NEOPHOTONICS CORP - FORM 10-Q - November 8, 2017

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EX-32.1 - EXHIBIT 32.1 - NEOPHOTONICS CORPexhibit321.htm
EX-31.2 - EXHIBIT 31.2 - NEOPHOTONICS CORPexhibit312.htm
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EX-10.2 - EXHIBIT 10.2 - NEOPHOTONICS CORPexhibit102.htm
EX-10.1 - EXHIBIT 10.1 - NEOPHOTONICS CORPexhibit101.htm

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

(Mark One)
☒        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017
OR
☐        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from        to        
Commission File Number: 001-35061
 
NeoPhotonics Corporation
(Exact name of registrant as specified in its charter)
 
 
 
 
 
Delaware
 
94-3253730
(State or other jurisdiction
of incorporation or organization)
 
(I.R.S. Employer
Identification No.)
2911 Zanker Road
San Jose, California 95134
(Address of principal executive offices, zip code)
(408) 232-9200
(Registrant’s telephone number, including area code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  ☒     No   ☐     
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  ☒     No   ☐ 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
☐
 
Accelerated filer
☒
Non-accelerated filer
☐
(do not check if a smaller reporting company)
Smaller reporting company
☐
Emerging growth company
☐
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ☐     No   ☒ 
 
As of October 31, 2017, there were approximately 43,945,300 shares of the registrant’s Common Stock outstanding. 



NEOPHOTONICS CORPORATION
For the Quarter Ended September 30, 2017
Table of Contents
 
 
Page
 
 
 
 
 
 
 
 
 
 
 



PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 
 
As of
 
September 30,
2017
 
December 31, 2016
(In thousands, except par data)
 
ASSETS
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
58,528

 
$
82,500

Short-term investments
12,281

 
19,015

Restricted cash
2,917

 
4,085

Accounts receivable, net of allowance for doubtful accounts
67,003

 
80,610

Inventories
82,809

 
48,237

Assets held for sale
—

 
13,953

Prepaid expenses and other current assets
34,568

 
22,396

Total current assets
258,106

 
270,796

Property, plant and equipment, net
127,316

 
106,867

Purchased intangible assets, net
4,594

 
5,562

Goodwill
1,115

 
1,115

Other long-term assets
6,858

 
6,547

Total assets
$
397,989

 
$
390,887

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
69,771

 
$
84,766

Notes payable and short-term borrowing
19,630

 
30,190

Current portion of long-term debt
5,740

 
747

Accrued and other current liabilities
44,743

 
30,625

Total current liabilities
139,884

 
146,328

Long-term debt, net of current portion
41,029

 
10,215

Other noncurrent liabilities
14,959

 
8,939

Total liabilities
195,872

 
165,482

Commitments and contingencies (Note 10)


 


Stockholders’ equity:
 

 
 

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

 
—

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

 
 

As of September 30, 2017, 43,909 shares issued and outstanding; as of December 31, 2016, 42,526 shares issued and outstanding
110

 
106

Additional paid-in capital
542,029

 
532,378

Accumulated other comprehensive loss
(2,294
)
 
(8,401
)
Accumulated deficit
(337,728
)
 
(298,678
)
Total stockholders’ equity
202,117

 
225,405

Total liabilities and stockholders’ equity
$
397,989

 
$
390,887

 
See accompanying Notes to Condensed Consolidated Financial Statements.


3

NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
(In thousands, except per share data)
2017
 
2016
 
2017
 
2016
Revenue
$
71,121

 
$
103,312

 
$
216,023

 
$
301,586

Cost of goods sold
60,608

 
75,863

 
170,230

 
215,486

Gross profit
10,513

 
27,449

 
45,793

 
86,100

Operating expenses:
 
 
 
 
 
 
 
Research and development
14,662

 
17,474

 
44,412

 
42,206

Sales and marketing
4,071

 
5,936

 
12,913

 
13,674

General and administrative
7,637

 
9,822

 
26,792

 
26,747

Amortization of purchased intangible assets
119

 
462

 
355

 
1,375

Acquisition and asset sale related costs
78

 
148

 
229

 
923

Restructuring charges
2,829

 
—

 
3,550

 
—

Gain on asset sale
—

 
—

 
(2,000
)
 
—

Total operating expenses
29,396

 
33,842

 
86,251

 
84,925

Income (loss) from operations
(18,883
)
 
(6,393
)
 
(40,458
)
 
1,175

Interest income
37

 
95

 
141

 
227

Interest expense
(495
)
 
(103
)
 
(743
)
 
(304
)
Other income (expense), net
(41
)
 
18

 
197

 
(828
)
Total interest and other income (expense), net
(499
)
 
10

 
(405
)
 
(905
)
Income (loss) before income taxes
(19,382
)
 
(6,383
)
 
(40,863
)
 
270

Income tax (provision) benefit
1,195

 
(804
)
 
1,813

 
(2,471
)
Net loss
$
(18,187
)
 
$
(7,187
)
 
$
(39,050
)
 
$
(2,201
)
 
 
 
 
 
 
 
 
Basic net loss per share
$
(0.42
)
 
$
(0.17
)
 
$
(0.90
)
 
$
(0.05
)
Diluted net loss per share
$
(0.42
)
 
$
(0.17
)
 
$
(0.90
)
 
$
(0.05
)
Weighted average shares used to compute basic net loss per share
43,790

 
42,038

 
43,212

 
41,589

Weighted average shares used to compute diluted net loss per share
43,790

 
42,038

 
43,212

 
41,589

 
See accompanying Notes to Condensed Consolidated Financial Statements.

4

 
NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS   
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
(in thousands)
2017
 
2016
 
2017
 
2016
Net loss
$
(18,187
)
 
$
(7,187
)
 
$
(39,050
)
 
$
(2,201
)
Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments, net of zero tax
2,177

 
(22
)
 
6,090

 
292

Unrealized gains on available-for-sale securities, net of zero tax
1

 
—

 
17

 
33

Total other comprehensive income (loss)
2,178

 
(22
)
 
6,107

 
325

Comprehensive loss
$
(16,009
)
 
$
(7,209
)
 
$
(32,943
)
 
$
(1,876
)
 
See accompanying Notes to Condensed Consolidated Financial Statements.

5

NEOPHOTONICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Nine Months Ended
September 30,
 
(In thousands)
2017
 
2016
Cash flows from operating activities
 
 
 
Net loss
$
(39,050
)
 
$
(2,201
)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
 
 
 
Depreciation and amortization
20,630

 
16,921

Stock-based compensation expense
5,692

 
14,445

Deferred taxes
673

 
(1,162
)
Amortization of investment, debt and other
158

 
125

Gain on sale of assets and other write-offs
(1,623
)
 
(18
)
Gain on foreign currency hedges
(1,501
)
 
—

Allowance for doubtful accounts
76

 
(415
)
Write-down of inventories
7,083

 
1,995

Asset impairment charge
275

 
—

Foreign currency remeasurement and other, net
1,576

 
(556
)
Change in assets and liabilities, net of effects of asset sale:
 
 
 
Accounts receivable
13,755

 
(12,169
)
Inventories
(36,466
)
 
4,518

Prepaid expenses and other assets
(12,002
)
 
(3,439
)
Accounts payable
(9,424
)
 
12,610

Accrued and other liabilities
8,937

 
(3,937
)
Net cash (used in) provided by operating activities
(41,211
)
 
26,717

Cash flows from investing activities
 
 
 
Purchase of property, plant and equipment
(41,461
)
 
(29,962
)
Proceeds from sale of property, plant and equipment and other assets
21,806

 
139

Purchase of marketable securities
(52,031
)
 
(69,520
)
Proceeds from sale of marketable securities
52,272

 
48,979

Proceeds from maturity of marketable securities
6,458

 
15,373

Change in restricted cash
1,316

 
(226
)
Settlement of foreign currency hedges
1,553

 
—

Net cash used in investing activities
(10,087
)
 
(35,217
)
Cash flows from financing activities
 
 
 
Proceeds from exercise of stock options and issuance of stock under ESPP
3,568

 
5,083

Tax withholding on restricted stock units
(973
)
 
(570
)
Payments for public stock offering
(117
)
 
(25
)
Proceeds from bank loans, net of debt issuance costs
96,039

 
71,400

Repayment of bank loans
(68,270
)
 
(72,090
)
Proceeds from issuance of notes payable
5,842

 
13,144

Repayment of notes payable
(9,789
)
 
(14,069
)
Proceeds from government grants
—

 
608

Net cash provided by financing activities
26,300

 
3,481

Effect of exchange rates on cash and cash equivalents
1,026

 
556

Net decrease in cash and cash equivalents
(23,972
)
 
(4,463
)
Cash and cash equivalents at the beginning of the period
82,500

 
76,088

Cash and cash equivalents at the end of the period
$
58,528

 
$
71,625

Supplemental disclosure of non-cash investing and financing activities:
 
 
 
Decrease (increase) in unpaid property, plant and equipment
$
6,430

 
$
(12,494
)
Asset retirement obligations
$
2,146

 
$
—

Unpaid deferred offering costs
$
—

 
$
76

 
See accompanying Notes to Condensed Consolidated Financial Statements.
 

6
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

 
Note 1. Basis of presentation and significant accounting policies
Basis of Presentation and Consolidation
The condensed consolidated financial statements of NeoPhotonics Corporation (“NeoPhotonics” or the “Company”) as of September 30, 2017 and for the three and nine months ended September 30, 2017 and 2016, have been prepared in accordance with the instructions on Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In accordance with those rules and regulations, the Company has omitted certain information and notes normally provided in the Company’s annual consolidated financial statements. In the opinion of management, the condensed consolidated financial statements contain all adjustments, consisting only of normal recurring items, except as otherwise noted, necessary for the fair presentation of the Company’s financial position and results of operations for the interim periods. The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by U.S. generally accepted accounting principles (“U.S. GAAP”). These condensed consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016. The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of the results expected for the entire fiscal year. All intercompany accounts and transactions have been eliminated.
Going Concern
Accounting Standards Update (“ASU”) No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, requires an entity to disclose information about its potential inability to continue as a going concern when conditions and events indicate that it is probable that the entity may be unable to meet its obligations as they become due within one year. Management has assessed the Company’s ability to continue as a going concern within one year of the filing date of this Quarterly Report on Form 10-Q with the SEC in November 2017. The accompanying unaudited condensed financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.
As of September 30, 2017, the Company’s working capital was $118.2 million, including available cash, cash equivalents, short-term investments and restricted cash of approximately $73.7 million. In the first nine months of 2017, the Company had operating losses of $40.5 million and negative cash flows from operations of $41.2 million. It had an accumulated deficit of approximately $337.7 million as of September 30, 2017.
The Company's operating results and cash flows during the first nine months of 2017 have been negatively affected by reduced demand in China stemming from delayed provincial deployments and a buildup of inventory at one or more of our leading customers, which is expected to continue into early 2018. In response, the Company implemented restructuring plans in May and September 2017 that included a reduction in force and consolidation of facilities, which are expected to reduce quarterly expenses by approximately $2.6 million when fully realized in the first quarter of 2018. The Company has also reduced or delayed certain product development projects and capital expenditures, aggressively pursued collections and continued to closely manage production and inventory levels.
In September 2017, the Company entered into a revolving line of credit agreement with Wells Fargo Bank, National Association ("Wells Fargo") which provides for borrowings under an accounts receivable based formula up to a maximum of $50.0 million. At September 30, 2017, $30.0 million was outstanding under this line, of which $20.0 million was used to pay the amount due under the Comerica facility. The remaining borrowing capacity at September 30, 2017 was $19.8 million, of which $5.0 million is required to be maintained as unused borrowing capacity. Borrowings under the Wells Fargo line are not due until June 30, 2022 as long as the borrowing base is not less than the outstanding amount (See Note 8). The Company also has approximately $21.6 million available for short-term borrowings under two line of credit agreements in with Pudong Bank in China that expire in July 2019. A third, $39.2 million line of credit agreement with CITIC Bank in China expired in September 2017 and the Company is currently discussing a potential renewal of the line with the bank. As of September 30, 2017, $17.0 million is outstanding under the CITIC Bank line, which is due on January 2, 2018. If the Company is not successful in renewing the CITIC bank line, its intention is to repay the $17.0 million using the amount available under its other existing lines of credit available in China. Additionally, the Company has $5.7 million of current portion of long-term debt as of September 30, 2017, which it plans to pay out of its existing available cash.
The Company currently believes it will have sufficient resources to fund its currently planned operations and expenditures over the next twelve months without additional financing or other actions.  In addition, the Company believes there are a number of ongoing and potential actions that may further strengthen its projected cash and projected financial position. 

7
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

The Company operates in an industry that makes its prospects difficult to evaluate with certainty. Future declines in China market demand or other changes to the Company’s forecasts could adversely affect the Company’s results of operations, financial position and cash flows. As a result, the Company may need to raise additional debt or equity capital to fund its operations.  Any additional debt arrangements may likely require regular interest and principal payments which could adversely affect the Company’s operations. There can be no assurance that additional debt or equity capital will be available on acceptable terms, or at all.  The accompanying unaudited condensed financial statements do not include any adjustments that may result from the outcome of these uncertainties.
Certain Significant Risks and Uncertainties
The Company operates in a dynamic industry and, accordingly, can be affected by a variety of factors.  For example, any of the following areas could have a negative effect on the Company in terms of its future financial position, results of operations or cash flows: the general state of the U.S., China and world economies; the highly cyclical nature of the industries the Company serves; the loss of any of a small number of its larger customers; ability to obtain additional financing; inability to meet certain debt covenants; fundamental changes in the technology underlying the Company’s products; the hiring, training and retention of key employees; successful and timely completion of product design efforts; and new product design introductions by competitors.
Concentration
In the three months ended September 30, 2017, Huawei Technologies Co. Ltd. and their affiliate HiSilicon Technologies (together with Huawei Technologies Co. Ltd., "Huawei"), Ciena Corporation ("Ciena") and Fiberhome Technologies Co, Ltd ("Fiberhome") accounted for approximately 39% , 14% and 11% of the Company’s total revenue, respectively, and the Company’s top five customers represented approximately 79% of the Company’s total revenue. In the three months ended September 30, 2016, Huawei and Ciena accounted for approximately 48% and 15% of the Company’s total revenue, respectively, and the Company’s top five customers represented approximately 79% of the Company’s total revenue. In the nine months ended September 30, 2017, Huawei and Ciena accounted for 39% and 16% of the Company’s total revenue, respectively, and the Company’s top five customers represented approximately 76% of its total revenue. In the nine months ended September 30, 2016, Huawei and Ciena accounted for 49% and 15% of the Company’s total revenue, respectively, and the Company’s top five customers represented approximately 79% of its total revenue.
As of September 30, 2017, two customers accounted for approximately 45% and 10% of the Company’s accounts receivable. As of December 31, 2016, three customers accounted for approximately 42%, 12% and 12%, respectively, of the Company’s accounts receivable.
Use of Estimates
The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported revenue and expenses during the reporting period. Significant estimates made by management include: the useful lives of property, plant and equipment and intangible assets as well as future cash flows to be generated by those assets; fair values of identifiable assets acquired and liabilities assumed in business combinations; allowances for doubtful accounts; valuation allowances for deferred tax assets; valuation of excess and obsolete inventories; warranty reserves; litigation accrual and recognition of stock-based compensation, among others. Actual results could differ from these estimates.
Accounting Standards Update Recently Adopted
Effective January 1, 2017, the Company adopted ASU 2016-9, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-9”). ASU 2016-9 simplifies certain aspects of the accounting for shared-based payment transactions, including income taxes, classification of awards and classification in the statement of cash flows. It eliminates the requirement to delay the recognition of excess tax benefits until current taxes payable are reduced. Upon adoption, the Company’s previously unrecognized excess tax benefits of $8.6 million had no impact on its accumulated deficit balance as the related U.S. deferred tax assets were fully offset by a valuation allowance. The Company elected to apply the change in presentation in the statements of cash flows prospectively and elected to continue to account for estimated forfeitures over the vesting period of the share-based awards.

8
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Effective January 1, 2017, the Company also adopted ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory (“ASU 2015-11”). ASU 2015-11 requires entities to measure most inventories “at the lower of cost and net realizable value” but does not apply to inventories that are measured by using either the last-in, first-out method or the retail inventory method. The impact on the Company’s consolidated financial statements upon the adoption of this standard was immaterial.
Effective December 31, 2016, the Company adopted ASU No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. (“ASU 2014-15”). Under the new standard, management must evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the financial statements are issued. This evaluation initially does not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date the financial statements are issued. When substantial doubt exists under this methodology, management evaluates whether the mitigating effect of its plans sufficiently alleviates substantial doubt about the Company’s ability to continue as a going concern. The mitigating effect of management’s plans, however, is only considered if both (1) it is probable that the plans will be effectively implemented within one year after the date that the financial statements are issued, and (2) it is probable that the plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. This ASU requires management to perform an analysis of the Company’s ability to continue as a going concern as of the issue date of the financial statements. See above – Basis of Presentation and Significant Accounting Policies for the discussion of the Company’s ability to continue as a going concern.
There have been no other changes in the Company’s significant accounting policies in the nine months ended September 30, 2017, as compared to the significant accounting policies described in its Annual Report on Form 10-K for the year ended December 31, 2016. 
Recent Accounting Standards Update Not Yet Effective 
In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-9, Compensation—Stock Compensation (718)—Scope of Modification Accounting (ASU 2017-9”). This guidance redefines which changes to the terms and conditions of a share-based payment award require an entity to apply modification accounting for a share-based payment. ASU 2017-9 is effective for interim and annual periods after December 15, 2017 and early adoption is permitted in any interim period. The Company has not yet determined whether it will elect early adoption and has determined that the adoption of this standard will not have a significant impact on its consolidated financial statements and related disclosures.
In March 2017, the FASB issued ASU No. 2017-7, Compensation-Retirement Benefits (Topic 715)-Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (“ASU 2017-7”). This guidance revises the presentation of employer-sponsored defined benefit pension and other postretirement plans for the net periodic benefit cost in the statement of operations and requires that the service cost component of net periodic benefit be presented in the same income statement line items as other employee compensation costs for services rendered during the period. The other components of the net benefit costs are required to be presented in the statement of operations separately from the service cost component and outside the subtotal of income from operations. This guidance allows only the service cost component of net periodic benefit costs to be eligible for capitalization. ASU 2017-7 is effective for interim and annual periods after December 15, 2018 and early adoption is permitted as of the beginning of an annual reporting period. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements and related disclosures.  
In January 2017, the FASB issued ASU 2017-4, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-4”). This standard amends the goodwill impairment test to compare the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, up to the total amount of goodwill allocated to that reporting unit. ASU 2017-4 is effective prospectively for interim and annual periods beginning after December 15, 2019. Early adoption is permitted for interim and annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company has not determined whether it will elect early adoption and is currently evaluating the impact of the adoption of this standard on its consolidated financial statements and related disclosures.

9
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

In January 2017, the FASB issued ASU 2017-1, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-1”). This standard provides a framework in determining when a set of assets and activities is a business. ASU 2017-1 is effective for interim and annual periods beginning after December 15, 2017 on a prospective basis. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements and related disclosures.  
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (“ASC 2016-18”). This standard provides guidance on the classification and presentation of restricted cash in the statement of cash flows and must be applied retrospectively. ASU 2016-18 is effective for fiscal years beginning after December 15, 2017. Early adoption is permitted. The Company is in the process of evaluating the impact of the adoption on its consolidated financial statements.
In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”). This standard provides guidance on the tax accounting for the transferring and receiving entities upon transfer of an asset. ASU 2016-16 is effective for the Company’s interim and annual periods beginning after December 15, 2017 and should be applied on a modified retrospective basis. Early adoption is permitted. The Company is in the process of evaluating the impact of the adoption on its consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). This standard provides guidance on the classification of certain cash receipts and payments in the statement of cash flows.   It is effective, retrospectively, for the Company’s annual and interim reporting periods beginning after December 15, 2017 or prospectively from the earliest date practicable if retrospective application is impracticable. Early adoption is permitted. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements and related disclosures.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 amends existing guidance on the impairment of financial assets and adds an impairment model that is based on expected losses rather than incurred losses and requires an entity to recognize as an allowance its estimate of expected credit losses for its financial assets. An entity will apply this guidance through a cumulative-effect adjustment to retained earnings upon adoption (a modified-retrospective approach) while a prospective transition approach is required for debt securities for which an other-than-temporary impairment had been recognized before the effective date. It is effective for the Company’s annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted. The Company is in the process of evaluating the impact of the adoption on its consolidated financial statements and related disclosure.
In February 2016, the FASB issued ASU 2016-2, Leases (Topic 842) (“ASU 2016-2”).  ASU 2016-2 introduces a lessee model that requires recognition of assets and liabilities arising from qualified leases on the consolidated balance sheets and consolidated statements of operations and to disclose qualitative and quantitative information about lease transactions. It is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. A modified retrospective transition is required with certain optional practical expedients allowed. The Company is in the process of evaluating the impact of the adoption on its consolidated financial statements and related disclosure.
In January 2016, the FASB issued ASU 2016-1, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-1”). ASU 2016-1 revises an entity’s accounting related to (1) the classification and measurement of investments in equity securities and (2) the presentation of certain fair value changes for financial liabilities measured at fair value. It also amends certain disclosure requirements associated with the fair value of financial instruments and is effective for the Company’s annual and interim reporting periods beginning after December 15, 2017. Early adoption is permitted. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements and related disclosures.

