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Ciena Corporation (NYSE:CIEN)

Q2 2009 Earnings Call

June 4, 2009 8:30 am ET

Executives

Gary Smith – President & CEO

Jim Moylan – CFO

Suzanne DuLong - CCO

Analysts

Mark Sue - RBC Capital Markets

Ehud Gelblum - JP Morgan

Alex Henderson – [Miller Tabak & Co.]

Todd Koffman - Raymond James

Simon Leopold - Morgan Keegan

Paul Silverstein - Credit Suisse

Nikos Theodosopoulos - UBS

John Marchetti - Cowen and Company

Jeff Kvaal - Barclays Capital

Samuel Wilson - JMP Securities

Tal Liani – Banc of America

Blair King - Avondale Partners

Operator

Good day everyone and welcome to the Ciena Corporation second 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

Good morning and welcome everyone. 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.

This morning’s prepared remarks will be presented in two segments. Gary will review our Q2 performance and discuss our outlook, Jim will review the financial results for the second quarter and provide some limited guidance for Q3. 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-Q filed with the SEC on March 5, 2009.

We have until June 11 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 at www.ciena.com.

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

Gary Smith

Thanks Suzanne and good morning everyone. Firstly I’ll talk to our Q2 performance as well as the overall environment before turning the call over to Jim to discuss the details of our Q2 results.

Any way you look at it Q2 was a tough quarter. In addition to the ongoing challenges of the macroeconomic environment, and continued cautious spending by customers, we experienced delays in revenue recognition in the quarter.

These delays combined with the effects of the initial pricing strategies associated with two new optical transport wins, negatively impacted the quarter’s revenue and gross margin. Let me spend a few minutes talking about the second quarter’s key metrics and how we are approaching the third quarter.

Firstly revenue was down in the quarter but for no one single reason. We continued to see customer project and deployment delays and push-outs but have not seen any project cancellations. Given our concentration amongst a relatively small number of large Tier 1 service provider customers, even under the best of circumstances our quarter-to-quarter revenue can be lumpy.

Unfortunately a difficult macroeconomic environment and cautious spending by customers only exacerbates that challenge. The good news is despite some ongoing customer specific challenges we did see increased order flow in the quarter and in general activity levels are up.

Turning to gross margin, at 43% non-GAAP Q2’s gross margin was disappointing. However we believe it improves in Q3 for the following reasons. We mentioned last quarter that we were seeing opportunities to claim footprint and that capitalizing on those opportunities might lead to short-term gross margin pressure.

That was the case in Q2. During the quarter we successfully captured footprint securing future optical transport revenue potential with two non-US Tier 1 service providers, one of which is in an entirely new region for Ciena. Q2’s gross margin was adversely effected by charges of $5.8 million related to lost contracts associated with the initial phases of deployments for these customers.

While we opted to pursue a pricing strategy that enabled us to secure strategic footprint with these two customers we do not envision an ongoing pattern of customer lost contracts in our business. In fact exclusive of these two lost contracts, our Q2 gross margin would have been within our mid to high 40’s target range.

And I think its fair to say we’re not seeing a notable increase in pricing pressure outside of the usual rough and tumble of the long haul transport business. And based on our current product mix expectations we expect that we’ll be able to return to the mid to high 40’s range in Q3.

Turning lastly to operating expenses, at $87 million our non-GAAP operating expenses were up slightly from Q1’s normalized roughly $8.6 million. Q2’s operating expenses reflected the already implemented portion of the headcount reductions we announced in early March offset by higher then expected R&D expenses.

The good news is our core switching and 100G developments are going well. However as a result prototype costs are running higher then anticipated with some early deployments. We are on track to close our Acton, Massachusetts facility on plan as of June 30 and expect cost savings associated with the facility closure and final associated headcount reductions in the last month of our fiscal Q3.

We continue to work towards our goal of balance, carefully managing our balance sheet while prioritizing the investments we believe are critical to our future. We’ll continue to monitor in the environment and our customers’ needs in assessing our operating expense levels going forward.

Before I ask Jim to review the details of the quarter as I did last quarter, let me spend a few minutes discussing the environment and what we’re seeing and hearing from customers. Without glossing over the difficulties in the quarter there were some indicators that lead us to be slightly more optimistic about the second half of the year.

As I mentioned previously order flow improved in the quarter. And while we continue to see push-outs and delays we’re not seeing cancellations. We’re also encouraged that recent public commentary indicates a sense that things are not getting worse for our customers. According to [carrier] CapEx estimates we believe our top service provider customers spent at historically low CapEx to revenue ratios in 2008.

While its unclear exactly how much CapEx will be spent in 2009 based on what we’ve heard thus far this year its unlikely to be greater then 2008. There is no question that underlying traffic demand continues to grow and traffic demand remains the fundamental CapEx driver for our customers.

