Trends in Communication Networks

and Optical Chips

NeoPhotonics as a Showcase of Trends

in Communication Networks and Optical Chips

A Market Brief ™

by

Steven Kim

MintKit Investing

www.mintkit.com

Disclaimer. This brief is provided as a resource for information

and education. The contents reflect personal views and should not
be construed as recommendations to any investor in particular.
Each investor has to conduct due diligence and design a strategy
tailored to individual circumstances.

© 2011 MintKit.com
 Summary

Optical devices continue to play a growing role in communication networks. In the current
setting, the upgrowth of the technology is spotlighted by the initial public offering (IPO) of
NeoPhotonics Corporation.

The market for communication networks has enjoyed strapping growth for decades on
end. In this environment, NeoPhotonics produces hardware modules which can be used to
increase the capacity and reliability of high-speed networks while reducing the cost and
size of the hardware. Due to the boons of optical devices on integrated chips, the
technology is destined to to play a growing role in the industry.

The bulk of the hardware units to date rely on the hookup of discrete components in order
to process the signals. The makeshift result is a clunky system marked by great complexity
and high cost in tandem with low reliability.

A better approach is to combine a multiplicity of functions on a single slab of silicon. The

benefits of a photonic integrated circuit (PIC) include high speed and high reliability.

On the downside, the initial cost of designing the hardware and building the production line
is apt to be a lot higher. On the other hand, the unit cost associated with mass production
can be far lower.

In a representative year, worldwide traffic on the Internet swells by 45% or so. According to
one estimate, the flow of digital signals will burgeon at a compound annual growth rate of
34% until the middle of the 2010s.

From the standpoint of the vendors, the market for optical hardware is slated to expand
along with the groundswell of digital traffic. Depending on the niche, the revenue stream is
expected to rise at an annual rate of 15% to 42%.

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Within the field of optical platforms, NeoPhotonics garnered sales of $155 million in 2009.
The intake comprised an increase of 16% over the previous year. During the first 9 months
of 2010, the revenues of $133M amounted to a rise of 19% above the corresponding figure
for the previous year.

In terms of profits, the company suffered a net loss of $6.8M in 2009. During the first 9
months of 2010, however, the firm enjoyed a net income of $2.9M.

As is often the case after an initial public offering, the price of NeoPhotonics stock ran into
a spate of turbulence in the stock market. Even so, the prospects for the equity look
promising over the longer range. If the company can keep up its momentum on the
business end, then the upswell of sales and earnings is bound to lift up the equity in
tandem.

* * *

Keywords:

Communication, Networks, NeoPhotonics, NPTN, IPO, Telecommunications, Outlook,

Review, Stock, Market, Photonics, Optics, QQQQ

* * *

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 * * *

Since the autumn of the 20 th century, optical devices have assumed an expanding role in
digital networks. The buoyant prospects for the technology is showcased by the debut of
NeoPhotonics Corporation in the stock market.

The field of communication networks has enjoyed robust growth for decades on end.
Within this market, NeoPhotonics produces hardware modules that can be used to boost
the capacity and reliability of high-speed networks while trimming the cost of the
equipment. Due to the advantages of optical devices on integrated chips, the technology
will continue to play a growing role in the industry.

In 2009, NeoPhotonics garnered revenues of $155 million, an increase of 16% over the
previous year. During the first 9 months of 2010, the intake of $133M amounted to a rise of
19% above the corresponding level for the prior year.

Despite the rise in revenues, though, the company reported a net loss of $6.8M in 2009.
On the other hand, the business turned a corner during the following year. For the first 9
months of 2010, the firm enjoyed a net income of $2.9M.

Market Outlook for Communications Networks

The traffic on telecommunications networks has been growing by leaps and bounds since
the autumn of the 20 th century. The swell of traffic springs from a raft of applications
ranging from streaming music and data warehousing to social networking and video
conferencing.

Other drivers behind the groundswell include the proliferation of digital devices attached to
fixed networks as well as wireless links. Another type of application in recent years
involves real-time interaction on the information highway through a raft of applications
known as cloud-based services.

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According to the Visual Networking Index from Cisco, worldwide traffic on the Internet
surged by 45% during 2009. Moreover, the volume is expected to grow at a compound
annual growth rate (CAGR) of 34% until the middle of the 2010s (NeoPhotonics, 2011).

Optical hardware represents a core technology for handling the upswell of throughput. As
an example, photonic devices can provide cost-effective solutions in upgrading a
transmission line from a speed of 40 gigabits per second (Gbps) to 100 Gbps and beyond.

According to Infonetics, the worldwide market for optical equipment in communication

networks is expected to expand from $12.9 billion in 2010 to $15.0 billion by 2014.
Depending on the market niche, the revenue stream will likely rise at a CAGR of 15% to
42% (NeoPhotonics, 2011).