10
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

In May 2014, the FASB issued ASU No. 2014-9, Revenue from Contracts with Customers (“ASU 2014-9”). The standard, along with the amendments issued in 2016 and 2015, provides companies with a single model for use in accounting for revenue arising from contracts with customers and supersedes current revenue recognition guidance, including industry-specific revenue guidance. The core principle of the model is to recognize revenue when control of the goods or services transfers to the customer, as opposed to recognizing revenue when the risks and rewards transfer to the customer under the existing revenue guidance. ASU 2014-9 is required to be adopted, using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-9; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-9 recognized at the date of initial application and providing certain additional disclosures. This standard, as amended, is effective for annual and interim periods beginning after December 15, 2017 and permits entities to early adopt for annual and interim reporting periods beginning after December 15, 2016. The Company will adopt this standard in the first quarter of 2018.
The Company is in the process of assessing the impact that implementation of this new standard will have on its consolidated financial statements, including evaluation of the disclosure requirements. Although its evaluation is ongoing, the Company currently believes that the impact will not be significant, as most revenue will continue to be recognized at a point-in-time when control transfers which is similar to the current revenue recognition model.
The Company will continue to assess the impact, including potential changes to its accounting policies, business processes, systems and internal controls over financial reporting and its current assessment is subject to change.
 
Note 2. Net loss per share
 
The following table sets forth the computation of the basic and diluted net loss per share for the periods indicated (in thousands, except per share amounts): 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Numerator:
    
 
 
 
 
 
 
Net loss
$
(18,187
)
 
$
(7,187
)
 
$
(39,050
)
 
$
(2,201
)
Denominator:
 

 
 

 
 

 
 

Weighted average shares used to compute per share amount:
 

 
 

 
 

 
 

Basic
43,790

 
42,038

 
43,212

 
41,589

Dilutive effect of equity awards
—

 
—

 
—

 
—

Diluted
43,790

 
42,038

 
43,212

 
41,589

 
 
 
 
 
 
 
 
Basic net loss per share
$
(0.42
)
 
$
(0.17
)
 
$
(0.90
)
 
$
(0.05
)
Diluted net loss per share
$
(0.42
)
 
$
(0.17
)
 
$
(0.90
)
 
$
(0.05
)
 
 
 
 
 
 
 
 
 
The Company has excluded the impact of the following outstanding employee stock options and restricted stock units as well as the shares expected to be issued under its employee stock purchase plan from the computation of diluted net loss per share, as their effect would have been antidilutive (in thousands): 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Employee stock options
4,227

 
4,344

 
4,227

 
4,344

Restricted stock units
2,504

 
2,044

 
2,504

 
2,044

Employee stock purchase plan
245

 
151

 
245

 
151

 
6,976

 
6,539

 
6,976

 
6,539

 

11
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 3. Cash, cash equivalents, short-term investments, and restricted cash
 
The following table summarizes the Company’s cash, cash equivalents, short-term investments and restricted cash (in thousands): 
 
September 30,
2017
 
December 31,
2016
 
 
Cash and cash equivalents:
 
 
 
Cash
$
53,716

 
$
58,691

Cash equivalents
4,812

 
23,809

Cash and cash equivalents
$
58,528

 
$
82,500

Short-term investments
$
12,281

 
$
19,015

Restricted cash
$
2,917

 
$
4,085

 
As of September 30, 2017 and December 31, 2016, restricted cash included approximately $2.0 million pursuant to an asset purchase agreement with Optoelectronics Components Co., Ltd. (“APAT OE”) relating to the asset sale closed in January 2017, in addition to the compensating balances relating to the Company’s notes payable issued under its line of credit facilities in China. See Note 8. The following table summarizes the Company’s unrealized gains and losses related to its cash equivalents and short-term investments in marketable securities designated as available-for-sale (in thousands): 
 
As of September 30, 2017
 
As of December 31, 2016
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Loss
 
Fair Value
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Loss
 
Fair Value
Marketable securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
$
11,530

 
$
—

 
$
—

 
$
11,530

 
$
199

 
$
—

 
$
—

 
$
199

Money market accounts
4,812

 
—

 
—

 
4,812

 
23,809

 
—

 
—

 
23,809

Corporate debt securities
—

 
—

 
—

 
—

 
9,438

 
4

 
(3
)
 
9,439

Government agency securities
—

 
—

 
—

 
—

 
3,767

 
—

 
(10
)
 
3,757

U.S. government securities
753

 
—

 
(2
)
 
751

 
5,008

 
—

 
(10
)
 
4,998

Sovereign government bonds
—

 
—

 
—

 
—

 
622

 
—

 
—

 
622

Total
$
17,095

 
$
—

 
$
(2
)
 
$
17,093

 
$
42,843

 
$
4

 
$
(23
)
 
$
42,824

Reported as:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash equivalents
$
4,812

 
$
—

 
$
—

 
$
4,812

 
$
23,809

 
$
—

 
$
—

 
$
23,809

Short-term investments
12,283

 
—

 
(2
)
 
12,281

 
19,034

 
4

 
(23
)
 
19,015

Total
$
17,095

 
$
—

 
$
(2
)
 
$
17,093

 
$
42,843

 
$
4

 
$
(23
)
 
$
42,824

 
As of September 30, 2017 and December 31, 2016, maturities of marketable securities were as follows (in thousands): 
 
September 30,
2017
 
December 31,
2016
 
 
Less than 1 year
$
17,093

 
$
36,054

Due in 1 to 2 years
—

 
6,468

Due in 3 to 5 years
—

 
302

Total
$
17,093

 
$
42,824


Realized gains and losses on the sale of marketable securities during the three and nine months ended September 30, 2017 and 2016 were insignificant. The Company did not recognize any impairment losses on its marketable securities during the three and nine months ended September 30, 2017 or 2016. As of September 30, 2017, 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.
 

12
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 4.  Fair value disclosures
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table presents the Company's assets that are measured at fair value on a recurring basis (in thousands):  
 
As of September 30, 2017
 
As of December 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents and short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
$
11,530

 
$
—

 
$
—

 
$
11,530

 
$
199

 
$
—

 
$
—

 
$
199

U.S. government securities
751

 
—

 
—

 
751

 
4,998

 
—

 
—

 
4,998

Money market accounts
—

 
4,812

 
—

 
4,812

 
—

 
23,809

 
—

 
23,809

Corporate debt securities
—

 
—

 
—

 
—

 
—

 
9,439

 
—

 
9,439

Government agency securities
—

 
—

 
—

 
—

 
—

 
3,757

 
—

 
3,757

Sovereign government bonds
—

 
—

 
—

 
—

 
—

 
622

 
—

 
622

Total
$
12,281

 
$
4,812

 
$
—

 
$
17,093

 
$
5,197

 
$
37,627

 
$
—

 
$
42,824

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign currency forward contracts*
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

Mutual funds held in Rabbi Trust, recorded in other long-term assets
$
927

 
$
—

 
$
—

 
$
927

 
$
622

 
$
—

 
$
—

 
$
622

________________________________________________________

*The fair value of the Company’s foreign currency forward contract was immaterial as of September 30, 2017 and December 31, 2016.
 
The Company offers a Non-Qualified Deferred Compensation Plan (“NQDC Plan”) to a select group of its highly compensated employees.  The NQDC Plan provides participants the opportunity to defer payment of certain compensation as defined in the NQDC Plan. A Rabbi Trust has been established to fund the NQDC Plan obligation, which was fully funded at September 30, 2017. The assets held by the Rabbi Trust are substantially in the form of exchange traded mutual funds and are included in the Company’s other long-term assets on its condensed consolidated balance sheets as of September 30, 2017 and December 31, 2016.
Effective July 1, 2016, the Company maintains a hedging program using forward exchange contracts as economic hedges, to protect against volatility of foreign exchange rate exposure when it is deemed economical to do so, based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The forward contracts are not designated for hedge accounting.
Under the hedging program, the Company enters into monthly forward exchange contracts, that have average maturities of one month, to offset the effects of exchange rate exposures for its net intercompany activities denominated in Chinese Renminbi, or RMB, by buying and selling the underlying foreign currency in the future at fixed exchange rates, to offset the consequences of changes in foreign exchange on the balance sheet. Accordingly, fair value changes in the forward contracts help mitigate the changes in the value of the re-measurement of the hedged assets and liabilities attributable to changes in foreign currency exchange rates, except to the extent of the spot-forward differences. The net effect of fair value changes is reported in other income (expense), net. As of September 30, 2017, the fair value of the Company’s foreign currency forward contract was immaterial due to the short-term nature of the contract, which generally expires at each month-end. The total notional value of the Company’s foreign currency exchange contract as of September 30, 2017 was $19.2 million for Chinese Yuan offshore or CNH that approximates the RMB.
The following table presents the Company's liabilities that are measured at fair value on a recurring basis (in thousands): 
 
As of September 30, 2017
 
As of December 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Rusnano payment derivative
$
—

 
$
—

 
$
389

 
$
389

 
$
—

 
$
—

 
$
389

 
$
389

 

13
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

As of September 30, 2017 and December 31, 2016 the Company had no assets or liabilities required to be measured at fair value on a nonrecurring basis. In the three months ended March 31, 2017, the Company recorded a $6.7 million contingent liability within accrued and other current liabilities on its balance sheet in connection with the contingent indemnification commitments pursuant to an asset sale closed in January 2017. See Note 5. This liability was measured using the Company's best estimate of the likelihood of payment based on circumstances the Company identified as having a significant impact on its fair value during the period, which is considered to be a level 3 fair value measurement.
 
Assets and Liabilities Not Measured at Fair Value
 
The carrying values of accounts receivable, accounts payable, notes payable and short-term borrowings approximate their fair values due to the short-term nature and liquidity of these financial instruments.

The estimated fair value of the Company's long-term debt approximated its carrying value as of September 30, 2017 and December 31, 2016, as the interest rates approximated rates currently available to the Company on the issuance of liabilities with a similar maturity. This estimate is considered to be a level 2 fair value measurement.

 
Note 5. Asset sale
In January 2017, the Company completed the sale of its Low Speed Transceiver Products’ assets to APAT OE pursuant to an asset purchase agreement dated December 14, 2016 for consideration of approximately $25.0 million (in RMB equivalent) plus approximately $1.4 million (in RMB equivalent) post-closing transaction service fees to be received under a transition services agreement with APAT OE in which the Company will provide short-term manufacturing and other specific services pursuant to such agreement. The related supply chain purchase commitments and value-added tax obligations have been assumed by APAT OE. The receivable and payable balances related to the transition service arrangement were $13.0 million and $12.6 million, respectively, as of September 30, 2017.
As of December 31, 2016, the balance in assets held for sale was $13.9 million, consisting of $13.1 million in inventories and $0.8 million in property, plant and equipment. As a result of post-closing adjustments, total consideration was reduced by approximately $3.4 million for inventory. In addition, an immaterial amount of property, plant and equipment was reclassified from assets held for sale. Upon closing, assets sold to APAT OE were approximately $12.8 million, including approximately $12.1 million in inventories and $0.7 million in property, plant and equipment. The adjusted consideration received of approximately $21.6 million is subject to further reduction of up to $10.0 million for any indemnification claims. As of September 30, 2017, the Company has a reserve of $7.0 million within accrued and other current liabilities for warranty claims and an estimated $0.2 million in additional property, plant and equipment purchases. The indemnification warranties expired on June 30, 2017 and resulted in no change to the gain on the sale that was recorded in the first quarter of 2017. The Company recognized a $2.0 million gain on the sale of these assets within operating loss in the nine months ended September 30, 2017.
All of the Low Speed Transceiver Products were part of the Company’s Network Products and Solution product group and included the low speed optical network (PON) products for which the end-of-life plan was announced in mid-2016. 
 
Note 6. Balance sheet components
 
Accounts receivable, net
 
Accounts receivable, net consists of the following (in thousands):
 
September 30, 2017
 
December 31, 2016
Accounts receivable
$
65,980

 
$
78,143

Trade notes receivable
1,148

 
2,892

Allowance for doubtful accounts
(125
)
 
(425
)
 
$
67,003

 
$
80,610

 

14
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Inventories, net 

Inventories, net consist of the following (in thousands): 
 
September 30, 2017
 
December 31, 2016
Raw materials
$
38,617

 
$
23,348

Work in process
14,746

 
10,996

Finished goods(1)
29,446

 
13,893

 
$
82,809

 
$
48,237

________________________________________________________

(1)
Finished goods inventory at customer vendor managed inventory locations was $8.7 million and $8.3 million as of September 30, 2017 and December 31, 2016, respectively.

Prepaid expenses and other current assets
 
Prepaid expenses and other current assets consist of the following (in thousands):
 
September 30, 2017
 
December 31, 2016
Prepaid taxes and taxes receivable
$
15,234

 
$
16,102

Transition services agreement receivable (Note 5)
13,006

 
—

Deposits and other prepaid expenses
4,162

 
3,571

Other receivable
2,166

 
2,723

 
$
34,568

 
$
22,396


Purchased intangible assets
 
Purchased intangible assets consist of the following (in thousands): 
 
September 30, 2017
 
December 31, 2016
 
Gross
Assets
 
Accumulated
Amortization
 
Net
Assets
 
Gross
Assets
 
Accumulated
Amortization
 
Net
Assets
 
 
 
 
 
 
Technology and patents
$
37,415

 
$
(34,458
)
 
$
2,957

 
$
36,918

 
$
(33,316
)
 
$
3,602

Customer relationships
15,302

 
(14,595
)
 
707

 
15,039

 
(13,990
)
 
1,049

Leasehold interest
1,280

 
(350
)
 
930

 
1,226

 
(315
)
 
911

 
$
53,997

 
$
(49,403
)
 
$
4,594

 
$
53,183

 
$
(47,621
)
 
$
5,562

 
Amortization expense relating to technology and patents and the leasehold interest intangible assets is included within cost of goods sold and customer relationships within operating expenses. The following table presents details of the amortization expense of the Company’s purchased intangible assets as reported in the condensed consolidated statements of operations (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Cost of goods sold
$
202

 
$
853

 
$
667

 
$
2,542

Operating expenses
119

 
462

 
355

 
1,375

Total
$
321

 
$
1,315

 
$
1,022

 
$
3,917

 

15
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

The estimated future amortization expense of purchased intangible assets as of September 30, 2017, is as follows (in thousands): 
2017 (remaining three months)
$
321

2018
1,209

2019
807

2020
689

2021
689

Thereafter
879

 
$
4,594

 
Accrued and other current liabilities
 
Accrued and other current liabilities consist of the following (in thousands): 
 
September 30, 2017
 
December 31, 2016
Transition services agreement payables (Note 5)
$
12,603

 
$
—

Employee-related
12,103

 
18,654

Asset sale related contingent liabilities (Note 5)
6,977

 
—

Accrued warranty
1,402

 
678

Deferred revenue, current
809

 
956

Income and other taxes payable
305

 
3,956

Rusnano payment derivative
—

 
389

Other accrued expenses
10,544

 
5,992

 
$
44,743

 
$
30,625

 
Warranty Accrual
 
The table below summarizes the movement in the warranty accrual, which is included in accrued and other current liabilities (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Beginning balance
$
528

 
$
669

 
$
678

 
$
1,175

Warranty accruals
1,047

 
126

 
1,019

 
25

Settlements
(173
)
 
(110
)
 
(295
)
 
(515
)
Ending balance
$
1,402

 
$
685

 
$
1,402

 
$
685

 
Other noncurrent liabilities
 
Other noncurrent liabilities consist of the following (in thousands): 
 
September 30, 2017
 
December 31, 2016
Pension and other employee-related
$
5,535

 
$
5,045

Deferred rent
2,856

 
1,509

Deferred revenue
916

 
136

Government grant
743

 
1,048

Rusnano payment derivative
389

 
—

Deferred income tax liabilities
64

 
46

Asset retirement obligations and other
4,456

 
1,155

 
$
14,959

 
$
8,939

 

16
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)


Note 7. Restructuring
 
During the six months ended June 30, 2017, the Company initiated restructuring actions consisting primarily of workforce reductions in order to reduce its operating costs. During the three months ended September 30, 2017, the Company initiated further restructuring actions in order to focus on key growth initiatives and a lower break even revenue level through lower operating expenses and manufacturing costs. Actions included a reduction in force, facilities consolidation and certain asset-related adjustments. These actions are expected to reduce quarterly operating expenses and costs of goods sold by approximately $2.0 million and $0.6 million, respectively, when fully realized in the first quarter of 2018. The Company recorded $3.1 million and $4.1 million in restructuring charges within cost of goods sold and operating expenses in the three and nine months ended September 30, 2017, respectively. Additionally, the Company recorded a charge of $2.0 million to cost of goods sold in the three months ended September 30, 2017 for discontinued product inventory write-downs related the Company's decisions to end-of-life certain products. Restructuring activities for the nine months ended September 30, 2017 were as follows (in thousands):
 
Employee Severance
 
Facilities Consolidation
 
Asset-Related
 
Total
Restructuring obligations December 31, 2016
$
—

 
$
—

 
$
—

 
$
—

Charges
1,790

 
1,930

 
394

 
4,114

Cash payments
(902
)
 
—

 
—

 
(902
)
Non-cash settlements and other
—

 
(149
)
 
(323
)
 
(472
)
Restructuring obligations September 30, 2017
$
888

 
$
1,781

 
$
71

 
$
2,740

The current restructuring liability reported in Accrued and other current liabilities in the Condensed Consolidated Balance Sheets as of September 30, 2017 was $1.7 million. The non-current restructuring liability reported in Other noncurrent liabilities in the Condensed Consolidated Balance Sheets as of September 30, 2017 was $1.0 million. The Company expects to incur additional costs of approximately $0.7 million in severance charges in connection with its restructuring activities in the three months ending December 31, 2017.


17
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 8. Debt
 
The table below summarizes the carrying amount and weighted average interest rate of the Company’s debt (in thousands, except percentages):  
 
September 30, 2017
 
December 31, 2016
 
Carrying
Amount
 
Interest
Rate
 
Carrying
Amount
 
Interest
Rate
 
 
 
 
Note payable to financial institution
$
17,000

 
4.06
%
 
$
—

 
—

Notes payable to suppliers
2,630

 
—

 
6,390

 
 
Short-term borrowing under Comerica Bank Credit Facility
—

 
—

 
23,800

 
3.37
%
Total notes payable and short-term borrowing
$
19,630

 
 

 
$
30,190

 
 

Long-term debt, current and non-current:
 

 
 

 
 

 
 

Borrowing under Wells Fargo Credit Facility
$
30,018

 
3.16
%
 
$
—

 
 
Mitsubishi Bank loans
17,168

 
1.44
%
 
11,253

 
1.43
%
Unaccreted discount and issuance costs within current portion of long-term debt
(103
)
 
 

 
(108
)
 
 

Unaccreted discount and issuance costs within long-term debt, net of current portion
(314
)
 
 

 
(183
)
 
 

Total long-term debt, net of unaccreted discount and issuance costs
$
46,769

 
 

 
$
10,962

 
 

 
 
 
 
 
 
 
 
Reported as:
 

 
 

 
 

 
 

Current portion of long-term debt
$
5,740

 
 

 
$
747

 
 

Long-term debt, net of current portion
41,029

 
 

 
10,215

 
 

Total long-term debt, net of unaccreted discount and issuance costs
$
46,769

 
 

 
$
10,962

 
 

 
Notes payable
 
The Company regularly issues notes payable to its suppliers in China. These notes are supported by non-interest bearing bank acceptance drafts issued under the Company’s existing line of credit facilities and are due three to six months after issuance. As a condition of the notes payable arrangements, the Company is required to keep a compensating balance at the issuing banks that is a percentage of the total notes payable balance until the amounts are settled. As of September 30, 2017, the Company’s subsidiary in China had two line of credit facilities with Pudong Bank:

•
Under the first line of credit facility, the Company can borrow up to RMB 120.0 million ($18.0 million) for short-term loans at varying interest rates, or up to approximately RMB 171.4 million ($25.8 million) for bank acceptance drafts (with a 30% compensating balance requirement). This line of credit facility expires in July 2019. 

