Opnext Inc. F2Q08 (Qtr End 9/30/08) Earnings Call Transcript

Nov. 4.08 | About: Opnext, Inc. (OPXT)

Opnext Inc. (NASDAQ:OPXT)

F2Q08 Earnings Call

November 4, 2008 9:00 am ET

Executives

Harry Bosco – President, CEO

Robert Nobile – Chief Financial Officer

Analysts

John Harmon – Needham & Company

Cobb Sadler – Deutsche Bank

Ehud Gelblum – J.P. Morgan

Michael Coady – B. Reilly

Todd Koffman – Raymond James

Paul Bonenfant – Morgan, Keegan

Ajit Pai – Thomas Weisel Partners

Sam Dubinsky – Oppenheimer

Operator

I would like to welcome everyone to the Opnext second quarter earnings conference call. (Operator Instructions) Mr. Dean, you may begin your conference.

Mr. Dean

Thank you for joining us today. My name is Doug Dean, and I'm the Vice President of Investor Relations for Opnext. Today we will discuss our financial results for the second quarter ended September 30, 2008 and provide some commentary regarding the market conditions and business outlook.

We'll begin with remarks from Harry Bosco, President and Chief Executive Officer of Opnext along with Bob Nobile, our Chief Financial Officer, and then we'll take your questions. Joining us for the Q&A session will be Giles Bouchard, our Chief Operating Officer.

As always in our prepared remarks and our responses to your questions, we rely on the Safe Harbor exemptions and the rules and regulations of the Securities Act and our Safe Harbor statements in the company's filings with the SEC. And now, let me introduce Harry Bosco.

Harry Bosco

I'd like to start by saying that in the September quarter, the market generally remained strong although we began to see some pockets of weakness near the end of the quarter in certain product areas and with certain customers. We believe this was a reaction to the global financial turmoil and tightened credit markets.

As a result, revenues for the September quarter were $80.2 million, a decrease of about 5% from the June quarter and an increase of nearly 5% from the September 2007 quarter. Earnings on a GAAP basis were $0.02 per diluted share and $0.05 per diluted share on a non-GAAP basis.

The revenue decrease from last quarter was primarily related to a reduction in the rate at which our products were pulled from our vendor managed inventory and a softening in the 40G sales. For the end of the quarter we experienced lower than anticipated rate at which our products were pulled from our vendor managed inventory which accounts for about 40% of our quarterly revenues.

We rely on historical trends as well as forecast information provided by our customers and our contract manufacturers to estimate the rate at which our products are utilized. Despite our best efforts there will always be some uncertainty surrounding the rate at which [end line] will be consumed. However in this case, resident timing and reduced pool may be more suggestive of a softness in demand related to the current economic contraction.

40 G sales, while disappointing suggest a typical pattern associated with the deployment of new networking technology. We've experienced significant growth in 40 G modules since we first introduced them in 2006. This initial growth occurred during the production and qualification phases of our customers and the early deployment of trial networks.

Today, our 40G client side modules is qualified in most of the key equipment suppliers of 40G systems and we anticipate that our growth will resume as the network deployments continue.

Lower volumes together with an unfavorable product mix primarily caused a decrease in our gross margin from 32.2% to 30.5%. In addition, there are several products that are second in overall margins as we continue to meet customer demands and respond to pricing pressures. These include 300 pin tunable products as well as the LRM and LX4 modules which are suitable for multi-mode fiber applications.

Over time, margins are expected to improve as new cost reduced product designs are qualified by our customers. And with that, I will now turn it over to Bob to review our second quarter results.

Robert Nobile

For the quarter ended September 30, we generated sales of $80.2 million representing a decrease of $4 million or about 5% as compared to the previous quarter. This decrease was primarily related to softness in sales of 40G and XENPAC products and was partially offset by increased sales of XFP consumable modules.

Our 10G and above products decreased 5.5% to $65.6 million and accounted for nearly 82% of our total revenue. Our less than 10G product line decreased about 6% to $9 million while industrial and commercial product sales increased by $0.4 million or nearly 8% to $5.6 million.

