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Finisar Corporation (NASDAQ:FNSR)

F2Q 2013 Earnings Conference Call

December 5, 2012 5:00 p.m. ET

Executives

Jerry Rawls – Executive Chairman

Eitan Gertel – Chief Executive Officer

Kurt Adzema – Chief Financial Officer

Analysts

Alex Henderson - Needham & Company

Michael Genovese - MKM Partners

Mark Sue - RBC Capital Markets

Bill Choi - Janney Capital Markets

Troy Jensen - Piper Jaffray

Patrick Newton - Stifel Nicolaus

Kent Schofield – Goldman Sachs

Ehud Gelblum – Morgan Stanley

James Kisner – Jefferies & Co.

Andrew Delia – Credit Suisse

Kevin Dennean - Citi

Alex Henderson – Needham and Company

Operator

Good afternoon, ladies and gentlemen, and welcome to the Finisar Corporation second quarter 2013 financial results. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Jerry Rawls, executive chairman of the board. Please go ahead, sir.

Jerry Rawls

Thank you, operator, and good afternoon, everyone. We appreciate your taking the time to listen our conference call. A replay of this call should appear on our website within eight hours. An audio replay will be available for two weeks by calling (888) 203-1112 for domestic or (719) 457-0820 for international. Then enter the ID number 7734918.

I need to remind all of you that any forward-looking statements in today’s discussions are subject to risks and uncertainties which are discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from any forward-looking statements. In addition, unless otherwise indicated, all results discussed are on a non-GAAP basis. A complete reconciliation of our GAAP to non-GAAP results may be found in our earnings press release and in the Investor Relations section of our website.

I would like to point out that we have prepared some slides for today’s earnings call, which you can access by connecting to the Investor Relations page of our website at www.finisar.com. Click on “Investors,” then scroll down to “Webcast Archives” and click, and then you’ll see a listing for today’s second quarter 2013 earnings call.

I am pleased to report fiscal second quarter revenues of $232 million, which is $11.5 million, or 5.2% greater than the prior quarter. Our growth in revenues came primarily from sales of tunable XFP transceivers and wavelength selective switches, including the ROADM linecards.

In addition, non-GAAP operating income increased $3.8 million, or 32%, and non-GAAP earnings per diluted share increased to $0.15 from $0.12 in the prior quarter. And with that, I’ll let Kurt review the rest of the numbers for you.

Kurt Adzema

Thanks, Jerry. For the second fiscal quarter, our revenues were $232 million, an increase of $11.5 million, or 5.2%, from $220.5 million in the preceding quarter. Revenue for telecom products was $92.2 million, an increase of $11.1 million, or 13.7% from Q1, primarily from the sale of tunable XFP transceivers and wavelength selective switches including in ROADM linecards. Revenue for products from data communications was $139.8 million, an increase of $0.4 million, or 0.3% from Q1.

In the second quarter, we had two 10% or greater customers. Our top 10 customers represented 56.4% of total revenue, compared to 62.1% in the preceding quarter.

Non-GAAP gross margin was 30.5% compared to 30.3% in the preceding quarter, primarily due to higher revenue levels. Non-GAAP operating expenses for the second quarter were relatively flat at $54.8 million compared to $54.7 million in the preceding quarter, in spite of the fact of the impact of a full quarter of operating expenses from the operation of our Red Sea subsidiary, which closed in Q1.

Second quarter non-GAAP operating income increased $3.8 million to $15.8 million, or 6.8% of revenue compared to $12 million, or 5.4% of revenue, as we controlled expenses and revenue levels increased.

Second quarter net interest expense was approximately $424,000. Other expenses were approximately $305,000. The adjustment for the net income of a noncontrolling interest was a negative $156,000, and non-GAAP taxes were approximately $748,000.

Non-GAAP income was $14.2 million, or $0.15 per diluted share, compared to $10.9 million, or $0.12 per diluted share in the preceding quarter. Average diluted shares for the quarter for non-GAAP purposes were 98.5 million. Please note that this diluted share count includes the impact of converting the principal amount of our outstanding convertible notes to equity for purposes of calculating EPS, and therefore you need to add back approximately $539,000 of interest expense and other costs associated with the aforementioned convertible notes in calculating diluted EPS for the second quarter.

The sum of net interest expense, other expenses, and the adjustment for net income of noncontrolling interest is expected to be a deduction of approximately $700,000 to income in Q3. Non-GAAP taxes are estimated at approximately 5.5% of non-GAAP pre-tax income for the remaining quarters of fiscal 2013.

In the third quarter of fiscal 2013, weighted average fully diluted shares are expected to be approximately 99 million for non-GAAP purposes, as we expect the convertible notes to be, again, dilutive for calculation purposes. Non-GAAP EBITDA increased $3.9 million to $28.7 million, or 12.4% of revenues, compared to $24.9 million, or 11.3% of revenues, in the preceding quarter.