•
Under the second line of credit facility, which expires in July 2019, the Company can borrow up to RMB 30.0 million ($4.5 million) for short-term loans at varying interest rates, or up to approximately RMB 42.9 million ($6.4 million) for bank acceptance drafts (with a 30% compensating balance requirement).
A third line of credit facility with CITIC Bank in China expired during September 2017. In July 2017, the Company borrowed $17.0 million under this line which bears interest at LIBOR plus 2.55% and will mature on January 2, 2018.
Under these line of credit facilities, the non-interest bearing bank acceptance drafts issued in connection with the Company’s notes payable to its suppliers in China, had an outstanding balance of $2.6 million and $6.4 million as of September 30, 2017 and December 31, 2016, respectively. In addition to the outstanding notes payable, three letters of credit totaling $1.6 million were issued to its suppliers in 2016 for equipment purchases delivered by December 2016. These letters of credit required a 30% compensating balance. As of December 31, 2016, the outstanding balance of these letters of credit was immaterial and was fully repaid as of September 30, 2017. The total amount available for short-term borrowings under these line of credit facilities as of September 30, 2017 was $21.6 million.

18
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

As of September 30, 2017 and December 31, 2016, compensating balances relating to these bank acceptance drafts and letters of credit issued to suppliers and the Company’s subsidiaries totaled $0.8 million and $2.1 million, respectively. Compensating balances are classified as restricted cash on the Company’s condensed consolidated balance sheets.
 
Credit Facilities
The Company had a credit agreement, as amended, with Comerica Bank as lead bank in the U.S. (the “Comerica Bank Credit Facility”) with a borrowing capacity of up to $30.0 million. In January 2017, the Company amended the Comerica Bank Credit Facility to extend the maturity to April 30, 2017 and to remove the covenant related to EBITDA. In April 2017, the Company amended the Comerica Bank Credit Facility to extend the maturity date to July 31, 2017 and to add a financial covenant that required maintenance of a modified EBITDA. In June 2017, the Company amended the Comerica Bank Credit Facility to extend the maturity to August 31, 2017, to allow NeoPhotonics China to borrow up to $17.0 million, to limit the indebtedness under the facility to $20.0 million and to modify the EBITDA requirement. In August 2017, the Credit Facility was further amended to extend the maturity to September 30, 2017. As of December 31, 2016, the Company was in compliance with the covenants of the credit facility except for exceeding the capital expenditure limit as of December 31, 2016 for which a waiver was obtained subsequent to the year end.
Borrowings under the Comerica Bank Credit Facility bore interest at an interest rate option of a base rate as defined in the agreement plus 1.75% or LIBOR plus 2.75%. The base rate was the greater of (a) the effective prime rate, (b) the Federal Funds effective rate plus one percent, and (c) the daily adjusting LIBOR rate plus one percent. As of December 31, 2016, the rate on the LIBOR option was 3.37% and the outstanding balance was $23.8 million.
In September 2017 the Company entered into a revolving line of credit agreement with Wells Fargo Bank, National Association ("Wells Fargo") as the administrative agent for a lender group (the "Wells Fargo Credit Facility" or "Credit Facility"), and the amount outstanding under the Comerica Bank Credit Facility was paid in full.
The Wells Fargo Credit Facility provides for borrowings equal to the lower of (a) a maximum revolver amount of $50.0 million, or (b) an amount equal to 80% - 85% of eligible accounts receivable plus 100% of qualified cash balances up to $15.0 million, less certain discretionary adjustments ("Borrowing Base"). The maximum revolver amount may be increased by up to $25.0 million, subject to certain conditions. At closing, $50.0 million was available, of which $30.0 million was drawn. The Company used $20.0 million of this amount to pay the principal and interest due under the Comerica Bank Credit Facility, which has since been terminated.
The Credit Facility matures on June 30, 2022 and borrowings bear interest at an interest rate option of either (a) the LIBOR rate, plus an applicable margin ranging from 1.50% to 1.75% per annum, or (b) the prime lending rate, plus an applicable margin ranging from 0.50% to 0.75% per annum.  The Company is also required to pay a commitment fee equal to 0.25% of the unused portion of the Credit Facility.
The Credit Facility agreement ("Agreement") requires prepayment of the borrowings to the extent the outstanding balance is greater than the lesser of (a) the most recently calculated Borrowing Base, or (b) the maximum revolver amount. The Company is required to maintain a combination of certain defined cash balances and unused borrowing capacity under the Credit Facility of at least $20.0 million, of which at least $5.0 million shall include unused borrowing capacity. The Agreement also restricts the Company's ability to dispose of assets, permit change in control, merge or consolidate, make acquisitions, incur indebtedness, grant liens, make investments and make certain restricted payments. Borrowings under the Credit Facility are collateralized by substantially all of the Company's assets. The Company was in compliance with the covenants of this Credit Facility as of September 30, 2017. As of September 30, 2017, the outstanding balance under the Credit Facility was $30.0 million and the weighted average rate under the LIBOR option was 3.16%. The remaining borrowing capacity as of September 30, 2017 was $19.8 million, of which $5.0 million is required to be maintained as unused borrowing capacity.
 
 

19
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Mitsubishi Bank loans
On February 25, 2015, the Company entered into certain loan agreements and related agreements with the Bank of Tokyo-Mitsubishi UFJ, Ltd. (the “Mitsubishi Bank”) that provided for (i) a term loan in the aggregate principal amount of 500 million JPY ($4.4 million) (the “Term Loan A”) and (ii) a term loan in the aggregate principal amount of one billion JPY ($8.9 million) (the “Term Loan B” and together with the Term Loan A, the “2015 Mitsubishi Bank Loans”). The Mitsubishi Bank Loans are secured by a mortgage on certain real property and buildings owned by the Company’s Japanese subsidiary. Interest on the 2015 Mitsubishi Bank Loans accrues and is paid monthly based upon the annual rate of the monthly Tokyo Interbank Offer Rate (TIBOR) plus 1.40%. The Term Loan A requires interest only payments until the maturity date of February 23, 2018, with a lump sum payment of the aggregate principal amount on the maturity date. The Term Loan B requires equal monthly payments of principal equal to 8,333,000 JPY until the maturity date of February 25, 2025, with a lump sum payment of the balance of 8,373,000 JPY on the maturity date. Interest on the Term Loan B is accrued based upon monthly TIBOR plus 1.40% and is secured by real estate collateral. In conjunction with the execution of the Bank Loans, the Company paid a loan structuring fee, including consumption tax, of 40,500,000 JPY ($0.4 million).

The 2015 Mitsubishi Bank Loans contain customary representations and warranties and customary affirmative and negative covenants applicable to the Company’s Japanese subsidiary, including, among other things, restrictions on cessation in business, management, mergers or acquisitions. The 2015 Mitsubishi Bank Loans contain financial covenants relating to minimum net assets, maximum ordinary loss and a dividends covenant. Outstanding principal balance under the 2015 Mitsubishi Bank Loans and unamortized debt issuance costs were approximately 1.2 billion JPY (approximately $4.4 million for Term Loan A and $6.6 million for Term Loan B) and 46.9 million JPY (approximately $0.4 million), respectively, as of September 30, 2017. The Company was in compliance with the related covenants as of September 30, 2017 and December 31, 2016.
 
In March 2017, the Company entered into a loan agreement and related agreements with the Mitsubishi Bank for a term loan of 690 million JPY (approximately $6.1 million) (the “2017 Mitsubishi Bank Loan”) to acquire manufacturing equipment for its Japanese subsidiary. This loan is secured by the manufacturing equipment acquired from the loan proceeds. Interest on the 2017 Mitsubishi Bank Loan is based on the annual rate of the monthly TIBOR rate plus 1.00%. The 2017 Mitsubishi Bank Loan matures on March 29, 2024 and requires monthly interest and principal payments over 72 months commencing in April 2018. The loan contains customary covenants relating to minimum net assets, maximum ordinary loss and a dividends covenant. The loan is available from March 31, 2017 to March 30, 2018 and 690 million JPY (approximately $6.1 million) under this loan was drawn as of September 30, 2017.
 
As of September 30, 2017, maturities of total long-term debt were as follows (in thousands):
2017 (remaining three months)
$
222

2018
6,099

2019
1,911

2020
1,911

2021
1,911

Thereafter
35,132

 
$
47,186


Note 9. Japan pension plan
 
The pension liability related to the Company’s Retirement Allowance Plan (“RAP”) in Japan as of September 30, 2017 and December 31, 2016 was $4.7 million and $4.8 million, respectively, of which $0.1 million and $0.4 million, respectively, was recorded in accrued and other current liabilities and the remainder in other noncurrent liabilities on the Company’s condensed consolidated balance sheet.
 
Net periodic pension cost associated with this plan was immaterial in the three and nine months ended September 30, 2017 and 2016.  


20
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 10. Commitments and contingencies
Litigation
From time to time, the Company is subject to various claims and legal proceedings, either asserted or unasserted, that arise in the ordinary course of business. The Company accrues for legal contingencies if the Company can estimate the potential liability and if the Company believes it is probable that the case will be ruled against it. If a legal claim for which the Company did not accrue is resolved against it, the Company would record the expense in the period in which the ruling was made. The Company believes that the likelihood of an ultimate amount of liability, if any, for any pending claims of any type (alone or combined) that will materially affect the Company’s financial position, results of operations or cash flows is remote. The ultimate outcome of any litigation is uncertain, however, and unfavorable outcomes could have a material negative impact on the Company’s financial condition and operating results. Regardless of outcome, litigation can have an adverse impact on the Company because of defense costs, negative publicity, diversion of management resources and other factors.
On January 5, 2010, Finisar Corporation, or Finisar, filed a complaint in the U.S. District Court for the Northern District of California, or the Court, against Source Photonics, Inc., MRV Communications, Inc., Oplink Communications, Inc. and the Company, or collectively, the co-defendants. In the complaint Finisar alleged infringement of certain of its U.S. patents. In 2010 the Company filed an answer to the complaint and counterclaims, asserting two claims of patent infringement and additional claims. The Court dismissed without prejudice all co-defendants (including the Company) except Source Photonics, Inc., on grounds that such claims should have been asserted in four separate lawsuits, one against each defendant. This dismissal does not prevent Finisar from bringing a new similar lawsuit against the Company. In 2011 the Company and Finisar agreed to suspend their respective claims and in 2012 the Company and Finisar further agreed to toll their respective claims. While there has been no action on this matter since 2012, the Company is currently unable to predict the outcome of this dispute and therefore cannot determine the likelihood of loss nor estimate a range of possible loss.
On January 2, 2013, the Company was served with a lawsuit, filed in Belgium by a distributor called Laser 2000 Beneluo SA (“Laser 2000”) claiming unpaid commissions. The distributor agreement was formally terminated as of January 3, 2012. The Company paid $492,000 to Laser 2000 as partial settlement of claims and to avoid penalties from the Belgian Court and submitted a legal brief to court on September 16, 2013. Laser 2000 filed a response on December 16, 2013 and the Company filed the final rebuttal brief on January 30, 2014. On March 23, 2015, the Belgian Court issued a ruling awarding Laser 2000 approximately one million euros in damages (approximately $1,100,000 at then-current exchange rates). The Company did not believe it would ultimately be liable for the full amount of damage and accrued $0.3 million in March 2015 for estimated probable net litigation expense relating to this matter.  The Company appealed this verdict and, in April 2017 settled this case and paid approximately $250,000.
On December 27, 2016 the Company was served with a lawsuit filed by Lestina International Ltd. (“Lestina”), in Santa Clara County, CA.  The lawsuit is regarding a dispute of approximately $3 million related to purchase orders for the Company’s Low Speed Transceiver Products that was soon thereafter sold by the Company to APAT OE in January 2017. The purchase orders in question were included in the asset sale and were assumed liabilities by the purchaser of the business. The Company is unable to predict with certainty the outcome of this matter, but is seeking to resolve the matter either through a court dismissal of the action or a resolution with the plaintiff and/or the purchaser of the Low Speed Transceiver Products’ assets. Discovery is currently in process. Because the purchase orders in question were an assumed liability of the Low Speed Transceiver Products’ assets that were transferred to the purchaser, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations or cash flows.
APAT Arbitration
On June 16, 2017, APAT Optoelectronics Components Co., Ltd. filed an arbitration claim against NeoPhotonics (China) Co., Ltd. (the Company’s China subsidiary), claiming that approximately $1.5 million of the inventory that was sold to APAT OE by NeoChina in an Asset Purchase Agreement executed between the parties on December 14, 2016 was aged inventory and of no value. The arbitration was heard in the Shenzhen Court of International Arbitration on August 2, 2017.  On October 25, 2017, NeoPhotonics (China) Co., Ltd. was informed that it was successful in the defense of the dispute and was also successful in its counterclaim against APAT Optoelectronics Components Co., Ltd.  NeoPhotonics (China) Co. Ltd. was awarded approximately RMB700,000 (USD $100,000) in compensatory damages and attorney fees as well as having the approximately $1.5 million claim against it rejected in its entirety. 

21
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Indemnifications
In the normal course of business, the Company enters into agreements that contain a variety of representations and warranties and provide for general indemnification. The Company’s exposure under these agreements is unknown because it involves claims that may be made against the Company in the future, but have not yet been made. To date, the Company has not paid any claims or been required to defend any action related to its indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.
In November 2016 Oyster Communications, Inc. filed nine patent lawsuits against several defendants in the U.S. District Court for the Eastern District of Texas, including one against Cisco Systems, Inc. One defendant has successfully transferred their case to the U.S. District Court for the Northern District of California. Additional defendant requested venue changes are still pending. The Company was not named as a defendant in any of the lawsuits. In July 2017, however, Cisco notified the Company that it would be seeking indemnification from the Company for claims against Cisco arising from the lawsuits. The Company is investigating the matter but is currently unable to predict the outcome of this matter and therefore cannot determine the likelihood of loss nor estimate a range of possible loss.
Leases
The Company leases various facilities under non-cancelable operating leases expiring through 2027. As of September 30, 2017, future minimum payments under these operating leases totaled approximately $32.4 million and future minimum sublease receipts were approximately $0.8 million. Rent expense was $1.3 million and $3.5 million in the three and nine months ended September 30, 2017, respectively,  and $0.6 million and $1.7 million in the three and nine months ended September 30, 2016 respectively.
On June 13, 2017, the Company entered into an office lease for approximately 39,000 square feet for the Company’s current headquarters in San Jose (the “Lease”) with a commencement date of June 1, 2017. The Company’s existing office lease for the facility was terminated and replaced by the new Lease. Upon commencement, the Lease had an initial term of one hundred and twenty-three (123) months, ending September 30, 2027, (the “Initial Term”) with a monthly rental rate of $41,388, escalating annually to a maximum monthly rental rate of approximately $72,525 in the last year of the Initial Term. Upon termination of the Lease, the Company anticipates a restoration cost of approximately $0.7 million. 
In September 2016, the Company entered into an office lease for approximately 64,000 square feet of office and laboratory space located adjacent to the Company’s current headquarters in San Jose (the “Lease”). The term of the Lease commenced on January 1, 2017. Upon commencement, the Lease has an initial term of one hundred and twenty-nine (129) months, ending on September 30, 2027 (the “Initial Term”), with a monthly rental rate of $144,000, escalating annually to a maximum monthly rental rate of approximately $194,000 in the last year of the Initial Term. The Landlord has agreed to provide the office and laboratory space to the Company free of charge for the first nine months of the Initial Term through September 30, 2017. Upon termination of the Lease, the Company anticipates a restoration cost of approximately $3.1 million.
Penalty Payment Derivative
In connection with a private placement transaction with Joint Stock Company “Rusnano” (formerly Open Joint Stock Company “RUSNANO”), or Rusnano, in 2012, the Company agreed to certain performance obligations including establishing a wholly-owned subsidiary in Russia and making a $30.0 million investment commitment (the “Investment Commitment’) towards the Company’s Russian operations, which could be partially satisfied by cash and/or non-cash investment inside or outside of Russia and/or by way of non-cash asset transfers.
The Rights Agreement as amended in 2015 (the “Amended Rights Agreement”) limits the maximum amount of penalties and/or exit fee (the “Rusnano Payment”) to be paid by the Company to $5.0 million in the aggregate and allows such payment to be reduced when certain milestones are met over time.  The Amended Rights Agreement also provides for an updated investment plan for the Company’s Russian subsidiaries that includes non-cash transfer of licensing rights to intellectual property, non-cash transfers of existing equipment and commitments to complete the remaining investment milestones through 2019. The Company fulfilled its investment commitment required by 2016 and had contributed over $21.0 million in cash and assets to its subsidiaries in Russia as of December 31, 2016. Therefore, no amounts of the Rusnano Payment were due as of December 31, 2016 or September 30, 2017.  

As of September 30, 2017, the remaining Investment Commitment was approximately $9.0 million to be invested at any time on or before December 31, 2019. At any point between September 30, 2017 and December 31, 2019, the Company may elect to pay a $2.0 million exit fee to terminate any remaining obligations associated with the Investment Commitment.
.  

22
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

In August 2016, the Company entered into a letter of agreement with Rusnano to agree to transfer a 10G SFP+ transceiver product line and incur expected costs of approximately $0.1 million, by July 30, 2017, which will not be counted toward the Company’s overall Investment Commitment. Since the asset sale of the Company’s Low Speed Transceiver Products was completed in January 2017, the Company may undertake such expense by spending such amount in another manner to be discussed and agreed between the parties.
Rusnano has non-transferable veto rights over the Company’s Russian subsidiaries’ annual budget during the investment period and must approve non-cash asset transfers to be made in satisfaction of the Investment Commitment.  The Company accounted for the Rusnano Payment as an embedded derivative instrument.  The fair value of the Penalty Payment derivative has been estimated at the date of the original common stock sale (April 27, 2012) and at each subsequent balance sheet date using a probability-weighted discounted future cash flow approach using unobservable inputs, which are classified as Level 3 within the fair value hierarchy. The primary inputs for this approach include the probability of achieving the Investment Commitment and a discount rate that approximates the Company’s incremental borrowing rate. After the initial measurement, changes in the fair value of this derivative are recorded in other income (expense), net. The estimated fair value of this derivative was $0.4 million as of each of September 30, 2017 and December 31, 2016. As of September 30, 2017, the derivative was reported within other noncurrent liabilities and as of December 31, 2016 the derivative was reported within accrued and other current liabilities on the Company’s condensed consolidated balance sheets. See Note 4.
 
Note 11. Stockholders’ equity
 
Common Stock
 
As of September 30, 2017, the Company had reserved 7,464,041 common stock for issuance under its equity incentive plans and 426,840 common stock shares for issuance under its employee stock purchase plan.
Accumulated Other Comprehensive Loss
The components of accumulated other comprehensive loss, net of related taxes, were as follows (in thousands):
 
Foreign Currency Translation Adjustments
 
Unrealized Gain (Loss) on Available-For-Sale Securities
 
Defined Benefit Pension Plan Adjustment
 
Total Accumulated Other Comprehensive Loss
Balance as of December 31, 2016
$
(8,235
)
 
$
(19
)
 
$
(147
)
 
$
(8,401
)
Other comprehensive income, net of taxes of zero and reclassifications
6,090

 
17

 
—

 
6,107

Balance as of September 30, 2017
$
(2,145
)
 
$
(2
)
 
$
(147
)
 
$
(2,294
)
 
No material amounts were reclassified out of accumulated other comprehensive income during the three and nine months ended September 30, 2017 and 2016 for realized gains or losses on available-for-sale securities.
  
