As filed with the Securities and Exchange Commission on October 27, 2006.

Registration Statement No. 333-          

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

 

 

 

 

 

 

1 Christopher Way

Eatontown, New Jersey 07724

(732) 544-3400

(Address, Including Zip Code, and Telephone Number, Including

Area Code, of Registrant’s Principal Executive Offices)

 

Harry L. Bosco

Chief Executive Officer

1 Christopher Way

Eatontown, New Jersey 07724

(732) 544-3400

(Name, Address Including Zip Code, and Telephone Number, Including Area Code, of Agent For Service)

 

 

 

 

 

 

 

 

Approximate date of commencement of proposed sale to the public:   As soon as practicable after this Registration Statement becomes effective.

 

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.   o

 

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

 

 

 

 

The Offering

 

Issuer		Opnext, Inc.
Common stock offered by Opnext		shares
Common stock offered by the selling stockholders		shares
Total common stock offered		shares
Underwriters’ option to purchase additional shares in this offering		shares
Common stock to be outstanding after this offering		shares
Use of proceeds		We estimate that the net proceeds from the sale of shares by us in the offering (based on an offering price of $      per share, the midpoint of the estimated price range shown on the cover page of this prospectus), after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, will be $        million. We will not receive any of the proceeds from sales of common stock by the selling stockholders in the offering. See “Principal and Selling Stockholders.”
Proposed NASDAQ Global Market Symbol		OPXT

	•	13,317,266 shares of Class B common stock issuable upon exercise of options outstanding as of September 30, 2006, with a weighted average exercise price of $4.93 per share;
	•	1,957,750 shares of Class B common stock issuable upon exercise of outstanding SARs with a weighted average exercise price of $5.00 per share;
	•	650,000 restricted shares of Class B common stock issuable upon vesting of restricted stock awards; and
	•	6,969,183 shares of Class B common stock reserved for future grant under our stock incentive plans as of September 30, 2006.

	•	no exercise of the underwriters’ option to purchase additional shares; and
	•	adoption of our amended and restated certificate of incorporation and amended and restated bylaws to be effective prior to the closing of this offering.

		Three Months Ended June 30,								Year Ended March 31,
		2006				2005				2006				2005				2004
		(In thousands, except per share data)
Consolidated statements of operations data:
Sales		$	40,424			$	31,370			$	151,691			$	138,432			$	79,390
Cost of sales			27,163				27,795				119,626				107,694				73,144
Gross margin			13,261				3,575				32,065				30,738				6,246
			32.8	%			11.4	%			21.1	%			22.2	%			7.9	%
Research and development expenses			8,023				7,962				33,669				33,251				30,921
Selling, general, and administrative expenses			8,344				8,305				33,116				33,629				33,164
Loss on disposal of property, plant and equipment			16				—				1,065				50				5,886
Asset impairment			—				—				—				—				19,150
Other operating expenses			—				53				399				17				247
Operating loss			(3,122	)			(12,745	)			(36,184	)			(36,209	)			(83,122	)
Interest income, net			759				1,021				4,102				2,138				2,374
Other income (expense), net			(1,111	)			208				1,886				52				258
Loss before income taxes			(3,474	)			(11,516	)			(30,196	)			(34,019	)			80,490
Income tax (expense) benefit			—				—				(278	)			1,275				—
Net loss		$	(3,474	)		$	(11,516	)		$	(30,474	)		$	(32,744	)		$	(80,490	)
Net loss per share, basic and diluted		$	(0.02	)		$	(0.07	)		$	(0.20	)		$	(0.21	)		$	(0.52	)
Weighted average number of shares used in computing net loss per share, basic and diluted			155,968				155,824				155,834				155,619				154,148

 

		June 30,								March 31,
		2006								2006				2005				2004
		(In thousands)
Consolidated balance sheet data:
Total assets		$	219,952							$	216,826			$	291,912			$	322,540
Long-term liabilities			6,355								6,643				1,868				20,774
Total shareholders’ equity			116,733								119,663				148,176				177,901

 

RISK FACTORS

 

Before deciding to invest in our common stock, you should carefully consider each of the following risk factors and all of the other information set forth in this prospectus. The following risks and the risks described elsewhere in this prospectus, including in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” could materially harm our business, financial condition, future results and cash flow. If that occurs, the trading price of our common stock could decline, and you could lose all or part of your investment. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business.

 

Risks Relating To Our Business And Industry

 

Uncertainty in customer forecasts of their demands and other factors may lead to delays and disruptions in manufacturing, which could result in delays in product shipments to customers and could adversely affect our business.

 

Fluctuations and changes in our customers’ demand are common in our industry. Such fluctuations, as well as quality control problems experienced in our manufacturing operations or those of our third party contract manufacturers, may cause us to experience delays and disruptions in our manufacturing process and overall operations and reduce our output capacity. As a result, product shipments could be delayed beyond the shipment schedules requested by our customers or canceled, which would negatively affect our revenues, gross margins, strategic position at customers, market share and reputation. In addition, disruptions, delays or cancellations could cause inefficient production which in turn could result in higher manufacturing costs, lower yields and potential excess and obsolete inventory or manufacturing equipment. In the past, we have experienced such delays, disruptions and cancellations.

 

If our customers do not qualify our products or if their customers do not qualify their products, our results of operations may suffer.

 

Most of our customers do not purchase our products, other than limited numbers of evaluation units, prior to qualification of our products and satisfactory completion of factory audits and vendor evaluation. Our existing products, as well as each new product, must pass through varying levels of qualification with our customers. In addition, due to the rapid technological changes in our market, a customer may cancel or modify a design project before we begin large-scale manufacture of the product and receive revenue from the customer. It is unlikely that we would be able to recover the expenses for cancelled or unutilized custom design projects. It is difficult to predict with any certainty whether our customers will delay or terminate product qualification or the frequency with which customers will cancel or modify their projects, but any such delay, cancellation or modification could have a negative effect on our results of operations.

 

If network service providers that purchase systems from our customers fail to qualify or delay qualifications of any products sold by our customers that contain our products, our business could be harmed. The qualification and field testing of our customers’ systems by network service providers is long and unpredictable. This process is not under the control of our company or our customers, and, as a result, timing of our revenues is unpredictable. Any unanticipated delay in qualification of one of our customers’ network systems could result in the delay or cancellation of orders from our customers for modules included in the applicable network system, which could harm our results of operations.

 

We do not have long-term volume purchase contracts with our customers, so our customers may increase, decrease, cancel or delay their buying levels at any time with minimal advance notice to us, which may significantly harm our business.

 

Our customers typically purchase our products pursuant to individual purchase orders. While our customers generally provide us with their demand forecasts, in most cases they are not contractually committed to buy any quantity of products beyond firm purchase orders. Our customers may increase,

decrease, cancel or delay purchase orders already in place. If any of our major customers decrease, stop or delay purchasing our products for any reason, our business and results of operations would be harmed. Cancellation or delays of such orders may cause us to fail to achieve our short and long-term financial and operating goals. In the past, certain of our largest customers have canceled significant orders which resulted in losses of revenues and excess and obsolete inventory, which led to inventory and asset disposals. Similarly, decreases or deferrals of purchases by our customers may significantly harm our business in these and in additional unforeseen ways, particularly if they are not anticipated.

 

We may experience low manufacturing yields or higher than expected costs.

 

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. Higher volume demand for more mature designs requiring less customization generally results in higher manufacturing yields than products with lower volumes, less mature designs and requiring extensive customization. Capacity constraints, raw materials shortages, logistics issues, the introduction of new product lines and changes in our customer requirements, manufacturing facilities or processes or those of our third party contract manufacturers and component suppliers have historically caused, and may in the future cause, significantly reduced manufacturing yields, negatively impacting the gross margins on and our production capacity for those products. Our ability to maintain sufficient manufacturing yields is particularly important with respect to certain products we manufacture such as lasers and photodetectors due to the long manufacturing process. Moreover, an increase in the rejection and rework rate of products during the quality control process either before, during or after manufacture would result in lower yields, gross margins and production capacity. Finally, manufacturing yields and margins can also be lower if we receive and inadvertently use defective or contaminated materials from our suppliers. Because a significant portion of our manufacturing costs is relatively fixed, manufacturing yields may have a significant effect on our results of operations. Lower than expected manufacturing yields could delay product shipments and decrease our revenues and gross margins.

 

There is a limited number of potential suppliers for certain components. In addition, we depend on a limited number of suppliers whose components have been qualified into our products and who could disrupt our business if they stop, decrease or delay shipments or if the components they ship have quality or consistency issues. We may also face component shortages if we experience increased demand for modules and components beyond what our qualified suppliers can deliver.

 

Our customers generally restrict our ability to change the component parts in our modules without their approval, which for less critical components may require as little as a specification comparison and for more critical components, such as lasers, photodetectors and key integrated circuits, as much as repeating the entire qualification process. We depend on a limited number of suppliers of key components we have qualified to use in the manufacture of certain of our products. Some of these components are available only from a sole source or have been qualified only from a single supplier. We typically have not entered into long-term agreements with our suppliers and, therefore, our suppliers could stop supplying materials and equipment at any time or fail to supply adequate quantities of component parts on a timely basis. It is difficult, costly, time consuming and, on short notice, sometimes impossible for us to identify and qualify new component suppliers. 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. We have in the past had to change suppliers, which has, in some instances, resulted in delays in product development and manufacturing until another supplier was found and qualified. Any such delays in the future may limit our ability to respond to changes in customer and market demands. During the last several years, the number of suppliers of components has decreased significantly and, more recently, demand for components has increased rapidly. Any supply deficiencies relating to the quality or quantities of components we use to

manufacture our products could adversely affect our ability to fulfill customer orders and our results of operations.

 

We rely substantially upon a limited number of contract manufacturing partners and if these contract manufacturers fail to meet our short and long-term needs and contractual obligations, our business may be negatively impacted.

 

We rely on a limited number of contract manufacturers to assemble, manufacture and test approximately half of our finished goods. The qualification and set up of these independent manufacturers under quality assurance standards is an expensive and time-consuming process. Certain of our independent manufacturers have a limited history of manufacturing optical modules or components. In the past, we have experienced delays or other problems, such as inferior quality, insufficient quantity of product and an inability to meet cost targets, which have led to delays in our ability to fulfill customer orders. Additionally, we have, in the past, been required to qualify new contract manufacturing partners and replace contract manufacturers, which led to delays in deliveries. Any future interruption in the operations of these manufacturers, or any deficiency in the quality, quantity or timely delivery of the components or products built for us by these manufacturers, could impede our ability to meet our scheduled product deliveries to our customers or require us to contract with and qualify new contract manufacturing partners. As a result, we may lose existing or potential customers or orders and our business may be negatively impacted.

 

We face increasing competition from other providers of competing products, which could negatively impact our results of operations and market share.

 

We believe that a number of companies have developed or are developing transmit and receive optical modules and components and lasers and infrared LEDs that compete directly with our product offerings. Current and potential competitors may have substantially greater financial, marketing, research and manufacturing resources than we possess, and there can be no assurance that our current and future competitors will not be more successful than us in specific product lines or as a whole.

 

Competition has intensified as additional competitors enter the market and current competitors expand their product lines. The industry has experienced an increase in low-cost providers of certain product lines. Companies competing with us may introduce products that are more competitively priced, have greater performance, functionality or reliability, or our competitors may have stronger customer relationships, and may be able to react quicker to changing customer requirements and expectations. Increased competitive pressure has in the past and may in the future result in a loss of sales or market share or cause us to lower prices for our products, any of which would harm our business and operating results. To attract new customers or retain existing customers, we may offer certain customers favorable prices on our products. If these prices are lower than the prices paid by certain of our existing customers, then we may be contractually obligated by price protection provisions to offer these existing customers the same pricing terms. In that event, our average selling prices and gross margins would decline. The loss of a key customer, a reduction in sales to any key customer or our inability to attract new customers could negatively impact our results of operations and market share.

 

If demand for optical systems, particularly for 10Gbps network systems, does not continue to expand as expected, our business will suffer.

 

Our future success as a manufacturer of transmit and receive optical modules and components ultimately depends on the continued growth of the communications industry and, in particular, the continued expansion of global information networks, particularly those directly or indirectly dependent upon a fiber optics infrastructure. Currently, while increasing demand for network services and for broadband access, in particular, is apparent, growth is limited by several factors, including, among others, an uncertain regulatory environment, reluctance from content providers to supply video and audio content due to insufficient copy protection and uncertainty regarding long-term sustainable business models as multiple industries (cable TV, traditional telecommunications, wireless, satellite,

etc.) offer competing content delivery solutions. Ultimately, if long-term expectations for network growth and bandwidth demand are not realized or do not support a sustainable business model, our business would be significantly harmed.

 

Our products may contain defects that may cause us to incur significant costs, divert our attention from product development efforts, result in a loss of customers and may possibly result in product liability claims.

 

Our products are complex and undergo quality testing as well as formal qualification by both our customers and us. However, defects may be found from time to time. Our customers’ testing procedures are limited to evaluating our products under likely and foreseeable failure scenarios and over varying amounts of time. For various reasons (including, among others, 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 and/or replace defective products under warranty, particularly when such failures occur in installed systems. We have experienced such failures in the past and will continue to face this risk going forward, as our products are widely deployed throughout the world in multiple demanding environments and applications. In addition, we may in certain circumstances honor warranty claims after the warranty has expired or for problems not covered by warranty in order to maintain customer relationships. We have in the past increased our warranty reserves and have incurred significant expenses relating to certain communications products. Any significant product failure could result in lost future sales of the affected product and other products, as well as severe customer relations problems, litigation and damage to our reputation.

 

In addition, our products are typically embedded in, or deployed in conjunction with, our customers’ products, which incorporate a variety of components and may be expected to interoperate with modules produced by third parties. As a result, not all defects are immediately detectable and when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significant damages or warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relation problems or loss of customers, all of which would harm our business.

 

The occurrence of any defects in our products could give rise to liability for damages caused by such defects. They could, moreover, impair the market’s acceptance of our products. Both could have a material adverse effect on our business and financial condition.

