared to the same periods in 2013. Escrow Settlement Gain In May 2014, we entered into a settlement agreement covering the outstanding claims in connection with our 2011 acquisition of Santur Corporation ("Santur"). Under the terms of the settlement agreement, a net amount of $1.9 million was paid to us from the escrow account that was setup under the original merger agreement. This amount comprised of $3.9 million related to indemnification claims by us (the "Indemnification Amount") which was partially offset by a $2.0 million liability related to additional consideration to Santur that was contingent upon Santur's gross profit performance in 2012 (the "Contingent Consideration"). We had recorded the entire Contingent Consideration as of December 31, 2013. The $3.9 million Indemnification Amount was recorded as a settlement gain in the second quarter of 2014. Restructuring In the three and nine months ended September 30, 2014, we incurred $0.8 million in severance and related restructuring expenses in connection with our 2014 Restructuring Plan. In the three and nine months ended September 30, 2013, we incurred restructuring charges of $1.1 million and $1.4 million, respectively, to reduce workforce and close certain facilities in the U.S. and in China. Restructuring charges in the 2014 and 2013 periods are included in cost of goods sold and operating expenses. Acquisition-related transaction costs In connection with our acquisition of NeoPhotonics Semiconductor in 2013, we incurred $5.3 million in acquisition-related transaction costs during the nine months ended September 30, 2013 related to investment banking, legal, accounting and other professional services and fees as well as transfer and acquisition taxes related to real property acquired. 25 --------------------------------------------------------------------------------Interest and other expense, net Interest income consists of income earned on our cash, cash equivalents, short-term investments as well as restricted cash and investments. Interest expense consists of amounts paid for interest on our bank and other borrowings. Other income (expense), net is primarily made up of government subsidies as well as foreign currency transaction gains and losses. The functional currency of our subsidiaries in China is the RMB and of our subsidiaries in Japan is the JPY. The foreign currency transaction gains and losses of our subsidiaries in China and Japan primarily result from their transactions in U.S. dollars. Three Months Ended Nine Months Ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Interest income $ 52 $ 66 $ 155 $ 269 Interest expense (375 ) (251 ) (937 ) (756 ) Other income (expense), net 1,735 115 493 (432 ) Total $ 1,412 $ (70 ) $ (289 ) $ (919 ) Three Months Ended September 30, 2014 Compared With Three Months Ended September 30, 2013 Total interest and other income (expense), net increased by $1.5 million in the three months ended September 30, 2014, compared with the three months ended September 30, 2013, primarily due to a $1.8 million foreign exchange gains mainly attributable to weaker Japanese Yen in the 2014 period. Nine Months Ended September 30, 2014 Compared With Nine Months Ended September 30, 2013 Total interest and other income (expense), net increased by $0.6 million in the nine months ended September 30, 2014, compared with the nine months ended September 30, 2013, mainly due to $0.9 million increase in other income attributable to foreign exchange gains mainly driven by weaker Japanese Yen, partially offset by a $0.3 million charge to adjust the fair value of our penalty payment derivative in the 2014 period. Income taxes We conduct our business globally and our operating income is subject to varying rates of tax in the United States, China, Japan and other various foreign jurisdictions. Consequently, our effective tax rate is dependent upon the geographic distribution of our earnings or losses and the tax laws and regulations in each geographical region. Historically, we have experienced net losses in the U.S. and in the short term, we expect this trend to continue. In China, one of our subsidiaries has historically qualified for a preferential 15% tax rate available for high technology enterprises as opposed to the statutory 25% tax rate for 2014 to 2016. Three Months Ended Nine Months Ended September 30, September 30, (in thousands) 2014 2013 2014 2013 Provision for income taxes $ (902 ) $ (777 ) $ (1,761 ) $ (870 ) Our income tax expense in the three and nine months ended September 30, 2014 was primarily related to income taxes of our non-U.S. operations. Liquidity and capital resources At September 30, 2014, we had working capital of $95.2 million and total cash and cash equivalents of $35.3 million, of which 20% was held in accounts by our subsidiaries in China and 20% was held in accounts by our subsidiaries in Japan. Approximately $6.5 million of our accumulated deficit at December 31, 2013 was subject to restriction due to the fact that our 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. This restricted amount is not distributable as cash dividends except in the event of liquidation. We have a bank credit agreement with Comerica Bank as the lead