Accumulated Deficit
Approximately $8.7 million of the Company’s retained earnings within its total accumulated deficit as of December 31, 2016 was subject to restriction due to the fact that the Company’s subsidiaries in China are required to set aside at least 10% of their respective accumulated profits each year end to fund statutory common reserves as well as allocate a discretional portion of their after-tax profits to their staff welfare and bonus fund.


23
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Note 12. Stock-based compensation
 
The following table summarizes the stock-based compensation expense recognized in the three and nine months ended September 30, 2017 and 2016 (in thousands):
 
September 30, 2017
 
September 30, 2016
 
 
 
2017
 
2016
 
2017
 
2016
Cost of goods sold
$
340

 
$
297

 
$
811

 
$
1,605

Research and development
606

 
2,981

 
1,779

 
4,508

Sales and marketing
393

 
2,352

 
1,170

 
3,604

General and administrative
595

 
3,146

 
1,932

 
4,728

 
$
1,934

 
$
8,776

 
$
5,692

 
$
14,445

 
Stock-based compensation expense in the three and nine months ended September 31, 2016 included a net amount of approximately $5.8 million associated with the accelerated vesting of stock options covering approximately 1.1 million shares of the Company’s common stock and stock appreciation units (“SAUs”) of approximately 0.2 million shares with a market-based vesting condition. In September 2016, the market-based condition of these stock options and SAUs was satisfied when the average closing price of the Company’s common stock over a period of 20 consecutive trading days was equal to or exceeded $15.00 per share and the recipients remained in continuous service with the Company.  Outstanding SAUs are re-measured each reporting period at fair value until settlement.  

Determining Fair Value 
The Company estimated the fair value of certain stock-based awards using a Black-Scholes-Merton valuation model with the following assumptions:  
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
Stock options
2017
 
2016
 
2017
 
2016
Weighted-average expected term (years)
6.0
 
5.9
 
6.0
 
5.8
Weighted-average volatility
65%
 
65%
 
65%
 
65%
Risk-free interest rate
2.02%
 
1.01%-1.15%
 
2.02%-2.08%
 
1.01%-1.76%
Expected dividends
—%
 
—%
 
—%
 
—%
Stock appreciation units
 
 
 
 
 
 
 
Weighted-average expected term (years)
2.2
 
2.6
 
2.3
 
2.8
Weighted-average volatility
71%
 
62%
 
71%
 
62%
Risk-free interest rate
1.03%-1.55%
 
0.45%-0.71%
 
0.51%-1.55%
 
0.45%-1.47%
Expected dividends
—%
 
—%
 
—%
 
—%
ESPP
 
 
 
 
 
 
 
Weighted-average expected term (years)
0
 
0
 
0.67
 
0.70
Weighted-average volatility
—%
 
—%
 
55%
 
70%
Risk-free interest rate
—%
 
—%
 
0.45%-0.91%
 
0.08%-0.39%
Expected dividends
—%
 
—%
 
—%
 
—%
  

24
NeoPhotonics Corporation
Notes to Condensed Consolidated Financial Statements (Continued)
(Unaudited)

Stock Options and Restricted Stock Units (RSUs)
 
The following table summarizes the Company’s stock option and RSU activity during the nine months ended September 30, 2017:
 
 
Stock Options
 
Restricted Stock Units
 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Number of
Units
 
Weighted
Average
Grant Date
Fair Value
 
 
 
 
Balance as of December 31, 2016
4,301,340

 
$
5.18

 
2,089,473

 
$
10.15

Granted
502,746

 
7.37

 
1,351,071

 
7.91

Exercised/Converted
(515,988
)
 
3.80

 
(789,123
)
 
9.40

Cancelled/Forfeited
(61,106
)
 
8.71

 
(147,783
)
 
10.50

Balance as of September 30, 2017
4,226,992

 
$
5.56

 
2,503,638

 
$
9.15

 
Stock appreciation units
 
SAUs are liability classified share-based awards. The Company did not grant any SAUs during the three and nine months ended September 30, 2017 or 2016. As of September 30, 2017 and December 31, 2016, there were 259,704 and 286,768 SAUs outstanding, respectively, and related SAU liabilities were $0.7 million and $2.0 million, respectively.  

Employee Stock Purchase Plan (“ESPP”)
As of September 30, 2017, there was $0.1 million of unrecognized stock-based compensation expense for employee stock purchase rights that will be recognized over the remaining offering period through November 2017.  
 
Note 13. Income taxes
The income tax (provision) benefit for income taxes in the periods presented is based upon the income (loss) before income taxes (in thousands):   
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Income tax (provision) benefit
1,195

 
(804
)
 
1,813

 
(2,471
)
 
The Company’s income tax (provision) benefit in the three and nine months ended September 30, 2017 and 2016 was primarily related to income taxes of the Company’s non-U.S. operations.
 
The Company conducts its business globally and its operating income is subject to varying rates of tax in the U.S., China and Japan. Consequently, the Company’s effective tax rate is dependent upon the geographic distribution of its earnings or losses and the tax laws and regulations in each geographical region. Historically, the Company has experienced net losses in the U.S. and in the short term, expects this trend to continue. One of the Company’s subsidiaries in China historically qualified for a preferential 15% tax rate available for high technology enterprises as opposed to the statutory 25% tax rate. In June 2016, the State Administration of Taxation in China issued a notice to adjust the requirements for high technology enterprise status. As a result, the Company’s China subsidiary did not meet the requirements for the tax year 2016. Therefore, the Company computed its China subsidiary’s tax provision (benefit) for 2016 and the three and nine months ended September 30, 2017 based on the 25% regular corporate income tax rate.
 
Due to historic losses in the U.S., the Company has a full valuation allowance on its U.S. federal and state deferred tax assets. Management continues to evaluate the realizability of deferred tax assets and the related valuation allowance. If management's assessment of the deferred tax assets or the corresponding valuation allowance were to change, the Company would record the related adjustment to income during the period in which management makes the determination.
As of September 30, 2017, there were no material changes to either the nature or the amounts of the uncertain tax positions previously determined for the year ended December 31, 2016.

25

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q for the period ended September 30, 2017 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, 2016 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, 2017 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, 2017 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, 2016, as filed with the SEC on March 16, 2017.  Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
Business overview
 
We develop, manufacture and sell optoelectronic products that transmit, receive and switch high speed digital optical signals for communications networks. Our products address the highest speed over distance applications and are designed for 100G and beyond data rates, such as at 200G, 400G, 600G and, in the near future, 1.2 Terabits, for telecom and datacenter, or content provider, networks. We sell our products to the world’s leading network equipment manufacturers, including Ciena Corporation ("Ciena"), Cisco Systems, Inc., Fiberhome Technologies, Ltd. ("Fiberhome"), HiSilicon Technologies, Ltd., an affiliate of Huawei Technologies, Co., Ltd. and Huawei Technologies Co., Ltd. (collectively “Huawei”) and Nokia (formerly Alcatel-Lucent, which was acquired by Nokia in January 2016). These companies are among our largest customers.
 
We have research and development and wafer fabrication facilities in San Jose and Fremont, California and in Tokyo, Japan that coordinate with our research and development and manufacturing facilities in Dongguan, Shenzhen and Wuhan, China and Ottawa, Canada. We also perform limited research and development and manufacturing in Moscow, Russia. We use proprietary design tools and design-for-manufacturing techniques to align our design process with our precision nanoscale, vertically integrated manufacturing and testing. We believe we are one of the highest volume PIC manufacturers in the world and that we can further expand our manufacturing capacity to meet market needs.

Our High Speed Products for data rates of 100G and beyond use our Advanced Hybrid Photonic Integration technology. These products using our advanced technology are the core focus of our strategy, and we believe that they are an important competitive differentiator. Our strategic focus on high speed components and coherent solutions recognizes the explosion of optics in the converged edge network applications. We align our product group reporting to “High Speed Products” which includes products designed for 100G and beyond applications and “Network Products and Solutions,” which comprises all products designed for applications below 100G. 

The current market situation for 100G and above product deployments in China materially affected our results beginning in the first quarter in 2017. Demand from our China-based customers was very strong in 2016 with our customers at that time providing optimistic forecasts for 2017 in anticipation of new tenders for provincial and metro 100G system deployments from the leading Chinese telecom carriers. However, tender awards from the China telecom carriers have been slower than expected,

26

through the third quarter of 2017, causing demand for our products by our customers to drop significantly starting in the first quarter of 2017. We believe one or more of our leading customers in China had accumulated significant inventory prior to the quarter ended March 31, 2017. We also believe they and other customers rapidly moved to adjust their inventory by reducing their purchases of our products, beginning in the first quarter of 2017 to align with the slowing market demand and their own production levels.

This softness in the China market has continued into the third quarter of 2017. We believe the market continues to face issues both of the timing of provincial deployments and of inventory management at certain customers. The transition in China from national backbone deployments to provincial backbone and metro deployments reduces our and our customers’ visibility into the timing and volumes of tender awards, as the provincial offices of the China telecom carriers are somewhat independent of their national headquarters and each other. Our near term revenue growth in China may continue to be restricted by reduced demand and inventory overhang, both directly with our China based customers and through the impact on some of our non-China customers who also sell to customers in China.

In September 2017, China Mobile Communications Corporation awarded tenders for new provincial deployments to Huawei, ZTE Corporation and Fiberhome. This was followed in October by the issue of tenders by China United Network Communications Group Co., Ltd., or China Unicom, and we anticipate tenders from China Telecommunications Corp, or China Telecom. While the timing is still uncertain, it is our expectation that these recent tender awards as well as new tender awards should create a more normalized demand environment in 2018.

These market developments in China have adversely affected our revenues, operating results and financial condition in 2017, as further addressed below.
In December 2016, we entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”) with APAT Optoelectronics Components Co., Ltd. (the “Purchaser”) for the sale of certain assets of our access and low speed transceiver product lines (the “Low Speed Transceiver Products”) which was completed in January 2017. All of these products were part of our Network Products and Solutions group and included the low speed passive optical network ("PON") products for which the end-of-life plan was announced in mid-2016. In 2016, the Low Speed Transceiver Products generated approximately 15% of our total revenue.
The asset sale consisted of approximately $25.0 million in cash consideration plus approximately $1.4 million post-closing transition services under a transition services agreement with the Purchaser. After closing, the consideration was reduced by $3.4 million for inventory adjustments to approximately $21.6 million and is subject to other adjustments of up to $10.0 million for any potential indemnification claims for which we recorded a reserve of $6.7 million as of March 31, 2017. We recognized a $2.0 million gain on asset sale in the three months ended March 31, 2017. As of September 30, 2017, we maintained the reserve of $7.0 million for any potential indemnification claims for which the warranty period expired on June 30, 2017, with no additional adjustment to the gain on asset sale.
In the three months ended September 30, 2017, High Speed Products represented approximately 84% of total revenue and Network Products and Solutions represented approximately 16% of total revenue.  In the three months ended September 30, 2016, High Speed Products were 67% of total revenue and Network Products and Solutions represented approximately 33% of total revenue, which included Low Speed Transceiver Products that were subsequently sold.
Revenue was $71.1 million in the three months ended September 30, 2017, compared to $103.3 million in the same period in 2016 primarily due to a reduction in demand in the China market as described above and the sale of our Low Speed Transceiver Products’ assets in January 2017. Our gross profit was 14.8% of revenue in the three months ended September 30, 2017, compared to 26.6% of revenue in the three months ended September 30, 2016, primarily attributable to inventory write-downs and reserves for non-cancelable purchase orders associated with discontinued projects and products, under-utilization attributable to lower volumes in our manufacturing plants and higher warranty reserves. 
In September 2017, we initiated certain restructuring actions to improve near-term profitability while focusing our investment and developments on key growth opportunities within and between datacenters, front and backhaul for 5G, traditional metro and long haul telecommunications, plus emerging cable TV and edge network applications. The costs to implement these actions are expected to be approximately $3.8 million, with $1.9 million for facilities consolidation, $1.5 million for severance charges and $0.4 million for asset write-downs. We incurred $3.1 million of these costs in the third quarter with the remainder to be incurred in the fourth quarter. Additionally, we recorded a charge of $2.0 million to cost of goods sold in the three months ended September 30, 2017 for discontinued product inventory write-downs related to our decisions to end-of-life certain products.

27

For coherent transport from DCI through long-haul, we are a vertically integrated designer and manufacturer of the highest speed optical components which we sell to the merchant market and incorporate into our own module level products. For applications inside the datacenter, we are focused on supplying the highest value laser and optical IC solutions to the merchant market. As disaggregation of optical equipment continues to gain momentum, we believe that high performance merchant components capability will be an increasingly important differentiator.
In line with this focus, we have recently introduced a number of new products. For Coherent Transport our 64 Gbaud Coherent Receivers and our Ultra-narrow Linewidth Tunable Lasers are currently shipping into applications that put 400 Gbps on a single wavelength, for both 400G ZR DCI and 400G MR metro networks. These products and our new 64 Gbaud Micro-Modulator, which is being sampled to major customers, have been designed into applications that will put 600 Gbps on a single wavelength and 1.2 Tbps in a single transponder using two wavelengths. We have continued to advance our DCO product offering, which uses our standard 32 Gbaud components in a CFP form factor, and are in the final stages of qualification with several customers. For applications inside the datacenter we now serve both the short reach and long reach segments by supplying lasers and optical ICs. For short reach Silicon Photonics based 100G transceivers, we supply the lasers or light sources that generate the signals that are then modulated using Silicon Photonics. For longer reaches and higher speeds inside the datacenter we produce electro-absorbtively modulated lasers (EMLs) which combine the laser and an Indium Phosphide modulator on a single chip for higher performance. We have recently introduced a low power 28 Gbaud EML with an integrated driver, and, for even higher speeds, we have announced 56 Gbaud EMLs with integrated drivers, designed for use in single wavelength 100G and 4x100 PAM4 configurations.
Critical accounting policies and estimates
Other than the policy changes disclosed in Note 1 in Notes to Condensed Consolidated Financial Statements in Item 1, Part I of this Report, there have been no material changes to our critical accounting policies and estimates during the three and nine months ended September 30, 2017 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, 2016.
Results of operations
 
Revenue
Our business is focused on the highest speed digital optics and signal processing communications applications. In 2016, we entered into an Asset Purchase Agreement for the sale of assets of our Low Speed Transceiver Products within our Network Products and Solutions product group. In 2016, the Low Speed Transceiver Products represented approximately 15% of total revenue. The asset sale was closed in January 2017.
We sell substantially all of our products to original equipment manufacturers ("OEMs"). Revenue is recognized when the product is shipped and title has transferred to the buyer. We price our products based on market and competitive conditions and may periodically reduce the price of our products as market and competitive conditions change and as manufacturing costs are reduced. Historically, our first quarter revenue is generally seasonally lower than the rest of the year primarily due to lower capacity utilization during the holidays in China and customer pricing schedules. However, this historical pattern should not be considered a reliable indicator of our future revenue or financial performance. Our sales transactions to customers are denominated primarily in U.S. dollars, with some portions in Chinese Renminbi (“RMB”) or Japanese Yen (“JPY”).
 
 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Total revenue
$
71,121

 
$
103,312

 
$(32,191)
 
(31)%
 
$
216,023

 
$
301,586

 
$(85,563)
 
(28
)%
 
We generate most of our revenue from a limited number of customers. Huawei has consistently been our largest customer, which was again the case in the three months ended September 30, 2017, as it accounted for approximately 39% of our revenue. Ciena and Fiberhome accounted for an additional 14% and 11%, respectively, of our third quarter 2017 revenue.

In addition to Huawei, we have several large customers which may or may not exceed 10% of revenue in any given quarter. After Huawei, our next four largest customers accounted for an additional 40% and 31% of our revenue in the three months ended September 30, 2017 and 2016, respectively, and an additional 37% and 30% of our revenue in the nine months ended September 30, 2017 and 2016, respectively.

28

We expect that a significant portion of our revenue will continue to be derived from a limited number of customers. As a result, the loss of, or a significant reduction in, orders from any of our key customers would materially affect our revenue and results of operations. Similarly, our accounts receivable are from a limited number of customers. As of September 30, 2017, two customers accounted for 45% and 10% of total accounts receivable and as of December 31, 2016, three customers accounted for 42%, 12% and 12% of total accounts receivable.
As previously discussed, demand from our China based customers was very strong in 2016 with optimistic forecasts for 2017.  However, tender awards from the China telecom carriers have been slower than expected through 2017, leading to lower revenue in the 2017 periods.  
Three Months Ended September 30, 2017 Compared With Three Months Ended September 30, 2016
 
Revenue decreased $32.2 million, or 31%, in the three months ended September 30, 2017, compared to the same period in 2016, primarily due to a reduction in demand from China-based customers as described in "Business Overview" above and lower revenue that resulted from the sale of assets related to our Low Speed Transceiver Products in January 2017.  Revenue generated by Low Speed Transceiver Products was zero in three months ended September 30, 2017, compared to $13.1 million in the same 2016 period. In the three months ended September 30, 2017, High Speed Products represented approximately 84% of total revenue, compared to 67% of total revenue in the same period in 2016 while Network Products and Solutions represented approximately 16% of total revenue in the three months ended September 30, 2017, compared to approximately 33% of total revenue in the same period a year ago, which included revenue from Low Speed Transceiver Products. In the three months ended September 30, 2017, revenue from China, United States, Japan and rest of the world was 57%, 17%, 1%  and 25% of total revenue, respectively, compared to 61%, 19%, 1% and 19% of total revenue, respectively, in the same period in 2016.
Nine Months Ended September 30, 2017 Compared With Nine Months Ended September 30, 2016
 
Revenue decreased $85.6 million, or 28% in the nine months ended September 30, 2017, compared to the same period in 2016, primarily due to a reduction in demand from China-based customers as described in "Business Overview" above and lower revenue that resulted from the sale of assets related to our Low Speed Transceiver Products in January 2017. Revenue generated by Low Speed Transceiver Products before the asset sale was $1.5 million in the nine months ended September 30, 2017, compared to $50.8 million in the same 2016 period. In the nine months ended September 30, 2017, High Speed Products represented approximately 82% of total revenue, compared to 66% of total revenue in the same period in 2016 while Network Products and Solutions represented approximately 18% of total revenue in the nine months ended September 30, 2017, compared to approximately 34% of total revenue in the same period a year ago, which included Low Speed Transceiver Products. In the nine months ended September 30, 2017, revenue from China, United States, Japan and rest of the world was 54%, 15%, 3% and 27% of total revenue, respectively, compared to 61%, 14%, 4% and 21% of total revenue respectively, in the same period in 2016.
 
Cost of Goods Sold and Gross Profit
Our cost of goods sold consists primarily of the cost to produce wafers and to manufacture and test our products. Additionally, our cost of goods sold generally includes stock-based compensation, write-downs of excess and obsolete inventory, amortization of certain purchased intangible assets, depreciation, acquisition-related fair value adjustments, restructuring charges, warranty costs, royalty payments, logistics and allocated facilities costs. 
Gross profit as a percentage of total revenue, or gross margin, has been and is expected to continue to be affected by a variety of factors including the introduction of new products, production volume, production volume compared to sales over time, the mix of products sold, inventory changes, changes in the average selling prices of our products, changes in the cost and volumes of materials purchased from our suppliers, changes in labor costs, changes in overhead costs or requirements, stock-based compensation, write-downs of excess and obsolete inventories and warranty costs. In addition, we periodically negotiate pricing with certain customers which can cause our gross margins to fluctuate, particularly in the quarters in which the negotiations occurred. Historically, our first quarter gross margins are generally seasonally lower than the fourth quarter of the prior year due to customer pricing schedules as well as lower capacity utilization during the holidays in China and the lower installment of outside plant equipment by customers in winter.   
As a manufacturing company, our margins are sensitive to changes in volume and factory utilization, and the softer demand in the China market led to lower production volume and factory utilization which contributed to the decrease in our gross profit in the three and nine months ended September 30, 2017.