 

Our market is subject to rapid technological change and, to compete effectively, we must continually introduce new products that achieve market acceptance or our business may be significantly harmed.

 

The markets for our products are characterized by rapid technological change, 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. We expect that new technologies will emerge as competition and the need for higher and more cost-effective bandwidth increases. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address these changes as well as current and potential customer requirements. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. In addition, a slowdown in demand for existing products ahead of a new product introduction could result in a write-down in the value of inventory on hand related to existing products. We have in the past experienced a slowdown in demand for existing products and delays in new product development, and such delays may occur in the future. To the extent customers defer or cancel orders for existing products for any reason, our

operating results would suffer. Product development delays may result from numerous factors, including:

 

 

The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product introductions by competitors, technological changes or emerging industry standards. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements, to license these technologies from third parties, or to stay competitive in our markets. Any failure to respond to technological changes could significantly harm our business.

 

Our products are complex and may take longer to develop and qualify than anticipated and we may not recognize revenues from new products until after long customer qualification periods.

 

We are constantly developing new products and using new technologies in these products. These products often take substantial time to develop because of their complexity, rigorous testing and qualification requirements and because customer and market requirements can change during the product development or qualification process. Such activity requires significant spending by the company. Due to the long development cycle and qualification process, we may not recognize revenue, if at all, from new products until long after such expenditures.

 

In the telecommunications market, there are stringent and comprehensive reliability and qualification requirements for optical networking systems. In the data communications industry, qualifications can also be stringent and time-consuming. However, these requirements are less uniform than those found in the telecommunications industry from application to application and systems vendor to systems vendor.

 

At the component level, such as for new lasers, the development cycle may be lengthy and may not result in a product that can be utilized cost-effectively in our modules or that meets customer and market requirements. Additionally, we often incur substantial costs associated with the research and development and sales and marketing activities in connection with products that may be purchased long after we have incurred the costs associated with designing, creating and selling such products.

 

If we fail to obtain the right to use others’ intellectual property rights necessary to operate our business, our ability to succeed will be adversely affected.

 

Numerous patents in our industry are held by others, including our competitors and academic institutions. Our competitors may seek to gain a competitive advantage or other third parties may seek an economic return on their intellectual property portfolios by making infringement claims against us. In the future, we may need to obtain license rights to patents or other intellectual property held by others to the extent necessary for our business. Unless we are able to obtain those licenses on commercially reasonable terms, patents or other intellectual property held by others could inhibit sales of our existing products and the development of new products for our markets. Generally, a license, if granted, would include payments of up-front fees, ongoing royalties or both. These payments or other terms could have a significant adverse impact on our gross margins and operating results. Our

competitors may be able to obtain licenses or cross-license their technology on better terms than we can, which could put us at a competitive disadvantage.

 

If we are unable to obtain a license from a third party, or successfully defeat their infringement claim, we could be required to:

 

 

Any of the foregoing results could have a material adverse effect on our business, financial condition and results of operations.

 

We license our intellectual property to Hitachi and its wholly owned subsidiaries without restriction, and Hitachi is free to license certain intellectual property used in our business to any third party, including our competitors, which could harm our business and operating results.

 

We were initially created as a stand alone entity by acquiring certain assets of Hitachi through various transactions. In connection with these transactions, we acquired a number of patents and know-how from Hitachi, but also granted Hitachi and its wholly owned subsidiaries a perpetual right to continue to use those patents and know-how, as well as other patents and know-how that we develop during a period ending in July of 2011 (and October of 2012 in certain cases). This license back to Hitachi is broad and permits Hitachi to use this intellectual property for any products or services anywhere in the world, including to compete with Opnext.

 

Additionally, while significant intellectual property owned by Hitachi was assigned to us when we were created, Hitachi retained and only licensed to us the intellectual property rights to underlying technologies used in both our products and the products of Hitachi. Under the agreement, Hitachi remains free to license these intellectual property rights to the underlying technologies to any party, including our competitors. The intellectual property that has been retained by Hitachi and that can be licensed in this manner does not relate solely or primarily to one or more of our products, or groups of products; rather, the intellectual property that is licensed to us by Hitachi is generally used broadly across our entire product portfolio. Competition by third parties using the underlying technologies retained by Hitachi could harm our business and operating results.

 

We may not be successful in establishing a brand identity, which may adversely affect our business, financial condition and results of operations.

 

Opnext uses the indication “Powered by Hitachi” extensively in its operations. We believe our customers recognize the value of the Hitachi brand name. Our right to use this indication will expire upon the later of (a) the one-year anniversary of the completion of this offering and (b) the six-month anniversary of the date upon which Hitachi ceases to own a majority of our common stock. The removal of the “Powered by Hitachi” indication may adversely affect our business, financial condition and results of operations.

 

As an independent company, we may experience increased costs resulting from a decrease in the purchasing power we had while we operated as a controlled subsidiary of Hitachi.

 

As a controlled affiliate of Hitachi, we were able to take advantage of Hitachi’s size and purchasing power in procuring goods, technology and services, including audit services, employee benefit support and insurance. As a stand-alone entity, we are significantly smaller than Hitachi and likely will not have access to financial and other resources comparable to those available to us when we were a controlled subsidiary of Hitachi. As an independent company, we may be unable to obtain goods, technology and services at prices and on terms as favorable as those available to us as a controlled subsidiary of Hitachi, which could increase our costs and reduce our profitability.

Our future operating results may be subject to volatility as a result of exposure to foreign exchange risks.

 

We are exposed to foreign exchange risks. Foreign currency fluctuations may affect our revenues and our costs and expenses and significantly affect our operating results. Portions of our revenues are derived in currencies other than the U.S. dollar, principally the Japanese yen and the Euro. In addition, a substantial portion of our cost of sales is derived in Japanese yen and portions of our operating expenses are derived in Japanese yen and Euros. As a result, we bear the risk that fluctuations in the exchange rates of these currencies in relation to the U.S. dollar could decrease our revenues, increase our costs and expenses and therefore have a negative effect on future operating results.

 

We may lose rights to key third-party intellectual property arrangements when Hitachi’s ownership in our company drops below certain levels.

 

As a majority-owned subsidiary of Hitachi, we are the beneficiary of some of Hitachi’s intellectual property arrangements, including cross-licensing arrangements with other companies and licenses from third parties of technology incorporated in our products and used to operate our business. We will no longer be a beneficiary under some of these agreements when Hitachi’s direct or indirect equity ownership in our company no longer exceeds 50%.

 

We are working with Hitachi and certain third parties with whom it has cross-licenses who have intellectual property that may be relevant to our business to determine if they will agree to extend those cross-licenses to Opnext when Hitachi’s direct or indirect equity ownership in our company no longer exceeds 50%. We cannot guaranty that those third parties will agree to such extensions, or what conditions they may impose in connection with agreeing to such extensions. If we do not successfully conclude such agreements and Hitachi’s direct or indirect equity ownership of our company no longer exceeds 50%, we may be exposed to infringement claims or lose access to important intellectual property and technology. Our patent portfolio is significantly smaller than Hitachi’s, which may make it more difficult for us to negotiate third-party patent cross licenses on terms that are as favorable to us as those previously negotiated by Hitachi. If as a result we were to infringe intellectual property rights of others or otherwise lose access to intellectual property or technology important in the conduct of our business, it could have a material and adverse effect on our business, financial condition and results of operations. We could, for example, be forced to agree to make substantially higher royalty payments to continue using that intellectual property or technology or, if we are unable to agree on licensing terms on our own, we could be forced to cease manufacturing products that use that intellectual property or technology.

 

We have a license to use certain patents of a wholly-owned subsidiary of Hitachi, Hitachi Communications Technologies, Ltd. This license will expire in July 2011, after which it will be subject to reasonable terms to be negotiated at that time. To the extent any of our products rely on any of these licensed patents, we will need to renegotiate this license agreement.

 

Our failure to protect our intellectual property may significantly harm our business.

 

Our success and ability to compete is dependent in part on our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as confidentiality agreements and internal procedures to establish and protect our proprietary rights. Although a number of patents have been issued to us and we have obtained a number of other patents as a result of our acquisitions, we cannot assure you that our issued patents will be upheld if challenged by another party. Additionally, with respect to any patent applications which we have filed, we cannot assure you that any patents will issue as a result of these applications. If we fail to protect our intellectual property, we may not receive any return on the resources expended to create the intellectual property or generate any competitive advantage based on it.

 

Pursuing infringers of our intellectual property rights can be costly.

 

Pursuing infringers of our proprietary rights could result in significant litigation costs, and any failure to pursue infringers could result in our competitors utilizing our technology and offering similar

products, potentially resulting in loss of a competitive advantage and decreased revenues. Despite our efforts to protect our proprietary rights, existing patent, copyright, trademark and trade secret laws afford only limited protection. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Protecting our know how is difficult especially after our employees or those of our third party contract manufacturers end their employment or engagement. Attempts may be made to copy or reverse-engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, we may not be able to prevent misappropriation of our technology or prevent others from developing similar technology. Furthermore, policing the unauthorized use of our products is difficult and expensive. Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. The costs and diversion of resources could significantly harm our business. If we fail to protect our intellectual property, we may not receive any return on the resources expended to create the intellectual property or generate any competitive advantage based on it.

 

Third parties may claim we are infringing their intellectual property rights, and we could be prevented from selling our products, or suffer significant litigation expense, even if these claims have no merit.

 

Our competitive position is driven in part by our intellectual property and other proprietary rights. Third parties, however, may claim that we, or our products, operations or any products or technology we obtain from other parties are infringing their intellectual property rights, and we may be unaware of intellectual property rights of others that may cover some of our assets, technology and products. In fact, this offering itself may result in such claims, as there may be third parties that have refrained from asserting intellectual property infringement claims against our products or processes while we were a majority-owned subsidiary of Hitachi that may elect to pursue such claims against us after this offering. From time to time we receive letters from third parties that claim we are infringing their intellectual property and asking us to license such intellectual property. We review the merits of each such claim, and such claims have not resulted in litigation as of the date of this prospectus. However, any litigation regarding patents, trademarks, copyrights or other intellectual property rights, even those without merit, could be costly and time consuming, and divert our management and key personnel from operating our business. The complexity of the technology involved and inherent uncertainty and cost of intellectual property litigation increases our risks. If any third party has a meritorious or successful claim that we are infringing its intellectual property rights, we may be forced to change our products or manufacturing processes or enter into licensing arrangement with third parties, which may be costly or impractical. This also may require us to stop selling our products as currently engineered, which could harm our competitive position. We also may be subject to significant damages or injunctions that prevent the further development and sale of certain of our products or services and may result in a material loss in revenue.

 

Our financial results may vary significantly from quarter-to-quarter due to a number of factors, which may lead to volatility in our stock price.

 

Our quarterly revenue and operating results 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 market analysts and investors respond to these quarterly fluctuations. These fluctuations are due to numerous factors, including:

 

 

 

We may not be able to obtain capital when desired on favorable terms, if at all, or without dilution to our stockholders.

 

We anticipate that the net proceeds of this offering, together with current cash and cash equivalents, cash provided by operating activities and funds available through our short-term loans with The Bank of Tokyo-Mitsubishi UFJ which are due monthly, will be sufficient to meet our current and anticipated needs for general corporate purposes for at least the next 12 months. We operate in a market, however, that makes our prospects difficult to evaluate. It is possible that we may not generate sufficient cash flow from operations or otherwise have the capital resources to meet our future capital needs. If this occurs, we may need additional financing to execute on our current or future business strategies, including to:

 

 

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, including those acquiring shares in this offering. We cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, if and when needed, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance our products, or otherwise respond to competitive pressures could be significantly limited.

 

If we fail to retain our senior management and other key personnel or if we fail to attract additional qualified personnel, we may not be able to achieve our anticipated level of growth and our business could suffer.

 

Our future depends, in part, on our ability to attract and retain key personnel. Our future depends on the continued contributions of members of our senior management team and key technical personnel, each of whom would be difficult to replace. The loss of services of members of our senior management team or key personnel or the inability to continue to attract qualified personnel could have a material adverse effect on our business. Competition for highly skilled technical people is extremely intense and we continue to face difficulty identifying and hiring qualified personnel in many areas of our business. We may not be able to hire and retain such personnel at compensation levels consistent with our existing compensation and salary structure. Some of the companies with which we compete for hiring experienced employees have greater resources than we have. In addition, in making employment decisions, particularly in the high-technology industries, job candidates often consider the value of the equity they are to receive in connection with their employment. Therefore, significant volatility in the price of our stock after this offering may adversely affect our ability to attract or retain technical personnel.

Potential future acquisitions may not generate the results expected, 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 may pursue acquisitions of companies, technologies and products that we believe could accelerate our ability to compete in our core markets or allow us to enter new markets. If we fail to manage our future growth effectively, in particular during periods of industry uncertainty, our business could suffer. Acquisitions involve numerous risks, any of which could harm our business, including:

 

 

Acquisitions also frequently result in the recording of goodwill and other intangible assets which are subject to potential impairments in the future that could harm our financial results. As a result, if we fail to properly evaluate acquisitions or investments, we may not achieve the anticipated benefits of any such acquisitions, and we may incur costs in excess of what we anticipate.

 

We depend on Hitachi for a number of services necessary for the operation of our business. Any failure of Hitachi to provide these services could have a material adverse effect on our business.

 

Since our formation in September 2000, we have continued to work closely with Hitachi in many respects and have relied on Hitachi for certain resources to run our business. We rely on Hitachi to provide certain services, such as procurement, inventory management and fulfillment in Japan, certain information technology services, support services in connection with the identification of patentable inventions, payroll services and other services. While we may be entitled to damages if Hitachi fails to perform these services, our agreement with Hitachi limits the amount of damages we may receive. In addition, we do not know whether we will be able to collect any award of damages or that any such damages would be sufficient to cover the actual costs we would incur as a result of Hitachi’s failure to perform under its agreement with us. In addition, Hitachi provides insurance, procurement, raw materials, contract employees, certain intellectual property, access to research facilities and cross licenses. Because we will be a smaller and less diversified company than Hitachi is today, and we may not have access to financial and other resources comparable to those of Hitachi, we may be unable to obtain goods, technology and services at prices and on terms as favorable as those available to us before we became a public company, which could have a material adverse effect on our business and profitability. We currently have agreements with Hitachi for capital leases, raw materials, procurement and outsourced services.