bank. As of September 30, 2014, this credit agreement included the following: - A revolving credit facility under which there was no outstanding borrowing at September 30, 2014 or December 31, 2013 and $20.0 million was available for borrowing at September 30, 2014, subject to covenant requirements. Amounts 26 -------------------------------------------------------------------------------- borrowed, if any, are due on or before March 2016 and bear interest at an interest rate option of a base rate as defined in the agreement plus 1.75% or LIBOR plus 2.75%. As of September 30, 2014, the rate on the LIBOR option was 2.90%. - A term loan facility under which $19.3 million was outstanding at September 30, 2014. Interest is payable monthly in arrears and the principal is paid in equal quarterly installments over the term of the loan ending in June 2017. Borrowings under the term loan bear interest at an interest rate option of a base rate as defined in the agreement plus 2.0% or LIBOR plus 3.0%. As of September 30, 2014, the rate on the LIBOR option was 3.15%. Our credit agreement requires the maintenance of specified financial covenants, including a debt to EBITDA ratio and liquidity ratios. The agreement also restricts our ability to incur certain additional debt or to engage in specified transactions, restricts the payment of dividends and is secured by substantially all of our U.S. assets, other than intellectual property assets. On May 19, 2014, we executed an amendment to the credit agreement that waived the testing of certain covenants for compliance, provided that we maintain compensating balances equal to outstanding amounts under the credit agreement in accounts for which the bank will have sole access. We intend to restructure the bank credit agreement, including the compensating balance requirements. In the absence of a restructured agreement, we believe we may need to continue to maintain the compensating balances at least through the end of 2014. As of September 30, 2014, the amount of our cash and investments in these compensating balance accounts, for the term loan with Comerica Bank, was $19.3 million, which is classified as current and non-current restricted cash and investments on our September 30, 2014 condensed consolidated balance sheet. We regularly issue notes payable to our suppliers in China in exchange for accounts payable. These notes are supported by noninterest bearing bank acceptance drafts and are due three to six months after issuance. As a condition of the notes payable arrangements, we are required to keep a compensating balance at the issuing banks that is a percentage of the total notes payable balance until the amounts are settled. At September 30, 2014, one of our subsidiaries in China had a short-term line of credit facility with a banking institution which expires in June 2015. Under the agreement, RMB 160.0 million ($26.0 million) can be used for bank acceptance drafts (with a 25% to 30% compensating balance requirement) and up to RMB 120.0 million ($19.5 million) can be used for short-term loans, which will bear interest at varying rates. In September 2014, the Company's China subsidiary renewed its second line of credit facility with a banking institution, under which RMB 150 million ($24.4 million) can be used for bank acceptance draft (with a 30% compensating balance requirement) or short-term loans. This line of credit facility expires in September 2015. As of September 30, 2014, the non-interest bearing bank acceptance drafts issued in connection with our notes payable to our suppliers in China under these line of credit facilities had an outstanding balance of $12.6 million. In May 2014, one of our subsidiaries in China issued a bank acceptance draft of $8.1 million to its subsidiary. This bank acceptance draft required a compensating balance of RMB 15 million ($2.4 million) prior to its cancellation in August 2014. As of September 30, 2014 and December 31, 2013, the compensating balance for these bank acceptance drafts totaled $3.4 million and $2.1 million, respectively, and was classified as restricted cash and investments on our condensed consolidated balance sheets. In May 2014, our subsidiary in China borrowed CNY 50 million ($8.1 million) under a working capital loan agreement with a bank. The loan bears interest at 7% per annum. Interest is payable monthly and the principal is due on November 23, 2014. The loan was repaid in full in November 2014. In October 2014, our subsidiary in China entered into a short-term advance financing agreement under one of its line of credit facilities to borrow $5.0 million against export sales to its parent company. The loan bears interest at 4.02% per annum. Interest and the principal are due on April 27, 2015. In connection with the acquisition of NeoPhotonics Semiconductor on March 29, 2013, we were obligated to pay 1,050 million Japanese Yen in three equal installments on the anniversaries of the closing date for the purchase of the real estate used by NeoPhotonics Semiconductor, of which 700 million Japanese Yen ($6.4 million) was outstanding at September 30, 2014. The obligation bears interest at 1.5% per year, payable annually, and is secured by the acquired real estate property. 