29


 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands, except percentages)
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Cost of goods sold
60,608

 
75,863

 
$
(15,255
)
 
(20
)%
 
170,230

 
215,486

 
$
(45,256
)
 
(21
)%
Gross profit
10,513

 
27,449

 
$
(16,936
)
 
(62
)%
 
45,793

 
86,100

 
(40,307
)
 
(47
)%
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2017
 
2016
 
2017
 
2016
Gross profit as a % of revenue
15
%
 
27
%
 
21
%
 
29
%
Three Months Ended September 30, 2017 Compared With Three Months Ended September 30, 2016
Gross profit decreased $17 million, or 62%, to $11 million in the three months ended September 30, 2017, compared to $27 million in the same period in 2016. Gross margin decreased by approximately 12 percentage points to 15% in the three months ended September 30, 2017, compared to the same period in 2016. Approximately 4 percentage points of the decline in gross margin was driven by under-utilization attributable to lower volumes in our manufacturing plants, approximately 7 percentage points of the decline was due to inventory write-downs and reserves for non-cancelable purchase orders associated with excess inventory related to the demand reductions from China based customers and higher warranty reserves related to a quality rework requirement. Approximately 3 percentage points of the decline in gross margin was driven by restructuring costs and discontinued product inventory write-downs related to our decisions to end-of-life certain products. These declines were somewhat offset by an approximately 2 percentage point improvement in product margins attributable to the sale of the low speed transceiver product assets in January 2017.
Nine Months Ended September 30, 2017 Compared With Nine Months Ended September 30, 2016
Gross profit decreased by $40 million, or 47% to $46 million in the nine months ended September 30, 2017, compared to $86 million in the same period in 2016. Gross margin decreased by approximately eight percentage points to 21% in the nine months ended September 30, 2017, compared to the same period in 2016. Approximately 6 percentage points of the decline in gross margin was driven by under-utilization attributable to lower volumes in our manufacturing plants, approximately 3 percentage points of the decline was due to inventory write-downs and reserves for non-cancelable purchase orders associated with excess inventory related to the demand reductions from China based customers and higher warranty reserves related to a quality rework requirement. Approximately 1 percentage point of the decline was driven by restructuring costs and discontinued product inventory write-downs related to our decisions to end-of life certain products, net of higher intangible amortization and stock-based compensation charges in 2016. These declines were partially offset by an approximately 2 percentage point improvement in product margins attributable to the sale of the low speed transceiver product assets in January 2017.
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, other variable compensation. In the three and nine months ended September 30, 2016, stock-based compensation expense of approximately $5.8 million was recorded in our operating expenses attributable to the accelerated vesting of our stock options and stock appreciation units (“SAUs”) with a market-based vesting condition as such condition was satisfied when the average closing price of our common stock over a period of 20 consecutive trading days exceeded $15.0 per share in September 2016.

30

 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands, except percentages)
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Research and development
$
14,662

 
$
17,474

 
$
(2,812
)
 
(16
)%
 
$
44,412

 
$
42,206

 
$
2,206

 
5
 %
Sales and marketing
4,071

 
5,936

 
(1,865
)
 
(31
)%
 
12,913

 
13,674

 
(761
)
 
(6
)%
General and administrative
7,637

 
9,822

 
(2,185
)
 
(22
)%
 
26,792

 
26,747

 
45

 
—
 %
Amortization of purchased intangible assets
119

 
462

 
(343
)
 
(74
)%
 
355

 
1,375

 
(1,020
)
 
(74
)%
Acquisition and asset sale related costs
78

 
148

 
(70
)
 
(47
)%
 
229

 
923

 
(694
)
 
(75
)%
Restructuring charges
2,829

 
—

 
2,829

 
—
 %
 
3,550

 
—

 
3,550

 
—
 %
Gain on asset sale
—

 
—

 
—

 
—
 %
 
(2,000
)
 
—

 
(2,000
)
 
—
 %
Total operating expenses
$
29,396

 
$
33,842

 
$
(4,446
)
 
(13
)%
 
$
86,251

 
$
84,925

 
$
1,326

 
2
 %
 
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, 2017 Compared With Three Months Ended September 30, 2016
Research and development expense decreased by $2.8 million, or 16%, in the three months ended September 30, 2017, compared to the same period in 2016. The decrease was primarily due to a $2.5 million decrease in stock-based compensation expense compared to the 2016 period, which included higher stock-based compensation relating to a higher market price of our stock and the accelerated vesting of our market-based stock awards. Additional changes included a $0.9 million decrease in outside development services, and a $0.6 million decrease in development project costs, partially offset by a $0.8 million increase in salaries and related expenses and a $0.7 million increase in net allocated expenses, including facilities and equipment costs.
Nine Months Ended September 30, 2017 Compared With Nine Months Ended September 30, 2016
Research and development expense increased by $2.2 million, or 5%, in the nine months ended September 30, 2017, compared to the same period in 2016. The increase was primarily due to a $2.2 million increase in salaries and related expenses, a $1.6 million increase in net allocated expenses, a $0.8 million increase in development project costs, a $0.6 million increase in depreciation expense and a $0.3 million increase in outside development services. These increases were partially offset by a $2.8 million decrease in stock-based compensation expense compared to the 2016 period, which included higher stock-based compensation relating to a higher market price of our stock and the accelerated vesting of our market-based stock awards, and a $0.7 million decrease in variable compensation.
Sales and marketing
Sales and marketing expense consists primarily of personnel costs, including stock-based compensation and other variable compensation, costs related to sales and marketing programs and services and facility costs.
Three Months Ended September 30, 2017 Compared With Three Months Ended September 30, 2016
Sales and marketing expense decreased by $1.9 million, or 31%, in the three months ended September 30, 2017, compared to the same period in 2016 primarily due to a $2.0 million decrease in stock-based compensation expense compared to the 2016 period, which included higher stock-based compensation relating to a higher market price of our stock and the accelerated vesting of our market-based stock awards.

31

Nine Months Ended September 30, 2017 Compared With Nine Months Ended September 30, 2016
Sales and marketing expense decreased by $0.8 million, or 6%, in the nine months ended September 30, 2017, compared to the same period in 2016. The decrease was primarily due to a $2.4 million decrease in stock-based compensation expense compared to the 2016 period, which included higher stock-based compensation relating to a higher market price of our stock and the accelerated vesting of our market-based stock awards, and a $0.7 decrease in commissions and other variable compensation. These decreases were partially offset by a $1.2 million increase in allocated personnel costs, a $0.4 million reversal of bad debt expense in the 2016 period due to collection and a $0.4 million increase in product promotion costs.
General and administrative
General and administrative expense consists primarily of personnel costs, including stock-based compensation, for our finance,  human resources and information technology personnel and certain executive officers, as well as professional services costs related to accounting, tax, banking, legal and information technology services, depreciation and facility costs.
Three Months Ended September 30, 2017 Compared With Three Months Ended September 30, 2016
General and administrative expense decreased by $2.2 million, or 22%, in the three months ended September 30, 2017, compared to the same period in 2016. The decrease was primarily due to a $2.6 million decrease in stock-based compensation expense compared to the 2016 period, which included higher stock-based compensation relating to a higher market price of our stock and the accelerated vesting of our market-based stock awards. Other changes included a $0.4 million decrease is payroll and related costs and a $0.4 million decrease in facilities-related costs, partially offset by a $0.5 million increase in sales and property taxes and a $0.2 million increase related to a lower benefit from government grants in the 2017 period.
Nine Months Ended September 30, 2017 Compared With Nine Months Ended September 30, 2016
General and administrative expense was flat in the nine months ended September 30, 2017, compared to the same period in 2016. Increases included a $1.7 million increase in audit and accounting related fees, a $1.2 million increase in professional and legal expenses and a $0.5 million increase in facilities-related costs. These increases were offset by a $3.7 million decrease in stock-based compensation expense compared to the 2016 period, which included higher stock-based compensation relating to a higher market price of our stock and the accelerated vesting of our market-based stock awards.
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, while customer relationships and other agreements are recorded within operating expenses. Amortization of purchased intangibles included in operating expenses decreased in the three and nine months ended September 30, 2017, compared to the same period in 2016 primarily due to certain intangible assets being fully amortized in 2016. 
Acquisition and asset sale related transaction costs
We incurred $0.2 million in acquisition and asset sale related costs primarily related to legal, accounting and other professional services in the nine months ended September 30, 2017 and $0.1 million in the three months ended September 30, 2017. There was $0.1 million and $0.9 million in the three and nine months ended September 30, 2016, respectively, in acquisition-related costs for legal, accounting and other professional services.  
Restructuring charges
During the three months ended September 30, 2017, we initiated restructuring actions in order to focus on key growth initiatives and a lower break even revenue level. Actions to lower operating expenses and manufacturing costs included a reduction in force, facilities consolidation and certain asset-related adjustments. Restructuring charges in the three months ended September 30, 2017 were $3.1 million, of which $2.8 million was included in operating expenses and the remainder in cost of goods sold. Restructuring charges in the nine months ended September 30, 2017 were $4.1 million, of which $3.6 million was included in operating expenses and the remainder in cost of goods sold. Restructuring charges in the first six months of 2017 included a reduction in force during the first six months of the year related to the sale of our Low Speed Transceiver Product assets and our lower market outlook for China.

32

Gain on Asset Sale
In the nine months ended September 30, 2017, we recognized a $2.0 million gain associated with the sale of our Low Speed Transceiver Products’ assets. See Note 5 in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report.
Interest and other income (expense), net
Interest income consists of income earned on our cash, cash equivalents and short-term investments, as well as restricted cash. 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 subsidiary in Japan is the JPY.  The foreign currency transaction gains and losses of our subsidiaries in China and Japan primarily result from transactions in U.S. dollars.
 
 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Interest income
37

 
95

 
$
(58
)
 
(61
)%
 
141

 
227

 
$
(86
)
 
(38
)%
Interest expense
(495
)
 
(103
)
 
$
(392
)
 
381
 %
 
(743
)
 
(304
)
 
$
(439
)
 
144
 %
Other income (expense), net
(41
)
 
18

 
$
(59
)
 
(328
)%
 
197

 
(828
)
 
$
1,025

 
(124
)%
Total
(499
)
 
10

 
$
(509
)
 
(5,090
)%
 
(405
)
 
(905
)
 
$
500

 
(55
)%
 
Total interest income and other income (expense), net increased by $0.9 million in the nine months ended September 30, 2017, compared to the same periods in 2016 due primarily to favorable foreign currency exchange rates. Interest expense increased by $0.4 million in the three and nine months ended September 30, 2017, primarily due to an increase in outstanding borrowings during the quarter.
Income taxes
 
We conduct our business globally and our operating income is subject to varying rates of tax in the U.S., 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.
 
 
Three Months Ended
September 30,
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
2017
 
2016
 
$ Change
 
% Change
 
2017
 
2016
 
$ Change
 
% Change
Income tax (provision) benefit
1,195

 
(804
)
 
$
1,999

 
(249
)%
 
1,813

 
(2,471
)
 
$
4,284

 
(173
)%
 
Our income tax (provision) benefit in the three months ended September 30, 2017 and 2016 was primarily related to income taxes of our non-U.S. operations. In June 2016, the State Administration of Taxation in China issued a notice to adjust the requirements for high technology enterprise status. As a result, one of our China subsidiaries which had historically qualified for a preferential 15% tax rate available for high technology enterprises changed to the statutory 25% tax rate for the tax year 2016. Therefore, since September 2016, we have computed our China subsidiary’s tax (provision) benefit based on a 25% regular corporate income tax rate.
Liquidity and capital resources
As of September 30, 2017, we had working capital of $118.2 million, including total cash, cash equivalents, short-term investments and restricted cash of $73.7 million. Approximately 22% of our total cash, cash equivalents, short-term investments and restricted cash were held by our foreign entities, including approximately $14.1 million in accounts held by our subsidiaries in China, of which $2.9 million was in restricted cash, and approximately $1.8 million in accounts held by our subsidiary in Japan. Cash, cash equivalents, investments and restricted cash held outside of the U.S. may be subject to taxes if repatriated and may not be immediately available for our working capital needs.

33

Approximately $8.7 million of our retained earnings within our total accumulated deficit as of December 31, 2016 was subject to restrictions due to the fact that our subsidiaries in China are required to set aside at least 10% of their respective accumulated profits each year end to fund statutory common reserves as well as allocate a discretionary 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.
In January 2017, we completed the sale of certain Low Speed Transceiver Products’ assets for an approximately $25.0 million consideration plus an approximately $1.4 million post-closing transition services fees. The consideration was reduced by $3.4 million for inventory adjustment after closing to approximately $21.6 million, which was subject to other adjustments of up to $10.0 million for any potential claims. See Note 5 in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report.
In September 2017 we entered into a revolving line of credit agreement with Wells Fargo Bank, National Association ("Wells Fargo") as the administrative agent for a lender group (the "Wells Fargo Credit Facility" or "Credit Facility"), and the $20 million amount outstanding under our Comerica Bank Credit Facility, which has since been terminated, was paid in full.
The Wells Fargo Credit Facility provides for borrowings equal to the lower of (a) a maximum revolver amount of $50.0 million, or (b) an amount equal to 80% - 85% of eligible accounts receivable plus 100% of qualified cash balances up to $15.0 million, less certain discretionary adjustments ("Borrowing Base"). The maximum revolver amount may be increased by up to $25.0 million, subject to certain conditions. At closing, $50.0 million was available, of which $30.0 million was drawn. We used $20.0 million of this amount to pay the principal and interest due under the Comerica Bank Credit Facility.
The Credit Facility matures on June 30, 2022 and borrowings bear interest at an interest rate option of either (a) the LIBOR rate, plus an applicable margin ranging from 1.50% to 1.75% per annum, or (b) the prime lending rate, plus an applicable margin ranging from 0.50% to 0.75% per annum.  We are also required to pay a commitment fee equal to 0.25% of the unused portion of the Credit Facility.
The Credit Facility agreement requires prepayment of the borrowings to the extent the outstanding balance is greater than the lesser of (a) the most recently calculated Borrowing Base, or (b) the maximum revolver amount. The Borrowing Base calculation contains a customary provision that gives the lender the ability to reduce the Borrowing Base by reserves that are subjectively determinable, which is considered a subjective acceleration clause. We are required to maintain a combination of certain defined cash balances and unused borrowing capacity under the Credit Facility of at least $20.0 million, of which at least $5.0 million must be unused borrowing capacity. Borrowings under the Credit Facility are collateralized by substantially all of our assets. We were in compliance with the covenants of this Credit Facility as of September 30, 2017. As of September 30, 2017, the outstanding balance under the Credit Facility was $30.0 million and the weighted average rate under the LIBOR option was 3.16%. The remaining borrowing capacity was $19.8 million of which $5.0 million is required to be maintained as unused borrowing capacity.
We regularly issue short-term notes payable to our suppliers in China in exchange for accounts payable. These notes are supported by non-interest 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. As of September 30, 2017, our subsidiary in China had two line of credit facilities with banking institutions. The total amount available for short-term borrowings under these line of credit facilities as of September 30, 2017 was $21.6 million. A third line of credit facility in China expired during September 2017. In July 2017, we borrowed $17.0 million under this line which bears interest at LIBOR plus 2.55% and will mature on January 2, 2018.
As of September 30, 2017 and December 31, 2016, 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 $2.6 million and $6.4 million, respectively. Compensating balances relating to these credit facilities totaled $0.8 million and $2.1 million, respectively, as of September 30, 2017 and December 31, 2016. Compensating balances are classified as restricted cash on our condensed consolidated balance sheets. See Note 3 and Note 8 of Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report. We also held approximately $2.0 million in restricted cash as potential compensation for any breach of closing provisions under the asset purchase agreement for the asset sale closed in January 2017.
As of September 30, 2017, we had three loan arrangements with the Bank of Tokyo-Mitsubishi UFJ, Ltd. (collectively the “Mitsubishi Bank Term Loans”). One of Mitsubishi Bank Term Loans requires interest only payments until the maturity date of February 23, 2018, with a lump sum payment of the aggregate principal amount on the maturity date while the other

34

requires equal monthly payments of principal equal to 8,333,000 JPY until the maturity date of February 25, 2025, with a lump sum payment of the balance of 8,373,000 JPY on the maturity date. Interest on these loans accrues and is paid monthly based upon the annual rate of the monthly Tokyo Interbank Offer Rate (TIBOR) plus 1.40% and is secured by real estate collateral. The third term loan of 690 million JPY (approximately $6.2 million) (the “2017 Mitsubishi Bank Loan”) was entered into in March 2017 to acquire manufacturing equipment for our Japanese subsidiary and has an annual interest rate of the monthly TIBOR rate plus 1.00%. The 2017 Mitsubishi Bank Loan requires monthly interest and principal payments over 72 months commencing in April 2018. This loan is available from March 31, 2017 to March 30, 2018 and 690 million JPY (approximately $6.1 million) under this loan was drawn as of September 30, 2017. As of September 30, 2017, our total outstanding principal balance under the Mitsubishi Bank Term Loans was 1.9 billion JPY (approximately 17.1 million). See Note 8 of Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report.
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.
In the first nine months of 2017, we generated operating losses of $40.5 million and negative cash flows from operations of $41.2 million. We had an accumulated deficit of $337.7 million as of September 30, 2017. Our operating results and cash flows during this period have been negatively affected by reduced demand in China stemming from delayed provincial deployments and a buildup of inventory at one or more of our leading customers, the impact of which is expected to continue into early 2018. In response, we have implemented restructuring plans in May and September 2017 that included a reduction in force and consolidation of facilities, which are expected to reduce quarterly expenses by approximately $2.6 million when fully realized in the first quarter of 2018. We have also reduced or delayed certain product development projects and capital expenditures, aggressively pursued collections and continued to closely manage production and inventory levels.
As noted above, in September 2017, we entered into a revolving line of credit agreement with Wells Fargo, which provides for borrowings under an accounts receivable based formula up to a maximum of $50.0 million. We also have approximately $21.6 million available for short-term borrowings under two line of credit agreements in China that expire in July 2019. A third, $39.2 million line of credit agreement with CITIC Bank in China expired in September 2017 and we are currently discussing a potential renewal of the line with the bank. As of September 30, 2017, $17.0 million is due to CITIC Bank, which matures on January 2, 2018. If we are not successful in renewing the CITIC bank line, our intention is to repay the $17.0 million using the amount available under our other lines of credit in China. Additionally, the Company has $5.7 million of current portion of long-term debt as of September 30, 2017, which it plans to pay out of its existing available cash.
We currently believe we will have sufficient resources to fund our currently planned operations and expenditures over the next twelve months without additional financing or other actions.  In addition, there are a number of ongoing and potential actions that may further strengthen our projected cash and projected financial position. 
We operate in an industry that makes our prospects difficult to evaluate with certainty. Future declines in China market demand or other changes to our forecasts could adversely affect our results of operations, financial position and cash flows.   As a result, we may need to raise additional debt or equity capital to fund our operations.  Any additional debt arrangements may likely require regular interest or principal payments which could adversely affect our operations. There can be no assurance that additional debt or equity capital will be available on acceptable terms, or at all.  The accompanying unaudited condensed financial statements do not include any adjustments that may result from the outcome of these uncertainties.
Rusnano Rights Agreement
Under our amended rights agreement, dated June 30, 2015, with Rusnano, one of our principal stockholders, we agreed to make a $30.0 million investment commitment (the “Investment Commitment”) toward our Russian operations. The Investment Commitment can be partially satisfied by cash and/or non-cash investment inside or outside of Russia. Our $21.0 million investment milestone for 2016 was met as of December 31, 2016. If certain of the Investment Commitments are not achieved in the indicated time frames through 2019, we have the ability to exit our Russian operations by paying an exit fee of up to $2.0 million at that time. See Note 10 in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report.

