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Ciena Corporation (NYSE:CIEN)

F1Q09 Earnings Call

March 5, 2009 8:30 am ET

Executives

Suzanne DuLong - Chief Communications Officer

Gary Smith - CEO and President

Jim Moylan – CFO

Steve Alexander - Chief Technology Officer

Analysts

Ehud Geldblum – JP Morgan

Mark Sue – RBC Capital Markets

Paul Silverstein – Credit Suisse

Tal Liani – Bank of America-Merrill Lynch

Nikos Theodosopoulos – UBS

George Notter – Jeffries

[Guy Erlin] – JMP Securities

Subu Subrahmanyan – Sanders Morris

Simon Leopold – Morgan Keegan

Operator

(Operator Instructions) Welcome to the Ciena Corporation First Quarter 2009 Results Conference Call. At this time for opening remarks and introductions, I would like to turn the call over to the Chief Communications Officer, Ms. Suzanne DuLong.

Suzanne DuLong

I am pleased to have with me Gary Smith, Ciena's CEO and President, and Jim Moylan, our CFO. In addition, Steve Alexander, our Chief Technology Officer will be with us for the Q&A portion of today’s call.

We’re using a slightly different format for our call this morning. Our prepared remarks will be presented in two segments. Gary will discuss our outlook and strategy, Jim will review the financial results for the first quarter and provide guidance for Q2 where possible. We’ll then open the call to questions from the sell side analysts. This morning’s press release is available on National Business Wire and First Call and also on Ciena's website at www.Ciena.com.

Before I turn the call over to Gary, I’ll remind you that during this call we will be making some forward looking statements. Such statements are based on current expectations, forecasts, and assumptions of the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in the context of the risk factors detailed in our 10-K filed with the SEC on December 23, 2008.

We have until March 12th to file our 10-Q for this quarter end and we expect to do so by then or before. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events or otherwise. Today’s discussion includes certain adjusted or non-GAAP measures of Ciena’s results. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today’s earnings release available on our website.

Lastly, as a reminder, this call is being recorded and will be available for replay from the Investor portion of Ciena.com.

Gary Smith

I’ll talk first about Q1 results and the actions we’ve announced today. I’ll then talk about the environment, what we’re seeing and hearing from customers before discussing how we’re running the business.

Our first quarter results reflect not only the near term challenges of today’s environment but also the benefits of the actions we’ve taken to align with current market realities. While revenue came in below the low end of our guidance range at $167.4 million we managed operating expense down sequentially 12% from the fiscal fourth quarter.

Our tight OpEx control made it possible for us to deliver adjusted or non-GAAP operating margin and EPS that was slightly better then Q4, despite the lower revenue and gross margin. We continue to take actions to reduce our operating costs.

Yesterday we took steps to affect the headcount reduction of some 200 employees or 9% of our global workforce with reductions occurring across every organization and geography. As part of this action we will close our Acton, Massachusetts research and development facility during the course of the next four months. Including Acton we currently operate development facilities in seven separate locations.

Closing a site is never an easy decision given the impact to people’s lives and the surrounding community. Because our R&D organization is comprised of highly integrated cross functional development sites we’re able to consolidate any ongoing work in Acton with related efforts already in progress at other Ciena locations.

In the light of the environment and our customers resulting uncertainty we’ve also been looking closely at our engineering plan of record during the last several months. We’re prioritizing and aligning our planned deliverables with market and customer opportunities. As a result, we do not envision any impact on near term customer deliverables due to this site closure.

We expect that during the next few quarters these headcounts and facilities related cost reductions combined with the cost reduction initiatives we implemented during our fiscal first quarter will reduce our adjusted non-GAAP quarterly operating expense to approximately $80 million.

Let me spend a few minutes now discussing the environment and what we’re seeing and hearing from our customers. While it now seems that this downturn will last longer then we originally anticipated we still believe we’re talking about recovery in terms of quarters and not years. At this point it’s clear that the slowing is pervasive, touching all product lines, geographies and customer types. Yet while we continue to see order push outs and delays we are still not seeing order cancellations.

Perhaps more importantly we maintain solid relationships with our customers who are telling us that we are closely aligned with their strategic focus and their business priorities. We continue to work closely with key customers as we prioritize our product related investment to ensure we’re aligned with their network plans.