Compared to the year ago quarter ended September 30, 2007, our sales increased $3.6 million or nearly 5% from $76.6 million. This increase was driven primarily by higher demand for our 300 pin tunable, XFP, X2 and SFP products partially offset by lower demands for our 40G, 300 pin six wavelength and XENPAC modules.

For the current quarter, Sisco and Alcatel-Lucent represented 39% and 15% of total sales as compared to about 44% and 10% in the previous quarter. Revenue diversification improved as sales for the balance of the current top ten customers grew about 3% sequentially and represented 31% of total revenues. Geographically, revenues in North America represented 54% of total sales while Europe represented 21%, Japan 15% and the rest of Asia was approximately 10%.

Gross margins for the quarter ended September 30, 2008 was 30.5% as compared to 32.2% in the previous quarter and 35.2% in the September quarter of last year. The sequential decrease was primarily due to the negative effects of unfavorable product mix and lower sales volumes which exceeded the benefits from foreign currency exchange fluctuations and related hedging programs that in the aggregate approximated 140 basis points.

We generally purchase our foreign contracts a quarter in advance but looking forward, we have more than 50% of next quarter's currency exposure covered at rates comparable to those realized this quarter.

As compared to the June quarter, R&D expenses increased $0.9 million to $11.2 million and increased as a percentage of revenue to 14% from 12.2%. The expense increase primarily reflects higher levels of R&D materials related to prototype builds.

SG&A expenses decreased $1.5 million from the June quarter to $13.2 million and decreased as a percentage of sales to 16.5% from 17.4%. This decrease primarily resulted from lower spending including lower commission and logistics costs associated with the decreased sales volumes and lower performance based compensation expense that were partially offset by higher litigation expense and higher marketing/communications costs associated with the E-cox trade show in September.

We incurred almost $700,000 this quarter and almost $1 million this year in connection with the defense of a class action claim and a patent infringement claim. Although we expect these costs to continue, we expect them to be at a lower rate as we benefit from insurance coverage for the respective class actions.

Operating income including $1.5 million of stock based compensation expense and about $700,000 of litigation expense was about $0.1 million or 0.1% of sales as compared with $2.2 million or 2.6% of sales in June.

Non-GAAP operating income which excluded stock based compensation or litigation expenses was $2.2 million or 2.7% of sales as compared to $3.6 million or 4.3% of sales last quarter.

After accounting for interest income of $1 million, a net other income of $0.1 million, net income was $1.2 million or $0.02 per diluted share. Excluding stock based compensation and litigation expenses, non-GAAP earnings were $0.05 per diluted share as compared to $0.06 per diluted share in the previous quarter.

Non-GAAP earnings per diluted share in the current quarter include a $0.02 sequential benefit from foreign currency exchange fluctuations and related hedging programs.

Cash generated from operations was $2.6 million during the quarter ended September 30. Cash and cash equivalents decreased by $9.5 million to $2.2 million at September 30, 2008 as compared to $221.7 million at March 31, 2008 primarily as a result of $5.6 million of short term loan repayments, $3.6 million of payments on capital lease obligations, $1.4 million of costs incurred with the StrataLight acquisition and $1.3 million of additional capital investments that were all offset by cash generated from operations.

Let me now turn it back to Harry for our closing remarks.

Harry Bosco

Let me close by saying that despite our lower revenues this quarter, we continue to believe that we are well positioned as a company in the highest growth market segments and that our broad portfolio products and customer base will help us weather a difficult financial environment.

Our work over the past year to improve our operational excellence had laid the groundwork to streamline operations while preparing us for future growth. In response to the growing economic uncertainty, we have recently stepped up our efforts to control costs. Hiring of new personnel has been trimmed to selective positions and we have introduced a vigilant campaign to control expenses which we're already starting to the benefits of this quarter.

Our R&D programs continue to be prioritized based on customer needs and margin improvement. We will continue to improve our execution and readiness in high growth areas of the business such as tunables and XFP modules as well as 40G which we will believe will rebound in the first half of next year.