27 -------------------------------------------------------------------------------- On October 22, 2014, we entered into the Purchase Agreement with EMCORE Corporation to purchase certain assets and assume certain liabilities of EMCORE's tunable laser and transceiver product lines for $17.5 million in total consideration. Purchase consideration would consist of $1.5 million in cash at closing with the balance to be paid pursuant to a promissory note with a two-year term. The promissory note will bear interest of 5% per annum for the first year and 13% per annum for the second year. The interest will be payable semi-annually in cash, and the promissory note will mature two years from the closing of the transaction. In addition, the promissory note will be subject to prepayment under certain circumstances and will be secured by certain of the assets to be sold pursuant to the Purchase Agreement. Under the Purchase Agreement, the purchase price is subject to certain adjustments for inventory, net accounts receivable, pre-closing revenues and the principal amount due under the promissory note will be increased and decreased, as applicable, by an amount corresponding to any such adjustment. Consummation of the Purchase Agreement is subject to customary closing conditions and is expected to close by early January 2015. From time to time we accept notes receivable in exchange for accounts receivable from certain of our customers in China. These notes receivable are non-interest bearing and are generally due within six months. Historically, we have collected on the notes receivable in full at the time of maturity. We believe that our existing cash, cash equivalents and expected cash flows from our operating activities will be sufficient to meet our anticipated cash needs for at least the next 12 months, even with the compensating balance requirements discussed above. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products, the costs to increase our manufacturing capacity and our foreign operations, the continuing market acceptance of our products and acquisitions of businesses and technology. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. Private placement transaction In connection with the 2012 private placement transaction, we 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 our Russian operations. The Investment Commitment can be partially satisfied by cash and/or non-cash investment inside or outside of Russia 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 Commitment is required to be satisfied by making capital expenditure investments, including those that are non-cash, and we expect that the remaining $15.0 million will be satisfied through cash and non-cash general working capital and research and development expenditures and commitments. 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 must be spent inside Russia. General working capital can include cash or stock acquisition of technology and other businesses or portions thereof to be owned by the Russian subsidiary. Our current plan is to substantially meet the $15.0 million capital expenditure portion of the Investment Commitment by transferring non-cash assets from other entities within the consolidated Company to the Russian subsidiary, subject to the purchaser's approval as required in the rights agreement. We expect that the remaining $15.0 million will be satisfied through some combination of working capital and research and development spending, which may include technology or other acquisitions acquired by cash or stock through March 2015. The exact timing and composition of those expenditures has not yet been determined. The purchaser of the common stock in the private placement transaction has nontransferable veto rights over our Russian subsidiary's annual budget during the investment period, and non-cash asset transfers to be made in satisfaction of the Investment Commitment requires approval by the purchaser. 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 amounts received in the private placement transaction or on withdrawal from our bank accounts for use in general corporate purposes. We were required to satisfy the Investment Commitment by July 31, 2014, which date has been extended to March 31, 2015 as we did not record aggregate revenue from sales of our products in the Russian Federation of at least $26.8 million during the period beginning July 1, 2012 and ending June 30, 2014. We intend to meet the Investment Commitment by March 31, 2015. If we fail to meet the Investment Commitment by the deadline, including failure to meet the Investment Commitment because the purchaser of the common stock does not approve the transfer of non-cash assets, we will be required to pay a $5.0 million penalty as the sole and exclusive remedy for damages and monetary relief available to the purchaser for failure to meet the Investment Commitment. 