Business Description

 

We are a leading designer and manufacturer of optical modules and components which enable high-speed telecommunications and data communications networks globally. Our transceiver modules, which typically utilize our lasers and detectors, convert signals between electrical and optical for transmitting and receiving data over fiber optic networks, a critical function in optical communications equipment. In particular, we are a leader in both the telecommunications and data communications applications for the fast growing market for 10Gbps and 40Gbps transceiver modules and optical components. 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 than other products currently available in the market. We view ourselves as a strategic vendor to our customers and we have well-established relationships with many of the leading telecommunications and data communications network systems vendors such as Alcatel-Lucent, Cisco Systems, Inc. and subsidiaries (“Cisco”) and Hitachi, Ltd. (“Hitachi”).

 

Telecommunications and data communications networks are becoming increasingly congested due to the growing demand from consumers, enterprises and institutions for high bandwidth applications. 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 is an important element of easing network congestion, and, as a result, network service providers are deploying 10Gbps and 40Gbps equipment more broadly throughout their networks. We have a broad portfolio of industry-defined product types, including tunable and fixed wavelength 300 pin, XENPAK, X2, XPAK, XFP, SFP+, XMD and SFP modules, which can be adjusted to operate at specific wavelengths enabling higher bandwidth on each optical fiber. We focus on the 10Gbps, 40Gbps and above markets 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 and subsequently spun-out of its fiber optic components business. We draw upon a 30-year history of fundamental laser research, manufacturing excellence, and product development that has 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 helps us remain a leader in fundamental semiconductor laser research for the communications market. These research efforts have enabled us to develop market leadership in the 10Gbps and 40Gbps transceiver module market and place us in a strong position to develop differentiated products for emerging higher-speed markets, such as the 40GbE and 100Gbps markets.

 

Since our founding in 2000, we have expanded our customer base, increased our design wins and made significant operational improvements. In addition, we have expanded our product lines and our patent portfolio, which, as of May 31, 2008, included 449 awarded patents and 328 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 the Americas, Europe, Japan and Asia Pacific. 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 where we can apply our core laser capabilities, such as medical systems, laser printers and barcode scanners. In February 2007, we completed our initial public offering from which we received net proceeds of approximately $170.9 million.

 

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 is 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-Lucent 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.

 

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. We believe we are a leader in the 40Gbps client and line side module market and a leader in the development of 40GbE and 100Gbps technologies. Our modules and components are utilized by leading telecommunications and data communications network systems vendors such as Cisco and Alcatel-Lucent. We have positioned ourselves as a strategic vendor for our customers by 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 more than 30 years of research and development experience, resulting in 449 patents awarded and 328 patent applications pending worldwide as of May 31, 2008. Our technological 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 10Gbps, 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 40Gbps lasers. We conduct our research both independently and through long-term contractual relationships with Hitachi. We are committed to conducting 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 and 40Gbps 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+, 40GbE, 100Gbps, XLMD 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 our 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 recent products is an indium phosphide and aluminum based 10Gbps uncooled DFB laser that enables 10Gbps optical transceivers to have an operating case temperature of 85° C and provides network system vendors additional heat tolerance margin. This technology delivers reduced power consumption that enables high port density and smaller packages such as SFP+. Additionally, 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, cooled and uncooled EA-DFBs, and new developments in tunable lasers. 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. 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 XENPAK and X2 transceivers, a 40Gbps laser and 300-pin transceiver, an APD that meets the more stringent long distance telecom specification and an uncooled XFP module operating at 85° C.

 

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 our extensive technical support resources. We were founders or early members of successful 10Gbps MSAs such as 300 pin, XENPAK, X2 SFP+, XLMD and XMD. Moving forward we expect to establish new MSA’s for 40GbE and 100Gbps modules. 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.

 

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 productizing 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 and 40Gbps 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 new 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 for use in developing new laser

structures that provide 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 and XLMD MSA’s which create a platform of miniature, high performance TOSAs and ROSAs for 10Gbps and 40Gbps 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 and in our participation in various MSAs, and by 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 collaboration with our 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. Our products are used in both telecommunications and data communications markets, and we have one of the most comprehensive transceiver product portfolios for these markets, particularly at 10Gbps and 40Gbps 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 product platforms such as SFP+, 40GbE, 100Gbps, XLMD 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, 10Gbps and 40Gbps data rates and 1310nm and 1550nm wavelengths. We expect our future developments to include tunable lasers, 25Gbps EA-DFB lasers for use in 100Gbps (4 x 25Gbps) applications, and 40GbE laser source(s). Photodetectors receive the optical signal; we offer high performance avalanche photodiodes, or APDs, that operate at the same data rates and wavelengths as 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 transmit and receive functions in a single module.

 

Our 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 transmit and receive functions in most of their new system designs.