Second quarter capital expenditures totaled $18.3 million, which is lower than our prior guidance of approximately $22 million. This is the result of a slight delay in the timing of some major expenditures related to the new manufacturing facility we are building in Wuxi, China. We still expect this building to be completed in the second half of calendar 2013.

Capital expenditures are expected to be approximately $26 million in Q3 of fiscal 2013, primarily driven by the increase related to the new building in Wuxi. Cash and cash equivalents totaled $262.4 million at the end of the second quarter, compared to $220.4 million in the preceding quarter, an increase of $42 million, primarily driven by exceptionally strong accounts receivable collections and a decrease in inventory levels.

At the end of the quarter, Finisar had approximately $40 million in principal amount of convertible notes outstanding, with a conversion price of $10.675 per share. There are a number of noncash or infrequently occurring charges which we exclude from our non-GAAP results. These totaled [unintelligible] million last quarter. If we include all these items, as required under GAAP, we generated net income for the quarter of $0.3 million, or $0.00 per diluted share, compared to a net loss of $6.2 million, or negative $0.07 per diluted share in the preceding quarter.

That concludes my comments. I’ll turn it over to Eitan.

Eitan Gertel

Thanks, Kurt. During the quarter, we continued to invest significantly in new technologies and products. Our products played an important role in our revenue growth last quarter, and enabled us to continue the expansion of our market share.

For our telecom business, we continued the expansion of our Flexgrid WSS product portfolio, and our 10G, 40G, and 100G transceivers and transponders. On the line side, we have begun shipping samples of our 100 gigabits per second coherent line side transponders. Customer feedback has been very positive, and we believe this market represents a significant growth opportunity for our company.

We are experiencing continued success in winning new customers across all of our WSS product offering. We are investing in next-generation, small form factor, lower power, and increased performance solutions which we believe will allow us to continue the expansion of our market share. Finisar has the broadest offering of Flexgrid products in the industry, and is the only company currently delivering a full portfolio of Flexgrid WSS modules that enable our customers to deploy their next general gridless networks.

In addition to our standalone WSS business, we are currently bidding on a number of new next-generation WSS linecards with multiple customers, based on our proprietary LCoS, Flexgrid, and [unintelligible] OCM technology, coupled with our optical amplifier technologies.

In the wireless segment, Finisar continues to win new tenders for our 6 gigabit SFP CPRI products for LTE base station deployment. The ramp of next-generation higher data rate LTE is driving the need for 10 gigabit SFP+ modules, which will allow Finisar to capitalize on our vertical integration to offer superior value for our customers.

For our tunable XFP transceiver business, we continue to grow our market share and expand our production capacity. As we are continuing to add new customers and new variations of the tunable XFP product, we expect the growth trends for this product line to continue.

In datacom, we are continuing to invest in a variety of form factors for high data rates, for short and long reach transceiver applications. Our [unintelligible] product, in the QSFP and CXP and proprietary form factors are seeing very strong traction in the market.

In the 40G space, the demand for our QSFP SR4 and LR4 product is strong, and we are investing to rapidly expand our capacity. Our proprietary optical engine product has been a great success for us, and we recently were awarded a large core routing opportunity.

Several OEMs are designing our 10 G per second per channel product, and we are well-positioned with this product for transitioning to a 25 G per second channel. One of the key segments in our datacom business is the 100 G client side transceivers. Our 100 G SR10 business is starting to ramp, and our LR4 CFP business continues to be very strong.

The newest form factor for short and long reach, 100 G client applications is the CFP2, which offers higher density and lower power than the CFP form factors. We recently shipped our first customer samples with industry leading power consumption, which was enabled by Finisar internally made 100 G transmitter section and receiver section.

We believe that our industry-leading portfolio of products and continued design wins will be the driver for revenue and market share growth. I’ll turn the call back to Jerry.

Jerry Rawls

Thanks, Eitan. While the world’s economic outlook is still a bit uncertain, I am happy to report that we expect revenue growth to continue in the third quarter, primarily driven by new products and increased market share.

We believe revenues for our fiscal third quarter 2013 will be in the range of $230 million to $245 million. Non-GAAP gross margins are expected to continue to improve to approximately 30.7%, and reflect the impact of one month of the annual telecom price reductions that typically take place on January 1. As a reminder, our fiscal fourth quarter will be the first quarter to experience three months of impact from the annual telecom price reductions.

We expect the fiscal third quarter operating expenses to be approximately $55.8 million, and non-GAAP operating margin to be in the range of 6.5% to 8%. Non-GAAP earnings per diluted share should be in the range of $0.14 to $0.18 per share.

I would remind you that Finisar is a company that is driven primarily by growth in the demand for bandwidth from a pervasive distribution and use of video, photos, and all forms of digital information. Over time, enterprise and carrier spending will increase to provide more bandwidth capacity.