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Cash flow discussion
 
The table below sets forth selected cash flow data for the periods presented:
 
 
Nine Months Ended
September 30,
 
(in thousands)
2017
 
2016
Net cash (used in) provided by operating activities
$
(41,211
)
 
$
26,717

Net cash used in investing activities
(10,087
)
 
(35,217
)
Net cash provided by financing activities
26,300

 
3,481

Effect of exchange rates on cash and cash equivalents
1,026

 
556

Net decrease in cash and cash equivalents
$
(23,972
)
 
$
(4,463
)


Operating activities
Net cash used in operating activities was $41.2 million in the nine months ended September 30, 2017, compared to $26.7 million provided by operating activities in the same 2016 period. The decrease was primarily attributable to a $41.0 million decrease in cash flows related to a buildup in inventories in the first half of 2017, a $35.1 million decrease in cash flows related to net loss and non-cash adjustments, a $22.0 million decrease in cash flows related to accounts payable due to lower spending and an $8.5 million decrease in cash flows from prepaid expenses and other assets primarily due to a receivable from the transition service agreement (TSA) with APAT OE. The decreases are partially offset by a $25.9 million increase in cash flows from accounts receivable primarily driven by lower revenue and strong collections and a $12.9 million increase in cash flows from accrued and other liabilities primarily relating to the TSA with APAT OE payable in the current year.
Investing activities
Net cash used by investing activities was $10.1 million in the nine months ended September 30, 2017, compared to $35.2 million used in the same 2016 period. Cash from investing activities increased primarily due to a $21.7 million increase due to proceeds from the sale of Low Speed Transceiver Products’ assets in January 2017, an $11.9 million increase due to lower net purchases of marketable securities, partially offset by an $11.5 million decrease due to higher property, plant and equipment purchases, primarily due to leasehold improvements related to our new San Jose, California facility.
Financing activities
Net cash provided by financing activities was $26.3 million in the nine months ended September 30, 2017, compared to $3.5 million provided by financing activities in the same 2016 period. The increase in cash flows from financing activities was due primarily to $30.0 million in new borrowing under our Wells Fargo Credit Facility ($10.0 million net of repayment of $20.0 million owed under the Comerica Bank Credit Facility), and $17.0 million from a note payable to a bank in China.

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Contractual obligations and commitments
As of September 30, 2017, our principal commitments consisted of obligations under operating leases, purchase commitments, debt and other contractual obligations. The following table presents additional contractual obligations and update the amounts disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations, set forth in Part II, Item 7, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016 (in thousands). See Note 8 in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Report.
 
Payments Due by Period
 
Total
 
Less than 1 Year
 
1-3 years
 
3-5 Years
 
More than 5 Years
Note payable to financial institution
$
17,000

 
$
17,000

 
—

 
—

 
—

Borrowing under Wells Fargo Credit Facility
30,018

 
—

 
—

 
30,018

 
—

Expected interest payments (1)
4,966

 
580

 
2,885

 
1,501

 
—

Total
$
51,984

 
$
17,580

 
$
2,885

 
$
31,519

 
$
—

(1) Expected interest payments were calculated using interest rates as of September 30, 2017.

Off-balance sheet arrangements
 
As of September 30, 2017, 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 in Item 1 of Part I of this Quarterly Report on Form 10-Q for a description of recent accounting pronouncements and accounting changes.

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 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We have entered into foreign currency forward contracts to minimize the short-term impact of foreign currency exchange rate fluctuations, related to RMB on our inter-company receivables and payables. Our exposures to other market risk have not changed materially since December 31, 2016. For quantitative and qualitative disclosures about market risk, see Item 7A Quantitative and Qualitative Disclosures About Market Risk, in our Annual Report on Form 10-K for the year ended December 31, 2016. 

ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2017. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
As previously reported in our Annual Report on Form 10-K, as of December 31, 2016, our management concluded that we did not maintain effective internal control over financial reporting as of December 31, 2016, because of the material weakness described in our Annual Report on Form 10-K, specifically our internal controls were not designed and operating effectively to ensure proper cut-off for certain revenue transactions. Our logistics personnel did not have adequate written procedures and training with respect to our shipping and handling policies for sales. As a result of these design and operating effectiveness deficiencies, our policies and controls related to our revenue recognition and shipping and handling practices did not operate effectively to provide reasonable assurance that revenue was properly accounted for in accordance with generally accepted accounting principles. No actual material misstatements were identified for the year ended December 31, 2016.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.
In the Evaluation of Disclosure Controls and Procedures included in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as a result of the material weakness described above.  
Changes in Internal Control over Financial Reporting
There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934, as amended) for the quarter ended September 30, 2017 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 

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Remedial Measures
Our management continued significant efforts in 2017 to establish a framework to improve internal controls over financial reporting. We committed considerable resources to the design, implementation, documentation, and testing of our internal controls. Additional efforts are required to remediate and re-test certain internal control deficiencies. Our management believes that these efforts have improved our internal control over financial reporting. With the oversight of senior management and our audit committee, we have taken steps and plan to take additional measures to remediate the underlying causes of our existing material weakness. Our management is in the process of completing the following steps as part of our ongoing remediation efforts to address the material weakness:
(a)
Strengthening our cut-off controls with improved documentation standards and training;
(b)
Improving logistics and operations documentation standards and procedures;  and
(c)
Restricting and enhancing system access rights to ensure adequate controls within the sales organization.
While these steps have helped address some of the root causes of the material weakness noted above, they have not fully remediated the material weaknesses that existed as of December 31, 2016. We are in the process of conducting additional training to remediate the material weakness.
Our goal is to remediate this material weakness by the end of 2017, provided that there are sufficient opportunities to conclude, through testing, that the enhanced controls are operating effectively.
Inherent Limitation on the Effectiveness of Internal Controls
The effectiveness of any system of internal control over financial reporting is subject to inherent limitations, including the exercise of judgment in designing, implementing, operating, and evaluating the controls and procedures, and the inability to eliminate misconduct completely.  Accordingly, any system of internal control over financial reporting can only provide reasonable, not absolute assurances.  In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. We intend to continue to monitor and upgrade our internal controls as necessary or appropriate for our business, but cannot assure that such improvements will be sufficient to provide us with effective internal control over financial reporting.


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PART II. OTHER INFORMATION
 
ITEM 1.    LEGAL PROCEEDINGS
 
From time to time, we are involved in litigation that we believe is of the type common to companies engaged in our line of business, including commercial disputes and employment issues. As of the date of this Quarterly Report on Form 10-Q, other than as described below, we are not involved in any pending legal proceedings that we believe could have a material adverse effect on our financial condition, results of operations or cash flows. However, as described below, a certain dispute involves a claim by a third party that our activities infringe their intellectual property rights. This and other types of intellectual property rights claims generally involve the demand by a third party that we cease the manufacture, use or sale of the allegedly infringing products, processes or technologies and/or pay substantial damages or royalties for past, present and future use of the allegedly infringing intellectual property. Claims that our products or processes infringe or misappropriate any third-party intellectual property rights (including claims arising through our contractual indemnification of our customers) often involve highly complex, technical issues, the outcome of which is inherently uncertain. Moreover, from time to time, we may pursue litigation to assert our intellectual property rights. Regardless of the merit or resolution of any such litigation, complex intellectual property litigation is generally costly and diverts the efforts and attention of our management and technical personnel which could adversely affect our business.
For a discussion of our current legal proceedings, please refer to the information set forth under the “Litigation” section in Note 10, Commitments and Contingencies, in Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q, which is incorporated herein by reference.

ITEM 1A.    RISK FACTORS 
Except for those risk factors denoted by an asterisk (*), the risk factors facing our company have not changed materially from those set forth in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2016, as filed with the SEC on March 16, 2017, which risk factors are set forth below.
 
Risks Related to Our Business
*We are dependent on Huawei Technologies Co., Ltd. and its affiliate HiSilicon Technologies Co., Ltd., Ciena, Nokia and our other key customers for a large portion of our revenue and the loss of, or a significant reduction in orders in any period from any of our major customers may reduce our revenue and adversely impact our results of operations.
We have generated most of our revenue from a limited number of customers. In the nine months ended September 30, 2017, Huawei Technologies Co. Ltd., together with its affiliate HiSilicon Technologies Co., Ltd. (collectively “Huawei”), and Ciena Corporation accounted for approximately 39% and 16% of our revenue, respectively, and our top ten customers represented 90% of our revenue. In the year ended December 31, 2016, Huawei Technologies, together with its affiliate HiSilicon (or collectively, Huawei), and Ciena Corporation accounted for approximately 49% and 16% of our revenue, respectively, and our top ten customers represented 91% of our revenue. In the year ended December 31, 2015, Huawei and Ciena accounted for approximately 44% and 21% of our revenue, respectively, and our top ten customers represented 91% of our revenue. The loss of, or a significant reduction in orders from these major customers or any of our other key customers would materially and adversely affect our revenue and results of operations.
*We are subject to risks and uncertainties related to our revenue growth outlook in China.
Fiber optics telecommunication growth in China is an important contributor to our success. We expect a major portion of our revenue to come from China infrastructure spending in wireline and wireless networks, notably from the three largest China telecom carriers, China Mobile Communications Corporation, China Telecommunications Corporation and China United Network Communications Group Co., Ltd. In part, this infrastructure spending originates from the publicly announced China Broadband 2020 and related initiatives. Tender awards from the China telecom carriers and spending under these initiatives have been slower in 2017 than anticipated, which has adversely affected our financial condition and results of operations in 2017. If the anticipated Chinese spending and carrier tender awards do not materialize as anticipated, or if there are further unanticipated and/or prolonged delays in the Chinese initiative, our business, financial condition, results of operations and prospects would be further adversely affected.


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*We have had a history of losses which may recur in the future.
We have had a history of losses and we may incur additional losses in future periods. As of December 31, 2016, our accumulated deficit was $298.7 million and we incurred a net loss of $39.1 million in the nine months ended September 30, 2017. We also expect to continue to make significant expenditures related to the ongoing operation and development of our business. These include expenditures related to the sales, marketing and development of our products and to maintain our manufacturing facilities and research and development operations.
*We may need to raise additional capital and/or extend or replace our current credit facilities in order to maintain our currently-planned operations, and we may not be able to obtain capital when desired on favorable terms, if at all, or without dilution to our stockholders
We believe that our existing cash and cash equivalents, and cash flows from our operating activities and funds available under our credit facilities will be sufficient to meet our anticipated cash needs for at least the next 12 months. However, in our Note 1 of Notes to Condensed Financial Statements in Item 1 of Part I of this report, we have disclosed our conclusions under ASU 2014-15, “Presentation of Financial Statements - Going Concern” that, if revenue is lower than our current forecasts, we may need to implement certain contingency plans to maintain our ability to continue as a going concern. Although we believe it is probable that we will be able to complete these plans, it is possible that we may not be successful in completing these plans and/or we may not generate sufficient cash flow from operations or otherwise have the capital resources to meet our future capital needs and continue as a going concern.
Additionally, in light of our current financial condition, we may need additional financing to continue operations or execute on our current or future business strategies, including to: 
•
invest in our research and development efforts, including by hiring additional technical and other personnel;
•
maintain and expand our operating or manufacturing infrastructure;
•
acquire complementary businesses, products, services or technologies; or
•
otherwise pursue our strategic plans and respond to competitive pressures.
We do not know with certainty what forms of financing, if any, will be available to us. If financing is not available on acceptable terms, if and when needed, our ability to fund our operations, enhance our research and development and sales and marketing functions, develop and enhance our products, respond to unanticipated events, including unanticipated opportunities, or otherwise respond to competitive pressures could be adversely impacted. In any such event, our business, financial position and results of operations could be materially harmed, and we may need to implement further contingency plans to further reduce expenses in order to continue operations. Moreover, if we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders could be significantly diluted, and these newly issued securities may have rights, preferences or privileges senior to those of existing stockholders. If we fail to raise sufficient additional capital if needed, we may not be able to completely execute our business plan and may not be able to continue as a going concern.
If we incur additional indebtedness through arrangements such as credit agreements or term loans, such arrangements may impose restrictions and covenants that limit our ability to respond appropriately to market conditions, make capital investments or take advantage of business opportunities. In addition, any additional debt arrangements we may enter into would likely require us to make regular interest payments, which could adversely affect our results of operations.
Manufacturing problems could impact manufacturing yields or result in delays in product shipments to customers and could adversely affect our revenue, competitive position and reputation.
We may experience delays, disruptions or quality control problems in our manufacturing operations or supply chain constraints, which could adversely impact manufacturing volumes, yields or delay product shipments. As a result, we could incur additional costs that would adversely affect our gross margin, and product shipments to our customers could be delayed beyond the shipment schedules requested by our customers, which would negatively affect our revenue, competitive position and reputation.

41

Additionally, manufacturing yields depend on a number of factors, including the stability and manufacturability of the product design, manufacturing improvements gained over cumulative production volumes, the quality and consistency of component parts and the nature and extent of customization requirements by customers. Capacity constraints, raw materials shortages, logistics issues, labor shortages, volatility in utilization of manufacturing operations, supporting utility services and other manufacturing supplies, the introduction of new product lines, rapid increases in production demands and changes in customer requirements, manufacturing facilities or processes, or those of some third party contract manufacturers and suppliers of raw materials and components have historically caused, and may in the future cause, reduced manufacturing yields, negatively impacting the gross margin on, and our production capacity for, those products. Our ability to maintain sufficient manufacturing yields is particularly challenging with respect to PICs due to the complexity and required precision of a large number of unique manufacturing process steps. Manufacturing yields for PICs can also suffer if contaminated materials or materials that do not meet highly precise composition requirements are inadvertently utilized. Because a large portion of our PIC manufacturing costs are fixed, PIC manufacturing yields have a substantial effect on our gross margin. Lower than expected manufacturing yields could also delay product shipments and decrease our revenue.
*Customer demand is difficult to accurately forecast and, as a result, we may be unable to optimally match production with customer demand.
We make planning and spending decisions based on our estimates of customer requirements. The short-term nature of commitments by many of our customers, and the possibility of unexpected changes in demand for their products, reduce our ability to accurately estimate future customer requirements. In 2016, we incurred substantial capital expenditures to increase manufacturing capacity in response to strong customer demand in 2016 (particularly in China) and in expectation of continued strong demand in 2017. However, tender awards from the China telecom carriers and spending under the China Broadband 2020 and related initiatives has been slower in 2017 than anticipated, which resulted in decreased customer demand and underutilization of certain of our manufacturing operations. Because many of our costs and operating expenses are relatively fixed, reduction in customer demand due to market downturns or other reasons would have a material adverse effect on our operating results, as occurred in 2017.

On the other hand, on occasion, customers may require rapid increases in production, which can strain our resources, cause our manufacturing to be negatively impacted by materials shortages, necessitate higher or more restrictive procurement commitments, increase our manufacturing yield loss and scrapping of excess materials, result in delayed shipments and/or reduce our gross margins. We may not have sufficient capacity at any given time to meet the volume demands of our customers, and we may have difficulty expanding our manufacturing operations on a timely basis to meet increasing customer demand. Additionally, one or more of our suppliers may not have sufficient capacity at any given time to meet our volume demands. Any inability to meet customer demands for rapid increases in production in the future could have a material adverse effect on our business, financial condition, results of operations and prospects.
We depend upon outside contract manufacturers for a portion of the manufacturing process for some of our products. Our operations and revenue related to these products could be adversely affected if we encounter problems with a contract manufacturer.
The majority of our products are manufactured internally. However, we also rely upon contract manufacturers in Thailand, China, Japan and other Asia locations to provide back-end manufacturing and produce the finished portion of some of our products. Our reliance on contract manufacturers for these products makes us vulnerable to possible capacity constraints and reduced control over their supply chains, delivery schedules, manufacturing yields, manufacturing quality/controls and costs. If one of our contract manufacturers is unable to meet all of our customer demand in a timely fashion, whether due to their direct operating control or due to their supply chain, this could have a material adverse effect on the revenue from our products.
We are under continuous pressure to reduce the prices of our products, which has adversely affected, and may continue to adversely affect, our gross margins.
The communications networks industry has been characterized by declining product prices over time as technological advances increase price and performance and put pressure on existing products. We have reduced the prices of many of our products in the past, most often during annual end-of-year price negotiation. We expect pricing pressure for our products to continue, including from our major customers. To maintain or increase their market share, our competitors also reduce prices of their products each year. In addition, our customers may seek to internally develop and manufacture competing products at a lower cost than we would otherwise charge, which would add additional pressure on us to lower our selling prices. If we are

42

unable to offset any future reductions in our average selling prices by increasing our sales volume, reducing our costs or introducing new products, our gross margin would be adversely affected.
If the Metro and datacenter interconnect market sectors do not grow as rapidly as we expect, or if demand for our products in these sectors is lower than we expect, our revenue growth may be adversely affected.
We expect that our future growth in the market for 100G and beyond coherent products to be driven in large part by the increased adoption of our products in the Metro market segment and in the high-performance datacenter interconnect market. Over the last several years, 100G and beyond coherent technology has seen increasing adoption in the Long Haul market segment and now is penetrating the much larger Metro sector of the market.
If we fail to achieve or sustain a leadership position in the Long Haul telecom sector and use our position in that market to penetrate the Metro and datacenter interconnect segments, if these segments fail to grow as expected, or if demand for our products in the Metro and datacenter interconnect market segments fails to materialize, our business, financial condition, results of operations and prospects would suffer.
We face intense competition which could negatively impact our results of operations and market share.
The communications networks industry is highly competitive. Our competitors range from large international companies offering a wide range of products to smaller companies specializing in niche products.
Some of our competitors have substantially greater name recognition, technical, financial, and marketing resources, and greater manufacturing capacity, as well as better-established relationships with customers, than we do. Some of our competitors have more resources to develop or acquire, and more experience in developing or acquiring, new products and technologies. Some of our competitors may be able to develop new products more quickly than us and may be able to develop products that are more reliable or which provide more functionality than ours. In addition, some of our competitors have the financial resources to offer competitive products at below-market pricing levels that could prevent us from competing effectively and result in a loss of sales or market share or cause us to lower prices for our products.
We also face competition from some of our customers who evaluate our capabilities against the merits of manufacturing products internally, including Huawei. Due to the fact that such customers are not seeking to make a comparable profit directly from the manufacture of these products, they may have the ability to provide competitive products at a lower total cost than we would charge such customers. As a result, these customers may purchase less of our products and there would be additional pressure to lower our selling prices which, accordingly, would negatively impact our revenue and gross margin.
If we fail to retain our key personnel or if we fail to attract additional qualified personnel, we may not be able to achieve our anticipated growth and our business could suffer.
Our success and ability to implement our business strategy depends upon the continued contributions of our senior management team and others, including senior management in foreign subsidiaries and our technical and operations employees in all locations. Our future success depends, in part, on our ability to attract and retain key personnel, including our senior management and others. The loss of services of members of our senior management team or key personnel or the inability to continue to attract and retain qualified personnel could have a material adverse effect on our business. Competition for highly skilled technical and operations people where we operate is extremely intense, and we continue to face challenges identifying, hiring and retaining qualified personnel in many areas of our business.


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The majority of our customer contracts do not commit customers to specified buying levels, and many of our customers may decrease, cancel or delay their buying levels at any time with little or no advance notice to us.
Our products are typically sold pursuant to individual purchase orders or by use of a vendor-managed inventory, or VMI, model, which is a process by which we ship agreed quantities of products to a customer-designated location and those products remain our inventory and we retain the title and risk of loss for those products until the customer takes possession of the products. Our customers are typically not contractually committed to buy any quantity of products beyond firm purchase orders. Many of our customers may increase, decrease, cancel or delay purchase orders already in place. We have experienced and expect to continue to experience wide fluctuations in demand from customers using VMI, particularly Huawei and its affiliate HiSilicon Technologies Co., Ltd., even in instances where we have built and shipped products to the customer-designated locations as VMI.
If we fail to adequately manage our long-term growth and expansion, our business and financial results will suffer.
Until our recent restructurings in 2017, we experienced significant growth over several years through, among other things, internal manufacturing and related expansion programs, product development and acquisitions of other businesses and products. Our business expanded to numerous locations, including foreign locations, and as a result became more complex, more demanding of management’s attention and subject to new laws and regulations.
Our success and ability to further scale our business will depend, in part, on our ability to manage changes in a cost-effective and efficient manner. If we cannot manage any future growth, we may be unable to take advantage of market opportunities, execute our business strategies or respond to competitive pressures. Any failure to effectively manage growth, maintain our quality and/or or customer satisfaction could adversely affect our business and reputation.
Our success will depend on our ability to anticipate and quickly respond to evolving technologies and customer requirements.
Our ability to anticipate and respond to evolving technology, industry standards, customer requirements and product offerings, and to develop and introduce new and enhanced products and technologies, will be critical factors in our ability to succeed. In addition, the introduction of new products by other companies embodying new technologies, or the emergence of new industry standards, could render our existing products uncompetitive from a pricing standpoint, obsolete or otherwise unmarketable.
While we rely on many suppliers, there are a few which, if they stopped, decreased or delayed shipments to us; it could have an adverse effect on our business and financial results.
We depend on a limited number of suppliers for certain components and materials we have qualified to use in the manufacture of certain of our products. Some of these suppliers could disrupt our business if they stop, decrease or delay shipments or if the components they ship have quality, consistency, or business continuity issues. Some of these components and materials are available only from a sole source, or have been qualified only from a single source. We may also face component shortages if we experience increased demand for components beyond what our qualified suppliers can deliver. If we experience component shortages from certain key suppliers, we may be unable to meet customer demand or may have higher purchasing costs, or both. Although we engage in various actions to mitigate the impact of these shortages, any inability on our part to obtain sufficient quantities of critical components at reasonable costs could adversely affect our ability to meet demand for our products, which could cause our revenue, results of operations, or both to suffer.
Our customers generally restrict our ability to change the component parts in our modules without their approval and such changes may require repeating product qualification processes. The reliance on a sole supplier, single qualified vendor or limited number of suppliers could result in delivery and quality problems, reduced control over product pricing, reliability and performance and an inability to identify and qualify another supplier in a timely manner. Any supply deficiencies relating to the quality, quantities or timeliness of delivery of components that we use to manufacture our products could adversely affect our ability to fulfill our customer orders and our results of operations.