So given the combination of traffic growth and new service demands on networks it seems unrealistic to believe current spending levels are in fact sustainable. These are encouraging data points and lead us to believe that our customers’ spending patterns will improve over time. However we don’t feel as though we have enough information to make a broader conclusion about spending expectations or patterns beyond Q3.

To that end as you’d expect the current environment has caused us to take a hard look at where we believe our development spend needs to be in order to meet customer deliverables. We’ve worked hard to prioritize our spend so that we remain on track and aligned with evolving market opportunities and customer market plans.

Right now we remain focused on four 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; filling out our converged optical service delivery portfolio including 100G technologies and capabilities; expanding our Ethernet service delivery portfolio and extending the value of software in unified network and service management across our portfolio.

Recently there’s been some speculation about the status over the next generation of CoreDirector, our family of intelligent optical core switches. Its no secret that we’ve focused a lot of resources on this development effort and while we’re not ready to launch anything today I’d like to spend a few minutes to help you understand where we’re headed.

Near-term we’re focused on a feature release, 7.0, that adds OTN capability to allow fundamentally more types of network traffic to be more easily managed. There is significant development however beyond this upcoming feature release. Our CoreDirector platforms currently lead the market in mesh network deployments and continue to support critical application requirements of our customer base.

To maintain that lead and offer customers a broader solution set we are expanding significantly the family, creating a richer more multidimensional solution. I think its important to note we are not working on a product replacement. We’re working on extensions of the current CoreDirector family.

To that end we’ve been working closely with current CoreDirector customers throughout the development process. As you’d expect they are the initial target customers for the extended family and functionality. We expect the new platforms to be in customers’ hands by fall of this year. And we expect to formally launch the extended family and functionality later this year.

I don’t mean to suggest by highlighting our core switching efforts that that is the only or even the most important development work ongoing. We feel strongly that we’re on the cusp of several important product cycles including the expansion of our carrier Ethernet service delivery portfolio and the addition of meaningful feature and functionality enhancements to our CN 4200 family.

Our recently announced 100G win at The New York Stock Exchange is a great example of the work we’ve been doing on CN 4200. In summary, our goal remains finding the balance between preserving and enhancing our strategic capabilities longer-term while preserving our balance sheet now, and as we’ve said before, 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 continue to believe Ciena is in fact in an enviable position. We’ve proven our ability to successfully execute our network specialist 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’re capitalizing on opportunities to expand our footprint and take share. And we continue to bring new products to market having already made significant investments over the past few years, we are in a strong position we believe for future cycles.

And we have substantial operational flexibility including a very strong balance sheet. The combination of these elements give us the confidence that we can strike the balance required to navigate today’s difficult environment and to emerge stronger as things improve.

With that I’ll hand it over to Jim who will talk through the details of our Q2 results.

Jim Moylan

Thanks Gary, good morning everyone. We reported second quarter revenue of $144.2 million. We had one 10% plus customer in the quarter who represented 28% of total sales. This customer is North American based and was also a greater then 10% customer in Q1.

Sales from international customers represented 36% of total revenue in the quarter, down from 41% in Q1. As you know we break out revenue by three major product groups. The first, optical service delivery which includes transport and switching products, as well as legacy data networking products and related software accounted for $105 million in revenue representing 73% of total revenue for the quarter.

Within optical service delivery, core switching was the largest contributor in the quarter at $43 million, down slightly from $45 million in Q1 but above Q4’s $38 million. Our CN 4200 advanced services platform contributed $32 million in the quarter. Long haul transport added $23 million.

Our second product group, carrier Ethernet service delivery includes service delivery in aggregation switches as well as Ethernet access products, broadband access products, and related software. For Q2 carrier Ethernet service delivery contributed $13 million, or 9% of total revenue.

Finally our Ciena specialist services group which includes all of our services related offerings was $25 million in revenue or 18% 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 detailed in our press release.

With respect to gross margin our GAAP gross margin in Q2 was 42%. Adjusted for share based compensation and amortization of intangibles, Q2’s gross margin was 43%. As Gary noted, Q2’s gross margin was adversely effected by $5.8 million in charges related to lost contracts. These charges were associated with wins at two non-US Tier 1 service providers.

Exclusive of these charges, our gross margin would have been in the mid to high 40’s range. Our GAAP product gross margin for the quarter was 45% consistent with Q1 despite the effect of the lost contracts which was reported through product gross margin.

Our services gross margin was 29%, once again better then our target mid 20’s range as a result of the mix of services revenue in the quarter. On a GAAP basis Q2’s operating expenses reflect the $456 million noncash impairment of goodwill, we’ve talked about that previously, as well as $6 million in amortization of intangibles and $6 million in restructuring related costs.

Excluding those items our adjusted operating expenses totaled $87 million. This is up from Q1 primarily as a result of higher R&D related costs. As Gary noted, this was largely the result of higher then anticipated prototype costs associated with our 100Gig and CoreDirector development efforts.