 

Our products include:

 

 

 

 

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 that consists of many of the leading network systems vendors worldwide including Alcatel-Lucent, Ciena Corporation, Cisco, ECI Telecom LTD, Extreme Networks, Inc., Fujitsu Limited, Hitachi, Huawei Technologies Co., Ltd, Juniper Networks, Inc., Mitsubishi Electric Corp., Neterion, Inc. and Sumitomo Electric Industries, Ltd. 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 and Alcatel-Lucent have consistently been our two largest customers. Cisco, our largest data communications customer, represented 40.0%, 37.7% and 27.9% of our total revenues in the fiscal years ended March 31, 2008, 2007 and 2006, respectively. Alcatel-Lucent is our largest telecommunications customer, representing 20.0% of our total revenue for the fiscal years ended March 31, 2008 and 2007 while Alcatel represented 12.7% our total revenues for the fiscal year ended March 31, 2006. Hitachi accounted for 3.2%, 4.3% and 15.0% of our total revenues for the fiscal years ended March 31, 2008, 2007 and 2006, respectively. Other than Cisco, Hitachi, Alcatel-Lucent and Alcatel, no other customer accounted for more than ten percent of sales in the fiscal years ended March 31, 2008, 2007 and 2006. 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, including 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.

 

Competition

 

The market for optical modules and components is highly competitive and is characterized by continuous innovation. While no company competes against us in all of our product areas, our competitors range from the large, international companies offering a wide range of products to smaller companies specializing in narrow markets. In the telecommunications and data communications markets, we compete primarily with the suppliers of transmit and receive optical modules and components, at both the level of basic building blocks, such as lasers and photodetectors, as well as at the integrated module level such as transceivers for telecommunications and data communications applications. Competitors include Avago, Avanex, Bookham, Emcore, Finisar, Fujitsu, JDS Uniphase, Mitsubishi, Optium, and Sumitomo (which markets products in North America as Excelight). The market for optical modules and components is highly competitive. We believe the principal competitive factors are:

 

 

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

 

 

Because some of our competitors have longer operating histories and have greater financial, technical, marketing and other resources than we have, these companies have the ability to devote greater resources to the development, promotion, sale and support of their products. For example, in the telecommunications and data communications markets, some of our competitors offer broader product portfolios by supplying passive components or a broader range of lower speed transceivers. Other competitors may also have preferential access to certain network systems vendors or offer directly competitive products which may have certain better performance measures than our products. In addition, our competitors that have large market capitalizations or cash reserves may be better positioned than we are to acquire other companies to gain new technologies or products that may compete with our product lines. Any of these factors could give our competitors a strategic advantage. Therefore, although we believe we currently compete favorably with our competitors, we cannot be assured that we will be able to compete successfully against either current or future competitors in the future.

 

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, Mexico 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 ensure 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 with 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

40Gbps 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 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 May 31, 2008, we had been issued 449 patents, of which 139 patents are from the same technology in different jurisdictions, and have 328 patent applications pending, of which 97 patents are from the same technology in different jurisdictions. 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. Of the 172 patents issued in the U.S., 20 will expire within the next five years and, of those, nine will expire in the next two years. Of the 202 patents issued in Japan, 32 will expire in the next five years and, of those, 22 will expire in the next two years. We do not expect the expiration of our patents in the next two years to materially affect our business. 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.

 

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 four product family names trademarked with one pending. The licensing agreement with Hitachi to utilize the indication “Powered by Hitachi” expired February 20, 2008 and we have ceased using such indication.

 

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.

Employees

 

As of May 31, 2008, we had 438 full-time employees. Of the 438 employees, 333 are located in Japan, 93 in the U.S., eight in Europe and four in China. Of our 438 total employees, 159 are in research and development, 146 are in manufacturing, 80 are in sales and marketing, and 53 are in administration. We consider our relationships with our employees to be good. In addition, none of our employees is represented by a labor union.

 

 

Risks Relating To Our Business and Industry

 

We depend on a limited number of customers for a significant percentage of our revenues, and any loss, cancellation, reduction or delay in purchases by these customers could harm our business.

 

A limited number of customers have, historically, consistently accounted for a significant portion of our revenues. For example, for the fiscal years ended March 31, 2008 and 2007, Cisco and Alcatel-Lucent accounted for 40.0% and 20.0% and 37.7% and 20.0% of revenues, respectively. Revenues from any of our major customers may decline or fluctuate significantly in the future. Although we are attempting to expand our customer base, the markets in which we sell our optical components products are dominated by a relatively small number of systems manufacturers, thereby limiting the number of our potential customers. Accordingly, our success will depend on our continued ability to develop and manage relationships with significant customers, and we expect that the majority of our revenues will continue to depend on sales of our products to a limited number of customers for the foreseeable future. We may not be able to offset any decline in revenues from our existing major customers with revenues from new customers or other existing customers. Because of our reliance on a limited number of customers, any decrease in revenues from, or loss of, one or more of these customers without a corresponding increase in revenues from other customers would harm our business, operating results and financial condition. In addition, any negative developments in the business of existing significant customers could result in significantly decreased sales to these customers, which could seriously harm our business, operating results and financial condition.