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We must continually achieve new design wins and enhance existing products or our business and future revenue may be harmed.
The markets for our products are characterized by frequent new product introductions, changes in customer requirements and evolving industry standards, all with an underlying pressure to reduce cost and meet stringent reliability and qualification requirements. Our future performance will depend on our successful development, introduction and market acceptance of new and enhanced products that address these challenges. The anticipated or actual introduction of new and enhanced products by us and by our competitors may cause our customers to defer or cancel orders for our existing products, and could result, and in the past, has resulted, in a write-down in the value of inventory. To the extent customers defer or cancel orders for our products for any reason or we fail to achieve new design wins, our competitive position would be adversely affected and our ability to grow revenue would be impaired.
Furthermore, fast time-to-market with new products can be critical to success in our markets. It is difficult to displace an existing supplier for a particular type of product once a network equipment vendor has chosen a supplier, even if a later-to-market product provides superior performance or cost efficiency. If we are unable to make our new or enhanced products commercially available on a timely basis, we may lose existing and potential customers and our financial results would suffer.
We may be exposed to costs or losses from product lines that we intend to exit or may undertake divestiture of portions of our business that require us to continue providing substantial post-divestiture transition services and support, which may cause us to incur unanticipated costs and liabilities and adversely affect our financial condition and results of operations.
In August 2016, we announced our intention to reduce the volume and end the production of certain of our lower-margin low speed transceiver product lines within a year of August 2016. In January 2017, we completed the sale of assets and transfer of certain liabilities of our access network and low speed transceiver product lines (the “Low Speed Transceiver Products”). The foregoing actions are part of our strategy to exit products that have been declining in revenue and have lower gross margins than our other higher speed products. We may incur additional costs in connection with the sale or end-of-life of these products, or other products and/or facilities in the future, and our revenues and net income could be negatively affected, particularly in the short term, in connection with the end-of-life or sales of such products and/or facilities.  It is also possible that we could incur continued costs or liabilities after the end-of-life process is completed, which could have a material adverse effect on our financial condition or operating results.
We are subject to the cyclical nature of the markets in which we compete and any future downturn may reduce demand for our products and revenue.
The markets in which we compete are tied to the aggregate capital expenditures of telecommunications service providers as they build out and upgrade their network infrastructure. These markets may be cyclical and characterized by rapid technological change, price erosion, evolving standards and wide fluctuations in product supply and demand. In the past, including recently to varying degrees in China, the U.S. and Europe, these markets have experienced significant downturns, often connected with, or in anticipation of, the maturation of product cycles—for both manufacturers’ and their customers’ products—or in response to over or under purchasing of inventory by our customers relative to ultimate carrier demand, and with declining general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. 
Our historical results of operations have been subject to substantial fluctuations, and we may experience substantial period-to-period fluctuations in future results of operations.
If spending for communications networks does not continue to grow as expected, our business and financial results may suffer.
Our future success as a provider of modules and subsystems to leading network equipment vendors depends on continued capital spending on global communications networks. Network traffic has experienced rapid growth driven primarily by bandwidth-intensive content, including cloud services, mobile video and data services, wireless 4G/LTE and 5G services, social networking, video conferencing and other multimedia. This growth is intensified by the proliferation of fixed and wireless devices that are enabling consumers to access content at increasing data rates anytime and anywhere. Our future success depends on continued demand for high-bandwidth, high-speed communications networks and the ability of network equipment vendors and carrier datacenter operators to fulfill this demand. In 2017, this growth has slowed, primarily due to soft demand and high inventory levels in China, which has adversely affected our business and financial condition in 2017. While we believe the long term prospects for growth in data traffic remain strong, our business and financial results will suffer if growth does not occur as expected.

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We face a variety of risks associated with international sales and operations, which if not adequately managed could adversely affect our business and financial results.
We derive, and expect to continue to derive, a significant portion of our revenue from international sales in various markets. In addition, a major portion of our operations is based in Shenzhen and Dongguan, China and we have additional operations in Japan, Russia and Canada. Our international revenue and operations are subject to a number of material risks, including, but not limited to:
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difficulties in staffing, managing and supporting operations in more than one country;
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difficulties in enforcing agreements and collecting receivables through foreign legal systems;
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fewer legal protections for intellectual property in foreign jurisdictions;
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the need for compliance with local laws and regulations;
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foreign and U.S. taxation issues and international trade barriers;
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general economic and political conditions in the markets in which we operate;
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difficulties in obtaining any necessary governmental authorizations for the export of our products to certain foreign jurisdictions;
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imposition of export restrictions on sales to any of our major foreign customers;
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fluctuations in foreign economies and fluctuations in the value of foreign currencies and interest rates;
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trade and travel restrictions;
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outbreaks of contagious disease;
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domestic and international economic or political changes, hostilities and other disruptions; and
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difficulties and increased expenses in complying with a variety of U.S. and foreign laws, regulations and trade standards, including the Foreign Corrupt Practices Act and international labor standards. Negative developments in any of these areas in China, Japan, Russia or other countries could result in a reduction in demand for our products, the cancellation or delay of orders already placed, difficulties in producing and delivering our products, threats to our intellectual property, difficulty in collecting receivables, higher labor costs and a higher cost of doing business.
In addition, although we maintain an anti-corruption compliance program throughout our company, violations of our compliance program may result in criminal or civil sanctions, including material monetary fines, penalties and other costs against us or our employees, and may have a material adverse effect on our business.
Failure to realize the anticipated benefits from our planned expansion in the Russian Federation may affect our future results of operations and financial condition.
In connection with our raising capital in an April 2012 private placement of common stock, we established a wholly-owned subsidiary and company operations in the Russian Federation. We also committed to make substantial investments in our Russian operations over a period of several years. We could be required to pay up to $2.0 million to Joint Stock Company “RUSNANO”, or Rusnano, at the time if we do not meet certain investment conditions towards our Russian operations by 2019.
The establishment of successful operations in the Russian Federation requires substantial capital expenditure, and is in part dependent on the cooperation of Russian entities that could include the Russia government and other third parties. We are also subject to economic, political, legal, and social events and developments in Russia, including but not limited to actions such as restrictions placed on U.S. companies doing business in Russia. If there are delays in our efforts to establish and maintain operations in the Russian Federation, the anticipated benefits of our Russian expansion may not be realized or may take longer to realize than expected.

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Our revenues and costs will fluctuate over time, making it difficult to predict our future results of operations. 
Our revenue, gross margin and results of operations have varied significantly and are likely to continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. For instance, changes in gross margin may result from various factors, such as changes in pricing, changes in our fixed costs, changes in the cost of labor, changes in the mix of our products sold, changes in the amount of product manufactured versus the amount of product sold over time, and charges for excess and obsolete inventory. In addition, our first quarter revenue is generally seasonally lower than the rest of the year primarily due to lower capacity utilization during the holidays in China and the impact of typical price negotiations during the fourth quarter. It is difficult for us to accurately forecast our future revenue and gross margin and plan expenses accordingly and, therefore, it is difficult for us to predict our future results of operations.
Increasing costs and other factors may adversely impact our gross margins.
We may not be able to maintain or improve our gross margins because of slow introductions of new products, pricing pressure from increased competition, failure to effectively reduce the cost of existing products, failure to improve our product mix, future macroeconomic or market volatility reducing sales volumes, changes in customer demand (including a change in product mix among different areas of our business) or other factors. Our gross margins can also be adversely affected for reasons including, but not limited to, fixed manufacturing costs that would not be expected to decrease in proportion to any decrease in revenues; unfavorable production yields or variances; increases in costs of input parts and materials; the timing of movements in our inventory balances; warranty costs and related returns; changes in foreign currency exchange rates; possible exposure to inventory valuation reserves; and other increases in our costs and expenses, including as a result of rising labor costs in China.  Such significant increases in costs without corresponding increases in revenue would materially and adversely affect our business, our results of operations and our financial condition and our gross margins. 
If our customers do not qualify our products for use, then our results of operations may suffer.
Prior to placing volume purchase orders with us, most of our customers require us to obtain their approval—called qualification in our industry—of our new and existing products, and our customers often audit our manufacturing facilities and perform other vendor evaluations during this process. The qualification process involves product sampling and reliability testing and collaboration with our product management and engineering teams in the design and manufacturing stages. If we are unable to qualify our products with customers, then our revenue would be lower than expected and we may not be able to recover the costs associated with the qualification process which would have an adverse effect on our results of operations.
In addition, due to evolving technological changes in our markets, a customer may cancel or modify a design project before we have qualified our product or begun volume manufacturing of a qualified product. It is unlikely that we would be able to recover the expenses for cancelled or unutilized custom design projects.
We have pursued and may continue to pursue acquisitions. Acquisitions could be difficult to integrate, divert the attention of key personnel, disrupt our business, dilute stockholder value and impair our financial results.
As part of our business strategy, we have pursued and intend to continue to pursue acquisitions of complementary businesses, products, services or technologies that we believe could accelerate our ability to compete in our existing markets or allow us to enter new markets. Any of these transactions could be material to our financial condition and results of operations. For instance, in October 2011, we completed the acquisition of Santur Corporation, a designer and manufacturer of InP-based PIC products, and in March 2013 we completed the acquisition of the optical semiconductor business unit of LAPIS Semiconductor Co., Ltd., now known as NeoPhotonics Semiconductor. We purchased the tunable laser product lines of EMCORE in January 2015 and the power monitoring products business of EigenLight Corporation, or Eigenlight, in November 2015.
Acquisitions involve numerous risks. The failure to successfully evaluate and execute acquisitions or otherwise adequately address such risks could result in excess costs and materially harm our business and financial results.
Acquisitions also frequently result in the recording of goodwill and other intangible assets which are subject to potential impairments which have occurred in the past and which, were they to occur in the future, could harm our financial results.

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It could be discovered that our products contain defects that may cause us to incur significant costs, divert our attention, result in a loss of customers and result in product liability claims.
Our products are complex and undergo quality testing as well as formal qualification, both by our customers and by us. For various reasons, such as the occurrence of performance problems that are unforeseeable in testing or that are detected only when products age or are operated under peak stress conditions, our products may fail to perform as expected long after customer acceptance. Failures could result from faulty components or design, problems in manufacturing or other unforeseen reasons. As a result, we could incur significant costs to repair or replace defective products under warranty, particularly when such failures occur in installed systems. Any significant product failure could result in lost future sales of the affected product and other products, as well as customer relations problems and litigation, which could harm our business.
The communications networks industry has long product development cycles requiring us to incur product development costs without assurances of an acceptable investment return.
Large volumes of communications equipment and support structures are installed with considerable expenditures of funds and other resources, and long investment return period expectations. At the component supplier level, these cycles create considerable, typically multi-year, gaps between the commencement of new product development and volume purchases. Due to changing industry and customer requirements, we are constantly developing new products, including seeking to further integrate functions on PICs and developing and using new technologies in our products. These development activities necessitate significant investment of capital. Our new products often require a long time to develop because of their complexity and rigorous testing and qualification requirements. Accordingly, we and our competitors often incur significant research and development and sales and marketing costs for products that, initially, will be purchased by our customers long after much of the cost is incurred and, in some cases, may never be purchased due to changes in industry or customer requirements in the interim.
We are subject to global governmental export and import controls that could subject us to liability, impair our ability to compete in international markets, or restrict our sales to certain customers.
We are subject to export and import control laws, trade regulations and other trade requirements that limit which products we sell and where and to whom we sell our products, especially laser-dependent products. In some cases, it is possible that export licenses would be required from the U.S. or other government agencies outside the U.S. such as, but not limited to, Japan, China or Russia for some of our products in accordance with various statutes. In addition, various countries regulate the export or import of certain technologies and have enacted laws that could limit our ability to distribute our products. Failure to comply with these and similar laws on a timely basis, or at all, or any limitation on our ability to export or sell our products or to obtain any required licenses would adversely affect our business, financial condition and results of operations.
If we fail to protect our intellectual property and other proprietary rights, our business and results of operations could be materially harmed.
Our success depends to a significant degree on our ability to protect our intellectual property and other proprietary rights. We rely on a combination of patent, trademark, copyright, trade secret and unfair competition laws, as well as license agreements and other contractual provisions, to establish and protect our intellectual property and other proprietary rights. We have applied for patent registrations in the U.S. and in other foreign countries, some of which have been issued. We cannot guarantee that our pending applications will be approved by the applicable governmental authorities.
Policing unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent the misappropriation, unauthorized use or other infringement of our intellectual property rights. Further, we may not be able to effectively protect our intellectual property rights from misappropriation or other infringement in foreign countries where we have not applied for patent protections, and where effective patent, trademark, trade secret and other intellectual property laws may be unavailable, or may not protect our proprietary rights as fully as U.S. or Japan law. Particularly, our U.S. patents do not afford any intellectual property protection in China, Japan, Canada or other Asia locations, including Russia, where we have company operations.
In the future, we may need to take legal actions to prevent third parties from infringing upon or misappropriating our intellectual property or from otherwise gaining access to our technology. Protecting and enforcing our intellectual property rights and determining their validity and scope could result in significant litigation costs and require significant time and attention from our technical and management personnel. If we fail to protect our intellectual property and other proprietary rights, or if such intellectual property and proprietary rights are infringed or misappropriated, our business, results of operations or financial condition could be materially harmed.

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We may be involved in intellectual property disputes, which could divert management’s attention, cause us to incur significant costs and prevent us from selling or using the challenged technology.
Participants in the markets in which we sell our products have experienced frequent litigation regarding patent and other intellectual property rights. Numerous patents in these industries are held by others, including our competitors. In addition, from time to time, we have been notified that we may be infringing certain patents or other intellectual property rights of others. Regardless of their merit, responding to such claims can be time consuming, divert management’s attention and resources and may cause us to incur significant expenses. In addition, there can be no assurance that third parties will not assert infringement claims against us. While we believe that our products do not infringe in any material respect upon intellectual property rights of other parties and/or meritorious defense would exist with respect to any assertions to the contrary, we cannot be certain that our products would not be found infringing the intellectual property rights of others.
In January 2010, Finisar Corporation, or Finisar, filed a complaint in the U.S. District Court for the Northern District of California against us and three other co-defendants. In the complaint, Finisar alleged infringement of certain of its U.S. patents arising from the co-defendants’ respective manufacture, importation, use, sale of or offer to sell certain optical transceiver products in the U.S. In March 2010, we filed an answer to the complaint and counterclaims, asserting two claims of patent infringement and additional claims asserting that Finisar has violated state and federal competition laws and violated its obligations to license on reasonable and non-discriminatory terms. In May 2010, the Court dismissed without prejudice all co-defendants (including us) except Source Photonics, Inc., on grounds that such claims should have been asserted in four separate lawsuits, one against each co-defendant. This dismissal without prejudice does not prevent Finisar from bringing a new similar lawsuit against us. In May 2012, we and Finisar agreed to toll our respective claims until the refiling of certain of the previously asserted claims from this dispute. As a result, Finisar is permitted to bring a new lawsuit against us if it chooses to do so, and we may bring new claims against Finisar upon seven days written notice prior to filing such claims.
Although we believe that we would have meritorious defenses to the infringement allegations and intend to defend any new similar lawsuit vigorously, there can be no assurance that we will be successful in our defense. Even if we are successful, we may incur substantial legal fees and other costs in defending the lawsuit. Further, a new lawsuit, if brought by either party, would be likely to divert the efforts and attention of our management and technical personnel, which could harm our business.
If we fail to obtain the right to use the intellectual property rights of others which are necessary to operate our business, and to protect their intellectual property, our business and results of operations will be adversely affected.
From time to time we may choose to or be required to license technology or intellectual property from third parties in connection with the development of our products. Failure to obtain a necessary third-party license required for our product offerings or to develop new products and product enhancements could adversely affect our business.
Participation in standards setting organizations may subject us to intellectual property licensing requirements or limitations that could adversely affect our business and prospects.
In the course of our participation in the development of emerging standards for some of our present and future products, we may agree to grant to all other participants a license to our patents that are essential to the practice of those standards on reasonable and non-discriminatory, or RAND, terms. If we fail to limit to whom we license our patents, or fail to limit the terms of any such licenses, we may be required to license our patents or other intellectual property to others in the future, which could limit the effectiveness of our patents against competitors.  
Any potential dispute involving our products, services or technology could also include our customers using our products, which could trigger our indemnification obligations to them and result in substantial expenses to us.
In any potential dispute involving allegations that our products, services or technology infringe the intellectual property rights of third parties, our customers could also become the target of litigation. Because we often indemnify our customers for intellectual property claims made against them for products incorporating our technology, any claims against our customers could trigger indemnification obligations in some of our supply agreements, which could result in substantial expenses such as increased legal expenses, product recalls, damages for past infringement or royalties for future use.

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Natural disasters, terrorist attacks or other catastrophic events could harm our operations and our financial results.
Our worldwide operations could be subject to natural disasters and other business disruptions, which could harm our future revenue and financial condition and increase our costs and expenses. For example, our corporate headquarters and wafer fabrication facility in Silicon Valley, California and our Tokyo, Japan facility are located near major earthquake fault lines, and our manufacturing facilities are located in Shenzhen and Dongguan, China, areas that are susceptible to typhoons. We are not insured against many natural disasters, including earthquakes.
Similarly, our worldwide operations could be subject to secondary effects of natural disasters, terrorist attacks or other catastrophic events. Even if our facilities are not directly affected, any of these types of events could substantially disrupt the business of our suppliers or customers, which could have a material adverse effect on us.
Rapidly changing standards and regulations could make our products obsolete, which would cause our revenue and results of operations to suffer.
We design our products to conform to regulations established by governments and to standards set by industry standards bodies worldwide, such as The American National Standards Institute, the European Telecommunications Standards Institute, the International Telecommunications Union and the Institute of Electrical and Electronics Engineers. Various industry organizations are currently considering whether and to what extent to create standards for elements used in 100Gbps and beyond systems. Because certain of our products are designed to conform to current specific industry standards, if competing or new standards emerge that are preferred by our customers, we would have to make significant expenditures to develop new products and our revenue and results of operations would suffer.
Potential changes in our effective tax rate could negatively affect our future results.
We are subject to income taxes in the U.S., China, Japan and other foreign jurisdictions, and our domestic and international tax liabilities are subject to the allocation of expenses in differing jurisdictions. Our tax rate is affected by changes in the mix of earnings and losses in countries with differing statutory tax rates, certain non-deductible expenses and the valuation of deferred tax assets and liabilities, including our ability to utilize our net operating losses. Increases in our effective tax rate could negatively affect our results of operations.
Our future results of operations may be subject to volatility as a result of exposure to fluctuations in foreign exchange rates, primarily the Chinese Renminbi (RMB) and Japanese Yen (JPY) exchange rates.
We are exposed to foreign exchange risks. Foreign currency fluctuations may adversely affect our revenue and our costs and expenses, and hence our results of operations. A substantial portion of our business is conducted through our subsidiaries based in China, whose functional currency is the RMB and Japan, whose functional currency is the JPY, and a smaller amount in Russian Rubles (RUB). The value of the RMB against the U.S. dollar and other currencies and the value of the JPY and RUB against the U.S. dollar and other currencies fluctuate and are affected by, among other things, changes in political and economic conditions.
To the extent that transactions by our subsidiaries in China and Japan are denominated in currencies other than the RMB and JPY, we bear the risk that fluctuations in the exchange rates of the RMB and JPY in relation to other currencies could decrease our revenue or increase our costs and expenses, therefore having an adverse effect on our future results of operations.
While we generate a significant portion of our revenue in U.S dollars, a significant portion of our cost of goods sold are in RMB and JPY. Therefore appreciation in RMB and JPY against the U.S. dollar would negatively impact our cost of goods sold upon translation to U.S. dollars.
We have entered into hedging transactions to reduce the short-term impact of foreign currency fluctuations. However, the availability and effectiveness of these hedging transactions may be limited and we may not be able to successfully hedge our exposure. In addition, our currency exchange variations may be magnified by Chinese exchange control regulations that restrict our ability to convert RMB into foreign currency.