Finisar is uniquely positioned, with our broad product line, extensive customer engagements, profitable vertically integrated business model, and strong balance sheet to capitalize on these market opportunities.

And now, with that, I’m going to turn it back over to the operator, and open it up for questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. [Operator instructions.] We will take our first question from Alex Henderson with Needham & Company.

Alex Henderson - Needham & Company

Could you give us the headcount, DSO, and inventory turns again? I don’t think I caught that.

Kurt Adzema

The DSO turns were up, in the low 60s. I think it was about 61. Inventory turns were about 3.3. Headcount was about 9,000.

Alex Henderson - Needham & Company

And relative to the commentary, I was wondering if there was something changed in the language there, Eitan. You said you were the only WSS player with a full portfolio. Last time it was the only one shipping. Is there a player that’s now shipping, or are you still the only player out there with a liquid crystal on silicon solution. And while I’m on the subject of that, if you could just give us a little bit more color there. I think you were implying that tunable XFPs and the WSS/WSS linecards grew faster than the average portion of the telecom. Is that accurate?

Eitan Gertel

The answer to your last question is yes. That is accurate. I think we said even in the last call that we expect that to happen, and that was a Q2 driver for the growth. As far as your question for the Flexgrid, and my statement, it hasn’t changed. I maybe used different words over the quarter, but we don’t know if anybody is shipping in production, a Flexgrid type product. We know people are sampling things, but it’s not to my knowledge that anybody [unintelligible] in production. And what we were referring to as our full portfolio is Flexgrid type products. So any product we sell, you can buy it on a Flexgrid format. And what was your third question?

Alex Henderson - Needham & Company

You got the bulk of the questions. Just one last question, then, if I could. As we look out into ’13, there’s been a lot of comments about AT&T and other changes in Chinese leadership and the like. Without giving us guidance on what you think’s going to happen, could you just give us a sense of what you think the tone of 2013 capex is going to look like from your perspective?

Eitan Gertel

As always, we’re only guiding one quarter at a time. And we’re waiting enthusiastically for that to happen. We had some projections before, and from the market, and we just want it to happen before we start projecting for next year. But we said that there’s a lot of noise around that, so hopefully it’s going to happen.

Operator

We’ll move next to Michael Genovese with MKM Partners.

Michael Genovese - MKM Partners

I’m really impressed with telecom growth, but if we can focus on datacom for a second, kind of flat sequentially. How does that compare with your expectations? What can you tell us about end market demand on the datacom side and also specifically market share there? I think it’s pretty clear that the telecom market share is going in your direction. But what do you think about datacom market share?

Jerry Rawls

The datacom results were pretty much as we expected, and I think pretty much as we predicted. And the fact that they increased only slightly in the quarter to me is an aberration. They’re up some quarters, they’re flat some quarters. They’re down. But I think overall the trend is clearly positive. And with respect to market share, I couldn’t point to any strong market share shifts in the quarter where we thought we’d gained market share in particular product area or where we particularly lost market share. So we’re sort of tracking with the industry.

Michael Genovese - MKM Partners

I realize you’re only giving guidance one quarter at a time, but on the telecom side, waiting for hopefully better spending to come through. On the enterprise side, though if you just extend the view beyond the next quarter, do you have reasons to think that enterprise spending will be better in ’13 than in ’12? Just any color there would be great.

Jerry Rawls

Well, our view is that enterprise spending on data center equipment and more high speed connections between all of the equipment in data centers is going to increase steadily for a very long time. Because those trends are strong, they’re well-established, and the need for speed in data centers only gets greater. So we’re pretty optimistic that we’re going to see continued growth through 2013, 2014, 2015, in terms of the market for data center equipment and optics in data centers. We think the optical content in data centers is growing, because as the speeds get faster, all of a sudden copper becomes less of a competitor for optical links.

Operator

We’ll move next to Mark Sue from RBC Capital Markets.

Mark Sue - RBC Capital Markets

Gentlemen, the strength during the quarter on the telecom side it seems mostly that came from computer [unintelligible] XFPs and WSS, of which a lot of that seems to be coming from share gains. And I’m assuming it’s at Siena. So maybe the question is just on the sustainability of your market share gains at that particular account, and whether you’re seeing that expand throughout the other customer base. And also, if there was any price stimulation to drive the market share gains.

Eitan Gertel

First of all, we’re not going to talk about specific customers during the call, so I can’t respond to anything regarding specific customers. And I think it’s a combination of the two. There’s the share gain, and then there’s the acceleration of transformation between 300 pin to tunable XFPs. So you can account for both. But definitely not take out the share gain, and that’s why we expect that tunable XFP to continue to grow, and we’re adding our capacity. What was your second question?

Mark Sue - RBC Capital Markets

Just wondering, is it price stimulated to get some share gains? It doesn’t seem like it. It seems more you were designed, so now you’re in. And maybe just your thoughts on how you can grow your share, I guess, for the next few quarters now that you have the product portfolio.