Our product expertise is based on our research ability developed within our Hitachi heritage and through joint research and development in lasers and optical technologies. A key factor to our business success and strategy is fundamental laser research. We rely on access to Hitachi’s research laboratories pursuant to a research and development agreement with Hitachi, which includes access to Hitachi’s research facilities and engineers, in order to conduct research and development activities that are important to the establishment of new technologies and products vital to our current and future business. Our research and development agreement with Hitachi and Opnext Japan’s research and development agreement with Hitachi will both expire on the fifth anniversary of the consummation of the offering. Should access to Hitachi’s research laboratories not be available or available at less attractive terms in the future, development of new technologies and products may suffer and our results could be materially adversely affected.

 

Hitachi and Clarity will collectively and individually control the outcome of shareholder actions in our company.

 

Upon completion of this offering, Hitachi will hold     % and Clarity Partners, L.P., Clarity Opnext Holdings I, LLC and Clarity Opnext Holdings II, LLC, collectively Clarity, will hold  % equity interest in our company, respectively, assuming the underwriters do not exercise their over-allotment option. In addition, Hitachi and Clarity Management, L.P. each hold options to purchase 3,030,000 and 3,000,000 shares of our common stock, respectively, which are fully vested. Their equity shareholding gives them the power to control actions that require shareholder approval, including the election of our board of directors. Hitachi has expressed its intention to reduce its ownership in us to less than 50% as and when business and market conditions permit, which Hitachi believes will increase Opnext’s autonomy. For so long as it continues to have a substantial equity interest in our company it may, as a practical matter, be in a position to control many or all actions that require shareholder approval. Significant corporate actions, including the incurrence of material indebtedness or the issuance of a material amount of equity securities may require the consent of our shareholders. Hitachi might oppose any action that would dilute its equity interest in our company, and may be unable or unwilling to participate in future financings of our company and thereby materially harm our business and prospects.

 

We may have conflicts of interest with Hitachi and, because of Hitachi’s controlling ownership interest in our company, may not be able to resolve such interests on favorable terms for us. For example, Hitachi has another majority-owned subsidiary, Hitachi Cable, Ltd., that is a direct competitor of ours in certain 10Gbps 300 pin and LX4 applications and certain SFP applications.

 

Business disruptions resulting from international uncertainties could negatively impact our profitability.

 

We derive, and expect to continue to derive, a significant portion of our revenue from international sales in various markets. Our international revenue and operations are subject to a number of material risks, including, but not limited to:

 

 

Negative developments in any of these areas in one or more 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, and a higher cost of doing business, any of which could negatively impact our business, financial condition or results of operations.

 

Our business and future operating results may be adversely affected by events outside of our control.

 

Our business and operating results are vulnerable to interruption by events outside of our control, particularly possible earthquakes which may affect our Japanese factories and our Fremont, CA facility. Other possible disruptions include: fire, volcanic activity, flood, power loss, telecommunications failures, political instability, military conflict and uncertainties arising out of terrorist attacks, including a global economic slowdown, the economic consequences of additional military action or additional terrorist activities and associated political instability, and the effect of heightened security concerns on domestic and international travel and commerce. In the event of an economic downturn, we may not be able to reduce costs fast enough by eliminating employees in foreign jurisdictions due to foreign labor regulations.

 

Environmental laws and regulations may subject us to significant costs and liabilities.

 

Our operations include the use, generation and disposal of hazardous materials. We are subject to various U.S. federal, state and foreign laws and regulations relating to the protection of the environment, including those governing the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. We could incur substantial costs, including cleanup costs as a result of violations of or liabilities under environmental laws.

 

Risks Relating To The Offering

 

There has been no prior market for our common stock, and an active trading market may not develop.

 

Prior to this offering, there has been no public market for our common stock. An active trading market may not develop following the closing of this offering or, if developed, may not be sustained. The lack of an active market may impair your ability to sell your shares at the time you wish to sell them or at a price that you consider reasonable. The lack of an active market may also reduce the fair market value and increase the volatility of your shares. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other companies or technologies by using our shares as consideration.

 

If equity research analysts do not publish research or reports about our business or if they issue unfavorable commentary or downgrade our common stock, the price of our common stock could decline.

 

The trading market for our common stock will rely in part on the research and reports that equity research analysts publish about us and our business. The price of our stock could decline if one or more equity research analysts downgrade our stock or if those analysts issue other unfavorable commentary or cease publishing reports about us or our business.

 

The price of our common stock may be volatile and fluctuate substantially which could result in substantial losses for investors purchasing shares in this offering.

 

The initial public offering price for the shares of our common stock sold in this offering will be determined by negotiation between the representatives of the underwriters and us. This price may not reflect the market price of our common stock following this offering. In addition, the market price of our

common stock is likely to be highly volatile and may fluctuate substantially due to many factors, including:

 

 

In addition, the stock market in general, the NASDAQ and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of particular companies affected. These broad market and industry factors may materially harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. Such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources, which could materially harm our financial condition and results of operations.

 

We currently do not intend to pay dividends on our common stock and, consequently, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates.

 

We currently do not plan to declare dividends on shares of our common stock in the foreseeable future. See “Dividend Policy” for more information. Consequently, your only opportunity to achieve a return on your investment in our company will be if the market price of our common stock appreciates and you sell your shares at a profit. There is no guarantee that the price of our common stock that will prevail in the market after this offering will ever exceed the price that you pay.

 

Future sales of our common stock may depress our share price.

 

After this offering and giving effect to the use of proceeds therefrom, we will have           shares of common stock outstanding. Sales of substantial amounts of our common stock in the public market following this offering, or the perception that these sales may occur, could cause the market price of our common stock to decline. After the lock-up agreements pertaining to this offering expire, additional stockholders will be able to sell their shares in the public market, subject to legal restrictions on transfer. As soon as practicable upon completion of this offering, we also intend to file a registration statement covering shares of our common stock issued or reserved for issuance under our stock option plan. In addition, under our stockholders’ agreement, some of our stockholders are entitled to registration rights. Subject to the terms of the lock-up agreements, registration of the sale of these shares of our common stock would generally permit their sale into the market immediately after registration. These registration rights of our stockholders could impair our ability to raise capital by depressing the price of our common stock. We may also sell additional shares of common stock in subsequent public offerings, which may adversely affect market prices for our common stock. See “Shares Eligible for Future Sale” for more information.

As a new investor, you will experience immediate and substantial dilution as a result of this offering.

 

The initial public offering price of our common stock will be considerably more than the net tangible book value per share of our outstanding common stock. Accordingly, investors purchasing shares of common stock in this offering will:

 

 

To the extent outstanding stock options are exercised, there will be further dilution to new investors. See “Dilution” for more information.

 

Certain provisions of our corporate governing documents and Delaware Law could make an acquisition of our company more difficult.

 

Certain provisions of our organizational documents and Delaware law could discourage potential acquisition proposals, delay or prevent a change in control of us or limit the price that investors may be willing to pay in the future for shares of our common stock. For example, our amended and restated certificate of incorporation and amended and restated bylaws will:

 

 

These and other provisions in our organizational documents could allow our board of directors to affect your rights as a stockholder in a number of ways, including making it more difficult for stockholders to replace members of the board of directors. Because our board of directors is responsible for approving the appointment of members of our management team, these provisions could in turn affect any attempt to replace the current management team. These provisions could also limit the price that investors would be willing to pay in the future for shares of our common stock.

 

Section 203 of the Delaware General Corporation Law also imposes certain restrictions on mergers and other business combinations between us and any holder of 15% or more of our common stock. See “Description of Capital Stock — Provisions of our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws and Delaware Law that May Have an Anti-Takeover Effect.”

 

Management may invest or spend the proceeds of this offering in ways with which you may not agree and in ways that may not yield a return.

 

Management will retain broad discretion over the use of the net proceeds we receive from this offering. There are a number of factors that will influence our use of the net proceeds, and these uses may vary substantially from our current plans. Stockholders may not deem the uses desirable, and our use of proceeds may not yield a significant return or any return at all.

The requirements of being a public company may strain our resources and distract management.

 

As a public company, we will be subject to the reporting requirements of the Securities Exchange Act of 1934 and the Sarbanes-Oxley Act of 2002. These requirements may place a strain on our systems and resources. The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business and financial condition. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal controls for financial reporting. In order to maintain and improve the effectiveness of our disclosure controls and procedures and internal control over financial reporting, significant resources and management oversight will be required. As a result, management’s attention may be diverted from other business concerns, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

This prospectus includes market and industry data that we obtained from industry publications and surveys. Industry publications and surveys generally state that the information contained therein has been obtained from sources believed to be reliable, but there can be no assurance as to the accuracy or completeness of included information. We have not independently verified any of the data from third-party sources nor have we ascertained the underlying economic assumptions relied upon therein.

 

We own or have rights to trademarks or trade names that we use in conjunction with the operation of our business. Our trademarks include the Opnext, Inc. name. This prospectus contains product names, trademarks and trade names that are the property of other organizations. Each trademark, trade name or service mark of any other company appearing in this prospectus belongs to its holder. Use or display by us of other parties’ trademarks, trade names or service marks is not intended to and does not imply a relationship with, or endorsement or sponsorship by us of, the trademark, trade name or service mark owner.

 

The contents of our website, www.opnext.com, are not a part of this prospectus.

 

 

All forward-looking statements included in this prospectus are based on information available to us on the date of this prospectus. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this prospectus.

 

 

Unless the context requires otherwise, we use the terms “Opnext,” the “Company,” “we,” “us,” and “our” in this prospectus to refer to Opnext, Inc. and its subsidiaries.

 

We estimate that the net proceeds to us from the sale of common stock that we are offering will be approximately $      million assuming an initial public offering price of $      per share, which is the midpoint of the range listed on the cover page of this prospectus, and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us. A $1.00 increase or decrease in the assumed initial public offering price of $      per share would increase or decrease the net proceeds to us from this offering by approximately $      million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

 

We intend to use the net proceeds to us from this offering for working capital and other general corporate purposes, including the financing of the development of new products, enhancement of existing products, sales, marketing and administrative activities, capital expenditures and the costs of operating as a public company. We may use a portion of the net proceeds to us to expand our current business through strategic alliances with, or acquisitions of, other businesses, products or technologies. We currently have no agreements or commitments for any such specific alliances or acquisitions.

 

Pending any use, as described above, we plan to invest the net proceeds in a variety of investment-grade, short-term and interest-bearing securities.

 

We will not receive any of the proceeds from the sale of shares of our common stock by the selling stockholders. See “Principal and Selling Stockholders.”

DIVIDEND POLICY

 

We have never declared or paid any cash dividends on our capital stock and we currently do not anticipate paying any cash dividends after the offering and for the foreseeable future. Instead, we anticipate that all of our earnings on our common stock will be used to provide working capital, to support our operations, and to finance the growth and development of our business. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, our future earnings, capital requirements, financial condition, future prospects, applicable Delaware law, which provides that dividends are only payable out of surplus or current net profits and other factors our board of directors deems relevant.

CAPITALIZATION

 

The following table sets forth our capitalization as of June 30, 2006 on:

 

 

The table below should be read in conjunction with “Use of Proceeds,” “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Description of Capital Stock” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

 

The share information in the table above excludes, as of June 30, 2006:

 

 

Except as otherwise indicated, all share information in this prospectus assumes:

 

 

At June 30, 2006, the net tangible book value of our common stock was approximately $111.0 million, or approximately $0.71 per share of our common stock. After giving effect to the issuance of shares of our common stock upon exercise of outstanding options and the sale of shares of our common stock in this offering at an assumed initial public offering price of $      per share, and after deducting estimated underwriting discounts and commissions and the estimated offering expenses of this offering, the as adjusted net tangible book value at June 30, 2006 attributable to common stockholders would have been approximately $      million, or approximately $      per share of our common stock. This represents a net increase in net tangible book value of $      per share, and an immediate dilution in net tangible book value of $      per share to new stockholders. The following table illustrates this per share dilution to new stockholders:

 

 

The table below summarizes, as of June 30, 2006, the differences for (1) our existing stockholders, (2) shares issuable upon exercise of outstanding options and (3) investors in this offering, with respect to the number of shares of common stock purchased from us, the total consideration paid and the average price per share paid before deducting fees and expenses.

 

 

The discussion and tables above assume no exercise of the underwriters’ option to purchase additional shares and excludes           shares of our common stock available for future grant or issuance under our stock plans.

SELECTED CONSOLIDATED FINANCIAL DATA

 

The following consolidated statements of operations data for each of the years ended March 31, 2006, 2005 and 2004 and the consolidated balance sheet data as of March 31, 2006 and 2005 have been derived from our audited financial statements and related notes which are included elsewhere in the document. The consolidated balance sheet data as of March 31, 2004 has been derived from our audited financial statements and related notes that do not appear in the document. The consolidated statements of operations data for each of the years ended March 31, 2003 and 2002 and the consolidated balance sheet data as of March 31, 2003 and 2002 have been derived from our unaudited financial statements and related notes that do not appear in the document. The consolidated statements of operations data for the three months ended June 30, 2006 and 2005 and the consolidated balance sheet data as of June 30, 2006 have been derived from our unaudited financial statements and related notes which are included elsewhere in the document. In the opinion of management, the unaudited interim consolidated financial statements have been prepared on the same basis as the audited financial statements and include all adjustments necessary for the fair presentation of our financial position and results of operations for these periods. The consolidated selected financial data set forth below should be read in conjunction with our consolidated financial statements, the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in the document. The historical results are not necessarily indicative of the results to be expected for any future period.

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

 

The following discussion includes forward-looking statements that involve risks and uncertainties. Our actual results could differ substantially from those anticipated as a result of many factors including those set forth in “Risk Factors,” included elsewhere in the document. The following discussion should be read together with our financial statements, the related notes thereto and the other financial information included elsewhere in the document.