For the existing networks, the bulk of the platforms rely on the mashup of discrete
components for processing and conveying the digital signals. The resulting contraption is a
clunky system marked by great complexity and high cost coupled with low reliability.

A superior approach is to combine multiple functions within a single module. The benefits
of an integrated chip lie in high speed along with low cost and heightened reliability.

On the downside, the initial cost of product design and fabrication system turns out to be
higher. On the other hand, the unit cost of the modules stamped out through mass
production can be far lower.

As with the technology sector in general, the market for communication networks tends to
be highly cyclical. Despite the chronic turbulence in the short run, though, the field is
destined to flourish over the years and decades to come.

Along with the secular uptrend in communication networks, the PIC approach is slated to
play a booming role in the marketplace. In fact, the technology will evolve and expand in
order to embody a growing clutch of digital functions within a single chip.

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Profile of NeoPhotonics

NeoPhotonics designs and builds optical modules for high-speed communication

networks. The core competence of the firm lies in the photonic integrated circuit.

A compound chip of this type can combine multiple functions which in the past were
handled by separate components. In certain cases, a single chip may incorporate the
functionality of a traditional system which required more than a hundred components.

The advantages of photonic integration include performance and reliability as well as

efficiency in terms of power consumption. Other strengths involve the cutdown of
production cost as well as physical size.

The optical modules have the ability to tweak the allocation of bandwidth in response to
the shifting pattern of digital traffic. In this way, the traffic within a communication network
can be optimized on the fly.

NeoPhotonics controls the vertical chain of production for its products. The functions in
hand range from the design and fabrication of the wafers to the marketing and distribution
of the chips.

The origins of the company date back to 1996, when it was incorporated in the state of
Delaware under the name of NanoGram Corporation. The outfit changed its name to
NeoPhotonics Corporation in 2002.

According to the prospectus prepared for potential investors, the company is a leading
supplier to the major vendors of capital equipment in the telecommunications industry.

We sell our products to the leading network equipment vendors globally, including ADVA AG
Optical Networking Ltd., Alcatel-Lucent SA, Ciena Corporation (including its recent
acquisition of Nortel’s Metro Ethernet Networks business), Cisco Systems, Inc., FiberHome
Technologies Group, ECI Telecom Ltd., Telefonaktiebolaget LM Ericsson, Fujitsu Limited,
Harmonic, Inc., Huawei Technologies Co., Ltd., Mitsubishi Electric Corporation, NEC
Corporation, Nokia Siemens Networks B.V. and ZTE Corporation. We refer to these

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 companies as our Tier 1 customers. According to Infonetics Research, or Infonetics, an
independent research firm, the top 12 optical network hardware vendors supplied over 90%
of the worldwide market for optical network hardware in 2009. Each of these vendors is one
of our Tier 1 customers.

The customers of NeoPhotonics in turn serve as the suppliers of capital equipment to the
operators of communication networks. The firms in the latter category provide
communication services to the end user. An example of a vendor at the retail level is an
operator of transmission services based on grounded cables. Another instance is a
telephone company that offers voice and data connections via wireless links.

The world headquarters for NeoPhotonics is located in San Jose, California. The company
employs around 2000 workers, of whom more than 300 are assigned to the group
responsible for research and development (R&D).

The work force includes over 45 professionals with doctorate degrees. In addition, a
technical staff in excess of 100 is employed in areas such as chip fabrication, process
engineering, and product support.

The company manufactures its products in San Jose, California, as well as Shenzhen,
China. In addition, the R&D activities are conducted at both sites. Moreover, the company
maintains sales offices in Europe as well as the U.S. and China.

According to the prospectus, revenues have grown steadily over the years: from $35
million for the 2005 calendar year to $155M in 2009. On a negative note, the company has
been losing money until recently.

On the other hand, the loss has been shrinking in recent years. As an example, the net
income for the 2005 calendar year was negative $41.5 million. Yet, the corresponding
figure for 2009 was a slim loss of $6.96M.

Better yet, the company has turned the corner and become profitable. As a reference
point, NeoPhotonics notched up sales amounting to a tad over $155M during the calendar

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year – which also coincides with the firm’s fiscal year – of 2009. During this period, the net
income for the shareowners was negative $7.1M.

By contrast, the revenues during the first 9 months of 2010 came out to nearly $133M.
Meanwhile, the net income for the owners of common stock was positive $2.75M.

As of September 2010, the long-term debt on the balance sheet came out to nearly $6.4M.
In contrast, the working capital – defined as the total current assets less total current
liabilities – amounted to some $43.8M. Based on these figures, the long-range debt was
amply covered by the working capital.

The compensation for the top executives is determined in part by the performance of the
company in relation to comparable outfits. For the purpose of benchmarking, the other
concerns within the peer group include the following firms.

• Aruba Networks Inc.