Eitan Gertel

Specifically in tunable XFPs?

Mark Sue - RBC Capital Markets

Yes, or WSS.

Eitan Gertel

We’ll continue to execute. We have product in WSS, which like we said we’re shipping all our products in Flexgrid. We see a large acceptance from the market of it. We are already qualified on the number of new systems and new customers. So we are excited about that. And from the growth of the market, and on our unique product portfolio. And on XFP, it’s continued execution. We have a very large number of customers qualified. There’s more customers being qualified, and as we ramp faster, we can ship more products. So that should continue well into next quarter and beyond.

Jerry Rawls

It should be pointed out that in our tunable XFP product line one of our challenges is just to increase the capacity fast enough to just meet the demand. So we are somewhat limited by our capacity, and we’re investing in expanding that capacity.

Operator

Bill Choi from Janney Capital Markets has your next question.

Bill Choi - Janney Capital Markets

Looking at guidance, you’re looking at somewhere around flat to being up sequentially. Wondering if you could provide some color on that by end market, telecom versus datacom. And then in the datacom quarter itself, clearly most of these products are pulled off of the hub. Can you talk about linearity and perhaps some more color about CFP, which it sounded like it was up sequentially. But where’s that lead time now, and is that continuing to grow when we look out into next quarter?

Jerry Rawls

First of all, we would expect next quarter we will have growth in revenues in both datacom and telecom. So we’re encouraged by that, and by all the indications so far. CFP, for us, continues to be a success story. Our lead times actually have come down some as we have expanded production capacity in Malaysia for that product. Formerly, we were producing all of it in the U.S., and we just frankly ran out of room. So have transferred a lot of the production to Malaysia and we are trying to bring up additional capacity.

Bill Choi - Janney Capital Markets

How did that do in the quarter? It sounded like it was up, but would you expect that to continue to grow next quarter with lead time coming down?

Jerry Rawls

Yeah, I would expect it will grow next quarter.

Bill Choi - Janney Capital Markets

When you look at your top 10 customer percent, it looks like on an absolute dollar leverage those guys are coming down sequentially. You had a nice expansion of other customers increasing their orders, but can we get any sense for what might be happening on the top 10 customers? I think on an absolute dollar basis it’s been coming down for the past two or three quarters.

Jerry Rawls

I thought it was interesting this quarter that, again, we had two 10% customers, as opposed to most quarters where we seem to have one 10% customer. So we’ve got obviously some customers that are growing, and some of our big customers that are growing in revenues. And overall, I would say that we’ve got a lot of growth in the tier 2 or tier 1 customers. We felt pretty good about our customer mix. For us it’s pretty positive.

Operator

Troy Jensen from Piper Jaffray, your line is open. Please go ahead.

Troy Jensen - Piper Jaffray

Kurt, first of all could you give us the number for the Red Sea contribution in the quarter?

Kurt Adzema

We’re not going to break out specific numbers for that. But I think what we said is it was around a million the prior quarter. We expected it to add an additional $3 million, and I would tell you it was in the ballpark with expectations.

Troy Jensen - Piper Jaffray

A couple of your competitors last month talked about VMI implementations with a couple of customers, and it’s nothing that I heard you guys talk about in your call. Did that in fact kind of happen to you this quarter? Or are you just not exposed to the same customers implementing VMI?

Jerry Rawls

We have VMI relationships with many of our customers. I wouldn’t tell you that we had any expansion of our VMI customer base during the quarter. For some of our competitors, who have limited exposure to some of these big customers, I think the fact that they put some inventory in a VMI hub was probably a positive for them.

Troy Jensen - Piper Jaffray

Last one for Eitan. You talked about a lot of new products. So we’ve got the tunable XFP+ 100G coherent transponders and the 100G CFP and CFP2. Can you just give us a sense of timing? You may be shipping now for new customer trials and stuff, but when do you think they start to hit the income statement?

Eitan Gertel

It depends on the product. There’s a lot of products that we talked about. Some of them are already shipping in small quantities, and are ramping. But I would say within the next six to nine months you will see all those products contributing to our revenue. Obviously to varying degrees. Some of them are already there, and some of them are coming in.

Operator

We’ll move next to Patrick Newton from Stifel Nicolaus.

Patrick Newton - Stifel Nicolaus

Dovetailing off of the new product question that you just answered, given the significant level of investment associated with the development of these new products, should we anticipate some healthy operating leverage as revenue grows from these investments?

Kurt Adzema

I think our goal is always to try to keep operating expenses relatively flat, and grow revenues, so that we can get some operating leverage. But there’s always good news bad news about some of these design wins we get. When we get the design wins, it’s license to spend more money, so I would expect as we continue to get design wins for R&D to increase. But obviously we hope to get some leverage in our model.