Our Q2 GAAP net loss was $503.2 million or a loss of $5.53 per share. Adjusted for the unusual and/or non operating items discussed previously, our second quarter net loss would have been $22.5 million which is a loss of $0.25 per share.

Turning now to cash flow and the balance sheet, notwithstanding the challenges we faced in the quarter we are pleased with cash management. Despite the loss we generated $2.9 million in cash from operations. So our balance sheet remains strong with $1.1 billion in cash, short-term and long-term investments at the end of the second quarter.

For Q2 our accounts receivable balance was $117 million, down from Q1’s $130 million. Days sales outstanding were 73, up slightly from Q1’s 70 days. Given the ongoing revenue uncertainties and lack of visibility we pay a lot of attention to our inventory position and manage it very closely. Inventories totaled $91 million in Q2 which was flat with Q1.

Product inventory turns were 2.9x in the quarter, down from 3.3x in Q1. The inventory breakdown for the quarter was as follows; raw materials $21 million, work in progress $1 million, finished goods $92 million, plus a reserve for excess and obsolescence of $22 million.

On headcount as of April 30 our worldwide headcount was 2,104. This is down 134 from Q1 reflecting a portion of the headcount reductions we announced in early March as well as normal attrition, offset by some strategic hiring.

Finally, an update on the restructuring costs in Q2 and those we expect in Q3. We recorded severance and other employee related costs of approximately $3.5 million in Q2. We expect to incur an additional $0.50 million of employee related restructuring charges in our fiscal third quarter.

In addition we expect to take facility restructuring charges in a range of $2 million to $4 million during Q3 associated with the closure of our Acton, Massachusetts facility. Let me conclude our prepared remarks today by talking to guidance for Q3.

Before doing so however, I would like to caution that although we are providing some limited guidance for the upcoming quarter our visibility remains extremely limited. Based on direct conversation with customers and supported by trends we are seeing currently in the business including improved order flow, we expect to deliver sequential revenue growth in our fiscal third quarter.

We also believe based on current expectations about product mix that gross margin will be in our mid to high 40’s target range. We continue to work toward our goal of balance, carefully managing our balance sheet while prioritizing the investments we believe are critical to our future. The higher then expected prototype costs that effected Q2’s operating expenses are also likely to effect Q3’s operating expenses.

As a result, we believe our Q3 non-GAAP operating expenses will be in the low $80 million range. We expect other income expense net in the third quarter will net to roughly zero. As for taxes, as we discussed for the last couple of quarters, because we are unprofitable on a GAAP basis in Q2, we did not reverse any portion of our deferred tax asset.

And as has been the case recently, we expect our tax obligation for Q3 will be mostly related to non-US taxes. Depending upon your assumptions, you may need either our diluted share count or our basic share count. We estimate Q3’s diluted share count at approximately 112 million total shares. We estimate Q3’s basic share count at approximately 91 million total shares.

We will now take questions from the sell side analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Mark Sue - RBC Capital Markets

Mark Sue - RBC Capital Markets

Direct conversations with customers, does that mean there’s a verbal agreement on purchase orders, does it mean you been [designed] into new networks or does it mean its as good as a done deal, if you could just give us some more granular thoughts there.

Gary Smith

Its probably a combination of them all, we’ve actually seen the physical, I guess the most important thing is the physical order flow which we’re seeing increased activity on. So I guess that would fall into your done deal category. I would also say that in engagements with the customers across the board I think the sentiment has been somewhat improved.

I would say that goes back to the sort of March type timeframe which I think coincides with the general macro environment as well. So I think it’s a combination of all of those.

Mark Sue - RBC Capital Markets

And the sequential revenue guidance, that’s based on the order growth and not just the put recognition of the push-outs, is that how we should look at it.

Gary Smith

Yes, correct otherwise we wouldn’t be as confident about that. So its orders and the other things that we’re seeing as well. We’re seeing increased activity up across the board and that’s somewhat encouraging. I think its too early to tell around connecting, we’ve haven’t got enough data points yet to connect that to draw a broader conclusion, so that’s why we’re taking it one quarter at a time right now.

Mark Sue - RBC Capital Markets

And you must have various scenarios of when you might be able to kind of break even from an operating income point of view, any thoughts on when that might be. Is it two quarters, three quarters, or kind of like a base case scenario.

Jim Moylan

It all depends upon what our revenue does and where our margins go. So its hard for me to answer that question. I think the strongest statement that we can make is we think that our OpEx are going to be low, mid 80’s and if we get sort of the revenue and margin that would get to that level, then we’ll be there.

I want to go back to this point that we’re really striving to run the company, balancing, maintaining the strength of our balance sheet, but also making sure that we invest in the strategic parties of the business. So that’s how I’d answer that.