 

OVERVIEW

 

We are a leading designer and manufacturer of optical modules and components which enable high-speed telecommunications and data communications networks globally. In particular, we design, manufacture and market optical modules and components that transmit and receive data and are primarily used in telecommunications and data communications networks. We have one of the most comprehensive transceiver product portfolios for both of these markets, particularly at the 10Gbps data rate, which we sell to many of the leading network systems vendors. Our product portfolio includes a broad range of solutions that vary by level of integration, communications protocol, form factor and performance level. Our portfolio consists of 10Gbps and 40Gbps transceiver modules, including tunable transceivers, a broad line of 2.5Gbps and lower speed SFP transceivers, and new or planned products for emerging standards such as SFP+ and XMD.

 

We were incorporated as a wholly-owned subsidiary of Hitachi, Ltd., or Hitachi, on September 18, 2000. On September 28, 2000, Opnext Japan, Inc. was established by Hitachi and on January 31, 2001, Hitachi contributed the fiber optic components business of its telecommunications system division to Opnext Japan, Inc. On July 31, 2001, Hitachi contributed 100% of the shares of Opnext Japan, Inc. to us in exchange for 70% of our then outstanding Class A common shares and Clarity Partners, L.P., Clarity Opnext Holdings I, LLC, and Clarity Opnext Holdings II, LLC (collectively referred to as Clarity) together contributed $321.3 million in exchange for Class A common stock representing a 30% interest in our company.

 

On October 1, 2002, we acquired 100% of the shares of Opto Device, Ltd. from Hitachi for a purchase price of $40.0 million. This acquisition of Hitachi’s opto device business expanded our product line into select industrial and commercial markets, which we refer to as our industrial and commercial products. On June 4, 2003 we acquired 100% of the outstanding shares of Pine Photonics Communication Inc., or Pine, in exchange for 5,017,546 shares of Opnext Class B common stock. This acquisition expanded our product line of SFP transceivers with data rates less than 10Gbps that are sold to telecommunication and data communication customers. We refer to these products as our less than 10Gbps products.

 

Since our founding we have expanded our global sales and marketing reach by opening several offices in the U.S., Europe and China which are strategically located in close proximity to our major customers. We established a corporate administrative headquarters and reduced our dependency on Hitachi to only those services which we can either perform ourselves or contract to an alternative service provider. We also integrated the acquisitions of Opto Device, Ltd. and Pine and improved the flexibility of our manufacturing processes by expanding the use of contract manufacturers. These accomplishments along with continued investments in product development and expansion of our customer base were achieved during one of the most drastic telecommunications and data communications market declines in history.

 

Due to the deteriorating market conditions our sales started to decrease during the quarter ended September 30, 2001 and significantly declined for the next eight quarters. Our sales began to recover during the quarter ended December 31, 2003 and have increased through our most recent quarter which ended on June 30, 2006. Much of this growth has been a result of increased demand for our 10Gbps and 40Gbps products which have grown from 38.9% of our revenue in the year ended March 31, 2004 to 73.3% of revenue in the quarter ended June, 30, 2006. Throughout this period our

quarterly sales fluctuated with demand and we experienced operating losses which, along with capital investments and the acquisitions of Opto Device, Ltd. and Pine, were primarily financed with funds received from the sale of shares to Clarity and short-term loans. During the quarter ended June 30, 2006 we achieved positive cash flow from operations of $1.2 million for the first time.

 

The following are factors that affect our results of operations:

 

Sales

 

Through our direct sales force supported by manufacturer representatives and distributors, we sell products to many of the leading network systems vendors throughout North America, Europe, Japan and Asia. Our customers include many of the top telecommunications and data communications network systems vendors in the world. We also supply components to several major transceiver module companies and sell to select industrial and commercial customers. Sales to telecommunication and data communication customers, our communication sales, accounted for 88.6%, 81.9%, 72.4% and 66.7% of our sales during the quarter ended June 30, 2006 and each of the years ended March 31, 2006, 2005 and 2004, respectively. Also during the quarter ended June 30, 2006 and each of the years ended March 31, 2006, 2005 and 2004, sales of our products with 10Gbps or higher data rates, which we refer to as our 10Gbps & above products, represented 73.3%, 69.4%, 58.7% and 38.9% of total sales, respectively.

 

The number of leading network systems vendors that supply the global telecommunications and data communications markets is concentrated, and so, in turn, is our customer base. For the year ended March 31, 2006, our top three customers, Cisco Systems Inc. and subsidiaries, “Cisco”, Hitachi together with its affiliates, and Alcatel accounted for 27.9%, 15.0% and 12.7% of our sales, respectively. Although we have and will continue to attempt to expand our customer base, we anticipate that these customers will generally continue to represent a significant portion of our customer base and be responsible for significant percentages of our revenues.

 

The evaluation and qualification cycle prior to the initial sale of our products generally spans a year or more. Although we negotiate the sale of our products directly with most of our customers, certain purchase orders for our products are received from contract manufacturers on behalf of several of our network systems vendor customers following our direct negotiation with the respective customers. We recognize revenue when title and risk of loss has been transferred to the customer, the price is fixed or determinable and collectability is reasonably assured. These conditions generally exist upon shipment or when certain customers in Japan have inspected and accepted the product.

 

Our revenues are affected by capital spending for telecommunications and data communications networks and for lasers and infrared LEDs used in select industrial and commercial markets. The primary markets for our products have been characterized by increasing volumes and declining average selling prices primarily due to industry over-capacity, increased competition and the introduction of new products. We anticipate that our average selling prices will continue to decrease in future periods, although we cannot predict the timing and extent of these decreases.

 

We began to sell high powered red laser diodes for the rewriteable DVD market to a subsidiary of Hitachi during the year ended March 31, 2004. Since then the market experienced a rapid pace of new product introductions and significant price erosion and we experienced significant losses from sales of these products. Accordingly, during the quarter ended December 31, 2005 we notified such subsidiary of Hitachi of our intention to discontinue sales of our DVD products and then agreed to a last time buy arrangement whereby we would continue to sell our DVD products to a subsidiary of Hitachi through September 2006 in exchange for a price increase on new orders received after December 31, 2005. Sales of DVD products were $1.0 million for the quarter ended June 30, 2006, and were $11.9 million, $13.6 million and $6.0 million in each of the years ended March 31, 2006, 2005 and 2004, respectively.

We operate sales and marketing offices in several countries. During the years ended March 31, 2006, 2005 and 2004 revenues attributed to geographic areas were 47.9%, 44.1% and 33.1% in the United States, 25.7%, 31.4% and 55.0% in Japan, 22.6%, 23.1% and 11.4% in Europe, and 3.8%, 1.4% and 0.5% in Asia Pacific, respectively. As a result of this geographic diversity, our sales are exposed to market risks related to fluctuations in foreign exchange rates because certain sales transactions and the related assets and liabilities are denominated in currencies other than the U.S. dollar, primarily the Japanese yen and the Euro. To the extent we generate sales in currencies other than the U.S. dollar our future sales will be affected by foreign currency exchange rate fluctuations.

 

Cost of Sales and Gross Margin

 

Our cost of sales primarily consists of materials including components which are either assembled at one of our three internal manufacturing facilities or at one of several of our contract manufacturing partner’s or procured from third party vendors. Due to the complexity and proprietary nature of laser manufacturing, and the advantage of having our internal manufacturing resources co-located with our research and development staffs, most of the lasers used in our optical module and component products are manufactured in our facilities in Komoro and Totsuka, Japan. Our materials include certain parts and components that are purchased from a limited number of suppliers or in certain situations from a single supplier. Our cost of sales also includes labor costs for employees and contract laborers engaged in the production of our components and the assembly of our finished goods, outsourcing costs, the cost and related depreciation of manufacturing equipment as well as manufacturing overhead costs including the costs for product warranty repairs and inventory adjustments for excess and obsolete inventory.

 

Our cost of sales is exposed to market risks related to fluctuations in foreign exchange rates because a significant portion of our cost of sales and the related assets and liabilities are denominated in Japanese yen. Our cost of sales denominated in Japanese yen during the quarter ended June 30, 2006 and the year ended March 31, 2006 was 75.9% and 89.0%, respectively. We anticipate that this trend will continue into the foreseeable future. However, we anticipate the percentage of cost of sales denominated in Japanese yen to diminish as we plan to expand the use of contract manufacturers outside of Japan and procure more raw materials in U.S. dollars.

 

Our gross margins vary among our product lines and are generally higher on our 10Gbps and above products. Our overall gross margins will primarily fluctuate as a result of our overall sales volumes, changes in average selling prices and product mix, the introduction of new products and subsequent generations of existing products, manufacturing yields and our ability to reduce product costs.

 

Research and Development Costs

 

Research and development costs consist primarily of salaries and benefits of personnel related to the design, development and quality testing of new products or enhancement of existing products as well as outsourced services provided by Hitachi’s renowned research laboratories pursuant to our long-term contractual agreements. We incurred $1.1 million and $3.9 million in connection with these agreements during the quarter ended June 30, 2006 and the year ended March 31, 2006. In addition our research and development costs primarily include the cost of developing prototypes and material costs associated with the testing of products prior to shipment, the cost and related depreciation of testing equipment used in the testing of products prior to shipment and other contract research and development related services. We expect that our future research and developments costs will increase with our efforts to meet the anticipated increased market demands for our new and planned future products and to support enhancements to our existing products.

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses consist primarily of salaries and benefits for our employees that perform our sales and related support, marketing, supply chain management, finance, information technology, human resource and other general corporate functions as well as internal and outsourced logistics and distribution costs, commissions paid to our manufacturers’ representatives, and professional fees and other corporate related expenses. We anticipate that these costs will rise as a result of higher revenues in the future. We also expect that the costs of being a publicly traded company, including but not limited to costs of compliance with the Sarbanes-Oxley Act of 2002 and other government regulations, will increase our future selling, general and administrative expenses.

 

Significant Accounting Policies

 

Revenue Recognition, Warranties and Allowances

 

Revenue is derived principally from the sales of our products. We recognize revenue when the basic criteria of Staff Accounting Bulletin No. 104 are met. Specifically, we recognize revenue when persuasive evidence of an arrangement exists, usually in the form of a purchase order, delivery has occurred or services have been rendered, title and risk of loss have passed to the customer, the price is fixed or determinable and collection is reasonably assured in terms of both credit worthiness of the customer and there are no uncertainties with respect to customer acceptance.

 

We sell certain of our products to customers with a product warranty that provides repairs at no cost or the issuance of credit to the customer. The length of the warranty term depends on the product being sold, but ranges from one year to five years. We accrue the estimated exposure to warranty claims based upon historical claim costs as a percentage of sales multiplied by prior sales still under warranty at the end of any period. Our management reviews these estimates on a regular basis and adjusts the warranty provisions as actual experience differs from historical estimates or as other information becomes available.

 

Allowances for doubtful accounts are based upon historical payment patterns, aging of accounts receivable and actual write-off history, as well as assessment of customers’ credit worthiness. Changes in the financial condition of customers could have an effect on the allowance balance required and a related charge or credit to earnings.

 

Inventory Valuation

 

Inventories are stated at the lower of cost, determined on a first-in, first-out basis, or market. Inventories consist of raw materials, work in process and finished goods at both our sites and those at our contract manufacturer’s sites. Inventory valuation and firm, committed purchase order assessments are performed on a quarterly basis and those items which are identified to be obsolete or in excess of forecasted usage are reserved or written down to their estimated realizable value. Estimates of realizable value are based upon managements’ analyses and assumptions including, but not limited to, forecasted sales levels by product, expected product lifecycle, product development plans and future demand requirements. We typically use a twelve month rolling forecast based on factors including, but not limited to, our production cycles, anticipated product orders, marketing forecasts, backlog, shipment activities and inventories owned by and held at our customers. If market conditions are less favorable than our forecasts or actual demand from our customers is lower than our estimates, we may require additional inventory reserves or write-downs. If demand is higher than expected, inventories that had previously been reserved or written down may be sold at prices in excess of the written down value.

 

Income Taxes

 

Income taxes are accounted for under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences

attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the consolidated and combined statements of operations in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if it is more likely that such asset will not be realized.

 

As of March 31, 2006, we have a U.S. federal net operating loss carry-forward of approximately $83.9 million and a foreign net operating loss carry-forward of approximately $304 million to offset future taxable income. The U.S. federal net operating loss carry-forward excludes $15.8 million of pre-acquisition losses of Pine which are subject to certain annual limitations under Section 382 of the Internal Revenue Code. The U.S. federal net operating loss carry-forward will expire between 2022 and 2027 and the foreign net operating loss carry-forward will expire between 2010 and 2014.

 

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. At March 31, 2006 and 2005, management considered recent operating results, the near-term earnings expectations, and the highly competitive nature of our markets in making this assessment. At the end of each of the respective years, management determined that it is more likely than not that the tax benefit of the deferred tax assets will not be realized. Accordingly, full valuation allowances have been provided against the net deferred tax assets. There can be no assurances that deferred tax assets subject to our valuation allowance will ever be realized.

 

Impairment of Long-Lived Assets

 

Impairment of long lived assets are accounted for in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for Impairment of Long-Lived Assets . Long-lived assets, such as property, plant, and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. In estimating future cash flows, assets are grouped at the lowest level of identifiable cash flows that are largely independent of cash flows from other groups. Assumptions underlying future cash flow estimates are subject to risks and uncertainties.

 

The communication industry experienced significant deterioration during the year ended March 31, 2001 and the outlook of future market trends was uncertain until the second half of the year ended March 31, 2004. As the industries began to recover, we re-evaluated our long-term business plans and determined that the carrying amount of certain long-lived assets exceeded their fair value as determined by the related discounted future cash flows. Accordingly, a non-cash impairment charge of $19.2 million was recorded for the year ended March 31, 2004. Our evaluations for the years ended March 31, 2006 and 2005 indicated that there were no further impairments.

 

March 31, 2006 will be accounted for under the provisions of Statement No. 123(R). Compensation expense for all employee stock-based plans was $6 thousand for the quarter ended June 30, 2006.