 

We are dependent on contract manufacturers for a significant portion of our revenue.

 

Many of our original equipment manufacturer (“OEM”) customers, including Cisco, use third party contract manufacturers to manufacture their networking systems. These contract manufacturers represented 54.0% and 47.0% of our total revenue for the fiscal years ended March 31, 2008 and 2007, respectively. Certain contract manufacturers purchase our products directly from us on behalf of networking OEMs. Although we work with our OEM customers in the design and development phases of their systems, these OEM customers are gradually giving contract manufacturers more authority in product purchasing decisions. As a result, we depend on a concentrated group of contract manufacturers for a significant portion of our revenue. If we cannot compete effectively for the business of these contract manufacturers or if any of the contract manufacturers which work with our OEM customers experience financial or other difficulties in their businesses, our revenue and our business could be adversely affected.

 

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, operating income, 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.

We participate in vendor managed inventory programs for the benefit of certain of our customers which could result in increased inventory levels and/or decreased visibility into the timing of revenues.

 

Certain of our more significant customers have implemented a supply chain management tool called vendor managed inventory (“VMI”) programs which require suppliers, such as Opnext, to assume responsibility for maintaining an agreed upon level of consigned inventory at the customer’s location or at a third-party logistics provider, based on the customer’s demand forecast. Notwithstanding the fact that the supplier builds and ships the inventory, the customer does not purchase the consigned inventory until the inventory is drawn or pulled from the customer or third-party location to be used in the manufacture of the customer’s product. Though the consigned inventory may be at the customer’s or third-party logistics provider’s physical location, it remains inventory owned by the supplier until the inventory is drawn or pulled, which is the time at which the sale takes place. Our participation in VMI programs could result in our experiencing higher levels of inventory than we might otherwise and decrease our visibility into the timing of when our finished goods will ultimately result in revenue generating sales.

 

Certain VMI programs, particularly any involving products considered to be standard products, may require us to commit to delivering certain quantities of our products to our customers as consigned inventory without the customers having committed to purchase any quantity of such products. Such VMI programs increase the likelihood that estimates of our customers’ requirements which prove to be greater than our customers’ actual purchases could result in surplus inventory and we could be required to record charges for obsolete or excess inventories. Some of our products and supplies have in the past become obsolete while in inventory due to rapidly changing customer specifications or a decrease in customer demand. For example, we incurred charges of $0.7 million and $1.6 million, respectively, for increased excess and obsolete inventory during the fiscal years ended March 31, 2008 and 2007, respectively. If we or our customers with which we participate in VMI programs fail to accurately predict the demand for our products, we could incur additional excess and obsolete inventory write-downs. If we are unable to effectively manage the implementation of, and proper inventory management planning associated with, our customers’ VMI programs, our financial condition and results of operations could be materially adversely affected.

 

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 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, because of 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 canceled 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, during periods of severe market downturns, certain of our largest customers canceled significant orders with us and our competitors which resulted in losses of revenues and excess and obsolete inventory, that led to inventory and asset disposals throughout the industry. Similarly, decreases or deferrals of purchases by our customers may significantly harm our industry and specifically 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 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 operating profit.

 

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 depend on facilities located outside of the United States to manufacture our products, which subjects us to additional risks.

 

In addition to our principal manufacturing facilities in Japan, we rely on contract manufacturers located in Asia and elsewhere for our supply of key products and we intend to expand our use of contract manufacturers outside of Japan. Each of these facilities and manufacturers subjects us to additional risks associated with international manufacturing, including:

 

 

Any of these factors could significantly impair our ability to source our contract manufacturing requirements internationally.

 

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. A reduction in pricing for any existing or future customers may result in reduced pricing for other existing or future customers since our customers’ pricing is established pursuant to pricing agreements of not more than one year in duration or upon receipt of purchase orders. All of the pricing agreements with our customers provide either that prices will be set at invoicing or at various intervals during the year or require us to offer our existing customers the most favorable pricing terms. All of these situations enable our customers to frequently negotiate based upon prevailing market price trends. As product prices decline, our average selling prices and operating profits would decline.

 

Decreases in average selling prices of our products may reduce operating profit and net income, particularly if we are not able to reduce our expenses commensurately.

 

The market for optical components continues to be characterized by declining average selling prices resulting from factors such as increased price competition among optical component manufacturers, excess capacity, the introduction of new products and increased unit volumes as manufacturers continue to deploy network and storage systems. We anticipate that average selling prices will decrease in the future in response to product introductions by our competitors or us, or in response to other factors, including price pressures from significant customers. In order to sustain profitable operations, we must, therefore, continue to develop and introduce new products on a timely basis that incorporate features that can be sold at higher average selling prices. Failure to do so could cause our revenues and operating profit to decline.

 

In the current environment of declining average selling prices, we must continually seek ways to reduce our costs to maintain our operating profit and net income. Our cost reduction efforts may not allow us to keep pace with competitive pricing pressures. To remain competitive, we must continually reduce the