Operator

Your next question comes from the line of Ehud Gelblum - JP Morgan

Ehud Gelblum - JP Morgan

A couple of questions, first of all, the cash both in terms of the guidance and what you did now, you’d said last quarter that your cash break-even levels were around $170 million revenue with gross margin in the mid to high 40’s, and this quarter maybe you’re there but your guidance is up sequentially from this number, doesn’t necessarily mean we get to $170. How should we be looking at what your cash burn looks like next quarter. It would imply that you don’t get to cash burn break-even. This quarter you brought in about $60 million from the balance sheet, mainly in accounts receivable and accounts payable, is that replicatable or do those reverse as your revenue goes up and I’m just trying to understand how if we’re not at $170 in revenue, how do we, with the balance sheet having provided so much cash, how should we look at the cash burn analysis for next quarter.

Jim Moylan

Just to get to the bottom line we’re not going to have a significant, at least we don’t expect a significant cash burn for the quarter. If you just look at all of the indicators that we’ve given you, but it does depend on the working capital as you rightly point out. As we grow in revenue you would expect receivables to grow. On inventory its not as clear because we have, we do carry a certain amount of offsite inventory related to customer acceptances and the timing of revenue rec.

So we can have movements in the inventory position that would tend to take it down even though revenue is growing so its not as clear as it is on the receivables side. There’s also this function of the fact that our receivables balance at the end of any given quarter is a function of what, customer mix and what happens during the quarter, a backend loaded quarter or a frontend loaded quarter. So there’s a lot of moving parts.

I can’t be as prescriptive as maybe you’d like but I think I can say that we don’t expect a significant cash burn in the third quarter all in.

Ehud Gelblum - JP Morgan

The 4200 fell pretty hard, went to $32 million, it was in the mid $50, $56 million in the prior quarter, that seemed to be one of the major factors. Was that due to one or two customers or was that more across the board and how do you correlate that with what you’re seeing across the carriers. Is there something that’s going on in the metro side or is there share loss do you think that happened in the 4200 or is there something that maybe core [end] transport fell off a year ago and now metro’s is falling off. How should we look at that.

Gary Smith

I’d start off to say we had two really good quarters, Q4 and even Q1 with 4200. Its still lumpy, we’re still getting adoption at the early stages of some large carriers. I wouldn’t draw too many conclusions around our product lines from the Q2 performance quite frankly. We’re not seeing anything specific to metro or long haul. We’re actually seeing good traction with the platform. We’ve had some decent sized wins.

You saw the one in Austria with KELAG. You’ve seen some of the other announcements with The New York Stock Exchange etc., so we’re continuing to get broader customer traction with it, and frankly I would expect it to be a growth platform going forward. We’re also adding a lot of new features and functionality with it as well.

Ehud Gelblum - JP Morgan

But no one [inaudible] necessarily ahead of those new features.

Gary Smith

No I don’t think there’s anything specific that comes to mind with any large customers.

Ehud Gelblum - JP Morgan

And then finally the two new wins, were they competitive wins against an incumbent.

Gary Smith

Yes, they were both competitive wins against actually a couple of incumbents.

Ehud Gelblum - JP Morgan

And you won them, did you win them on price or did you win them on features that you had to match their price, just curious as to why the price point has—

Gary Smith

Surprising we did not win them on price, that’s not normally how we position the company. We had to be aggressive on the initial profile for it so it was more a very considered pricing strategy. We do it from time to time. We haven’t done it for a while. We had I think this environment is throwing up these kinds of opportunities and we made sure that we thought that through but we think its two very good strategic wins for us and I think they will be profitable going forward as well.

That’s that other thing that I would say.

Operator

Your next question comes from the line of Alex Henderson – [Miller Tabak & Co.]

Alex Henderson – [Miller Tabak & Co.]

Got a couple of questions for you, the first piece of it though I’d like to go back and talk about the prototype costs a little bit and how that progresses over time. Clearly you get hit in the quarter that just reported and then you said again in the third quarter, presumably if those parts are going into the CoreDirector products that are going out to customers in the fourth quarter that that would fall off pretty precipitously as a cost element but would that also imply a little bit lower margins on the initial CoreDirector shipments in the back half when the newer boxes start to hit. Can you give us a little sense of how that, those pieces fit together.

Gary Smith

Yes, it’s a complex picture around the prototype costs, let me sort of start at the top and work through, we’ve got a number of very large platforms coming to market over the next 18 months and some of the prototypes are quite expensive for that and they’re very difficult to predict. Some of the, particularly with CoreDirector, 100Gig and some of the other things that we’re doing on the Ethernet switching side as well.

And so it can be quite lumpy. But also, if you want to spin it in a positive light, particularly around some of the 100G, we’ve got people wanting to deploy even the early sort of prototype type versions of it and that’s causing us to accelerate some of those. But we’ve got a lot of these platforms coming out over the next 18 months.

Frankly I would expect it to be somewhat lumpy. A number of those came together in this quarter unfortunately.

Alex Henderson – [Miller Tabak & Co.]

I’m just trying to get a handle on the trajectory, does it start to fall off as the prototype costs start to fall back off and normalize R&D into the fourth quarter, first half, or does this continue to stay high because of the continuing high level of new products.