That said, the environment is obviously volatile and our customers continue to delay and more carefully scrutinize capital expenditures. As a result, as short term visibility is extremely limited and we do not feel that we’re in a position to provide specific revenue guidance for the second quarter. I know this is a departure from past practice. We’ve always worked to be as transparent as possible with the financial community and we intend to continue to do so. In this environment the potential range of revenue outcomes has widened to the point where we believe it is not constructive to talk to it.

What we can talk to with confidence is exactly how we’re running the business and what our assumptions are. As I mentioned previously we expect that the headcount and facilities related cost reductions announced today we will reduce our adjusted non-GAAP quarterly operating expense to approximately $80 million.

With our revised operating expense level we’ve sized the business to roughly break even as adjusted net income and cash flow if we achieve revenue and gross margin at approximately fiscal first quarter levels. There’s no question that we’re working to find the balance between preserving and enhancing our strategic capabilities longer term while preserving our balance sheet now. It’s not an easy balance and it’s a very different balance then the one we struck during the last downturn.

Because we remain confident in the fundamental demand drivers of our target markets we’re looking forward with the goal of emerging from this challenging period positioned to drive future revenue and EPS growth. Let’s talk about why we’ve chosen to size the business as we have and take this approach.

Firstly, underlying traffic demand continues to grow, while traffic growth may have slowed it has not stopped and traffic demand remains the fundamental CapEx driver in our business. The transition to converge more cost efficient Ethernet based networks is clearly a driver as well but there’s arguably more flexibility in the timing of transitioning existing networks then there is in dealing with today’s capacity demands.

A note on CapEx, after averaging roughly 14% since 2004 the CapEx to revenue ratio for our top 10 service providers fell to 12.5% in 2008 and could be less then 12% in 2009. If that happens, it would represent an historically low CapEx to revenue ratio which we do not believe is sustainable given the dynamics around expected traffic growth.

The second factor we considered in sizing the business was specific customer input. We appreciate that our customers are uncertain about the effects of the macro environment on their business and that their plans are subject to change. While we don’t know exactly when or how much they will spend, after much discussion with them we believe we have a sense of their priorities for the coming year. Beyond their 2009 goals we also feel strongly that we understand where their networks are headed and we believe that our product cycles will align well with that direction.

Thirdly, we’ve taken a hard look at where we believe our development spend needs to be in order to meet customer deliverables and we are prioritizing that spend to ensure we remain on track and aligned with changing market opportunities. In the short term we’re focused on significant ongoing development efforts including bringing to market our data optimized switching solutions which can also be described as the evolution of our CoreDirector family.

We’re focused on filling out converged Optical Service Delivery portfolio including 100g technologies and capabilities and also expanding our Ethernet service delivery portfolio. Finally, extending the value of software and unified network and service management across our portfolio.

Our final consideration was working under the assumption that we’re able to sustain overall gross margin at least in the mid 40s. Despite the current uncertainty we are seeing the opportunity to expand footprint both in new geographies and as a result of specific competitive situations. We factored that into our gross margin assumption. All of these things contributed to our decision to size the business as we have.

Again, we’re working to find the balance between preserving and enhancing our strategic capabilities longer term while preserving our balance sheet now. If we get indications that our current assumptions are incorrect then we are prepared to pursue additional alternatives to reduce costs.

Despite the short term challenges we’re facing I believe Ciena is in many ways in an enviable position. We’ve proven our ability to successfully execute our network specialty strategy globally and we’ve proven it’s a strategy that resonates with customers. In addition to establishing a recognized position as a market leader we’ve got a broad customer base and portfolio with incumbency at many of the world’s largest service providers.

We are capitalizing and in a position to capitalize on opportunities to expand our footprint and take share. We are also bringing several significant new products to market in the next six to 12 months. We have an agile operating model with substantial operational flexibility. Finally, we have a very strong balance sheet. The combination of these elements gives us the confidence that we can strike the balance required to navigate today’s difficult environment and to emerge stronger when things improve.

Jim, with that will you please talk to the details of Q1.

Jim Moylan

We reported first quarter revenue of $167.4 million, this represents a decrease of 7% sequentially and 26% year over year. We had three 10% plus customers in the quarter that combined to represent 41% of total sales. Two of the 10% customers are North American based and one is international. All three were 10% customers in Q4 as well. Sales from international customer represented 41% of total revenue in the quarter down from 47% in Q4.

We break out our revenue by three major product groups. The first Optical Service Delivery which includes our transport and switching products as well as legacy data networking products and related software accounted for $130 million in revenue representing 77% of total revenue for the quarter. This is down slightly in real dollars from Q4 when it was $137 million in revenue but roughly flat as a percentage.