 

In connection with the adoption of SFAS 123(R) we estimate the fair value of our share-based awards utilizing the Black-Scholes pricing model. The fair value of the awards is amortized as compensation expense on a straight-line basis over the requisite service period of the award, which is generally the vesting period. The fair value calculations involve significant judgments, assumptions, estimates and complexities that impact the amount of compensation expense to be recorded in current and future periods. The factors include:

 

 

Prior to April 1, 2006, we accounted for our stock-based incentive plans in accordance with SFAS No. 123, Accounting for Stock-Based Compensation which requires entities to disclose pro-forma net income or loss as if the fair value of share-based awards were expensed. For pro forma disclosure purposes, the estimated fair value was amortized to expense over the vesting period. If we had elected to adopt the fair value recognition provisions of SFAS No. 123 for our stock-based incentive plans, our net loss would have decreased by $0.1 million in the year ended March 31, 2006 and would have increased by $0.3 million and $0.4 million during the years ended March 31, 2005 and 2004, respectively.

 

Pending Adoption of New Accounting Standards

 

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109 (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have not completed an assessment of the impact of FIN 48 on the consolidated financial statements and plan to adopt the provisions of FIN 48 on April 1, 2007.

Research and Development Expenses.   Research and development expenses remained constant at $8.0 million for the three months ended June 30, 2006 and 2005 including a $0.4 million benefit from fluctuations in foreign exchange rates. Research and development expenses decreased as a percentage of sales to 19.8% for the three months ended June 30, 2006 from 25.4% for 2005. Research and development costs excluding the benefit from fluctuations in foreign exchange rates increased due to additional funding for contract research with Hitachi and others offset by lower material costs used in the development of our products and lower personnel and depreciation costs resulting from the consolidation of two U.S. based research centers during the second half of the year ended March 31, 2006.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses remained constant at $8.3 million in the three months ended June 30, 2006 and 2005 including a $0.2 million benefit from fluctuations in foreign exchange rates. Selling, general and administrative expenses decreased as a percentage of sales to 20.6% for the three months ended June 30, 2006 from 26.5% for 2005. Selling, general and administrative costs excluding the benefit from fluctuations in foreign exchange rates increased primarily as a result of higher commission and logistics costs associated with increased sales volumes.

 

Other Operating Expenses.   Other operating expenses for the three months ended June 30, 2006 were $16 thousand and consist of non-cash charges related to the disposal of certain obsolete fixed assets. Other operating expenses for the three months ended June 30, 2005 were $53 thousand and consist of severance costs.

 

Interest Income, Net.   Interest income, net decreased by approximately $0.3 million or 25.7% to $0.8 million in the three months ended June 30, 2006 from $1.0 million in 2005. Interest income, net for the three months ended June 30, 2006 and 2005 consists of interest earned on cash and cash equivalents offset by interest expense on short-term debt of $0.1 million for each year. The decrease reflects lower cash and cash equivalent balances and higher interest rates on short term debt offset by lower short term debt balances and higher interest rates received on cash and cash equivalent balances during the period.

 

Other Income (Expense), Net.   Other (expense), net was $1.1 million for the three months ended June 30, 2006 and other income was $0.2 million for the three months ended June 30, 2005 and consisted primarily of net exchange losses and net exchange gains, respectively, on foreign currency transactions.

 

Income Taxes.   Due to the uncertainty regarding the timing and extent of our future profitability, we have recorded a valuation allowance to offset potential income tax benefits associated with our operating losses. As a result, we did not record an income tax benefit during the quarters ended June 30, 2006 and 2005. There can be no assurances that deferred tax assets subject to our valuation allowance will ever be realized.

 

Sales.   Overall sales increased $13.3 million or 9.6% to $151.7 million in the year ended March 31, 2006 from $138.4 million in the year ended March 31, 2005 including a $2.9 million decrease from fluctuations in foreign exchange rates. During the year ended March 31, 2006 our 10Gbps and above products increased $23.9 million or 29.4% to $105.2 million while our less than 10Gbps products remained constant at $18.9 million and sales of our industrial and commercial products decreased by $10.6 million or 27.8% to $27.5 million. The increase in our 10Gbps and above products primarily resulted from increased demand for our 300 pin, XFP and X2 modules offset by lower sales of components to transceiver module companies. Sales of less than 10Gbps products remained constant as increased demand for our SFP products was offset by lower demand for our 2.5Gbps custom modules and 50/150 Mbps products. The decrease in sales of our industrial and commercial products primarily resulted from DVD price declines, as well as volume decreases in other industrial and commercial products partially offset by DVD volume increases. Sales of DVD products were $11.9 million and $13.6 million in the years ended March 31, 2006 and 2005, respectively.

 

For the year ended March 31, 2006, Cisco, Hitachi and its affiliates, and Alcatel accounted for 27.9%, 15.0% and 12.7% of revenues, respectively. For the year ended March 31, 2005, Cisco, Hitachi and its affiliates and Alcatel, accounted for 28.5%, 16.7% and 15.3% of revenue, respectively. No other customers accounted for more than 10% of total sales in either period.

 

Gross Margin.   Gross margin increased $1.3 million or 4.3% to $32.1 million in the year ended March 31, 2006 from $30.7 million in the year ended March 31, 2005 including a $2.9 million benefit from fluctuations in foreign exchange rates offset by a $2.3 million negative effect from changes in excess and obsolete inventory reserves. During the year ended March 31, 2006 we recorded a $1.3 million charge for excess and obsolete inventory while a $1.0 million benefit was realized during the year ended March 31, 2005 from the sale of inventory that was previously written down. As a percentage of sales, gross margin decreased to 21.1% for the year ended March 31, 2006 from 22.2% for the year ended March 31, 2005.

 

Gross margin improved primarily as a result of lower manufacturing costs per unit derived from higher volumes, improved yields and lower material and outsourcing costs on most communication and DVD products as well as the benefit from fluctuations in foreign exchange rates offset by higher manufacturing costs per unit resulting from lower volumes of certain industrial and commercial

products, decreases in average selling prices of most products and the negative effect from changes in excess and obsolete inventory reserves. Gross margin of DVD products was approximately a loss of $9.3 million and a loss of $10.4 million in the years ended March 31, 2006 and 2005, respectively.

 

Research and Development Expenses.   Research and development expenses increased by $0.4 million or 1.3% to $33.7 million in the year ended March 31, 2006 from $33.3 million in the year ended March 31, 2005 including a $1.4 million benefit from fluctuations in foreign exchange rates. Research and development expenses decreased as a percentage of sales to 22.2% for the year ended March 31, 2006 from 24.0% for the year ended March 31, 2005. Research and development costs increased due to additional funding for contract research with Hitachi and others as well as higher material costs used in the development of our products offset by lower personnel and depreciation costs resulting from the consolidation of two U.S. based research centers during the second half of the year ended March 31, 2006.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses decreased by $0.5 million or 1.5% to $33.1 million in the year ended March 31, 2006 from $33.6 million in the year ended March 31, 2005 including a $0.7 million benefit from fluctuations in foreign exchange rates. Selling, general and administrative expenses decreased as a percentage of sales to 21.8% for the year ended March 31, 2006 from 24.3% for the year ended March 31, 2005. The decrease in selling, general and administrative expenses primarily consisted of lower non-employee stock option expense to related parties, foreign franchise tax savings resulting from the restructuring of our Japan subsidiary’s equity and the benefit from fluctuations in foreign exchange rates offset by higher logistics costs associated with the sales volume increase, higher costs associated with our preparatory efforts to comply with Sarbanes-Oxley requirements and increased personnel costs.

 

Other Operating Expenses.   Other operating expenses increased $1.4 million to $1.5 million for the year ended March 31, 2006 from $0.1 million for the year ended March 31, 2005. During the year ended March 31, 2006 other operating expenses included a $1.1 million non-cash charge related to the disposal of certain obsolete fixed assets as well as fees to restructure our Japan subsidiary’s equity and severance costs. Other operating expenses for the year ended March 31, 2005 consisted of non-cash charges related to the disposal of certain obsolete fixed assets and severance costs.

 

Interest Income, Net.   Interest income, net increased by $2.0 million or 91.9% to $4.1 million in the year ended March 31, 2006 from $2.1 million in the year ended March 31, 2005. Interest income, net for the years ended March 31, 2006 and 2005 consist of interest earned on cash and cash equivalents offset by interest expense on short-term debt of $0.5 million for each year. The increase reflects lower short term debt balances and higher interest rates received on cash and cash equivalent balances offset by higher interest rates on short term debt and lower cash and cash equivalent balances during the period.

 

Other Income, Net.   Other income, net was $1.9 million and $0.1 million, respectively, for the years ended March 31, 2006 and 2005 and consisted primarily of net exchange gains on foreign currency transactions.

 

Income Taxes.   We recorded a $0.3 million current income tax expense during the year ended March 31, 2006 which resulted from foreign withholding taxes on the repayment of interest expense on debt owed by a subsidiary to the parent corporation. During the year ended March 31, 2005 we recorded a $1.3 million current income tax benefit which resulted from the reversal of an income tax contingency reserve for certain previously filed foreign tax returns that did not materialize prior to the expiration of the related statute of limitations.

 

Due to the uncertainty regarding the timing and extent of our future profitability, we have recorded a valuation allowance to offset potential income tax benefits associated with our operating losses. As a result, we did not record an income tax benefit during the years ended March 31, 2006 and 2005. There can be no assurances that deferred tax assets subject to our valuation allowance will ever be realized.

 

Comparison of The Years Ended March 31, 2005 and 2004

 

Sales.   Overall sales increased $59.0 million or 74.4% to $138.4 million in the year ended March 31, 2005 from $79.4 million in the year ended March 31, 2004 including a $3.0 million benefit from fluctuations in foreign exchange rates. During the year ended March 31, 2005, our 10Gbps and above products increased $50.4 million or 163.0% to $81.3 million while our less than 10Gbps products decreased $3.1 million or 14.2% to $18.9 million and sales of our industrial and commercial products increased by $11.8 million or 44.6% to $38.2 million. The increase in our 10Gbps and above products resulted from increased demand for our 300 pin and XENPAK modules and higher sales of components to transceiver module companies. Sales of less than 10Gbps products decreased as lower demand for our 50/150 Mbps products and a last time buy of Interconnect products in the year ended March 31, 2004 was offset by increased demand for our SFP products and 2.5Gbps custom modules. The increase in sales of our industrial and commercial products primarily resulted from higher volumes offset by lower average selling prices for DVD products. Sales of DVD products were $13.6 million and $6.0 million in the years ended March 31, 2005 and 2004, respectively.

 

For the year ended March 31, 2005, Cisco, Hitachi and its affiliates and Alcatel, accounted for 28.5%, 16.7% and 15.3% of revenue respectively. For the year ended March 31, 2004, Hitachi and its affiliates and Cisco accounted for 21.9% and 20.6% of revenue respectively. No other customers accounted for more than 10% of total sales in either period.

 

Gross Margin.   Gross margin increased $24.5 million or 392.1% to $30.7 million in the year ended March 31, 2005 from $6.2 million in the year ended March 31, 2004 including a $1.7 million decrease from fluctuations in foreign exchange rates. As a percentage of sales, gross margin increased to 22.2% for the year ended March 31, 2005 from 7.9% for the year ended March 31, 2004. We recorded a non-cash asset impairment charge of $19.2 million during the year ended March 31, 2004. As a result, our depreciation expense for the year ended March 31, 2005 was less than the prior year which resulted in an improvement of our gross margins by $4.7 million for the year ended March 31, 2005. We also realized a $1.0 million benefit from the sale of previously written down inventory during the year ended March 31, 2005.

 

Gross margin improved primarily as a result of higher volumes, lower depreciation expense and the benefit from the sale of previously written down inventory offset by decreases in average selling prices, unfavorable DVD production yields and the negative effect from fluctuations in foreign exchange rates. Gross margin of DVD products decreased to a loss of approximately $10.4 million in the year ended March 31, 2005 from a profit of approximately $0.8 million in 2004.

 

Research and Development Expenses.   Research and development expenses increased by $2.3 million or 7.5% to $33.3 million in the year ended March 31, 2005 from $30.9 million in the year ended March 31, 2004 including a $1.2 million increase from fluctuations in foreign exchange rates. Research and development expenses decreased as a percentage of sales to 24.0% for the year ended March 31, 2005 from 38.9% for the year ended March 31, 2004. The increase in research and development expenses included additional funding for contract research with Hitachi as well as higher personnel and material costs used in the development of our products offset by lower depreciation costs resulting from the non-cash asset impairment charge recorded during the year ended March 31, 2004.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses increased by approximately $0.5 million or 1.4% to $33.6 million in the year ended March 31, 2005 from $33.2 million in the year ended March 31, 2004 including a $0.6 million increase from fluctuations in foreign exchange rates. Selling, general and administrative expenses decreased as a percentage of sales to 24.3% for the year ended March 31, 2005 from 41.8% for the year ended March 31, 2004. The increase in selling, general and administrative expenses primarily consisted of higher commission, logistics and other costs associated with increased sales volumes and the increase from fluctuations in foreign exchange rates offset by lower non-employee stock option expense to related parties and

lower depreciation costs resulting from the non-cash asset impairment charge recorded during the year ended March 31, 2004.

 

Other Operating Expenses.   Other operating expenses decreased $25.2 million to $0.1 million for the year ended March 31, 2005 from $25.3 million for the year ended March 31, 2004. Other operating expenses for the year ended March 31, 2005 consisted of non-cash charges related to the disposal of certain obsolete fixed assets and severance costs. During the year ended March 31, 2004 we recorded a non-cash impairment charge associated with certain long-lived assets of $19.2 million, a $5.9 million non-cash charge related to the disposal of certain obsolete fixed assets and $0.2 million of severance and other costs.

 

The communication industry experienced significant deterioration during the year ended March 31, 2001 and the outlook of future market trends was uncertain until the second half of the year ended March 31, 2004. As the industries began to recover, we re-evaluated our long-term business plans and determined that the carrying amount of certain long-lived assets exceeded their fair value as determined by the related discounted future cash flows. Accordingly, a non-cash impairment charge of $19.2 million was recorded for the year ended March 31, 2004. Our evaluations for the years ended March 31, 2006 and 2005 indicated that there were no further impairments.