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We have identified a material weakness in our internal control over financial reporting which could, if not remediated, result in material misstatements in our financial statements.
As part of our annual evaluation of internal controls for fiscal 2016, our management identified several deficiencies (including inadequate written shipping procedures) in our internal control over financial reporting related to certain revenue cut-off procedures. These deficiencies aggregated to a material weakness in our controls over revenue cut-off procedures, which affected the timing of our revenue recognition. A material weakness is defined as a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. While no actual material misstatements were identified for the year ended December 31, 2016, the material weakness had not been remediated as of September 30, 2017.
Over remainder of 2017, we intend to complete implementation of a remediation plan designed to address this material weakness. However, if our remediation measures are insufficient to address this material weakness, if any of our personnel overrides our controls or if additional material weaknesses in our internal control are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results. For more information see “Item 4. Controls and Procedures”.
If we fail to maintain effective internal control over financial reporting in the future, the accuracy and timing of our financial reporting may be adversely affected.
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended, or the Exchange Act.
Preparing our consolidated financial statements involves a number of complex manual and automated processes, which are dependent upon individual data input or review and require significant management judgment. One or more of these elements may result in errors that may not be detected and could result in a material misstatement of our consolidated financial statements. If we fail to maintain the adequacy of our internal controls over financial reporting, our business and operating results may be harmed and we may fail to meet our financial reporting obligations. If material weaknesses in our internal control are discovered or occur, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results.
Our internal control over financial reporting may not prevent or detect misstatements because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud. Even effective internal controls can provide only reasonable assurance with respect to the preparation and fair presentation of financial statements. Any failure of our internal controls could adversely affect the results of the periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting. If we cannot provide reliable financial reports or prevent fraud, our business and results of operations could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock may decline.
We may be subject to disruptions or failures in information technology systems and network infrastructures that could have a material adverse effect on our business and financial condition.
We rely on the efficient and uninterrupted operation of complex information technology systems and network infrastructures to operate our business. A disruption, infiltration or failure of our information technology systems as a result of software or hardware malfunctions, system implementations or upgrades, computer viruses, cyber-attacks, third-party security breaches, employee error, theft or misuse, malfeasance, power disruptions, natural disasters or accidents could cause breaches of data security, loss of intellectual property and critical data and the release and misappropriation of sensitive competitive information and partner, customer and employee personal data. Any of these events could harm our competitive position, result in a loss of customer confidence, cause us to incur significant costs to remedy any damages and ultimately materially adversely affect our business and financial condition.

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Covenants in our borrowing arrangements may limit our flexibility in responding to business opportunities and competitive developments and increase our vulnerability to adverse economic or industry conditions.
We have lending arrangements with several financial institutions, which generally require us to maintain certain financial covenants and limit our ability to take certain actions such as incurring some kinds of additional debt, paying dividends, or engaging in certain transactions like mergers and acquisitions, investments and asset sales without the lenders’ consent. These restrictions may limit our flexibility in responding to business opportunities, competitive developments and adverse economic or industry conditions. In addition, a breach of any of these covenants, or a failure to pay interest or indebtedness when due under any of our credit facilities, could result in a variety of adverse consequences, including the acceleration of our indebtedness.
We may be unable to utilize our net operating loss carryforwards to reduce our income taxes, which could adversely affect our future financial results.
As of December 31, 2016, we had net operating loss, or NOL, carryforwards for U.S. federal and state tax purposes of $207.3 million and $51.0 million, respectively. As these net operating losses have not been utilized and may not be utilized prior to their expiration in the future. The utilization of the NOL and tax credit carryforwards are subject to a substantial limitation imposed by Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, and similar state provisions. We recorded deferred tax assets, net of valuation allowance, for the NOL carryforwards currently available after considering the existing Section 382 limitation. If we incur an additional limitation under Section 382, then the NOL carryforwards, as disclosed, could be reduced by the impact of any future limitation that would result in existing NOL carryforwards and tax credit carryforwards expiring unutilized and increases in future tax liabilities.
We may utilize conflict minerals in our production or rely on suppliers who utilize conflict minerals in their production, and the use of such conflict minerals may negatively impact our results of operations.
Since 2013, we have been subject to reporting obligations for the use of conflict minerals originating in the Democratic Republic of the Congo and adjoining countries and subsequently have timely filed our conflict minerals reports with the SEC. If we fail to comply with these requirements, our operating results could be harmed.

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

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

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

Our manufacturing operations and our products are subject to a variety of federal, state, local and international environmental, health and safety laws and regulations in each of the jurisdictions in which we operate or sell our products. Our failure to comply with present and future environmental, health or safety requirements, or the identification of contamination, could cause us to incur substantial costs, including cleanup costs, monetary fines, civil or criminal penalties, or curtailment of operations, which could have a material adverse effect on our business, financial condition and results of operations.

Additionally, increasing efforts to control emissions of greenhouse gases, or GHG, may also impact us. Additional climate change or GHG control requirements are under consideration at the federal level in the U.S. and in China. Additional restrictions, limits, taxes, or other controls on GHG emissions could increase our operating costs and, while it is not possible to estimate the specific impact any final GHG regulations will have on our operations, there can be no assurance that these measures will not have significant additional impact on us.

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Risks Related to Our Operations in China
Our business operations conducted in China are critical to our success. A significant portion of our revenue was recognized from customers for whom we shipped products to a location in China. Additionally, a substantial portion of our net property, plant and equipment, approximately 30% as of September 30, 2017, was located in China. We expect to make further investments in China in the foreseeable future. Therefore, our business, financial condition, results of operations and prospects are to a significant degree subject to economic, political, legal, and social events and developments in China.
Adverse changes in economic and political policies in China, or Chinese laws or regulations could have a material adverse effect on business conditions and the overall economic growth of China, which could adversely affect our business.
The Chinese economy differs from the economies of most developed countries in many respects, including the level of government involvement, level of development, growth rate and control of foreign exchange and allocation of resources. The Chinese economy has been transitioning from a planned economy to a more market-oriented economy. Despite reforms, the government continues to exercise significant control over China’s economic growth by way of the allocation of resources, control over foreign currency-denominated obligations and monetary policy and provision of preferential treatment to particular industries or companies. Moreover, the laws, regulations and legal requirements in China, including the laws that apply to foreign-invested enterprises are relatively new and are subject to frequent changes. The interpretation and enforcement of such laws is uncertain. Any adverse changes to these laws, regulations and legal requirements, including tax laws, or their interpretation or enforcement, or the creation of new laws or regulations relating to our business, could have a material adverse effect on our business.
Furthermore, any slowdown or economic downturn, whether actual or perceived, in China could have a material adverse effect on our business, financial condition and results of operation.
The termination, expiration or unavailability of our preferential income tax treatment in China may have a material adverse effect on our operating results.
Effective January 1, 2008, the China Enterprise Income Tax Law, or the EIT law, imposes a single uniform income tax rate of 25% on all Chinese enterprises, including foreign-invested enterprises. Historically, one of our subsidiaries in China qualified for a preferential 15% tax rate that is available for new and high technology enterprises. In June 2016, the State Administration of Taxation issued a notice to adjust the requirements for high technology enterprise status. As a result, we did not meet the requirements for 2016 and became subject to the 25% regular income tax rate, which may impact our operating results for future years.
Our subsidiaries in China may be subject to restrictions on dividend payments, on making other payments to us or any other affiliated company, and on borrowing or allocating tax losses among our subsidiaries.
Current Chinese regulations permit our subsidiaries in China to pay dividends only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations, which are different than U.S. accounting standards and regulations. In addition, our subsidiaries in China are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund their statutory common reserves until such reserves have reached at least 50% of their respective registered capital, as well as to allocate a discretional portion of their after-tax profits to their staff welfare and bonus fund. As of September 30, 2017 and December 31, 2016, our Chinese subsidiaries’ common reserves had not reached this threshold and, accordingly, these entities are required to continue funding such reserves with accumulated net profits. Accordingly, we may not be able to move our capital easily, which could harm our business.
Restrictions on currency exchange may limit our ability to receive and use our revenue and cash effectively.
Because a portion of our revenue is denominated in RMB, any restrictions on currency exchange may limit our ability to use revenue generated in RMB to fund any business activities we may have outside China or to make dividend payments in U.S. dollars. Under relevant Chinese rules and regulations, the RMB is convertible under the “current account,” which includes dividends, trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment and loans, without the prior approval of the State Administration of Foreign Exchange, or SAFE. We cannot be certain that Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB, especially with respect to foreign exchange transactions. If such restrictions are imposed, our ability to adjust our capital structure or engage in foreign exchange transactions may be limited.

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Uncertainties with respect to China’s legal system could adversely affect the legal protection available to us.
Our operations in China are governed by Chinese laws and regulations. Our subsidiaries in China are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to wholly foreign-owned enterprises. China’s legal system is a civil law system based on written statutes. Unlike common law systems, it is a legal system where decided legal cases have limited value as precedents. However, China has not developed a fully-integrated legal system, and recently-enacted laws and regulations may not sufficiently cover all aspects of economic activities in China. Uncertainties in the Chinese legal system may impede our ability to enforce the contracts we have entered into with our distributors, business partners, customers and suppliers. In addition, protections of intellectual property rights and confidentiality in China may not be as effective as in the U.S. or other countries or regions with more developed legal systems. All of these uncertainties could limit the legal protections available to us and could materially and adversely affect our business and operations.
If the Chinese government determines that we failed to obtain approvals of, or registrations with, the requisite Chinese regulatory authority with respect to our current and past import and export of technologies, or failed to obtain the necessary licenses to file patent applications outside China for inventions made in China, we could be subject to sanctions, which could adversely affect our business.
China imposes controls on technology import and export. The term “technology import and export” is broadly defined to include, without limitation, the transfer or license of patents, software and know-how, and the provision of services in relation to technology. Depending on the nature of the relevant technology, the import and export of technology to or from China requires either approval by or registration with, the relevant Chinese governmental authorities. Additionally, the Chinese government requires the patent application for any invention made at least in part in China to be filed first in China, then undergo a government secrecy review and obtain a license before such application is filed in other countries.
If the Chinese government determines that we failed to obtain follow required procedures and obtain the appropriate license before filing a patent application outside China for an invention made at least in part in China, our China patents on such products may be invalidated, which could have a material and adverse effect on our business and operations.
China regulation of loans and direct investment by offshore holding companies to China entities may delay or prevent us from using our cash proceeds to make loans or additional capital contributions to our China subsidiaries.
From time to time, we may make loans or additional capital contributions to our China subsidiaries. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all, with respect to our future loans or capital contributions to our China subsidiaries. If we fail to receive such registrations or approvals, our ability to capitalize our China subsidiaries may be negatively affected, which could materially and adversely affect our liquidity and ability to fund and expand our business.
Dividends paid to us by our Chinese subsidiaries may be subject to Chinese withholding tax.
The EIT Law and the implementation regulations provide that a 10% withholding tax may apply to dividends payable to investors that are “non-resident enterprises,” to the extent such dividends are derived from sources within China and in the absence of any tax treaty that may reduce such withholding tax rate.
Our contractual arrangements with our subsidiaries in China may be subject to audit or challenge by the Chinese tax authorities, and a finding that our subsidiaries in China owe additional taxes could substantially reduce our net income and the value of our stockholders’ investment.
Under the applicable laws and regulations in China, arrangements and transactions among related parties may be subject to audit or challenge by the Chinese tax authorities. We would be subject to adverse tax consequences if the Chinese tax authorities were to determine that the contracts with or between our subsidiaries were not executed on an arm’s length basis, and as a result the Chinese tax authorities could require that our Chinese subsidiaries adjust their taxable income upward for Chinese tax purposes. Such an adjustment could adversely affect us by increasing our tax expenses.

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We may have difficulty maintaining adequate management, legal and financial controls in China, which we are required to do in order to comply with Section 404 of the Sarbanes-Oxley Act and securities laws, and which could cause a material adverse impact on our consolidated financial statements, the trading price of our common stock and our business.
Chinese companies have historically not adopted a western style of management and financial reporting concepts and practices, which includes strong corporate governance, internal controls and computer, financial and other control systems. Most of our middle management staff in China are not educated in the western system, and we may have difficulty hiring new employees in China with experience and expertise relating to accounting principles generally accepted in the U.S. and U.S. public-company reporting requirements. These issues could make it more difficult for us to establish and maintain adequate internal control over our financial reporting, which could then result in errors that could cause a material misstatement of our consolidated financial statements.
We may be exposed to liabilities under the FCPA and Chinese anti-corruption laws, and any determination that we violated these laws could have a material adverse effect on our business.
We are subject to the Foreign Corrupt Practices Act of 1977, or FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute, for the purpose of obtaining or retaining business. We have operations, agreements with third parties and we make significant sales in China. China also strictly prohibits bribery of government officials. Our activities in China create the risk of unauthorized payments or offers of payments by our employees, consultants, sales agents or distributors, even though they may not always be subject to our control. Although we have implemented policies and procedures to discourage these practices by our employees, our existing safeguards and any future improvements may prove to be less than effective, and our employees, consultants, sales agents or distributors may engage in conduct for which we might be held responsible. Violations of the FCPA or anti-corruption laws in other countries may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition.
Risks Related to Ownership of Our Common Stock
Our stock price may be volatile due to fluctuation of our financial results from quarter-to-quarter and other factors.
Our quarterly revenue and results of operations have varied in the past and may continue to vary significantly from quarter to quarter. This variability may lead to volatility in our stock price as research analysts and investors respond to these quarterly fluctuations. These fluctuations are due to numerous factors, including:
•
fluctuations in demand for our products;
•
the timing, size and product mix of sales of our products;
•
changes in our pricing and sales policies, particularly in the first quarter of the year, or changes in the pricing and sales policies of our competitors;
•
our ability to design, manufacture and deliver products to our customers in a timely and cost-effective manner and that meet customer requirements;
•
quality control or yield problems in our manufacturing operations;
•
our ability to timely obtain adequate quantities of the components used in our products;
•
length and variability of the sales cycles of our products;
•
unanticipated increases in costs or expenses; and
•
fluctuations in foreign currency exchange rates.
The foregoing factors are difficult to forecast, and these, as well as other factors, could materially adversely affect our quarterly and annual results of operations in the future. In addition, a significant amount of our operating expenses is relatively fixed in nature due to our internal manufacturing, research and development, sales and general administrative efforts. Any failure to adjust spending quickly enough to compensate for a revenue shortfall could magnify the adverse impact of such revenue shortfall on our results of operations. Moreover, our results of operations may not meet our announced financial outlook or the expectations of research analysts or investors, in which case the price of our common stock could decrease significantly. There can be no assurance that we will be able to successfully address these risks.

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The market price of our common stock could be subject to wide fluctuations in response to, among other things, the risk factors described in this section of this Quarterly Report on Form 10-Q, and other factors beyond our control, such as fluctuations in the valuation of companies perceived by investors to be comparable to us.
The stock markets have experienced price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political and market conditions, such as recessions, sovereign debt or liquidity issues, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock.
In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may become the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.
Our failure to prepare and file timely our periodic reports with the SEC may make it more difficult for us to access the public markets to raise debt or equity capital. 
In January 2017 we did not file a Current Report on Form 8-K reporting the completion of the sale of the assets of our Low Speed Transceiver Products within the time frame required by the SEC. As a result of our failure to file this Current Report by the filing date required by the SEC, we are not eligible to file or use a Form S-3 registration statement to conduct public offerings until our filings with the SEC have been timely made for a full year. Our ineligibility to use Form S-3 during this time period may have a negative impact on our ability to quickly access the public capital markets because we would be required to file a long-form registration statement and wait for the SEC to declare such registration statement effective. This may limit our ability to access the public markets quickly to raise debt or equity capital. Our limited ability to access the public markets could prevent us from pursuing transactions or implementing business strategies that we believe would be beneficial to our business.
The concentration of our capital stock ownership with our principal stockholders, executive officers and directors and their affiliates may limit other stockholders’ ability to influence corporate matters.
As of December 31, 2016, our executive officers and directors, and entities that are affiliated with them or that have a right to designate a director, beneficially own an aggregate of approximately 39% of our outstanding common stock. This significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. Also, as a result, these stockholders, acting together, may be able to control our management and affairs and matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions.
Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.
Our amended and restated certificate of incorporation and our amended and restated bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:
•
providing for a classified board of directors with staggered, three-year terms;
•
not providing for cumulative voting in the election of directors;
•
authorizing our board of directors to issue, without stockholder approval, preferred stock rights senior to those of common stock;
•
prohibiting stockholder action by written consent;
•
limiting the persons who may call special meetings of stockholders; and
•
requiring advance notification of stockholder nominations and proposals.
In addition, we have been governed by the provisions of Section 203 of the Delaware General Corporate Law since the completion of our initial public offering. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding common stock, from engaging in certain business combinations without approval of substantially all of our stockholders for a certain period of time.

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

ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None. 

ITEM 3.    DEFAULTS UPON SENIOR SECURITIES
 
None.

ITEM 4.    MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.    OTHER INFORMATION
 
On November 6, 2017, we entered into an amendment to our retention agreement dated August 15, 2017 with Elizabeth Eby, our Senior Vice President, Finance and Chief Financial Officer.  The amendment provides that if Ms. Eby’s employment terminates as a result of involuntary termination on or within 12 months following a change in control, and provided that Ms. Eby provides a valid and effective release of all employment related claims, the vesting of each of Ms. Eby’s outstanding equity awards will accelerate as to the number of shares that would have vested subject to continued service with the Company over the 24 month period following termination (but no waiver of any performance-based criteria).  Previously, the retention agreement provided that an 18-month period would apply to such vesting acceleration.  Other than this time period change from 18 to 24 months, no other changes were made to Ms. Eby’s retention agreement as a result of the amendment. The amendment was intended to bring this provision into line with the corresponding term in the agreements with certain other management-level employees.
 

57

ITEM 6.    EXHIBITS

Exhibit
no.
 
Exhibit Description
 
Form
 
SEC File No.
 
Exhibit
 
Filing Date
Filed herewith
 
 
 
Form 8-K
 
001-35061
 
2.1
 
January 23, 2017
 
 
 
 
Form 8-K
 
001-35061
 
2.2
 
January 23, 2017
 
 
 
Form 8-K
 
001-35061
 
2.3
 
January 23, 2017
 
 
 
Form 8-K
 
001-35061
 
3.1
 
February 10, 2011
 
 
 
Form S-1
 
333-166096
 
3.4
 
November 22, 2010
 
 
 
Form S-1
 
333-166096
 
4.1
 
May 17, 2010
 
 
 
Form S-1
 
333-166096
 
4.2
 
April 15, 2010
 
 
 
Form S-1
 
333-201180
 
4.4
 
December 19, 2014
 
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
X
 
 
Form 8-K
 
001-35061
 
10.1
 
September 7, 2017
 
 
 
Form 8-K
 
001-35061
 
10.1
 
September 11, 2017
 

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Exhibit
no.
 
Exhibit Description
 
Form
 
SEC File No.
 
Exhibit
 
Filing Date
Filed herewith
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
X
101.INS
 
XBRL Instance Document.
 
 
 
 
 
 
 
 
X
101.SCH
 
XBRL Taxonomy Extension Schema Document.
 
 
 
 
 
 
 
 
X
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document.
 
 
 
 
 
 
 
 
X
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document.
 
 
 
 
 
 
 
 
X
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document.
 
 
 
 
 
 
 
 
X
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document.  
 
 
 
 
 
 
 
 
X

+ Management compensatory plan or arrangement.
* Translation to English of an original Chinese document.




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SIGNATURE
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
NeoPhotonics Corporation
 
 
Date:
November 8, 2017
By:
/S/  ELIZABETH EBY
 
 
Elizabeth Eby
 
 
Senior Vice President, Finance and Chief Financial Officer
 
 
(Principal Financial and Accounting Officer)
 

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