28 --------------------------------------------------------------------------------Cash flow discussion The table below sets forth selected cash flow data for the periods presented: Nine Months Ended September 30, (in thousands) 2014 2013 Net cash used in operating activities $ (11,428 ) $ (5,007 ) Net cash (used in) provided by investing activities (11,939 ) 10,164 Net cash provided by financing activities 2,062 1,495 Effect of exchange rates on cash and cash equivalents (527 ) 64 Net (decrease) increase in cash and cash equivalents $ (21,832 ) $ 6,716 Operating activities Net cash used in operating activities was $11.4 million in the nine months ended September 30, 2014, which was a $6.4 million increase compared with the nine months ended September 30, 2013. The increase was primarily due to a $17.3 million reduction in cash flows related to accounts payable as well as accrued and other liabilities primarily attributable to timing of payments and a $7.2 million reduction in accounts receivable related cash flows attributable to higher accounts receivable balance driven by increased sales and timing of collections. The increase was partially offset by an $11.4 million decrease in inventories related cash outflows due to inventory reduction measures and an $8.6 million decrease in net loss during the 2014 period. Investing activities Net cash used in investing activities increased $22.1 million to $11.9 million in the nine months ended September 30, 2014 as compared with the nine months ended September 30, 2013. The increase was primarily due to a $75.3 million decrease in proceeds from the sale and maturity of marketable securities and a $13.3 million increase in restricted cash pertaining to the compensating balance requirements under our term loan arrangement and our line of credit facilities, partially offset by a $48.2 million decrease in marketable securities purchases, a net cash payment of $13.1 million for the acquisition of NeoPhotonics Semiconductor in 2013 and a $5.2 million decrease in capital equipment purchases. Financing activities Net cash provided by financing activities increased $0.6 million to $2.1 million in the nine months ended September 30, 2014 as compared with the nine months ended September 30, 2013. The increase was primarily due to a $13.7 million decrease in bank loan repayments, a $4.7 million increase in proceeds from issuance of notes payable and a $2.6 million decrease in notes payable repayments, partially offset by a $18.3 million decrease in proceeds from bank loans and a $2.0 million payment for the contingent consideration liability related to the Santur acquisition. Contractual obligations and commitments As of September 30, 2014, our principal commitments consist of obligations under operating leases, purchase commitments, debt and other contractual obligations. There have been no significant changes to these obligations during the nine months ended September 30, 2014 compared to the contractual obligations disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, except as follows: · In May 2014, we executed an amendment to the credit agreement with Comerica Bank that waived the testing of certain covenants for compliance provided that we maintain compensating balances equal to outstanding amounts under the credit agreement in accounts for which the bank will have sole access. As of September 30, 2014, our cash and investments in these compensating balance accounts was $19.3 million, which have been classified as current and non-current restricted cash and investments on our September 30, 2014 condensed consolidated balance sheet. · In May 2014, our subsidiary in China borrowed CNY 50 million ($8.1 million) under a working capital loan agreement with a bank, which was outstanding as of September 30, 2014. The loan bears interest at 7% per annum. Interest is payable monthly and the principal is due on November 23, 2014. The loan was repaid in full in November 2014. · In June 2014, our subsidiary in China renewed a short-term line of credit facility with a banking institution which expires in June 2015. Under the agreement, RMB 160.0 million ($26.0 million) can be used for bank acceptance drafts (with a 25% to 30% compensating balance requirement) and up to RMB 120.0 million ($19.5 million) can be used for short-term loans, which will bear interest at varying rates. In September 2014, our China subsidiary renewed its second short-term line of credit facility with a banking institution, under which RMB 150.0 million ($24.4 million) can be used for bank acceptance drafts (with a 30% compensating balance requirement) or short-term loans. This line 29 -------------------------------------------------------------------------------- of credit facility expires in September 2015. As of September 30, 2014, the non-interest bearing bank acceptance drafts issued in connection with the Company's notes payable to its suppliers in China, under these line of credit facilities, was $12.6 million, which has been classified as notes payable on our September 30, 2014 condensed balance sheet. Off-balance sheet arrangements During the three and nine months ended September 30, 2014, we did not have any significant off-balance sheet arrangements. Recent accounting pronouncements See Note 1 "Basis of presentation and significant accounting policies" in the Notes to Condensed Consolidated Financial Statements on this Quarterly Report on Form 10-Q for a description of recent accounting pronouncements and accounting changes. |