 

Interest Income, Net.   Interest income, net decreased by $0.2 million or 9.9% to $2.1 million in the year ended March 31, 2005 from $2.4 million in the year ended March 31, 2004. Interest income, net for the years ended March 31, 2005 and 2004 consist of interest earned on cash and cash equivalents offset by interest expense on short-term debt of $0.5 million for each year. The decrease reflects lower cash and cash equivalent balances and higher interest rates on short term debt offset by lower short term debt balances and higher interest rates received on cash and cash equivalent balances during the period.

 

Other Income, Net.   Other income, net for the year ended March 31, 2005 was $0.1 million and consisted primarily of net exchange gains on foreign currency transactions. Other income, net for the year ended March 31, 2004 was $0.3 million and primarily consisted of $1.1 million of net exchange gains on foreign currency transactions and $0.8 million of investment losses.

 

Income Taxes.   During the year ended March 31, 2005 we recorded a $1.3 million current income tax benefit which resulted from the reversal of an income tax contingency reserve for certain previously filed foreign tax returns that did not materialize prior to the expiration of the related statute of limitations.

 

Due to the uncertainty regarding the timing and extent of our future profitability, we have recorded a valuation allowance to offset potential income tax benefits associated with our operating losses. As a result, we did not record an income tax benefit during the years ended March 31, 2005 and 2004. There can be no assurances that deferred tax assets subject to our valuation allowance will ever be realized.

 

 

During the quarter ended June 30, 2006 cash and cash equivalents increased by $0.9 million to $90.3 million from $89.4 million. This increase consisted of $1.2 million of net cash provided by operating activities, $0.3 million used for capital expenditures, $0.5 million used for payments on capital lease obligations and a $0.5 million favorable effect from fluctuations in foreign exchange rates. Net cash provided by operating activities reflected our net loss of $3.5 million offset by a decrease in working capital of $1.6 million and depreciation and amortization of $3.0 million. The decrease in working capital primarily resulted from a decrease in accounts receivable related to the decrease in sales from the quarter ended March 31, 2006 and increase in accounts payable offset by an increase in inventories to fund new products and improve customer service levels. During the quarter ended June 30, 2006 we also entered into $0.2 million of new capital lease obligations.

 

During the year ended March 31, 2006 cash and cash equivalents decreased by $80.1 million to $89.4 million from $169.5 million. This decrease consisted of $30.2 million of net cash used by operating activities, $3.1 million used for capital expenditures, $46.5 million to fund financing activities and a $0.3 million negative effect from fluctuations in foreign exchange rates. Net cash used by operating activities reflected our net loss of $30.5 million and an increase in working capital of $13.4 million offset by depreciation and amortization of $12.6 million and $1.1 million of non-cash expenses. The increase in working capital primarily resulted from the increase in accounts receivable and inventories resulting from the increase in sales during the year. Net cash used by financing activities consisted of a $25.3 million net reduction of short term loans primarily in connection with the restructure of our Japan subsidiary’s equity, $20.0 million for final payment of the Opto Device, Ltd., acquisition, and $1.3 million for payments of capital lease obligations. During the year ended March 31, 2006 we also entered into $7.9 million of new capital lease obligations.

 

During the year ended March 31, 2005 cash and cash equivalents decreased by $33.7 million to $169.5 million from $203.2 million. This decrease consisted of $27.3 million of net cash used by operating activities, $4.4 million used for capital expenditures and $2.0 million to fund financing activities. Net cash used by operating activities reflected our net loss of $32.7 million and an increase in working capital of $9.2 million offset by depreciation and amortization of $12.6 million and $2.0 million of non-cash expenses. The increase in working capital primarily resulted from the increase in accounts receivable and inventories resulting from the increase sales during the year. Net cash used by financing activities consisted of a $1.3 million net reduction of short term loans and $0.7 million for payments of capital lease obligations. During the year ended March 31, 2005 we also entered into $2.2 million of new capital lease obligations.

 

We believe that existing cash and cash equivalent balances, available short term loans and cash flow expected to be provided or used by future operations will be sufficient to fund our capital expenditure requirements and our capital lease obligations at least for the next twelve months. However, we may require additional financing to fund our operations in the future and there is no assurance that additional funds will be available, especially if we experience operating results below expectations. If adequate financing is not available as required, or is not available on favorable terms, our business, financial condition and results of operations will be adversely affected.

 

Debt consists of short-term loans with The Bank of Tokyo-Mitsubishi UFJ bank which are due monthly. Interest is paid monthly at the TIBOR rate plus a premium which ranged in total from 0.56% to 0.59% during the three month period ended June 30, 2006 and 0.56% to 0.57% during the year ended March 31, 2006.

 

Capital lease obligations consist primarily of manufacturing assets under non-cancelable capital leases.

 

Operating leases consist primarily of leases on buildings with arrangements that expire in various years through March 31, 2011.

 

Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services. These obligations include purchase commitments with our contract manufacturers. We enter into agreements with contract manufacturers and suppliers that allow them to procure inventory based upon agreements defining our material and services requirements. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to the delivery of goods or performance of services.

 

Quantitative and Qualitative Disclosures about Market Risk

 

We are exposed to foreign currency, interest rate and commodity price risks.

 

To the extent we generate sales in currencies other than the U.S. dollar, our sales will be affected by currency fluctuations. For the quarter ended June 30, 2006 and for the year ended March 31, 2006, 26.9% and 30.4% of revenues were denominated in Japanese yen, respectively and 1.2% and 1.7% were denominated in euros, respectively. The remaining revenues were denominated in U.S. dollars.

 

To the extent we manufacture our products in Japan, our cost of sales will be affected by currency fluctuations. During the quarter ended June 30, 2006 and the year ended March 31, 2006, approximately 75.9% and 89.0% of our cost of sales was denominated in Japanese yen, respectively. We anticipate that this trend will continue into the foreseeable future. However, we anticipate the percentage of cost of sales denominated in Japanese yen to diminish as we plan to expand the use of contract manufacturers outside of Japan and procure more raw materials in U.S. dollars.

 

To the extent we perform research and development activities and selling, general and administrative functions in Japan, our operating expenses will be affected by currency fluctuations. During the quarter ended June 30, 2006 and the year ended March 31, 2006 approximately 56.0% and 57.0% of our operating expenses were denominated in Japanese yen, respectively. We anticipate that this trend will continue into the foreseeable future.

 

As of June 30, 2006 and March 31, 2006, we had net receivable positions of $8.1 million and $10.3 million, respectively, subject to foreign currency exchange risk between the Japanese yen and the U.S. dollar. During the quarter ended June 30, 2006, we began to mitigate a portion of the exchange rate risk by utilizing forward contracts to cover the net receivable positions. At June 30, 2006 we had entered into $5.0 million of such foreign exchange forward contracts. These forward contracts generally have maturities of ninety days or less. We do not enter into foreign exchange forward contracts for trading purposes, but rather as a hedging vehicle to minimize foreign currency fluctuations. Gains or losses on these derivative instruments are not anticipated to have a material impact on financial results.

 

We have short-term loans with Bank of Tokyo-Mitsubishi UFJ which are due monthly. Interest is paid monthly at TIBOR rate plus a premium which ranged from 0.56% to 0.59% and 0.56% to 0.57% during the quarter ended June 30, 2006 and the year ended March 31, 2006, respectively.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet financing or unconsolidated special purpose entities.

BUSINESS

 

Business Description

 

We are a leading designer and manufacturer of transmit and receive optical modules and components which enable high-speed telecommunications and data communications networks globally. In particular, we are a leader in both the telecommunications and data communications applications for the fast growing market for 10Gbps and above transceiver modules and optical components with a long history of market innovation. Our expertise in core semiconductor laser and other optical communications technologies has helped us create a broad portfolio of products that address customer demands for higher speeds, wider temperature ranges, smaller sizes, lower power consumption and greater reliability. We view ourselves as a strategic vendor to our customers and maintain longstanding supplier relationships with many of the leading telecommunications and data communications network systems vendors such as Alcatel, Cisco and Hitachi.

 

Telecommunications and data communications networks are becoming increasingly congested due to the growing demand for high bandwidth applications by consumers, enterprises and institutions. This bandwidth constraint has caused network service providers to turn to their equipment vendors to provide solutions that maximize bandwidth and reliability while minimizing cost. Increasing the communications data rate in networks has been an important element of easing network congestion, and, as a result, network service providers are deploying 10Gbps equipment more broadly throughout their networks. We have a broad portfolio of products encompassing a number of form factors, including 300 pin, XENPAK, X2, XPAK, XFP, XMD, SFP and in the future SFP+. We focus on the 10Gbps and above markets including tunable modules which we believe are some of the fastest growing and most important in the communications industry.

 

We were founded in September 2000 as a subsidiary of Hitachi Ltd. and subsequently spun-out of its fiber optic components business. We draw upon a 30 year history in fundamental laser research, manufacturing excellence, and product development that helped create several technological innovations such as the creation of 10Gbps and 40Gbps laser technologies. We work closely with Hitachi’s renowned research laboratories under long-term contractual relationships to conduct research and commercialize products based on fundamental laser and photodetector technology. We view our relationship with Hitachi as a competitive advantage because this relationship makes us a leader in fundamental semiconductor laser research for the communications market. These research efforts enable us to develop market leadership in the 10Gbps transceiver module market and place us in a strong position to develop differentiated products for emerging higher-speed markets, such as the 40Gbps and 100Gbps markets.

 

Since April 2001, we have generated cumulative revenue of approximately $700 million, expanded our customer base, increased our design wins eight fold across our top ten customers by revenue and made significant operational improvements. In addition, we have expanded our product lines and our patent portfolio which, as of September 30, 2006, includes 311 awarded patents and 381 pending patent applications as well as acquired and integrated two businesses. Through our direct sales force supported by manufacturer representatives and distributors, we sell products to many of the leading network systems vendors throughout North America, Europe, Japan and Asia. Our customers include many of the top telecommunications and data communications network systems vendors in the world. We also supply components to several major transceiver module companies and sell into select industrial and commercial applications such as medical systems, laser printers and barcode scanners where we can apply our core laser capabilities.

Industry Background

 

Over the past several years, telecommunications networks have undergone significant changes as network service providers pursue more profitable service offerings and lower operating costs. Network service providers continue to add high speed network access such as Wi-Fi, WiMAX, 3G, DSL, cable and FTTx, and are converging traditionally separate networks for delivering voice, video and data into IP-based integrated networks. Concurrent with these trends, a growing demand for high bandwidth applications such as e-mail, music and video downloads and streaming, on-line gaming, peer-to-peer file sharing and IPTV are challenging network service providers to supply increasing bandwidth to their customers. These applications drive increased network utilization across the core and at the edge of wireline, wireless and cable networks, which we collectively refer to as telecommunications networks. Additionally, in data communications, enterprises and institutions are managing the rapidly escalating demands for data and bandwidth and are upgrading and deploying their own high speed local, storage and wide area networks, also called LANs, SANs and WANs respectively. These deployments increase the ability to utilize high bandwidth applications that are growing in importance to their organizations and also increase utilization across telecommunications networks as this traffic leaves the LANs, SANs and WANs and travels over the network service providers’ edge and core networks.

 

Both telecommunications and data communications networks are utilizing optical networking technologies capable of supporting higher speeds, additional features and greater interoperability to accommodate higher bandwidth requirements and achieve the lowest cost. Today, both telecommunications network systems vendors such as Alcatel and data communications network systems vendors such as Cisco are producing optical systems increasingly based on 10Gbps and 40Gbps speeds including multi-service switches, DWDM transport terminals, access multiplexers, routers, Ethernet switches and other network systems. Mirroring the convergence of telecommunications and data communications networks, these network systems vendors are increasingly addressing both telecommunications and data communications applications. Faced with technological and cost challenges, they are focusing on their core competencies of software and systems integration, and are relying upon established module and component suppliers for the design, development and supply of critical hardware components such as products that perform the optical transmit and receive functions.

 

In order to address the increased network speed requirements, optical module and component companies need to provide products that incorporate improved semiconductor laser technology that addresses power consumption, operating temperature and size, all of which are inter-related primary challenges, while also meeting customers’ stringent demands for product reliability:

 

 

 

The increasing complexity of the components, industry consolidation and the need to increase the pace of innovation while reducing costs have led the network systems vendors to reduce their number of module and component suppliers and favor vendors with more comprehensive product portfolios and deeper product expertise. Suppliers who can successfully meet these challenges may become involved early in network systems vendors’ product development and become a strategic part of their product planning process. Advantages of being one of these select suppliers can include faster time to market and cost advantages.

 

Our Key Advantages

 

We are a leading designer and manufacturer of transmit and receive optical modules and components which enable high-speed telecommunications and data communications networks globally. We believe we offer the most comprehensive 10Gbps transceiver product portfolio in the communications industry and are a leader in the rapidly developing 40Gbps technology market. Our modules and components are utilized by leading telecommunications and data communications network systems vendors such as Cisco and Alcatel. We have positioned ourselves as a strategic vendor for our customers engaging them early in their planning cycle to help guide product development, addressing the key market requirements and maintaining market leadership in core semiconductor laser-based technology. We believe customers choose to work with us for several reasons including:

 

Technology Leadership.   Our products are built on a foundation of optical technologies based on over 30 years of research and development experience, resulting in 311 patents awarded and 381 patent applications pending worldwide. Our technology innovation extends to core semiconductor laser design and materials systems, optical and electronic component integration, high precision wavelength stability for DWDM and tunable applications, and high speed transmission design for 40Gbps and higher speeds. The semiconductor laser is at the core of all optical systems and is one of the most complex aspects of optical communications with a long development cycle. We are one of only a limited number of global providers of high performance 10Gbps and above lasers. We conduct our research both independently and through long-term contractual relationships with Hitachi. We are committed to conduct fundamental semiconductor laser research as a source of differentiation. By maintaining leadership in semiconductor laser technology, we are able to better maximize the performance of our transceiver modules as well as gain cost and operational efficiencies through selective vertical integration.