Within Optical Service Delivery core switching was the largest contributor in the quarter increasing 19% sequentially to $45 million. At $50 million revenue from our CN 4200 advanced services platform was down from its Q4 high of $59 million but still well above prior quarters revenue levels. Long haul transport added $26 million down slightly from $28 million in Q4.

Our second product group Carrier Ethernet Service Delivery includes service delivery and aggregation switched acquired from World Wide Packets as well as Ethernet access products, broadband access products and the related software. For Q1 carrier Ethernet service delivery contributed $10 million or 6% of total revenue. Finally, our Ciena specialist’s services group which includes all of our services related offerings was $28 million in revenue or 17% of total revenue in the quarter.

In the remainder of my comments today I’ll speak both to the GAAP results and to what the results would have been if we excluded those items which we detail in our press release. Turning to gross margin, Q1 GAAP gross margin was 43%. Adjusted for share based compensation and amortization of intangibles Q1 gross margin was 44%. This is close to the bottom of our mid to high 40s guidance.

Let me speak to that a little more particularly. Q1 gross margin includes a higher then average charge related to excess and obsolete inventory the largest part of which is related to a write off of inventory related to our DSL access products in our CNX family. Had the charge for excess and obsolete inventory been at a more normal level our gross margin would have been two percentage points higher. As usual the biggest variable in gross margin in this quarter was product and customer mix.

Our GAAP product gross margin for the quarter was 45%. Our services gross margin was 31% significantly better then our target mid 20s range as a result of the mix of services revenue in the quarter.

On a GAAP basis Q1 operating expenses were down 12% sequentially from Q4 at $99 million. As a result of aggressive expense management our as adjusted operating expenses totaled $84 million which is also down 12% sequentially from Q4. Our as adjusted operating margin in Q1 improved slightly to -6% versus -7% in Q4.

Our Q1 GAAP net loss was $25 million or a loss of $0.27 per share. Adjusted for unusual and/or non-operating items discussed previously our first quarter net loss is $8 million or $0.09 per share.

Turning now to cash flow and the balance sheet, I am very pleased with our cash management in the quarter. Despite the loss we used less then $1 million in cash from operations. Our balance sheet remains strong with $1.1 billion in cash, short term and long term investments at the end of the first quarter.

For Q1 our accounts receivable balance was $130 million down slightly from Q4 $138 million. Day sales outstanding were 70, about flat with Q4. Given revenue uncertainties we continue to closely manage our inventory position. Inventories totaled $91 million at the end of Q1 down slightly from $93 million in Q4. Product inventory turns were 3.3 times in the quarter up from 3.2 times in Q4. The inventory breakdown for the quarter was as follows: raw materials $23 million, work in progress $1 million, finished goods $92 million, a reserve for excess and obsolescence $25 million.

Before I close a quick update on taxes and our $1.2 billion deferred tax asset. As we’ve discussed in previous quarters we have accumulated substantial tax deductions from our operations and acquisitions which can be used to offset future tax payments. We continue to regularly evaluate this asset but due to our GAAP loss for the quarter we did not release any portion of the valuation allowance in Q1 and so in effect this $1.2 billion asset remains off of our balance sheet.

Finally, as of January 31, 2009, our worldwide headcount was 2,238. This is up slightly from Q4 2,203. As Gary noted we expect that total will come down in Q2 as a result of the headcount reductions we detailed today. We expect that the majority of the cost savings resulting from the headcount reductions and facilities closure will be in place by the end of the second fiscal quarter of this year which means we should see the full effects of the benefits by our third fiscal quarter. We expect to record total restructuring charges of $5 to $8 million associated with these actions during the next couple of quarters.

Let me conclude our prepared remarks today by reiterating what Gary has said about how we are going to run the business. As we said, we are not in a position to provide revenue guidance for Q2. We have taken actions that we expect will enable us to reduce our adjusted operating expenses roughly to $80 million per quarter run rate over the next couple of quarters. This represents the combined effect of the cost reductions that we made at the end of Q4 as well as the headcount and facility related actions we announced today.

With our revised operating expense level we’ve sized the business to roughly break even as adjusted net income and cash flow if we achieve revenue and gross margin at approximately fiscal first quarter levels. We expect other income expense net in the second quarter will be roughly $2 million. With respect to taxes because we were unprofitable on a GAAP basis in Q1 we did not reverse any portion of our deferred tax asset and has been the case recently we expect our tax obligation for Q2 will be related basically to foreign taxes.

Our basic share count will be approximately 91 million total shares and if we’re in a loss position in Q2 diluted share count will equal basic share count. If we’re in a profit position in Q2 we estimated diluted share count at approximately 112 million total shares.

Operator we’ll now take questions from the sell side analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ehud Geldblum – JP Morgan

Ehud Geldblum – JP Morgan

You were down to $84 million in OpEx reduction now, the Acton facility and the extra 200 people would bring you only incrementally down $4 million. Why wouldn’t it bring you down more then just the $4 million to $80 million in OpEx on the quarterly run rate and what actions did you do during the quarter to bring you down the 12% that you did to the $84 million you did this quarter?

Jim Moylan

There are always puts and takes in a quarter if you look at our underlying run rate in Q1 its slightly higher then the $84 million so we’re sort of starting from a little bit higher run rate and that’s why the 200 people gets us down to an $80 million run rate.

With respect the actions that we have taken, recall at the conference call for Q4 we announced we took about 3% or 4% or 5% of our headcount in a trimming exercise to get us down to a little bit lower level. That’s the basic thing that’s happened. We also had a little bit lower expense with respect to outside services, with respect to discretionary spending and lower travel. We’ve managed all of our spending that is discretionary in a very tight way and that’s how we’ve gotten to $84 million in the quarter.

Ehud Geldblum – JP Morgan

Could there be other trimming that could get you below $80 million or to get appreciably below $80 million like $75 million that would require another plant closing if you had to?

Jim Moylan

We did say that there are other things that we can do. I don’t want to get into specifics but if we feel that we have to take the costs down father then there are things we can do. I want to go back to our philosophy here. We’re trying to strike the balance between being break even and maintaining the strength of our balance sheet and yet holding our strategic investments in product features and functionality at a level where we’d like them to be. That’s why we’ve struck this $80 million number. If we find that we need to take it lower then we’ll do what we have to do.

Ehud Geldblum – JP Morgan

The strategy to this point seems to have been keeping your cash burn positive or break even. It sounds as though the OpEx reduction came because you hit the break even point a quarter or two ago and you’re trying to keep that stable. Your lack of guidance for the next quarter you mentioned that the possible range of values that next quarter could come out would make it unconstructive or talk about it right now. If it does come lower I would presume then in that case you would be burning cash next quarter. How many quarters of that would you go through before you took the next action on the OpEx side?

Gary Smith

We’re not going to react just to one particular quarter’s data. Clearly what we’ve seen since we went through Q3, Q4 is a deteriorating macro environment and we’re clearly responding to that. It’s a confluence of indicators. If it meant that we were losing money in a quarter then we wouldn’t necessarily respond to that with more operating expense cuts we’d look at it on the balance of inputs including what’s the order flow, what’s going on with our customers, what’s going on in the macro, etc.

The objective as you point out is really for us to manage the business clearly even in this environment with the intent of not losing money.

Ehud Geldblum – JP Morgan

You mentioned traffic growth slowed. That’s the first time I’ve heard of that if you can expand on that. As you look at the project fee you’re working on right now are any of them late right now or your not being assessed fees for any late projects as you play around with the R&D and the projects that you’re working on specifically CoreDirector 2 and things like that.

Gary Smith

The traffic growth, we’re not really seeing it and the dialogue we’re having with our customers we’re not really picking up much of that and we’re clearly questioning them intensely. There is a view that some of the enterprise growth, what’s going on in the macro is clearly going to have some kind of an impact on traffic growth. It is fair to say that we’re not seeing any of that really being related back to us from a customer point of view yet. Most industry analysts believe it’s got to have some kind of impact given unemployment rates etc.

On the alignment around development we’re always looking, making sure that we’ve got that timed with market realities and opportunities particularly in this kind of environment. Our key developments remain on track and we think that even in this environment it’s very important that we push forward with the strategic roll out of things like the evolution of the CoreDirector family etc.

Operator

Your next question comes from Mark Sue – RBC Capital Markets

Mark Sue – RBC Capital Markets

What’s your best sense of where we are in terms of network utilization and capacity requirements? If you can parse your response between business critical traffic and regular traffic.

Gary Smith

I really wish I had a crisp answer to that. As you go around and talk to the large carriers they all have different ways of measuring utilization. I would say that overall my impression is that they are running the networks hotter then they have done typically. Some carriers, probably more hotter then others given the last downturn it’s very different from that when they had a bunch of capacity out there. Now they don’t and they’re living more hand them out. I think we’ll get a better view of that as we get through the next couple of quarters.

Mark Sue – RBC Capital Markets

With that being said, do you think that $140 million is a base number in terms of product revenues do you think it will kind of bounce around that for the foreseeable future.

Gary Smith

I caveat my answer to that with I don’t know being the honest answer to it. I still feel in dialogue with our customers and the overall market that I feel pretty positive around the overall dynamics in the industry and our position in it.

Mark Sue – RBC Capital Markets

On gross margin should we model 46% going forward at a minimum considering the write offs will decline?

Jim Moylan

That puts us in a position of giving guidance there. What we’re saying is we’re assuming that we built our OpEx at a point where with an assumed revenue an operating level would break even. That’s as much as I can tell you.

Operator

Your next question comes from Paul Silverstein – Credit Suisse

Paul Silverstein – Credit Suisse

From a geographic perspective any incremental insight in terms of the visibility or lack thereof between the US and non-US markets?

Gary Smith

The main markets that we play in are Europe and North America. Frankly we’re not seeing much difference. The European markets have been as badly affected as the North American markets. I would add a side bar to it if you will in that we are specifically seeing opportunities in some of the European carriers that we’ve been working on for a while seem to be opening up a little in this environment. We do see that as an opportunity to expand our geographic footprint.

Paul Silverstein – Credit Suisse

Are there any concrete data point relative to Nortel and what’s going on over there in terms of you seeing specific opportunities?

Gary Smith

I would be unfair for me to comment directly on a competitor. We are seeing opportunities present themselves generally around concerns of continuity of supply, etc. There’s nothing I could concretely point to as a piece of revenue or a piece of business. I would more describe it as engagements with customers.

Paul Silverstein – Credit Suisse

We all understand the challenging environment you and everybody else are operating in. When you talk about your belief that it’s still going to be measured in quarters rather then in years in terms of the recovery, what is the basis for that? Is that concrete data points or is that just more optimism.

Gary Smith

You can also say that quarters equal years as well. The real bedrock to that is around the dialogue with our customers and looking at the traffic growth and the dynamics around that. Back to the question that Mark was asking around utilization of the networks. The utilization rate is pretty high and traffic continues to grow on that. You look at things like the CapEx to revenue ratio and I mentioned that in our comments coming down below 12% that’s at a pretty low rate historically so you join all of those dots together and that really forms the basis for our thesis around that.

Operator

Your next question comes from Tal Liani – Bank of America-Merrill Lynch

Tal Liani – Bank of America-Merrill Lynch

You said that second quarter guidance that you would be break even if sales and gross margin level will remain flat. Do you mean the gross margin including or excluding the $6.5 million?

Jim Moylan

We are expressly not giving guidance for Q2. What we’ve given you is what we can control which is our OpEx. We’re going to manage our OpEx for now to an $80 million per quarter level. What we said was that assuming that revenue in the second quarter and gross margin is approximately where they were in the first quarter that results in about a break even. When we think about that we’re really thinking more like the margin without the extra excess and obsolescence charge.

Let me clarify, we haven’t taken away, when we’ve done that two percentage points we don’t take away the entire excess and obsolete charge we just took away that which represents an unusually high amount so its an incremental piece which happened in the second quarter that we’ve taken away to get to two points. Clearly we’re going to manage the business over the long term to better then break even but at least as we’re sitting here today given our OpEx level and assuming Q2 being roughly like Q1 then we’re going to be at about break even.

Tal Liani – Bank of America-Merrill Lynch

In your last answer Gary you highlighted utilization rates and bandwidth as drivers for growth. If I look at your big customers big projects last year if you look at Bridge Telecom, AT&T and Verizon none of them was actually related to traffic growth it was more related to transformation of networks and deployment of new types of technologies. Do you think that we’re going to see decisions about this kind of transformation of projects already in 2009?

Second, its about goodwill write downs, some of your competitors have taken goodwill write down and are taking the opportunity to do it in this kind of environment. My question is more about World Wide Packet; do you expect it to deliver the same level of top line growth as you did before? What should we expect from this acquisition and the original AT&T win.

Gary Smith

The point that you make is an interesting one around capacity versus transformation and what a carrier is thinking around that. If you look at some of the examples that you gave certainly there’s a large element of transformation around the spend from them but there’s also some element of pure capacity requirements with people like AT&T and Verizon and BT as well given the fact that we’ve already built out some of their newer networks.

This balance, I will say to you that overall the dialogue that we’re having at the executive level with a number of the carriers around their strategic direction and what they’re planning to prioritize is very aligned around the transformation projects. To be candid, I don’t think that’s being particularly represented in what’s going on in the CapEx cuts to date.

Overall I think they’re just trying to preserve capital spending and watch it very carefully. It’s been more indiscriminate across the board right now of just holding on projects be it capacity or be it the transformation. I would expect that as the challenging macro environment continues a re-visitation of that around really prioritizing some of these more strategic projects but that’s just a personal view.

Regarding the World Wide Packets clearly, I think this is an example of that I would say the adoption of some of the Ethernet business services has been slower then we would have anticipated and some of that is clearly, its difficult to say how much of that is macro, how much of that is just slower then we thought.

In fact, I think we still feel very confident around that sector and the take up of that, it’s a very nascent market. It is taking longer then we would have anticipated notwithstanding the macro. We’re very comfortable around the value proposition that we’re bringing to market. We’ve got some additions to that being rolled out during the quarter, the year as well.

Specifically relating to AT&T I think that project continues to be committed on their part for obvious reasons. It is taking longer then we both anticipated to roll out.

Jim Moylan

With respect to goodwill we do have a fair amount of goodwill on our balance sheet as a result of the number of acquisitions that we made. We report as one segment so therefore any goodwill write off that we may take would be in total not looking at any individual acquisition that we’ve made. We took a hard look at the question of goodwill impairment at the end of Q4. We took another hard look at it at the end of Q1. We believe in both cases that goodwill write down was not called for given the rules.

The rules ask us to look at a number of things including the sustained level of our stock price compared to our book value, rate of orders in the business, our outlook for the business. There are a number of things that we look at. I would say that as we move through this year and if it gets worse or if it doesn’t start to get better I think its possible we could be looking at a goodwill impairment. We will make that judgment on a quarter by quarter basis as we move through this year.

Operator

Your next question comes from Nikos Theodosopoulos – UBS

Nikos Theodosopoulos – UBS

What are the actually R&D activities that were done in Acton?

Steve Alexander

Acton came to us through the Wave Smith acquisition and they were responsible for some of the first data product integrations for the rest of the portfolio. The D&A that came into the company through that shows up on some of the services at CoreDirector offers, some of the cards in the 4200 now, some of the activities around On Center. It was spread across different portions of the portfolio.

Nikos Theodosopoulos – UBS

Can you give an update on the timing under the new plan here on CoreDirector 2 when that would be made available to the market?

Steve Alexander

We haven’t put any go to market plans public yet around what you’re calling CoreDirector 2. CoreDirector has continued to evolve over the last several years. It started out as a layer one switch its now in networks today provisioning layer to Ethernet services and such. We’re adding additional functionality to it to integrate it in with things like the 4200 family and such. Clearly there is an objective to the scale of the product to be a much more capable family of service providing and service delivery switches. Over time you can expect additional features functionality as well as additional scale out of the product.

Nikos Theodosopoulos – UBS

On the number, services gross margin over 30% is that something that was an anomaly do we have a new range going forward, what do we think about that.

Jim Moylan

Without giving guidance about what we expect I would just say that we have really put a lot of effort into improving our services top line and margin. We’ve seen very good progress on both sides. I believe we feel very, very good about what we’re doing in services and we’re pleased with the 31% in the quarter and we’ll see what happens going forward. It was due to a nice mix and we’re hopeful that we can keep that mix going.

Nikos Theodosopoulos – UBS

On the inventory write down the extra two points maybe you can explain to me some rationale behind that because if I look at your balance sheet you typically have about $25 million give or take every quarter on reserve provisions for inventory obsolescence in excess. I’m curious why would you have to take a higher number this quarter given that you’ve got almost 25% of your inventory reserves every quarter going into the quarter.

Jim Moylan

If you look back over the past three years the amount that we’ve taken in terms of a reserve for excess and obsolescence has averaged about 1.8% of revenue. In this most recent quarter it was about 3.9% that’s how we get the two gross margin points is what resulted this quarter. As to why it occurred we do a very thorough job every quarter of looking at our inventory balances by product and even within each product by component. We have a forecast for demand. We then have a process by which we estimate the amount that we reserve or in some cases we write off.

I can just that what has happened is that forecasts are changing and we’re taking a careful look each quarter and we’re making decisions with respect to portfolio and all that factors into forecasts versus inventory levels and that’s how we took the charge.

Nikos Theodosopoulos – UBS

On the inventory, are there any other, what I would call small products, in terms of quarterly revenue like you mentioned this quarter it was on the broadband access side? If I look at products like in storage, your traditional data networking products are there any other categories where maybe you don’t have much reserve that you think there could be potentially additional above normal inventory reserves in the next couple of quarters?

Jim Moylan

None that we know of. We try to put this reserve on a constant basis, keep it current every quarter. Forecasts will change. As we move through this period of uncertainty I can’t say that we’ll have unusually high inventory charges. We’ll just have to wait and see what happens.

Operator

Your next question comes from George Notter – Jeffries

George Notter – Jeffries

In the monologue you talked about the variable outcomes for revenue in Q2. I understand you didn’t give guidance but could you talk a little bit about what the factors are that could potentially contribute to a wide range of outcomes on revenues for Q2?

Gary Smith

Outside of obvious ones, water flow and things like that its revenue recognition being a factor, its all of those things, the ability for supply chain to operate effectively, customers taking delivery and not delaying those kinds of things. It’s really a confluence of elements that create a range. There’s always in any quarter a range in puts and takes even when things are moving in an upward direction. We just feel that given the environment it’s a wider range then normal that we’re going into Q2 with.

George Notter – Jeffries

How do you look at capital budgeting as it relates to that outcomes for revenues in Q2? Are you assuming that operators will pass budgets internally, they’ll be more capital dollars around, are you assuming budgets get delayed in terms of passing internally any thoughts there.

Gary Smith

We we’re seeing is a very cautious approach on behalf of the carriers. They’ve typically on an annual basis they’ve approved their budgets but I would also say that whilst they’re approved they’re looking at it on a monthly basis and they’re scrutinizing all of that CapEx. Just like every other business right now they’re scrutinizing all of their capital expenditures.

We don’t take too much comfort frankly from the fact that they’ve approved their annual budgets because they’re managing it truly quarterly. We’re seeing things like say a project would be an order for $10 million, we’re getting an order for $5 million and it’s smaller across the board. We’re seeing things like that. Yet they’ve got the budget for the $10 million but they’re not spending it all.

George Notter – Jeffries

In the October quarter you guys bought a couple million dollars in debt back you’re well below par. I haven’t looked in a little while but its trading below $0.50 from $1.00 in some cases. I was trying to understand what your appetite is for any potential buy backs of that debt off the balance sheet.

Jim Moylan

As you noted, we did buy a very small amount. We’ve been monitoring the market. We’re in a situation of high uncertainty. We like our cash balance and we’re going to use great judgment and discretion as we move forward through time. That’s about all I can say on the topic.

Operator

Your next question comes from [Guy Erlin] – JMP Securities

[Guy Erlin] – JMP Securities

I was wondering if you have seen any changes in the competitive environment if you feel like there’s been any change in share or change in aggressiveness in pricing or if it’s more of a fallen hand across the board.

Gary Smith

Overall it’s been a challenging environment and has been for a while before the macro stuff across the board. I haven’t seen particularly any changes. As we go into new geographies and we break into new accounts and displace competitors that tends to be a little more challenging from a pricing point of view. That’s nothing different then we’ve seen in the last few years.

Jim Moylan

I think it is generally true as we said earlier though that we are seeing a few more opportunities to gain footprint in this environment then we have seen. That does tend to affect margins.

[Guy Erlin] – JMP Securities

I think of carrier investments as alternating between the core and ent and I was wondering if you have seen any shift in that investment pattern or if carriers are just holding everything back together.

Steve Alexander

Your model historically has been correct. You would tend to think of people building out core capacity first then maybe the metro or metro first and then core. What we have seen and they do try to strike a balance in how they do their investments. What we have seen them move to is as some of these new technologies become available in particular Ethernet. Ethernet is a technology that is applicable on the enterprise side and the metro side as well can be used in the core side. It also give the ability to scale capacity very quickly.

In the past where they may have been putting lets say a SONET or SDH infrastructure in place they’ll now go for an Ethernet infrastructure with the understanding that that’s going to start to give them scale up into the multiple gigabits arguably now coming to 100 gigabit. I think they’re looking at a little bit more holistically in how they look at building out their entire infrastructure.

Operator

Your next question comes from Subu Subrahmanyan – Sanders Morris

Subu Subrahmanyan – Sanders Morris

Could you talk a little bit about whether your product portfolio between core, transport and switching on the Ethernet side where you think carriers can first spend more, you mentioned a scenario where it’s a transition technology where they can put it out more versus where they have capacity requirements that they need to fill more on a near term basis.

My second question was on the product introductions you talked about the priorities for this year. Any more detail, I know you answered on the CoreDirectors side but on the transport and Ethernet side if you could give us any more details.

Steve Alexander

The first question around the switching and the core transport and such, what you see is obviously its going to vary carrier to carrier they also have some regional flavors to it. The folks who have done large scale builds, some of these we talked about earlier, and it wasn’t driven entirely on the transformation or driven entirely around a capacity expansion.

What they basically did is put a network architecture in place that started them down a transition path towards a more packet centric or Ethernet centric world but also gave them the ability to scale very quickly. They really got two solutions that way. They have to strike a balance in how they invest in terms of adding capacity versus making an architectural transition.

When you look at what we’re doing with the portfolio, the basic strategic themes continue. We’re going to continue to do data optimized switching solutions; we’re adding additional features on to the CoreDirector family. CoreDirector is converging together with the 4200 into an extended family. We’ve done the demonstrations of the 100 gig transport portions of it. You would expect that as we look at bigger switches having those switches built for 100 gig world with maybe a gig as the occurrence would be a sensible thing for us to pursue.

Moving Ethernet service delivery out to the edge and particularly simplifying how it gets delivered I think is pretty key to us then that gives you the opportunity to unify it all together with a common softer infrastructure that’s really where the portfolio is headed.

Subu Subrahmanyan – Sanders Morris

Do you see on the metro Ethernet transformation a capability of carriers to push it out a little bit more because they have reducing their port they’re able to do a less efficient job but still able to carry the traffic and more requirements in the core side because there’s just traffic that they need to support.

Steve Alexander

Specifically to the metro side of it I think you’re going to find they’re going to take a tool box approach. There’s going to be some people that will pack what’s an existing legacy sonnet full of Ethernet and we’ll give them the tools to do that. You’re also going to have people who will do it as an overbuild and realize they eventually want to get to an Ethernet infrastructure as well as treating Ethernet as a service. We can help them do that also. The trick for us to have those tools in the toolbox so that we can address a variety of problems that are out there.

Operator

Your last question comes from Simon Leopold – Morgan Keegan

Simon Leopold – Morgan Keegan

I want to clarify the operating expense trend here because you mentioned it would take perhaps months to fully close down the Acton facility. I just want to make sure should we be thinking about the April quarter as reaching your $80 million target or trending towards it.

Jim Moylan

You will see it trending toward it and by our third quarter we should be roughly at the $80 million.

Simon Leopold – Morgan Keegan

In terms of the poor visibility, point understood, just wondering how big a factor it is that historically your largest customer, AT&T is in strike preparation mode with a union contract expiring in April. Trying to get a sense of what’s been going on there in terms of preparation the potential for a strike factors into your forecast.

Gary Smith

It’s difficult for me to comment a particular customer like that. The general consensus is very hard to predict what’s going to happen. There’s always the potential this time of year with a number of these large carriers with the union negotiations. There’s always potential for a distraction.

Simon Leopold – Morgan Keegan

I’m not asking you to predict whether there is or isn’t a strike. I’m really trying to get at is the preparation activity serving as a distraction right now that’s led to some slower business.

Gary Smith

We’re not particularly seeing that any more than normal. I don’t think so; I think they’re balance around it.

Simon Leopold – Morgan Keegan

In terms of linearity it sounded like the last quarter really wound down and January was pretty awful. If you could confirm that and then talk about how things have been trending just over the last five weeks.

Gary Smith

Typically the first quarter is not a good one for us given the timing from a CapEx, you’re at the end of the fiscal year for a bunch of carriers and they don’t want to deploy stuff at that time. When you’ve only got January and they’re just starting back up again then you’ve got all of the various holidays. There is some seasonality to that and it’s difficult to separate that out from the overall macro stuff that we’re seeing quite frankly. We’re seeing that environment continue.

Simon Leopold – Morgan Keegan

How would the most recent five weeks coming up to today compare to the month of January?

Gary Smith

On balance, similar.

Operator

That does conclude our question and answer session. Mr. Smith I’ll turn it back to you for any additional or closing comments.

Gary Smith

I’d like to thank everybody for their time this morning and for your continued support and look forward to talking to you soon. Thank you.

Operator

That does conclude today’s conference. Thank you for your participation. You may disconnect at this time.

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Source: Ciena Corporation F1Q09 (Qtr End 01/31/09) Earnings Call Transcript
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