• IPG Photonics Corporation
• Oplink Communications, Inc.
• BigBand Networks, Inc.
• Opnext, Inc.
• Emcore Corporation
• Harmonic Inc.
• Infinera Corporation
• Mindspeed Technologies, Inc.
• Occam Networks, Inc.
• Oclaro, Inc.
• Vitesse Semiconductor Corporation

Rollout of the Stock

The initial public offering was conducted on February 1, 2011 under the ticker symbol of
NPTN. At the time, a stash of 7.5 million shares was offered for sale at a unit price of

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$11.00. The underwriters for the IPO were led by the Bank of America along with
Deutsche Bank AG.

The price of the stock jumped by 20.5% on the first day. Moreover, the equity managed to
rise to 63.8% in the weeks to follow.

The stock reached a peak of $20.94 on Feb. 14, then faltered for a while. As is often the
case after an IPO, the equity hit a rough patch and fell back before long.

Despite the bumpy ride at the outset, the prospects for the equity look cheery enough over
the longer range. If the company can keep up its momentum on the business end, then the
rise in revenues will doubtless lead to a groundswell of profits in the years to come. The
growth in earnings will then buoy the stock in tandem.

Cautions and Tips for Investors

As part of the case study, the foregoing sections talked about a gaggle of companies. The
names were brought up in order to illustrate a variety of concepts and concerns.

The trends and events discussed above represent a number of crucial factors behind
competitive strategy, along with the implications for investment planning. Even so, the
views and outlooks have been presented for the sake of illustration. For this reason, the
remarks should not be construed as recommendations for action by any reader or investor
in particular.

The heedful investor has to keep in mind a number of generic issues. An exemplar of this
sort lies in the difference between the prospects for an industry and the fortunes of the
companies in the marketplace.

To say that a technology will flourish, or that an industry should thrive, has no direct
bearing on the outlook for the companies in the field. The lack of linkage applies to the
outfits that might have been active in the past or the present as well as those that may
enter the fray in the future.

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In this light, a telling example is found in the realm of television sets. The TV was of course
invented in the West in the 20 th century. Since then, the innovation has established itself as
an integral aspect of the modern culture all over the globe.

Despite of its huge success, though, the technology has not been kind to the vanguards
who first developed the gadgetry and created the market. In fact, none of the original
pioneers managed to survive the vicissitudes of the market along with the rigors of
competition.

From a larger stance, a lead in technology or any other edge is simply part of a larger set
of skills needed to succeed in the marketplace. Moreover, a critical item of competitive
advantage at one stage could well be rendered obsolete by a radical breakthrough further
down the line. The innovations of the latter type run the gamut from unexpected leaps in
technology to new-fangled schemes in marketing.

In this shifty milieu, a rising star today could well end up as a spent force within a matter of
years or decades if not sooner. For this reason, the companies jostling in the arena always
face an uncertain future.

According to popular wisdom, the stocks of commercial firms – be they fledgling ventures
or mature giants – serve as viable candidates for investment by the general public. In truth,
though, the reality happens to be entirely different.

As a rule, the stocks of operating companies are too unstable for direct ownership by the
bulk of investors. In this light, an obvious risk lies in the turbulence of the stock market as a
whole along with the volatility of each equity in particular.

Unfortunately, the news from the financial front is bleaker still. A second form of danger
happens to be more crippling but tends to be overlooked by most of the pundits as well as
the amateurs in the marketplace.

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The vast majority of businesses in the real economy break down and go bust within half a
decade of their launch. Moreover, the fate of the equities in the stock market does not
differ a great deal from the lot of the outfits in the tangible economy.

In this treacherous environment, the wily investor has to be mindful of the obvious as well
as subtle dangers lurking in the marketplace. Ignoring the threats and whistling in the dark
does nothing to banish the bogeys for real.

The menace of unseen threats is examined in greater detail in other sources. A case in
point is a lowdown on the major types of risk faced by investors (Kim, 2011b).

For a variety of reasons, the best type of vehicle for investment for the majority of players
in the financial arena happens to be an index fund (Kim, 2011a). Within this category, the
exchange traded fund (ETF) stands out as a vehicle of choice by virtue of its versatility and
resilience as well as efficiency and convenience.

References

Kim, S. “How to Beat the Investment Funds: Outrun Most Mutual Funds and Hedge Funds
while Earning a Bonus”. http://www.mintkit.com/beat-investment-funds – tapped
2011a/3/21.

Kim, S. Risk. http://www.mintkit.com/risk – tapped 2011b/3/25.

NeoPhotonics Corp. “Prospectus”. Registration No. 333-166096, Securities and

Exchange Commission, Washington, D.C. (www.sec.gov). 2011/2/1.

Wikipedia. “Telecommunications Network”.

http://en.wikipedia.org/wiki/Telecommunications_network – tapped 2011/3/25. The article
provides an overview of the subject, along with links to additional sources of information on
communication networks, optical devices, and kindred topics.

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