We are proceeding our closing in StrataLight acquisition and looking forward to combining our efforts to provide a broad portfolio of 40G and 100G modules and sub systems.

Looking ahead, we believe the industry fundamentals remain intact and that network demand will continue to drive optical sales even in a slowing capital expenditure environment. But we are not naive to the severity of the global economic and financial turmoil and its potential to slow sales in the optical component sector.

So given the mixed signals within the past quarter, particularly near the end of the quarter coupled with a tempered customer view, we have taken a prudently cautious view of next quarter's guidance. With that in mind, we expect revenues to be in the range of $72 million to $78 million for our third fiscal quarter ending December 31, 2008, excluding any potential impact from the pending StrataLight acquisition.

With that, we'll begin the Q&A portion.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Harmon – Needham & Company.

John Harmon – Needham & Company

Could you give us a little bit of a differentiated outlook for three segments; datacom, telecom and industrial in your business? Your were talking about tunable transponders as putting pressure on your margins, maybe you could talk about that a little. Is it just due to a high level of competition given that it is a product that not everybody can make?

Harry Bosco

First of all from a telecom perspective we grew this past quarter. From a data conference we were down this past quarter, and from a non communications in 10G we also went down a little bit this past quarter.

The effect of the tunable, right now we are going out and getting multiple suppliers on all the key components that make up the tunable. Up until now, there's been some primary suppliers of tunable components that the prices have remained relatively high and there are some competitors out there willing to take less margin and sell their products. So we are under pricing pressure but we have known this for a long time and have programs under way to drive the cost down.

John Harmon – Needham & Company

If I could clarify my first question, is the outlook for telecom and datacom any different? You're probably seeing slowness in the industrial segment as well.

Harry Bosco

The industrial segment, some of it is slowing down also on the consumer side. Some of the levers and pointers and that kind of stuff that people buy. The telecom piece right now we still see fairly significant demand come in of XFP and certainly the tunable.

And datacom I think is going to be under pressure from a couple of points. You have the core network stuff probably the demand will still be there but the enterprise piece will be up and down.

Operator

Your next question comes from Cobb Sadler – Deutsche Bank.

Cobb Sadler – Deutsche Bank

I had a question on the XFP business. I guess with telecom being up, I was wondering if that was down more than the quarter average and are you seeing the SFP plus short ridge substitution into the XFP business?

Harry Bosco

We see the SFP plus is coming in on the LR and also the LRM so that's just coming out now. Really what's happening is X2 demand is still fairly strong, up and down now again between SR and LR and XENPAC still plays a key part into this.

In general it's not one particular type because we see fluctuations in all kind of XENPAC versus X2 between short reach and longer reach.

Cobb Sadler – Deutsche Bank

LR, you said you're starting to see some volume there?

Harry Bosco

No.

Cobb Sadler – Deutsche Bank

That's kind of the area that you are focused on with the SFP plus?

Harry Bosco

We have both SR and LR.

Cobb Sadler – Deutsche Bank

Could you tell us what percentage of revenue the six wave length is a percentage of sales, and then on the tunable side where are you on, are you still sourcing the actual laser from third parties and where are you on the internal product?

Robert Nobile

The six wave length business is about 10% of the business.

Harry Bosco

On the tunable we have three different plans underway right now. Obviously multiple suppliers of those critical components, and the laser is a piece of that, but it's certainly not the total cost. We have our own internal laser which we have put a very aggressive program together now for a more integrated version which is going to put us out into 2010 realistically to have that laser. But in the meantime, we are working on all fronts to get multiple suppliers and drive the cost down.

Operator

Your next question comes from Ehud Gelblum – J.P. Morgan

Ehud Gelblum – J.P. Morgan

On StrataLight given that you revised your outlook and that you saw some of your G&A sales decline at the end of the quarter, is there any update to the guidance that you gave us on StrataLight and have they had to take a look at their book of business going forward? On that same vein, does that mean given the share prices now, somewhat lower at the time the acquisition was first announced, a substantial equity portion of the take out price would have to be adjusted at all? Can you give us the number for 40 gig itself, what the revenue number was for that? I know you've been working on higher capacity, can you tell us what the capacity is for 40 gig production is right now versus that revenue number and how much does that impact OpEx to have it unutilized in the quarter?

Harry Bosco

We've just filed our second generation bank into the SEC in addressing their comments, and we continued down that path and clearly we'll have to see what they come back with.

From a business perspective, StrataLight, I think you have to talk to StrataLight. I don't see any changes than what was in the filing S-4 right now. StrataLight has very significant growth but again you have to address that with them right now. We really can't comment until we close the business.

Robert Nobile

Contractually the shares are fixed based on the data we provided at that time of signing of the contract.

Ehud Gelblum – J.P. Morgan

If StrataLight had changed its opinion as to what its outlook was and from what it was the day of the acquisition could you give us the numbers from an OpEx perspective?

Harry Bosco

Like any business it's up and down based on as business goes on. It's a fundamental strategy that we have and to the advantage of the company to OpEx is still there.

Robert Nobile

The 40 gig business this quarter was about $7 million, down from about $10 million last quarter.

Ehud Gelblum– J.P. Morgan

And the capacity now is around 13, 14? Is that correct?

Robert Nobile

Roughly correct, yes.

Ehud Gelblum – J.P. Morgan

At what point during the quarter did you start noticing the BMI slow down? Was it a week before the quarter ended, a month before the quarter ended? At what point did you really notice and now that we're into the next quarter has that slowness continued?

Harry Bosco

First of all you see fluctuations on a weekly basis on the BMI, there's no question and we started to see it slowdown somewhat toward the latter part of September. We're seeing a little weakness also in October. It's not a catastrophic thing but it certainly is running at a lower level than we had earlier in the second quarter.

Ehud Gelblum – J.P. Morgan

So that's probably a large part of the basis for the new guidance, that it's lower than before.

Harry Bosco

That's exactly right. It's really uncertain because no one is saying that the business is going away, but everybody is saying it's cautious of what's out there.

Operator

Your next question comes from Michael Coady – B. Reilly.

Michael Coady – B. Reilly

I wanted to get a sense of your confidence and the weakness in the last couple of quarters, being more uncertainty rather than true weakness.

Harry Bosco

Every one of our customers we talk to talks about they still see the growth coming. They're just uncertain about the near term period of what this whole economic situation will cost, and our customers have business customers.

Michael Coady – B. Reilly

Related to BMI the weakness at the end of the quarter, the revenue level was still down. I expected it to be up a little bit based on the trends at the end of the quarter. Can you explain that? Is there any reason other than it's just bouncing around and what's your target for inventory levels on a turns basis?

Harry Bosco

It does bounce around but it's basically what happens, the whole BMI programs purpose in life is that our inventories in there and they give us some long term forecasting to replenish that inventory and it pulls it when it's needed. So when it gets projects it pulls out. So you'll see spikes in there of different kinds of products.

We are fortunate in that we have products across the gamut of different products that our customers have.

Robert Nobile

Your question regarding inventory terms, was that specific to BMI?

Michael Coady – B. Reilly

Yes.

Robert Nobile

BMI inventory is generally held at about a month's levels. In other words whatever we've got in here today generally gets pulled in the next thirty days.

Michael Coady – B. Reilly

Just to clarify on StrataLlight, negotiations are ongoing or final with the SEC? Did you provide an update on the time of close or your expectations?

Harry Bosco

What we said was that we were closing in the fourth calendar quarter of this year. It looks like it will be the later part or early next year.

Operator

Your next question comes from Todd Koffman – Raymond James

Todd Koffman – Raymond James

Where did this business go? You've been operating basically at $300 million business with great technology, but no real earnings or economic return for quite some time. Now you're reining things in for what may be an extended slow down? As you look out and you try to create some value, where does this business have to go, or what do you do to actually create some value? It would seem as though you've got critical mass at the level of business you're doing unlike a lot of other players in this space.

Harry Bosco

I think we're certainly going to stay on the front edge of technological achievement expanding that product line. The reason we're going after the acquisition of StrataLight and expanding our 40 gig business, we think there's tremendous growth in that business and 100 G going forward.

There will be less competitors in that business and therefore better margins. The 10G on the lower end has turned into more like a 2 1/2 gig and the higher than 10 G stuff, we're going to apply our technology to it to get our margins. We see growth in 40 G, 100 G certainly and growth by applying our technology in the 10 G space for growth as far as margins go.

Todd Koffman – Raymond James

Is that to imply that there's no value to be extracted in terms of making any real economic return from the 10 G and below and that you've got to wait for 40 G to come on big in order to actually show some economic return?

Harry Bosco

I think what happens is, we have three products in particular in 10 G that we put cost reduction efforts after to fix them and they happened to be the ones that are starting to grow now. We do have plans in place. In fact one of them is going to be going into qualification which will give us substantially more margin out of that product. Again, we're taking multiple paths on that to get more margin on that product.

We have very healthy XFP business. We have a very healthy 10 G business.

Operator

Your next question comes from Paul Bonenfant – Morgan, Keegan.

Paul Bonenfant – Morgan, Keegan

Did the terms of the StrataLight acquisition change with the filing today or are they substantially unchanged with a fixed number of shares plus the $30 million in cash?

Harry Bosco

No change.

Paul Bonenfant – Morgan, Keegan

Given that you're calling for a 2% to 10% sequential decline in revenue this quarter, how should we think about the OpEx and the gross margin progression? From the OpEx perspective it sounds like you've already taken steps to more closely align costs with revenues and I'm wondering if the current down turn continues from your perspective are there additional steps you would take, programs or products that you would back down from? In terms of gross margin, should we think about the mix remaining about the same or will that bounce around as well?

Robert Nobile

On the OpEx you should think that the next quarter are fairly consistent. We may have some fluctuations up and down in our R&D materials, but our SG&A expenses are fairly well under control. We do have some other levers we can pull and we will watch that very closely and if necessary, we'll take some more actions on that especially as we get closer to the integration with StrataLight, that's going to provide us an opportunity to really leverage our SG&A infrastructure.

On the gross margin side, the big question will be is where we begin, where will the yen fall out. As you know the yen has strengthened significantly against the dollar in the last couple of weeks. That will continue to put significant pressure on margins. We are in fairly good condition for next quarter with our hedging program so we do not expect a significant deterioration quarter over quarter with respect to yen, assuming yen doesn't shrink any further from where it is as of today, which is probably 98, 99, 100 or so.

And we'll see some continued product mix pressure as the tunable business grows, as the multi-fiber products continue to grow. As Harry discussed, we do have actions in place to improve the cost profiles of those and as soon as they kick in, that should stabilize and start to turn itself around.

Paul Bonenfant – Morgan, Keegan

Regarding actions you talked about taking in the past, could you give us an update on where you are in reducing your cost exposure to the yen? You had talked about reducing that by 20% or 25% by year end? And also on your 40 G capacity expansion, is that substantially complete at this point or are you still expanding capacity through the end of the calendar year?

Robert Nobile

Regarding the yen exposure, we had indicated that we would be able to decrease it about 25% from 80% of our cost of goods to around 60% of cost of goods by the end of the year. That program is on track.

Harry Bosco

On the 40 G expansion, we've completed that expansion. It's really test steps for the time on manufacturing the products. We have plenty of capacity that we share between 10 G, 4G and beyond for the wiring boards and stuff like that. So it's test sets, and we have those test sets in place and the amount of time used on these test sets depends on the product mix you have. We're well positioned for when this thing starts to recover.

Operator

Your next question comes from Ajit Pai – Thomas Weisel Partners.

Ajit Pai – Thomas Weisel Partners

Your largest customer on the datacom side, what gives you confidence that it's actually end market weakness rather than share losses that are driving some of the weakness, you're seeing from that particular customer? On the pricing front, of the gross margin drop, you have attributed a large part of that to mix. How much of that is competitive behavior and going into a slow down do you expect competitor behavior to actually get far more rational than it has been over the past 10 to 12 quarters?

Harry Bosco

When you take a look at our largest customer, and we're spread across multiple products with that customer, and we have multiple products in their products. We see when we get orders in certain areas, we'll get a bunch of pulls out of our BMI which is the purpose of it. And in certain quarters we'll see it come out it will take more than the share we expected. We have share allocations given us by that, so we pretty well know what's being pulled out at all times.

Ajit Pai – Thomas Weisel Partners

You know the total of what's being pulled out?

Harry Bosco

It varies. It's ZENPAC. It's SFP. It's tunables. It spreads across our 10 G internet family too because it's short range. Sometimes it's long range. It depends on the projects they have.

Ajit Pai – Thomas Weisel Partners

Do you have visibility into how much share you have in each one of those?

Harry Bosco

Oh yes.

Ajit Pai – Thomas Weisel Partners

And how do you have that visibility?

Harry Bosco

We know what products are being pulled and how much product is being pulled. We have computer feeds coming in from them to give us this forecast on a weekly basis.

Ajit Pai – Thomas Weisel Partners

On pricing and competitive behavior?

Harry Bosco

I think there could be some irrational pricing behavior out there as the market starts to slow down. That's a natural trend that you see in the industry. So we have to take reaction to that.

Ajit Pai – Thomas Weisel Partners

Do you have a strategy of dealing with that? Any kind of approach you'd like to share with us?

Harry Bosco

The approach right now is, we want to drive the cost out of the product to give us more flexibility. We have major customers and we're going to stay and service those major customers. We may not do any more customization for smaller customers.

Operator

Your next question comes from Sam Dubinsky – Oppenheimer.

Sam Dubinsky – Oppenheimer

Can you give some color in terms of with the market dynamics all over the place in telecom and datacom, can you give us an update of how accreted to you think the StrataLight acquisition will be next year.

Robert Nobile

We've indicated that the StrataLight transaction would be accreted in the first quarter, closing in double digit accreted in the first full year of closing. It's all going to depend upon revenue when the 40 G business comes around. We expect as Harry has indicated that if the demand is still strong, we expect that business to remain and we should be able to maintain our expectations of that StrataLight acquisition.

Harry Bosco

I also think that the 40 G is not different than the 10 G when it first got introduced. You basically get a blast of business. Your customers start to qualify the products, your products and their products. And then they go through their qualification process with their customers. And once they're out there, then you start putting routes in place.

We've seen some pretty significant cost savings using 40 G versus 10 G in long haul routes. The economics are there. It's just getting it going.

Sam Dubinsky – Oppenheimer

On the gross margin front, can you walk me through any currency impacts you've got? I'm looking at the yen chart. It seems like it's rebounded recently but it's still well off peak. Where do gross margins go if the yen is stable, and then if the yen appreciates a little bit more, where should we see gross margin in the next couple of quarters?

Robert Nobile

Think about it this way. From our June quarter to our September quarter the dollar strengthened against the yen by about 3 yen. That impact alone had about an 80 point improvement quarter over quarter. The other 60 basis points was due to the hedging programs we had in place.

Sam Dubinsky – Oppenheimer

What is you targeted gross margin now?

Robert Nobile

It will all depend upon where the yen is at. We were talking about a 35% to 40% range of margins. The yen was in the 115% range. Now, it's down at 100%. So proportionately you can do the math.

Sam Dubinsky – Oppenheimer

On the OpEx front how should we think about OpEx? You said you're trying to control costs for the next couple of quarters. Does that mean OpEx will be down or is that just stable?

Robert Nobile

From this day forward from what you saw in this quarter you should assume it's going to be stable. We are going to watch it closely and we still have some things we can work with in the event things get worse.

Sam Dubinsky – Oppenheimer

In terms of customers, it seems like Alcatel-Lucent had a take down and was weak for several quarters and have recently recovered pretty strongly. Could you give me some color there because I assume they're also seeing some macro head winds just like every one else?

Harry Bosco

Alcatel has been going up and down for the past several years. It depends on the quarter that you're in. We see a strong demand coming in for XFP which I suspect they're selling in their 10 G products out there right now and so XFP is a replacement for the Legacy stuff which we knew was going to happen.

You get the tunable but you also get fluctuation in the 40 G on the projects that they get. I think we'll see fluctuations going into the future. We did some things to give them our next generation XFP products which helped us out.

Operator

Your next question comes from Ehud Gelblum – J.P. Morgan.

Ehud Gelblum – J.P. Morgan

What should we look at for taxes as we go forward?

Robert Nobile

For the rest of this year I think you can assume no income taxes depending upon where things go out at next year, as we've always said, less than 5%, more like 2% or 3%.

Ehud Gelblum – J.P. Morgan

The acquisition costs that you called out in the press release, where are they? Are they SG&A?

Robert Nobile

Those are deferred until the transaction closes. For checking cash flow, they're not in the P&L.

Ehud Gelblum – J.P. Morgan

Can you give any sense as to what the pricing environment looks like? Are you seeing anything changing in pricing and the comments you made on foreign exchange as well as product mix, it sounded like you're pointing to gross margin going down next quarter and then depending on where foreign exchange is going forward into March, if it stays where it is, it will probably go down again in March if you get hit from the hedges coming off that you have right now. Is that the right way to look at it?

Robert Nobile

In terms of currency, let's assume that with the hedging programs in place and a stable yen from now we should not have any significant deterioration going into next quarter, consistent with our program, we're looking at hedges and forwards one quarter in advance. So we still have some time this quarter to get things in place for the follow on quarter.

Ehud Gelblum – J.P. Morgan

But you're locking it in at a much lower dollar rate.

Robert Nobile

Yes. If there isn't any change in the situation from where it is today, then that will be deterioration.

Ehud Gelblum – J.P. Morgan

So if we look just at December we're looking at no change in the currency rate because you've locked that in for the most part. However, we are looking at a product mix problem.

Harry Bosco

I see continued growth in the tunable and I don't believe 40 G is going to recover in this quarter. I think we're still going to see softness based on what we're hearing and there will be pushing out. We'll see customers push out their 40 G orders.

Ehud Gelblum – J.P. Morgan

So the tunable does not have the same gross margin as the 40 G?

Harry Bosco

That's right.

Ehud Gelblum – J.P. Morgan

So we do have a product mix issue the next quarter but no currency issue. In March we may have a bit of a product mix rebound. It depends but we'll probably have, assuming no change to the yen/dollar, I imagine it will probably only move in the direction of the stronger yen. We'll probably see more of a currency hike in March as well. So it could be in June before we start seeing gross margin recover.

Harry Bosco

That's when the new products kick in, and the yen.

Ehud Gelblum – J.P. Morgan

Any comment on pricing at all or has the environment been more impacted by demand than the pricing?

Harry Bosco

It's pockets. We see certain kinds of products with certain customers, somebody comes in there and gets more aggressive. In general, they're in line with where we think they should be. There's nothing really out of whack here.

Operator

Your last question comes from John Harmon – Needham & Company.

John Harmon – Needham & Company

Another CEO was talking about in times of a slow down that leading edge technologies were the first thing to go. I'm asking specifically about your 40 G business, given that there's really not a cost advantage in using it, I would think carriers would be using it when they're running out of capacity, so I would expect it to have held up better than it did. Do you have any comments you can add on the direction of that business?

Harry Bosco

We know the carriers that are deploying it right now, and I think there are some in the start up stages. They will deploy it, because when you look at it, there's routes that are going to get exhausted. We know a couple of carriers that are absolutely going to deploy it. But there's a state where they run through a long qualification process, then have to turn up the operations.

It's a fairly complicated process to get it started, but once it gets started, then you start to see the follow on.

John Harmon – Needham & Company

So you think most of the demand is from trials and quals and not really reflecting steady growth and demand, so it will probably stay lumpy like this for some time.

Harry Bosco

You'll see the 40 G interface on the routers go up and down which means that it's waiting for the wiring to get put in. You're going to constantly see that back and forth between the datacom side and the telecom side.

Robert Noble

With no more questions that includes our investor call for today. Thank you for joining us.

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