 

Broad Product Line.   We have one of the most comprehensive transmit and receive optical module portfolios for both telecommunications and data communications applications particularly for 10Gbps transceiver modules. Our products support a wide range of data rates, protocols, wavelengths, transmission distances and industry standard platforms. Our portfolio consists of 10Gbps and

40Gbps transceiver modules, including tunable transceivers, a broad line of 2.5Gbps and lower speed SFP transceiver modules, and new or planned products for emerging product platforms such as SFP+ and XMD. We believe the breadth of our product portfolio positions us favorably with leading network systems vendors seeking to reduce their number of suppliers in favor of partnering with suppliers with greater product capabilities and expertise.

 

Superior Performance.   Our performance advantage is, in most cases, due to the use of our industry leading lasers, superior integration and module design capabilities. Our core semiconductor laser technology allows us to efficiently design products that exceed the current power, size, temperature and reliability requirements of our customers, thus providing them with additional system level reliability and design flexibility. For example, one of our newest products is an indium phosphide and aluminum based 10Gbps uncooled DFB that enables 10Gbps optical transceivers to have an operating case temperature of 85ºC and provides network system vendors additional heat tolerance margin. This technology delivers reduced power consumption that enables high port density and smaller packages. This technology is allowing us to develop new 10Gbps modules to be used in outdoor non-temperature controlled environments and enable higher capacity in our customers’ next generation systems. In addition to our superior technological performance, we have established long-term relationships with customers by working closely with them to better understand the individual requirements of their products and by providing superior customer service and technical support.

 

Continuous Innovation.   We continuously innovate in laser and optical technologies such as uncooled DFB lasers and EA-DFBs. As a result, our customers often involve us early in the planning process for their next generation of products or engage us to create custom solutions for complex problems. Our early involvement in the design cycles of our customers’ products deepens our understanding of their long-term needs, increases our strategic importance to these customers and enhances our ability to cost effectively introduce new products that best address their needs. As an example of our successful innovation history, we have won several customer awards including Cisco’s prestigious Technology Alignment Award. We were also the first to market or have been a leading market innovator in products such as 10Gbps lasers, 10Gbps 300 pin transceivers, a DWDM version of a XENPAK transceiver, a 40Gbps laser and transceiver, an APD that meets the more stringent long distance telecom specification and an uncooled XFP module operating at 85ºC.

 

MSA Leadership.   We actively participate with network systems vendors and module and component vendors in the establishment of multi-source agreements, also known as MSAs, which define new product generations. Many customers use these MSAs as a framework for the design of their new systems. These MSAs specify the mechanical dimensions, electrical interface, diagnostic and management features and other key specifications such as heat and electrical interference that enable network systems vendors to plan their new systems accordingly. We are able to substantially influence the MSAs due to our sustained leadership position in the industry and understanding of key customer needs, an understanding developed via our close relationships at the research and development planning level and extensive technical support resources. We are founders or early members of successful 10Gbps MSAs such as 300 pin, XENPAK, X2 and XMD. We believe our involvement in MSA committees, in which our customers also participate, contributes to customer confidence that our new products will meet their performance, quality and manufacturing expectations.

 

Strategy

 

Our strategy is to be the leading provider of high performance optical modules and components by providing a broadening range of transmit and receive products that address our customers’ needs. Elements of our strategy include the following:

 

Focus on High Growth Product and Market Opportunities.   We will continue to focus our product development resources on high growth market segments both within the markets we currently serve as well as in new markets that utilize our core technologies. We will continue to invest substantially in the market for 10Gbps optical components and are selectively increasing our

investments in 40Gbps technologies as the market gains momentum. We believe high growth opportunities exist even within more mature communications segments by virtue of introducing innovative laser device structures such as short cavity DBR and long wavelength VCSEL lasers with superior performance characteristics to current generation products. Outside of communications, we believe we can address opportunities by developing products based upon our core laser technology. One such product is a semiconductor green laser diode which our non-communications customers have been requesting for consumer applications such as displays, construction tools and laser pointers.

 

Grow Revenues Within Existing Customer Base and Selectively Add New Customers.   We will continue to broaden our strategic relationship with key customers by maximizing design wins across their product lines. We will continue to leverage the approved vendor status we have with these key customers to qualify our products into additional optical systems, a process which is accelerated when we are already qualified in our customers’ other systems. To this end, we are adding sales and technical support staff to better serve key customers, markets and regions. We also intend to add to our number of strategic relationships by selectively targeting certain existing customers with whom we are not yet a strategic vendor. We will expand our development efforts with these customers through initiatives including providing specialized sales and support resources, holding technology forums to align our product development effort and implementing custom manufacturing linkages. Lastly, we plan to selectively approach and achieve design wins with the few network systems vendors who we do not currently serve.

 

Continue to Invest in Technology.   We believe our semiconductor laser technology together with our expertise in module design and integration are the main contributors to the on-going performance improvements in our high performance modules. The cost of the laser makes up a substantial portion of the total module cost. Through our vertical integration and ownership of key high performance laser technology, we believe we have a substantial cost advantage over competitors that must buy lasers from third parties at higher costs and with less ability to drive innovation. In order to maintain our position at the forefront of next generation optical modules and components, we intend to continue our longstanding relationship with Hitachi and our joint commitment to fundamental laser and materials research. These factors, combined with the number of patents we hold, provide us with a competitive advantage. Notably, we have fewer competitors for the lasers we make than at the module level.

 

Engage our Customers Early in their Product Planning Cycle.   By engaging our customers early in their system design process, we gain critical information regarding their system requirements and objectives which influences our module and component design. Our sales force, product marketing teams and developmental engineers engage regularly with our customers to understand their product development plans. Additionally, for certain customers, we hold periodic technology forums so that the product development teams of our customers can interact directly with our research and development teams. Likewise, our early involvement in their system development processes also enables us to influence MSAs and introduce differentiated products that comply with MSAs and customer specific requirements. Moreover, this dynamic interaction between ourselves and our customers provides us a significant competitive advantage, valuable insight and a close customer relationship that grows over each generation of products introduced by our customers.

 

Continue to Improve Our Manufacturing Process.   We will continue to improve our manufacturing process thereby extending our leadership in product quality and performance, time to market and cost effectiveness. The tight integration between our research and development teams and our manufacturing operations enables us to successfully operationalize manufacturing innovations and selectively outsource operations to lower cost manufacturers when the technology has stabilized. We will continue to manage our supplier base and purchasing to streamline parts management, minimize inventory and strengthen key vendor relationships.

Explore Strategic Acquisitions.   We intend to pursue selective acquisitions to strengthen our market position, enhance our technology base, optimize our production capacity and expand our geographic presence. We intend to evaluate and potentially acquire companies with synergistic or complementary technologies, customer relationships and product offerings. We intend to be selective about our acquisitions and will require companies to meet both strategic and financial goals. An example of this strategy is our acquisition of Pine Photonics which expanded our presence and product offerings to network systems vendors.

 

Technology and Research and Development

 

We utilize our proprietary technology at many levels within our product development, ranging from the basic materials research that created the innovative materials we use in our lasers to the sophisticated component integration and optimization techniques we use to design our modules. We are committed to conducting fundamental research in laser technologies. In addition, we have a proven record of successfully producticizing this research. Our technology is protected by our strong patent portfolio and trade secrets developed in deployments with our extensive customer base. Our leading technologies start with our fundamental laser technology and extend through design and assembly. In particular, the following technologies are central to our business:

 

Semiconductor Laser Design & Manufacturing.   We are a leading manufacturer and designer of lasers for high speed fiber optic communications such as 10Gbps and 40Gbps. In the development and manufacturing of new lasers, we utilize accumulated knowledge in areas such as semiconductor growth, semiconductor materials systems, quantum well engineering, design for very precise wavelengths, and high frequency performance. This knowledge enables performance improvements such as miniaturization, wavelength control, wide temperature, and high speed operation, and provides us with a time and knowledge advantage over companies that source their 10Gbps lasers from other companies.

 

Optical Semiconductor Materials.   Central to our laser design and manufacturing is our experience and research in materials, one of the most challenging aspects of optical communications technology and a source of competitive advantage. Our advances in optical semiconductor materials have enabled us to develop new lasers that are more compact, offer greater control of the light emitted and utilize less power to operate. For example, our innovations in the use of aluminum in semiconductor lasers are utilized in several of our newest lasers including our uncooled DFB laser and an EA-DFB laser which integrates a modulator with the DFB laser on the same chip. The use of aluminum gives these lasers increased temperature tolerance, improved efficiency, faster response time and greater wavelength stability, all while achieving or exceeding industry reliability requirements. Our research continues on new materials systems such as GaInNAs which we are developing for use in long wavelength VCSELs and further improvements in laser operating temperature and efficiency. We also have developed novel techniques for the use of the materials system InAlAs in the construction of high performance avalanche photodiodes which is central to performing the receive function.

 

Subassembly Design.   Laser diodes and photodetectors are particularly sensitive to external forces, fields and chemical environments, so they are typically housed in a hermetically sealed package. These laser diodes and photodetectors are placed upon special ceramic circuit boards and are packaged into a mechanical housing with certain electronics into transmit or receive optical subassemblies, or TOSA and ROSA, respectively. We have experts dedicated to TOSA and ROSA design with fundamental knowledge in laser physics, high frequency design and mechanical design who have garnered numerous patents. We are a founding member of the XMD MSA which creates a platform of miniature, high performance TOSAs and ROSAs for 10Gbps that can be used across multiple products and sold to external customers.

 

Module Design.   Transceiver modules integrate the TOSA, ROSA, integrated circuits and other components into compact packages specified by various MSAs. We possess key technology in the

form of high speed circuit design skills for error-free processing, transmitting, receiving and outputting of information, exceptional mechanical design to allow for higher tolerance of electrical and mechanical shock, and excellent thermal design to transfer heat away from key components and out of the module. We also have expertise in the design and manufacture of optical modules for long distance transmission including tunable laser modules. Long distance transmission modules require special manipulation of the optical signal to insure that error free transmission is achieved over tens to hundreds of kilometers of optical fiber.

 

Our research and development plans are driven by customer input obtained by our sales and marketing teams, in our participation in various MSAs, and our long-term technology and product strategies. We review research and development priorities on a regular basis and advise key customers of our progress to achieve better alignment in our product and technology planning. For new components and more complex modules, research and development is conducted in close proximity to the manufacturing operations to shorten the time to market and optimize the manufacturing process. We generally perform product commercialization activities ourselves and utilize our Hitachi relationship to jointly develop or fund more fundamental optical technology such as new laser designs and materials systems.

 

Products

 

We design, manufacture and market optical modules and components that transmit and receive data, used in both telecommunications and data communications markets, and have one of the most comprehensive transceiver product portfolios for these markets, particularly at 10Gbps data rates. Our product portfolio includes a broad range of solutions that vary by level of integration, communications protocol, form factor and performance level. Our portfolio primarily consists of 10Gbps and 40Gbps transceiver modules, including tunable transceivers, a broad line of 2.5Gbps and lower speed SFP transceiver modules, and new or planned products for emerging MSAs such as SFP+ and XMD. We sell transmit and receive optical modules and components, which are optical components that either generate or receive light signals, and our products are distinguished by their reliability and superior performance across several technical parameters.

 

The primary components that comprise all of our products are laser diodes and photodetectors. The laser diode provides the light source for communication over fiber optic cables. Our current communications laser diode product offering includes DFB lasers and EA-DFB lasers at selected 2.5Gbps and 10Gbps data rates and 1310nm and 1550nm wavelengths. Photodetectors receive the optical signal; we offer high performance avalanche photodiodes, or APDs, that operate at the same data rates and wavelengths of our lasers. We believe our laser diodes and photodetectors offer superior performance in key metrics such as reliability, temperature range, power consumption, stability and sensitivity.

 

The next level of integration involves packaging the laser diodes or photodetectors with integrated circuits and other electronic components that perform various control and signal conversion functions. A transmitter combines a laser diode with electronic components that control the laser and convert electrical signals from the network systems equipment into optical signals for transmission over optical fiber. A receiver combines a photodetector with electronic components that performs the opposite function, namely, converting the optical signal back into electrical form for processing by the network systems equipment. A transceiver combines both transmitter and receiver functions in a single module.

 

These modules support a wide range of protocol interfaces for telecommunications and data communications systems such as Ethernet, Fibre Channel, and SONET/SDH ranging in speeds from 155Mbps to 40Gbps as well as utilizing DWDM and tunable technology. Depending on the system type, telecommunications systems may have two to sixteen transceiver modules typically mounted onto line cards while data communications systems may have from two to forty-eight ports. Optical

network systems vendors now rely upon transceiver modules to perform the transmit and receive functions in most of their new system designs.

 

Our products include:

 

 

Note: MSS refers to multi-service switches and AM refers to access multiplexers.

 

For the industrial and commercial markets, we offer lasers and infrared LEDs for a variety of specialized applications. Our products include visible lasers around the 635nm, 650nm and 670nm wavelengths for applications such as laser printing, industrial barcode scanning, medical imaging and professional contractor tools; lasers around the 780nm and 830nm wavelengths for scientific measurement, night vision, and other infrared applications, and infrared LEDs around the 760nm, 840nm and 880nm wavelengths for sensors used in robotics and other industrial applications.

 

Customers

 

We have a global customer base for both the telecommunications and data communications markets. Our customers include many of the leading network systems vendors worldwide.

 

The number of leading network systems vendors that supply the global telecommunications and data communications market is concentrated, and so, in turn, is our customer base. Additionally, Cisco, Hitachi and Alcatel have consistently been three of our largest customers. Cisco represented 27.9%, 28.5% and 20.6% of our total revenues for the years ended March 31, 2006, March 31, 2005 and March 31, 2004 respectively. Hitachi accounted for 15.0%, 16.7% and 21.9% of our total revenues for the years ended March 31, 2006, March 31, 2005 and March 31, 2004,

respectively. Alcatel is our largest telecommunications customer representing 12.7%, 15.3% and 5.4% of our total revenues for the years ended March 31, 2006, March 31, 2005 and March 31, 2004, respectively. For the quarter ended June 30, 2006, Cisco and Alcatel accounted for 32.5% and 13.5% of revenues, respectively. For the quarter ended June 30, 2005, Cisco, Hitachi and its affiliates and Alcatel, accounted for 28.2%, 22.1% and 15.3% of revenue, respectively.