Gary Smith

I don’t think it will fall off per say, but I think normally you wouldn’t see such a high spike as we saw in Q3. Its on an ongoing basis and normally its included in our normal operating expenses so it wouldn’t show quite the spike that it showed in Q2.

Alex Henderson – [Miller Tabak & Co.]

Second question, as you talked about the new customers, two new wins, sounded like you had some initial pricing that was fairly low, but that normalize over a period of time to more reasonable price levels or is that a contract pricing level that will stay at that level through the course of the next X number of contract years.

Jim Moylan

It’s a mixed bag, generally they will both go up, but in one case clearly it will clearly go up and then the other case, what really happens is it opens up a new region with a set of customers related to this first deal which will be, we think, at significantly higher margins.

The general shape of it is margins will go up on both those deals, or follow-on deals.

Alex Henderson – [Miller Tabak & Co.]

One more question on the business model, the comment about the interest income cost lines being net to zero, is that what I heard you say.

Jim Moylan

Yes.

Alex Henderson – [Miller Tabak & Co.]

That’s a little bit of a step down, is there something other then the restructuring costs driving that down.

Jim Moylan

No, and I’m really referring to that without restructuring costs. That’s a conservative statement but we have over the past really several quarters, moved all of our cash into very conservative positions. Not that it wasn’t conservative before, but essentially we’re entirely in treasury bills of relatively short durations. So because generally interest rates have trended down and we have really conservatized our portfolio over several quarters, that’s why I think net interest expense will be roughly zero.

Gary Smith

Just to follow-up on one question on the prototype thing, you talked about, I wouldn’t extrapolate it out to sort of CoreDirector margins. In fact as we extend the CoreDirector family a lot of that is with very intensive software architecture that I would actually say would preserve if not enhance CoreDirector margins going forward.

Operator

Your next question comes from the line of Todd Koffman - Raymond James

Todd Koffman - Raymond James

As it relates to the visibility and you highlighted some improved order flow, can you give any granularity with regard to geography, US versus outside the US.

Gary Smith

I wish I could give you some sort of insightful regional aspects to that. I think its fair to say its across the board. We’ve seen it in Europe, as I said some of our recent wins in Europe, in Austria, the KELAG deal, and things like that. We’ve seen some new wins in North America as well. I think its across the board.

Operator

Your next question comes from the line of Simon Leopold - Morgan Keegan

Simon Leopold - Morgan Keegan

I wanted to get a couple of quick clarifications and then some questions, in terms of the clarification I think you mentioned that CoreDirector this quarter was up from $38 million and just looking at last quarter’s transcript, I thought it was $45 million, was there some restatement of the January quarter segments.

Jim Moylan

No, there was no restatement. I’ll just have to follow-up on that. There’s been no restatement of any of these numbers, no.

Simon Leopold - Morgan Keegan

Okay, so just if we can follow-up later on that one, because just looking at the transcript it’s a little bit different then what I thought. So that’s okay. Moving along, in terms of the wins you talked about effecting gross margin, I think that was all long haul, can you give us a little bit more color in terms of what the revenue contribution was in that particular business that hit the gross margin.

Jim Moylan

Actually in neither case was there significant revenue in the quarter, it was the function of taking orders for the contracts that resulted in the losses.

Simon Leopold - Morgan Keegan

So you’re recognizing the expenses up front.

Jim Moylan

Precisely, yes. That’s associated with the estimated loss.

Simon Leopold - Morgan Keegan

Okay great, in terms of the competitive environment, do you have any ability to quantify what you may be gaining due to Nortel’s bankruptcy and carriers perhaps showing some hesitancy of doing business with a bankrupt vendor and how that’s maybe hitting your business.

Gary Smith

Its difficult to quantify that. I mean I would say its more around, we’ve got a multitude of engagements right now. These things take time to filter through to market share and orders, orders first of all. I think we’re probably getting a little benefit from that but I wouldn’t characterize it as large frankly. Right now I think there’s a function of time over this. If this continues for a long period of time, then I think it will clearly have a more positive impact for us.

Simon Leopold - Morgan Keegan

How about the wins that you highlighted today, were they Nortel incumbent accounts that you’re winning or others.

Gary Smith

Actually both of those were not against Nortel.

Simon Leopold - Morgan Keegan

And last thing, if you could just drill down and give us a bit of an update of what’s going on with the former worldwide packets business in terms of where it is versus your expectations and how you see that particular business trending through the year in terms of applications, customer types, drivers, size.

Gary Smith

I think its fair to say to characterize it is, it’s the adoption has not been as, we were either over optimistic around that market space or the impact of the overall economic downturn has affected it adversely. Its difficult to separate the two but the net result is the same. But we are encouraged by what we are seeing. I think its fair to say that in the Tier 1 where we’ve seen good wins, its taken longer then we had anticipated to get that to actual service delivery for our customers.

But I think we should start to see an uptick in the second half for that. From an order point of view it was up sequentially in Q2. Still an [inaudible] market, but very strong interest, and we think its going to be a good growth segment for us going forward.

We launched some new platforms this quarter in that space as well. So I think with the level of engagement that we have and the broad engagements around a number of carriers we still feel very good about it.

Simon Leopold - Morgan Keegan

And what’s the better application here, enterprise Ethernet, or wireless backhaul.

Gary Smith

We’re seeing certainly Ethernet business services and wireless backhaul and we’ve got customers that are using them for both which is great, but we’re being able to get into just wireless backhaul applications and also into Ethernet business services. The Ethernet business services takes a little bit longer because of the integration into all of the OSS and service delivery systems.

And the software that we’re rolling out now helps carriers do that faster.

Simon Leopold - Morgan Keegan

The 10% customer, was it also a 10% customer in the quarter last year.

Jim Moylan

Yes. Let me come back to, your first question on quarter CoreDirector revenue this is what I meant to say and if I didn’t say it then we can talk about it later. Q2 CoreDirector revenues were $43 million. That compares to Q1 $45 million, and Q4 of 2008 $38 million.

Operator

Your next question comes from the line of Paul Silverstein - Credit Suisse

Paul Silverstein - Credit Suisse

Two questions if I might, first off on those long haul wins and I know you’ve had several questions on this but can you give us a sense for the scope of the revenue opportunity.

Gary Smith

In terms of scope, early days initial deployment on one of them is tens of millions, actually both of them is sort of tens of millions and good scope up from there.

Paul Silverstein - Credit Suisse

And the tens of millions, is that, do you think that’s over the next four quarters or is that over a lengthier period.

Gary Smith

No, that’s over the next couple of quarters. That’s over the next probably three to four quarters.

Paul Silverstein - Credit Suisse

And with the opportunity for more.

Gary Smith

Yes.

Jim Moylan

In one case its in a new region for us which we think is opening up to us so its hard to size it but we hope that its going to be very meaningful.

Paul Silverstein - Credit Suisse

And having booked the expenses up front, as you realize the revenues in that deployment are the margins consistent with the rest of your long haul business.

Gary Smith

Yes.

Paul Silverstein - Credit Suisse

And could you tell us where margins are these days for long haul, is it still around 45 give or take.

Gary Smith

I don’t we’ve ever talked, separated it out, but it can be anywhere in sort of 30’s to 40’s.

Paul Silverstein - Credit Suisse

And on the centor, but can you give us some sense for what, I know it’s a very big box, five terabits, it’s a huge capacity, how big is the opportunity. How many of those can you sell over the next couple of years once it starts, once its commercially available, how big is the opportunity over the next two to three years given the capacity of the box and where carriers are at these days.

Steve Alexander

I think you’re pretty much on track in terms of the size of it. You should be thinking in numbers of 6X bigger to get started with and there’s obviously ways to make that even larger going forward, double speed back planes, those sorts of things.

In terms of the traffic demands for a box like that and keep in mind this is going to be a pretty rich extension of the existing family. Current CoreDirectors have a good set of Ethernet services on it, the extensions to it, you can imagine it will have that much more Ethernet packet capabilities. A lot of that goes to what we’re just seeing in terms of natural traffic growth. If you kind of look at what’s happened over the last let’s say four or five years, what used to be a core switch is now considered kind of a metro switch.

So that’s a factor of five or so. They typically start with what you would call kind of the top 10, 20 cities in the country and they would expand outward as traffic continues to grow. So initial deployments would be measured in the dozens and final deployments would be measured in the several 100’s and that kind of goes carrier by carrier, country by country as long as the bandwidth demand keeps going like it is.

Paul Silverstein - Credit Suisse

Should the margin profit in centor be consistent with CoreDirector 1.

Steve Alexander

Yes, because a lot of the margin is derived off of the software value. So the margins of boxes that do a lot of traffic management, switching, aggregation, protection, provisioning, service delivery, generally are substantially higher.

Paul Silverstein - Credit Suisse

Did you break out worldwide packets contribution for the quarter.

Gary Smith

No we didn’t but we included it in the Ethernet access section so you can see it.

Operator

Your next question comes from the line of Nikos Theodosopoulos - UBS

Nikos Theodosopoulos - UBS

I just have a quick question on these two long haul wins, can you kind of explain the accounting rationale of taking the loss up front before revenues were recorded. Why not just record the losses as the revenue, I’m just trying to understand how that flows. And then the second part of that, I’m a little confused when you say it opens up a new region. That almost suggests that it’s a customer that you’re dealing with and it opens up a new region with that customer but you said it’s a new customer so I’m trying to understand the terminology opens up a new region.

Jim Moylan

On the second part, I was referring to a geographic region that we have not yet been in. One of the lost contracts that we recorded was in this new geographic region with a new customer. The customer has other opportunities in that region and associated with other companies. We believe that there’s really a lot of opportunity in this new geographic area.

With respect to the lost contracts its just a function, a feature of GAAP that once you have an order in place that you’re going to deliver against, that you know that you will have a loss on, you have to book the loss even though you don’t book the associated revenue until you delivered the equipment.

So that’s just the way GAAP works. I don’t know if that answers the question but it’s a technical side to GAAP.

Nikos Theodosopoulos - UBS

Okay but then going forward when you start shipping, what’s the gross margin on when you ship. Do you have any costs, you have 100% gross margin.

Jim Moylan

Well it’s a little different for each of the two, but in one case the later orders and shipments will be at a very good margin. The delivery of the revenue under the initial amount that was recognized in the lost contract will be at a zero margin. But the net effect of some amount at zero margin, some amount at a very good margin gets us in the sort of long haul transport range.

Nikos Theodosopoulos - UBS

Okay, and then in terms of the new region, I’m still confused because I thought you pretty much shipped to every region of the world, I gather you’re not talking continents, you’re talking countries when you say a new region.

Gary Smith

Yes, I’d say it is a new geography for us. We’ve typically been focused on North America and Western Europe. And this is in a new region for us.

Operator

Your next question comes from the line of John Marchetti - Cowen and Company

John Marchetti - Cowen and Company

Quick follow-up, in terms of the kind of the way you’ve laid out the second half here, you talked about things improving a little bit, you’re winning footprint, all else being equal if things stay the way that you’re looking at them right now, should we be looking at this April quarter as potentially the sort of trough for your top line business.

Gary Smith

I would sincerely hope so. I think the caution that you’re hearing with us right now is we just haven’t got enough data points. So that’s why we’ve taken it sort of step by step. We’re seeing improved sentiment, we’re seeing improved order flow but we need some more dots to join up before we sort of make any broader claims.

But we’d certainly hope so.

John Marchetti - Cowen and Company

And then just getting back to the prototype costs just for a second here, given the way that’s going to run a little bit hotter for the next little bit, should we just look at where your OpEx is coming out and take it back to the comments you made last quarter when you first set out the $80 million and roughly a break-even level at the Q1 levels that just sort of, scaling those things up maybe a little bit marginally at a mid 80’s range or little bit below that in terms of OpEx for your break-even level now.

Jim Moylan

I guess I’d start by saying what we’re saying, what we’re saying right now is prototypes are running hotter then we thought when we last spoke to you and frankly that’s a good new story because what it means is that deployments of some of these new development projects are happening faster and in greater quantity then we thought.

So it’s a good news story and we can speak to Q3 now. We know its going to be low 80’s instead of the $80 million that we said last quarter. I think going forward from here, we’re just, given all of the lack of visibility that we have, we’re just not prepared to say anything beyond what we’ve said about Q3.

Operator

Your next question comes from the line of Jeff Kvaal - Barclays Capital

Jeff Kvaal - Barclays Capital

I do want to dial into that OpEx question a bit more, I think at one point in the call you had said low to mid 80’s, so I just wanted to make sure that low was the way you were thinking of it.

Jim Moylan

Low is what I said for Q3.

Jeff Kvaal - Barclays Capital

Okay, but wouldn’t the subsequent quarter be a little bit lower all else equal if you have three months of the facility’s closure.

Jim Moylan

Let’s see now, the facility’s closure cost will not be in the quarter and we did take out sort of 130 people in Q2. There still remains people in Acton. Those people will be leaving at the end of June so the July quarter will be effected by some costs that will be coming out sort of end of Q3.

Jeff Kvaal - Barclays Capital

Okay, so would it be reasonable then for us to assume that the subsequent quarter would be lower for OpEx or are there other things going on with higher say prototyping and—

Jim Moylan

We’re just not prepared to answer that question right now. We do, we have seen demand from customers for new generation products. Its effecting prototypes. As I say, I think that’s a good news story. I’d like to think that it will continue, I just don’t know.

Operator

Your next question comes from the line of Samuel Wilson - JMP Securities

Samuel Wilson - JMP Securities

Two small questions, one in most of the RFP activity and the increased orders, can you just give us a sense who you’re seeing in terms of competition these days for that business.

Gary Smith

It’s a little geographic dependent, and obviously and value proposition dependent too particularly as we get more into the sort of converged Ethernet. It can be anybody from Sysco, Alcatel, etc. Alcatel particularly is who we come up with probably most across the board given their broad product portfolio. As we also get a broader platform out there. Still see Nortel, particularly on the sort of metro side. They’ve got a huge incumbency.

So those are the key players we see. If its just transport, you’ll see [Walway] particularly outside of North America as well. You’ll see those folks. But we tend to focus on value propositions that its tough for them to play in because its very software intensive.

Samuel Wilson - JMP Securities

Second question is, comes more from your sales background then maybe being CEO, but you’ve now publically released that you [loss leadered] two contracts, what sort of stops your other customers from demanding the same.

Gary Smith

I think these situations are very specific. They’re in new situations for us and to new customers and markets. Its not unusual for that kind of profile to take place. We only do it from time to time in very specific situations. Its just a different kind of situation. It’s a different kind of challenge.

Samuel Wilson - JMP Securities

And then lastly stock option expense looked like it was up noticeably quarter on quarter, I just wanted to know if there was anything there.

Jim Moylan

No, nothing that I can think of.

Operator

Your next question comes from the line of Tal Liani – Banc of America

Tal Liani – Banc of America

Just a couple of questions and one clarification, first on the clarification I think you mentioned share count would be 112 million, at what net income do we start including the shares associated with your convert.

Jim Moylan

Really its just slightly above break-even, below break-even, the converts would be accretive rather then dilutive so you don’t use that share count, you don’t add back the convertible interest below break-even. Slightly above break-even and I can’t give you a precise number but its, you can sort of consider break-even as the dividing point.

Tal Liani – Banc of America

Next thing, if CapEx visibility is low, how do you know when and if carriers will start adopting your new platforms and especially curious to see what kind of discussions you have had about the timing and the magnitude of adoption of your new CoreDirector by the largest customer you have had so far for that platform.

Gary Smith

I think, as Steve said, most of the initial engagements are clearly with our existing customers and I think given the benefits that the extensions bring to them both in terms of some of the capacity stuff, but just as importantly I think the features and functionality and the convergence that that provides. That really is very much in the next generation target architecture for a lot of these Tier 1 carriers.

So they are very keen to get that tested in their labs and deployed and out and we’re at various stages of engagement with a number of Tier 1’s around that because both from a capacity point of view, an economics point of view, and new service creation its going to be impactful to their business. So we’ve seen very good engagement with them.

Tal Liani – Banc of America

And then Q3 sales in the last two years have grown about 4% to 5%, in that trend sequentially, is conceptually that’s the kind of range you’re looking at this year.

Gary Smith

I think to be honest we have some seasonal trends that are more on the order side then necessarily on the revenue, but I’d also say that in this environment I wouldn’t look to seasonal trends given the macroeconomics. I think you can, its not much of a signpost unfortunately.

Tal Liani – Banc of America

On the loss that you have to book initially, I think you mentioned about $5.8 million or so or $6 million or so—

Gary Smith

Yes, $5.8 million, yes.

Tal Liani – Banc of America

Is that 100% of the cost of goods for that particular deployment.

Jim Moylan

No, its just the loss associated on the two.

Tal Liani – Banc of America

Okay so when you do start recognizing revenue, I think maybe you had answered that question before, but if you could clarify that. When you start, let’s assume you recognize $10 million of revenue and let’s assume that its at say 40% gross margin when you do recognize it in a normalized situation, what really would be the revenue and margins you start recognizing when it starts.

Jim Moylan

What I said was that in the one case, the pricing strategy on the deal is such that depending upon the mix of the product which is ordered, you can have a very low margin on some types of orders and a very high margin on other types of orders. We just so happened in this case to get the lower margin orders kind of grouped together in this quarter.

So what we did was we booked the loss on that contract. When we get later orders, what will happen is they presumably should be more heavily weighted toward the higher margin piece of the business so, but that piece of the business, whatever the revenue is, we’ll book a very significant margin, a very comfortable margin.

However let’s assume that we then deliver some amount of the material which is associated with the loss contract that we booked this quarter, those would go out at a zero margin. You’d book the revenue and costs at zero and then the other piece of the order would be at a very nice margin.

And I think somebody asked us before, the net result of all of that is that later on you’ll get margins that are equal to or maybe even a little better then our sort of average margins on particular types of equipment.

Operator

Your final question comes from the line of Blair King - Avondale Partners

Blair King - Avondale Partners

Just one quick one, if you could give some clarification on the development of the 40G interface relative to the 100G interface and to the extent you can put some timing around that would be helpful.

Steve Alexander

So 40Gig is available today. That’s kind of the high end that people are deploying. The 100Gig is generally considered the next gen. I think if anything we’ve always looked at it as the real high ground with 40Gig as kind of a stepping stone to it, 40Gig is important but obviously 100Gig would be more so once it gets into market.

We’re fortunate to have one of the first, [arguably] the first deployable 100Gig solution.

Blair King - Avondale Partners

Just one quick follow-up then, I realize the 40G is available today, I was under the impression that there was some development effort internal to Ciena that perhaps there was a 40G interface being created internally. Is there anything you can say about that.

Steve Alexander

We do 40Gig interfaces for all the products that should support 40Gig and its kind of a make versus buy, whether you build it, stick build it or you buy it as a module or whatever. That’s kind of the designer’s choice. But you can assume all the products will have 10Gigs, 40Gigs, 100Gigs if that’s what’s appropriate to their applications.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Gary Smith

Thanks everyone for your time this morning and for your continued support, very much appreciated. Thank you.

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Source: Ciena Corporation F2Q09 (Qtr End 04/30/09) Earnings Call Transcript
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