Patrick Newton - Stifel Nicolaus

And I guess Eitan, you did cite WSS and tunable XFP strength in the quarter driving the sequential uptick in revenue. You quantified WSS growth as being at a greater rate than telecom on a sequential basis. And could you provide a similar data point for tunable XFPs? You alluded to share gains in both product lines, so is it fair to assume that tunable XFPs grew more than 25% quarter-over-quarter given your competitors results? And then on WSS, I’m curious if the increase was driven by more Asian or North American customers.

Eitan Gertel

Basically both products grew faster than an average rate. And I think it’s fair to say that tunable XFP grew faster than 25%. And the new customers are in North America, but also internationally for the tunable XFP.

Patrick Newton - Stifel Nicolaus

But you’re not willing to comment on Asia?

Eitan Gertel

Some of them in Asia, yes.

Patrick Newton - Stifel Nicolaus

And then Jerry, you do sound relatively bullish. You guys were talking about tunable XFPs in essence needing to add capacity. You were talking about sequential growth expectation in both datacom and telecom. So can you help us understand, if we look at the range of revenue from $230 million to $245 million, Kurt, what’s baked in at the low end of guidance, and what are the expectations on the high end of guidance, specifically from a macro perspective?

Kurt Adzema

Well, there’s obviously a lot of macroeconomic concern today, and all I can really comment is on this next quarter. I think in general, we’re assuming there’s going to be no big macroeconomic shocks as the result of the fiscal cliff or anything else. And based on what we see in terms of orders and what customers are telling us, we think we can grow modestly, both the datacom and telecom side.

Operator

Kent Schofield from Goldman Sachs is up next.

Kent Schofield – Goldman Sachs

Can you talk a little bit about what you think the inventory situation is on the datacom side? From your perspective, as well as your customers.

Jerry Rawls

We think inventory is well under control, at least for our products. I can’t tell you how finished goods are for any of the guys that are equipment makers. But remember that in the datacom world, our products are held in VMI hubs, just in time hubs, for each one of our big datacom customers. And they pull the product on the day they need it. So it is instant order, instant shipment, instant gratification, instant invoice. So there is no customer inventory to speak of with respect to optics.

Kent Schofield – Goldman Sachs

And then as we think about 40 G to 100 G, can you talk a little bit about your ability to sell in the 40 G versus 100 G? And where this question is coming from is that from talking to some industry folks it seems like you could start to see some slowing down of the 40 G side of things as 100 G starts to take over. So just want to understand what that impact would have for you guys.

Eitan Gertel

I think you’re talking [unintelligible] into telecom, I think that’s where the 40 G [unintelligible]. In datacom, we see actually growth in 40 G. And on the telecom side, we do have product in 40 G, and we expect the biggest growth in the 100 G. As we said on the call, on the script, we said we are actually seeing great reaction to our coherent 100 G product. But we see that as a great opportunity for us, for growth. But as I think we’ve said in a number of calls, we have no plans at this point to develop a 40 G coherent. And the 40 G products we have on the line side are like a [TPSK] type product or client side. So the majority of the growth is expected to be on the 100 G.

Operator

We’ll move on to Ehud Gelblum from Morgan Stanley.

Ehud Gelblum – Morgan Stanley

Jerry, the guidance. You said both telecom and datacom are going to grow next quarter. Can you give us a sense of which grows faster? We know that there are going to be some price declines for one month on the telecom side that you’re not going to see on the datacom side. So should we be looking for more growth in datacom than in telecom?

Jerry Rawls

I don’t know that we’re likely to see more in datacom. And the reason is because we think that the wavelength selective switch and the tunable XFP are still going to be two of our more rapidly growing products. And despite the fact that we had one quarter of price declines in there, I would expect that growth in datacom and telecom might well be on par.

Ehud Gelblum – Morgan Stanley

Even though the CFP is growing as well? Is it not growing as much as the WSS and the tunable XFPs?

Jerry Rawls

No, I think right now the hottest thing in the product portfolio is tunable XFPs and WSSs.

Ehud Gelblum – Morgan Stanley

When do you think CFP rejoins the hottest category, because you talked a lot about it in CFP2?

Jerry Rawls

Well, CFP2 is a product that is not yet in production. It will become a very hot product, but it’s still going to be second half of next year before we’ve got production volumes of CFP2.

Ehud Gelblum – Morgan Stanley

And do you think CFP ahead of that slows down? Or doesn’t grow as much, as people are waiting for CFP2, because of the power improvement?

Jerry Rawls

I think that’s possible. Often there is a delay when customers see the next generation of product about to emerge, and so I think it’s possible that that could be the case. But demand for 100 G continues to be pretty strong. And it doesn’t seem like it’s waning. One of the things that we’ve been surprised, it’s not only 100 G Ethernet, but Eitan was talking about our 100 G coherent. We’ve seen demand in the whole world of 100 G has been stronger than we expected.

Ehud Gelblum – Morgan Stanley

It sounds like you’re saying that telecom is going to grow faster than datacom. And I’m just wondering if that’s because it just happened last quarter, so you’re kind of extrapolating, or if there’s a fact pattern to be looked at going forward that would support that.

Jerry Rawls

I don’t think that’s what I said. I said overall, I thought both markets would grow roughly the same. But we do have two strong products in the telecom side that are offsetting some of the price reductions. And I just think our growth in the datacom and telecom are likely to be comparable.

Ehud Gelblum – Morgan Stanley

Last quarter I think you said both telecom and datacom would grow as well. The big point was that telecom would start growing again, but that datacom would grow. But it didn’t grow this quarter.

Jerry Rawls

It was almost flat. It was up a little, but almost flat.

Ehud Gelblum – Morgan Stanley

But I think you thought it would be growing more than just almost flat three months ago.

Jerry Rawls

Hard for us to predict. The problem that we have is that because everything in the datacom world is just in time hubs, you can reach the last few weeks of your quarter and all of a sudden if some of your customers are... They don’t pull the product, you don’t really have any control. And we don’t have any backlog, so you don’t have visibility in a traditional sense. So I would say one of the things that, because of this just in time hub relationship we have with all those customers, it makes the actual timing of shipments a little bit unpredictable sometimes.

Ehud Gelblum – Morgan Stanley

Is there one particular area in datacom that didn’t grow the way you thought it might grow, and it may have just been timing?

Jerry Rawls

I don’t have any particular area that I would point out.

Ehud Gelblum – Morgan Stanley

On the 10% customers, of those two, was one of those two the same as the one from last quarter?

Jerry Rawls

Yes.

Ehud Gelblum – Morgan Stanley

Is it fair to say that one was telecom and one was datacom? Or one’s a mix?

Jerry Rawls

The other one was predominantly a telecom equipment company.

Ehud Gelblum – Morgan Stanley

And then what is your assessment on the price declines? You’re assuming one month, but what are you assuming for that? How should we be looking at that? 10%?

Kurt Adzema

Our normal range is 10-15%, and we’re still finalizing stuff, but we expect the price erosion to be at the higher end of the range for this year.

Ehud Gelblum – Morgan Stanley

What did last year turn out to be?

Kurt Adzema

It turned out to be at the higher end of the range.

Ehud Gelblum – Morgan Stanley

So you expect it to be similar to last year?

Kurt Adzema

Yes.

Ehud Gelblum – Morgan Stanley

Utilization rates. One thing that’s always kind of intrigued me is that your gross margins a couple of years ago were obviously in the 35% range, and then fell to 32%, and now they’re in the 30-31%. Is that because of the utilization? Your revenue numbers are back to where they were. Is your utilization low in your Malaysian factory? Why are the gross margins where they are? What does utilization look like?

Kurt Adzema

I would say that for [unintelligible] products, our utilization is still lower than it was in the peak. Obviously you look at some of the WSS numbers we had during the peak, they were very big numbers. We’re not back at those levels. But I think more importantly, what you have to remember is since that peak it’s been roughly two years, and during that two years, there’s been, at the higher end of ASP erosion during that time period. So just because you have the same nominal dollar amount of revenue does not mean you’re going to get back to the same gross margin levels. You need to have revenue growth in order to maintain gross margin.

Jerry Rawls

But you can also remember, back when our margins were 35%, our revenues were $263 million in that Q3 of fiscal ’11. [unintelligible] hit $263.

Ehud Gelblum – Morgan Stanley

But you were $208 million in July of 2010. And you did 35% margin.

Kurt Adzema

Since 2010 that’s three years ago. If you take the ASP erosion during that time period, and compound it basically, we would have to sell double the number of units during that time period.

Ehud Gelblum – Morgan Stanley

Okay. And so your utilization rates are high, but they are just lower price points.

Kurt Adzema

Again, I think utilization rate depends on the product you’re talking about. Some of them, they’re very high, as Jerry said. We’re trying to add capacity for tunable XFP. Other places, we’re still not back to our peak capacity. For instance, with WSS. But again, if you’ve got three years of price erosion baked in, and you’re at very similar nominal dollar revenue levels, you’re not going to be at the same gross margin, because you’ve got to make up for that erosion. You’re selling a lot more units, so you’ve got a lot more material COGS, and you’ve got a lot more direct labor involved.

Operator

James Kisner from Jefferies & Company, your line is open.

James Kisner – Jefferies & Co.

My first question is just on your gross margin guidance. It looks like you’re guiding up 20 basis points sequentially, yet you’re expecting pricing to be worse than usual. And I assume it’s mostly mixed, but can you give us some texture on why you think gross margins are going to go up sequentially?

Kurt Adzema

I think part of it is mix. And again, at this point it’s only the one month of the price erosion. So obviously, depending on if we’re at the higher end of the range or at the lower end of the range, gross margin will vary based on volume. But I think part of it is mix that’s helping offset that, and obviously we’re doing whatever we can to control costs at the same time.

James Kisner – Jefferies & Co.

Your sequential growth, you said in the release that [tunable XFPs and WSS] were up sequentially. I know you don’t want to break out very often here, but just the tunable XFP number, your competitors are all breaking it down. I’m wondering if I could cajole you into hearing that. And just wanted to confirm, would you say that the sequential growth, if you stripped out those two product categories, the rest of the business is flat. Like those categories by themselves drive all the sequential growth?

Kurt Adzema

Again, if you look at the growth in telecom, and we said that approximately $3 million of that growth is Red Sea. And you assume the vast majority of the remaining growth in telecom was tunable XFP and WSS, I think that gives you a lot of data.

James Kisner – Jefferies & Co.

And then on the linecard, I just want to clarify. So linecards helped drive WSS sequentially and I’m wondering is that primarily with your current customers? You’ve been talking about a specific project for linecard and ROADM that you thought was an opportunity for you. Was that what drove it? Was it your existing customers, or a new project that primarily drove the linecard improvement sequentially?

Eitan Gertel

We have started the ship with a new project, but they’re not significant to the linecard revenue at this point, but they’re ramping. So that’s going to plan, within a few weeks. The significant portion of linecard came from existing customers.

Operator

We’ll move next to Paul Silverstein with Credit Suisse.

Andrew Delia – Credit Suisse

Hi, this is Andrew Delia calling for Paul. Just to pick up on that last question, about the linecard, referenced in the press release, because it said including ROADM linecards. Because that was with existing customers. So for the new linecards, are you still expecting a slow ramp? How do you see that for the second half of this year. Last quarter you mentioned it would be a slow ramp. Just wondering if there’s been any change in that.

Eitan Gertel

No change. It’s proceeding as we expected. It’s not only from existing customers. We said the new customers have started to ship, but in smaller quantities. And that’s the way the qualification is happening, and then you start shipping [pilots and mounts] and then you’re ramping your capacity. So we’re still thinking it’s going to ramp. As we expected before, we don’t break down exactly what piece of our product. But it’s still per our expectations. It will continue to grow.

Andrew Delia – Credit Suisse

And last quarter you had mentioned about some of the orders that came in at the end of the quarter, that helped build some backlog, but was too late to ship or be counted for last quarter. I was just wondering, of those orders that came in late in the quarter, how much that helped for this quarter, and what type of order strength you’re seeing going forward.

Eitan Gertel

I don’t remember us actually mentioning that. And we seem to be guiding, again, flat to up for the following quarter. I think on the average the booking looks like any other quarter. But I honestly don’t remember us saying something about the last portion of the orders last time.

Kurt Adzema

There’s always orders that come in at the end of the quarter that we can’t ship, just given lead time. I don’t think it was any different this quarter than prior quarters.

Andrew Delia – Credit Suisse

And on margins last quarter, you had mentioned that the telecom margins, due to the depressed volumes, that it was atypically lower than the sort of datacom with the growth this quarter. Did that revert back to higher margins for telecom and datacom?

Kurt Adzema

No, on the gross margin [unintelligible], because again, we’re still nowhere near the telecom revenue level that we were at during the peak. There’s still underutilization on the telecom side, and so at the gross margin level I would say on average datacom are still higher than telecom.

Andrew Delia – Credit Suisse

Regionally, last quarter in terms of some of the weakness you had mentioned Europe. Of course some of these trends are continuing, but in terms of regions that are looking weaker versus stronger, I was wondering if you could provide any context.

Jerry Rawls

It’s hard for us to distinguish region to region. And the reason is that most of the datacom equipment companies are U.S. based. Telecom equipment companies are broadly based: U.S., Europe, Japan, Asia. And almost all of them do business with contract manufacturers, many of which are all located in Asia. So we may ship to Asia, to a contract manufacturer for a European equipment company, and actually where they ship the product may be invisible to us. Because it may go to South America or it may go to the Middle East. But we typically would not know that. So I will just tell you, from the customer base where we think our products were shipped to and from, we saw, across the board, I would say pretty stable from most of the geographic areas. And maybe the North America was a little stronger.

Operator

Kevin Dennean from Citi, your line is open.

Kevin Dennean - Citi

Kurt, question for you. You had mentioned that the cost of getting some new wins is that it frees up money for R&D to support those design wins…

Kurt Adzema

No, I think what I said was that when you get the design wins, you actually have to go spend R&D money to ultimately get those revenues. And so a lot of what drives the increase of an R&D over time is design wins. We’ve got to hire people, we’ve got to spend more money on project materials, etc.

Jerry Rawls

That’s particularly the case in linecard projects, where you normally go and you compete for the opportunity to design a linecard for a customer. In a transceiver or a transponder project, you often have to front-end load it with R&D, so that you develop the product, you build the qualifiable prototypes, and then you submit them to customers for them to approve them and put you on the AVL, or design them into a system. So we have different R&D characteristics depending on the product area.

Kevin Dennean - Citi

Thanks for the clarification. So the question is if we look forward, R&D right now is running 15.5% of revenues, pre-elevated level. What’s the gameplan for bringing R&D down as a percentage of revenue. Because it seems like we’re kind of stuck in this low-growth environment. But putting together both parts of what you just said, you have to sometimes front-load the investment. Sometimes you have to invest as you get the design wins. What’s the gameplan? What’s the roadmap for bringing R&D down as a percentage of revenue to help bring operating margins higher?

Kurt Adzema

Well, again, I think it all comes down to revenue growth. Our hope is to keep R&D flat to modestly growing, and obviously to have revenue grow faster than that. We saw that this quarter, given that opex was flat, despite the full quarter of Red Sea, and we had some nice revenue growth. So if we can continue that trend, I’d expect to bring it down. And our goal is to get R&D down to 12-13%. But it’s going to take time, and it’s going to take some revenue growth.

Kevin Dennean - Citi

And then on the gross margin front, could you help us understand, if we kept mix constant, what sort of incremental revenues would we need to see 100 basis points or 200 basis points gross margin expansion from here?

Kurt Adzema

Well, there’s more than just product mix that influences that, right? So obviously you’ve got the ASP erosion, and you’ve also got whatever savings that we can get from our suppliers, or whatever savings we can get in terms of moving stuff from high-cost locations to low-cost locations. So there’s a lot of variables that factor into that. And then there’s always time. To come up with a revenue number to hit a certain gross margin is really tough. And so we’re giving one quarter gross margin guidance, and our hope is that we’ll see improvements in Q3.

Kevin Dennean - Citi

I would imagine that the ASP declines, you kind of have those locked in through your negotiation process. I would imagine that you have some sort of a roadmap and understanding with your supplier base about cost savings from your suppliers. But can you give us any sense for what sort of incremental margins we can see from here?

Kurt Adzema

Again, it’s all going to come down to revenue growth, and I think that’s the number-one driver. So I think since we aren’t providing revenue growth guidance beyond this quarter, I really can’t comment on that.

Operator

Your last question will come from Alex Henderson from Needham & Company.

Alex Henderson – Needham and Company

Just wanted to come back one more time on the tunable XFP and 300 pin market. So I know your business was up in tunable XFPs sharply. You made that clear. But we also know that you own a pretty good chunk of business in 300 pin. Now, I guess the question is did the combination of 300 pin, which is being cannibalized, and tunable XFP actually increase solidly? I think the answer is probably yes, but I wanted to make sure that I was explicit about the question.

Eitan Gertel

Yes, you are correct. The answer is yes. But I do expect that next year, in 2013, calendar, to see the acceleration of the cannibalization of 300 pin by tunable XFP.

Alex Henderson – Needham and Company

Just to be clear, you’re one of maybe five players that are in the tunable XFP market. There’s probably, what, 20 some-odd players in 300 pin. So is it reasonable to think your share will be higher in tunable XFPs than in 300 pin in ’13, so the cannibalization to your business would be still less than the impact of the overall growth of tunable XFPs? In other words, if I put the two together in ’13, would it be reasonable to think the tunable XFP will offset any cannibalization to your existing 300 pin?

Eitan Gertel

That’s our plan of execution, and that’s what you see us investing in capacity, and we’re doing all the things to get to exactly what you said. But since we are guiding only to one quarter, it’s tough to talk beyond that point.

Alex Henderson – Needham and Company

No, it was just a conceptual issue. This same kind of line of logic, that if I were to put the WSS modules versus the WSS linecards, as the linecards ramp, will the linecards start to become a larger portion of the unit volume? And obviously they’ll become a larger portion of the revenue, because they’re starting from such a small base. I think the revenue delta on those is pretty substantial. It’s like two and a half times for a linecard versus a module, is that right?

Eitan Gertel

Yeah, the assumption is that the ASP, in general - it’s tough to generalize, because no two linecards are resembling each other, so it depends what they have on them - you can say it’s about 2x of the WSS price. And the only other thing I can comment on what you said is none of the wins we had in linecard cannibalized our WSS customers. So it’s in addition to our WSS component customers.

Alex Henderson – Needham and Company

So it’s reasonable to think that the WSS would ramp independently as the linecard grows, then?

Eitan Gertel

That’s part of our assumption, yeah.

Operator

And that does conclude our question and answer session. I’d like to turn the conference back over to Mr. Rawls for any concluding remarks.

Jerry Rawls

Thank you, operator, and thanks to everyone. We appreciate you tuning into our second quarter conference call. And we hope you’ll be able to join us again three months from now. Have a good day.

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