 

Other than Cisco, Hitachi and Alcatel, no other customer accounted for more then ten percent of sales for the years ended March 31, 2006, March 31, 2005 and March 31, 2004.

 

These customers purchase from us directly or, in certain cases, indirectly through their specified contract manufacturers.

 

Our customers in the industrial and commercial markets consist of a broad range of companies that design and manufacture laser-based products. These include medical and scientific systems, industrial bar code scanners, professional grade construction and surveying tools, gun sights and other security equipment, sensors for robotics and industrial automation, and printing engines for high-speed laser printers and plain paper copiers.

 

Backlog

 

We believe that backlog orders are not a meaningful indicator of future business prospects. A substantial portion of our revenues are derived from sales pursuant to individual purchase orders. Commitments under these purchase orders remain subject to negotiation with respect to quantities and delivery schedules and are generally cancelable without significant penalties. In addition, manufacturing capacity and availability of key components may impact the timing and amount of revenue ultimately recognized under such sale arrangements. Accordingly, we do not believe that the backlog of undelivered product under these purchase orders is a meaningful indicator of our future financial performance.

 

 

In our industrial and commercial product lines, we principally compete with Sanyo, Sony, Arima and QSI. We believe the principal competitive factors are:

 

 

Manufacturing

 

We fabricate key lasers and photodetectors for use in our modules and for sale to other module suppliers in our dual research and development and manufacturing facilities in Totsuka and Komoro in Japan. Optical component manufacturing is highly complex, utilizing extensive know-how in multiple disciplines and accumulated knowledge of the fabrication equipment used to achieve high manufacturing yields, low cost and high product consistency and reliability. Co-location of our research and development and manufacturing teams and utilization of well-proven fabrication equipment helps us shorten the time to market and achieve or exceed manufacturing cost and quantity targets. After chip fabrication, we utilize contract manufacturing partners for the more labor intensive step of packaging the bare die into standardized components such as TOSAs, ROSAs, laser diode modules and TO cans that are then integrated into transceiver modules and other products.

 

For our 10Gbps transceiver modules, we use a combination of internal manufacturing and contract manufacturing. Typically, we begin manufacturing new 10Gbps modules in-house to optimize manufacturing and test procedures to achieve internal yield and quality requirements before transferring production to our contract manufacturing partners. We develop long-term relationships with strategic contract manufacturing partners to reduce assembly costs and provide greater manufacturing flexibility. The manufacture of some products such as certain customized 10Gbps modules and 40Gbps modules may remain in-house even in mass production to speed time to market and bypass manufacturing transfer costs.

 

For our 2.5Gbps and lower speed SFP modules, we typically move new product designs directly to contract manufacturing partners. These lower speed modules are generally less complex than 10Gbps modules and ramp up to much greater volumes in mass production.

 

Our contract manufacturing partners are located in China, Japan, the Philippines, Taiwan, Thailand and the United States. Certain of our contract manufacturing partners that assemble or produce modules are strategically located close to our customers’ contract manufacturing facilities to shorten lead times and enhance flexibility.

 

We follow established new product introduction processes that ensures product reliability and manufacturability by controlling when new products move from sampling stage to mass production. We have stringent quality control processes in place for both internal and contract manufacturing. We utilize comprehensive manufacturing resource planning systems to coordinate procurement and manufacturing to our customers’ forecasts. These processes and systems help us closely coordinate with our customers, support their purchasing needs and product release plans, and streamline our supply chain.

 

Sales, Marketing and Technical Support

 

In the communications market, we primarily sell our products through our direct sales force supported by a network of manufacturer representatives and distributors. Our sales force works closely with our field application engineers, product marketing and sales operations teams in an integrated approach to address a customer’s current and future needs. We assign account managers

for each customer account to provide a clear interface to our customers, with some account managers responsible for multiple customers. The support provided by our field application engineers is critical in the product qualification stage. Transceiver modules, especially at 10Gbps and above, are complex products that are subject to rigorous qualification procedures of both the product and the supplier and these procedures differ from customer to customer. Also, many customers have custom requirements in addition to those defined by MSAs in order to differentiate their products and meet design constraints. Our product marketing teams interface with our customers’ product development staffs to address customization requests, collect market intelligence to define future product development, and represent us in MSAs.

 

For key customers, we hold periodic technology forums for their product development teams to interact directly with our research and development teams. These forums provide us insight into our customers’ longer term needs while helping our customers adjust their plans to the product advances we can deliver. Also, our customers are increasingly utilizing contract manufacturers while retaining design and key component qualification activities. As this trend matures, we continually upgrade our sales operations and manufacturing support to maximize our efficiency and flexibility and coordination with our customers.

 

In the industrial and commercial market, we primarily sell through a network of manufacturing representatives and distributors to address the broad range of applications and industries in which our products are used. The sales effort is managed by an internal sales team and supported by dedicated field application engineering and product marketing staff. We also sell direct to certain strategic customers. Through our customer interactions, we continually increase our knowledge of each application’s requirements and utilize this information to improve our sales effectiveness and guide product development.

 

Since inception, we have actively communicated the Opnext brand worldwide through participation at trade shows and industry conferences, publication of research papers, bylined articles in trade media, advertisements in trade publications and interactive media, interactions with industry press and analysts, press releases and our company web site, as well as through print and electronic sales material.

 

Patents and Other Intellectual Property Rights

 

We rely on patent, trademark, copyright and trade secret laws and internal controls and procedures to protect our technology and brand.

 

As of September 30, 2006, we have been issued 311 patents and have 381 patent applications pending. Patents have been issued in various countries including the U.S., Japan, Germany and France, with the main concentrations in the U.S. and Japan. Our patent portfolio covers a broad range of intellectual property including semiconductor design and manufacturing, optical device packaging, TOSA/ROSA and module design and manufacturing, electrical circuit design, tunable and DWDM technology, connectors and manufacturing tools. We follow well-established procedures for patenting intellectual property and have internal incentive plans to encourage the protection of new inventions.

 

For technologies that we develop in cooperation with Hitachi, either on a joint development or funded project basis, we have contractual terms that define the ownership, use rights, and responsibility for intellectual property protection for any inventions that arise. We also benefit from long-term cross-licensing agreements with Hitachi that allow either party to leverage certain of the other party’s intellectual property rights worldwide and obligate Hitachi to try to extend its third party cross licenses to us.

 

Opnext is a registered trademark in the U.S., Japan and the European Union as a Community Trademark (CTM). Trademark registration is pending in China. We have three product family names trademarked with two pending. We also have a licensing agreement in place with Hitachi to utilize the indication “Powered by Hitachi” in our logo.

 

We take extensive measures to protect our intellectual property rights and information. For example, every employee enters into a confidential information, non-competition and invention

assignment agreement with us when they join and are reminded of their responsibilities when they leave. We also enforce a confidential information and invention assignment agreement with contractors.

 

 

 

 

 

Harry L. Bosco has served as our president, chief executive officer and board director since November 2000. Mr. Bosco served in various management, engineering and executive positions at Lucent Technologies/AT&T/Bell Laboratories from 1965 to October 2000; his most recent position as Optical Networking Group President. Mr. Bosco holds an Associate of Science and Bachelor of Science in Electrical Engineering from Pennsylvania State University/Monmouth University and a Master of Science in Electrical Engineering from Polytechnic Institute of New York. Mr. Bosco has been a Director on the Arris Inc. Board since 2002.

 

Michael C. Chan has served as our executive vice president of business development and product portfolio management since December 2000. Mr. Chan spent more than 18 years with Lucent Technologies, AT&T and Bell Laboratories. Mr. Chan’s last position at Lucent was as chief strategy officer for the Optical Networking Group and before that as Chairman and President of Lucent China. Mr. Chan holds a Bachelor of Arts in Physics, Brandeis University and a Master of Science in Operations Research, Columbia University, and is a graduate of the Wharton Advanced Management Program, University of Pennsylvania.

 

Chi-Ho Christopher Lin has served as our senior vice president of global sales and marketing since December 2000. Prior to joining Opnext, Mr. Lin held several senior engineering and sales positions at various telecommunications companies; his most recent position as Chief Operating Officer for Lucent Technologies China Ltd. Mr. Lin holds a Bachelor of Science in Electrical Engineering from the University of Washington and a Master of Science from Columbia University.

 

Robert J. Nobile has served as our senior vice president of finance since March 2001. Mr. Nobile served in various financial positions throughout his career; his most recent at Kodak Polychrome Graphics, a global joint venture between Eastman Kodak and Sun Chemical, whereby he held the position of senior vice president of business integration, and before that as senior vice president and chief financial officer. Mr. Nobile holds a Bachelor of Science in Accounting from St. John’s University and is a CPA.

Kei Oki has served as executive vice president and Opnext Japan Inc. president since April 2004. Mr. Oki served in various management and executive positions at Hitachi from 1988 to 2004; his most recent position as executive project manager at Information and Telecommunication Systems, International Sales Division. Mr. Oki holds a Bachelor of Arts in Economics from Keio University.

 

Tammy L. Wedemeyer has served as our vice president of business management since January 2001 and board secretary since May 2005. Ms. Wedemeyer spent more than ten years at Lucent Technologies in a variety of business management roles, most recently as senior operations manager of the Optical Networking Group. Ms. Wedemeyer holds an Associate of Arts in Administration from Brookdale Community College.

 

Dr. Naoya Takahashi has served on our board of directors as chairman since June 2006. Dr. Takahashi presently serves as Vice President and Executive Officer, Executive Vice President and Chief Technology Officer of Information & Telecommunication Systems Group at Hitachi, Ltd, responsible for leading the company’s storage and platform network business. Since joining Hitachi in 1973, Dr. Takahashi has held a number of positions, playing key roles in marketing, research and development and business management. Dr. Takahashi holds a bachelor’s degree and a master’s degree in Electrical Engineering from Keio University in Japan. He also holds a PhD in Information Engineering from Keio University and served as a visiting scholar at the Computer Systems Laboratory, Stanford University.

 

Dr. David Lee has served on our board of directors as co-chairman since November 2000. Dr. Lee is a co-founder and Managing General Partner of Clarity Partners, L.P., a private equity investment firm based in Los Angeles. Prior to the formation of Clarity Partners, Dr. Lee co-founded Global Crossing Ltd. in 1997, a global broadband communication services provider, and was its president through June 2000. Global Crossing Ltd. filed for bankruptcy in January 2002. Dr. Lee is a graduate of McGill University and holds a Doctorate in physics with a minor in economics from the California Institute of Technology.

 

Tetsuo Takemura has served as a board director since April 2006. Mr. Takemura has held various positions at Hitachi from 1975 to present. He is currently the Corporate Officer of Hitachi and serves as the Chief Operating Officer for the Information and Technology Systems Group. Mr. Takemura holds a master’s degree in Engineering from Tokyo Institute of Technology.

 

Ryuichi Otsuki has served as a board director since December 2005. Mr. Otsuki has held various positions at Hitachi from 1981 to present including Hitachi Data Systems and PC Corporation as well as many functions within the Global Business Planning and Operation Division. He is currently the Executive General Manager, Global Business Planning & Operations Division, Information & Telecommunication Systems at Hitachi. Mr. Otuski graduated from Nagoya University School of Law.

 

Corporate Governance and Board Composition

 

Our board of directors is composed of five directors. Upon consummation of this offering, we will divide the terms of office of the directors into three classes:

 

Class I, whose term will expire at the annual meeting of stockholders to be held in 2007;

 

Class II, whose term will expire at the annual meeting of stockholders to be held in 2008; and

 

Class III, whose term will expire at the annual meeting of stockholders to be held in 2009.

 

Upon the closing of this offering, Class I will consist of           and          , Class II will consist of          ,           and          , and Class III will consist of          ,           and          . At each annual meeting of stockholders after the initial classification, the successors to directors whose terms will then expire serve from the time of election and qualification until the third

annual meeting following election and until their successors are duly elected and qualified. A resolution of the board of directors may change the authorized number of directors. Any additional directorships resulting from an increase in the number of directors will be distributed among the three classes so that, as nearly as possible, each class will consist of one-third of the directors. This classification of the board of directors may have the effect of delaying or preventing changes in control or management of our company.

 

Our board of directors has determined that      are independent within the meaning of the NASDAQ rules.

 

Board Committees

 

Our board of directors directs the management of our business and affairs, as provided by Delaware law, and conducts its business through meetings of the board of directors and standing committees. Our board of directors currently has an audit committee and compensation committee. Upon completion/prior to the consummation of this offering, our board of directors intends to appoint a nominating/corporate governance committee. Our board of directors may establish other committees to facilitate the management of our business.

 

Audit Committee.   Our audit committee currently consists of Dr. Naoya Takahashi and Dr. David Lee. Our board of directors has determined that      and      satisfy the independence requirements of the NASDAQ Global Market and the SEC.      serves as the chairman of this committee, and our board of directors has determined that      qualifies as an “audit committee financial expert” as that term is defined in the rules and regulations established by the SEC. The functions of this committee include:

 

 

Both our independent auditors and internal financial personnel regularly meet privately with our audit committee and have unrestricted access to this committee.

 

Compensation Committee.   Our compensation committee currently consists of Dr. Naoya Takahashi and Dr. David Lee. Our board of directors has determined that     ,      and      satisfy the independence requirements of the NASDAQ Global Market. Each member of this committee is a non-employee director, as defined pursuant to Rule 16b-3 promulgated under the Exchange Act, and

an outside director, as defined pursuant to Section 162(m) of the Internal Revenue Code of 1986.      serves as the chairman of this committee. The functions of this committee include:

 

 

Nominating/Corporate Governance Committee.   We intend to appoint a nominating/corporate governance committee. The functions of this committee will include: