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Ciena Corporation (NYSE:CIEN)

F3Q09 Earnings Call

September 3, 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

George Notter – Jeffries

Jack Monte – UBS

Samuel Wilson – JMP Securities

Mark Sue – RBC Capital Markets

Mike Genovese – Soleil Securities

Alex Henderson - Miller Tabak

John Marchetti – Cowen and Company

Tal Liani – Bank of America/Merrill Lynch

Sanjiv Wadhwani – Stifel Nicolaus

Jeff Kvaal – Barclays

Simon Leopold – Morgan Keegan

Operator

(Operator Instructions) Welcome to the Ciena Corporation Third 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.

This morning’s prepared remarks will be presented in two segments. Gary will review our third quarter performance and discuss our outlook; Jim will review the financial results for the third quarter and provide our guidance for Q4. We will then open the call for questions from the sell side analysts. This morning’s press release is available on National Business Wire and 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 June 4, 2009.

We have until September 10th to file our 10-Q 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 investors portion of our website.

Gary Smith

On balance, industry, and macro economic sentiment is somewhat improved over the last quarter. We’re seeing some signs of stability specifically in North America. While in other parts of the world the recovery may be somewhat slower. In general we continue to see cautious spending across our customer base. In the last 12 months we’ve managed the business with the objective of balancing operating performance with a disciplined approach to strategic investment. We believe we’ve done this successfully.

For example, in the last nine months we’ve reduced our quarterly non-GAAP operating expenses by 17%. This discipline has enabled us to invest more in R&D and we expect our annual R&D investment will actually be higher in absolute dollars this year then last. In addition, we’ve delivered cash from operations over the first nine months of this year and we’re on track to have positive cash flow from operations for the complete year. Also to our third quarter performance as well as the overall environment before turning the call over to Jim, to discuss the details our Q3 results.

First, we’re pleased to deliver strong revenue growth in the third quarter. Our sequential revenue increase was driven by improvements from long haul transport, our CN4200 platform and notably revenue from our carrier Ethernet service delivery of CESD portfolio. CESD revenue increased more then 70% sequentially contributing $23 million or 14% of the quarter’s total revenue.

You’ll recall this category includes both our broadband access products as well as our service delivery and aggregation switches and Ethernet access products. We’re starting to see solid traction with the Ethernet service delivery, aggregation and access products with nearly 90% or $20 million of this quarters CESD revenue coming from those platforms.

In addition to business Ethernet service applications which we’ve talked about in the past we’re also seeing demand for these platforms in support of wireless backhaul. In fact, the largest portion of Q3 CESD revenue came from a 4G WiMax related deployment. While it may not happen in a neat or even linear fashion we do expect that along with our CN4200 and core director platforms our CESD portfolio will become a meaningful revenue driver of our business going forward.

At 46% our non-GAAP gross margin was generally consistent with Q2 gross margin absent the effect of the lost contracts we called out last quarter. Despite the broader environmental challenges we’ve been able to sustain gross margin generally in our target mid to high 40’s range. In part through the combination of discipline and continuous product cost reduction efforts as well as our fundamentally strong value propositions.

While pricing remains competitive in certain segments and geographies we believe our portfolio and feature sets are differentiated and will enable us to sustain gross margins in the mid to high 40’s range in the near term. As we’ve said in the past, a key motivator for many of our portfolio investments we’ve made and are making is a desire to achieve a sustainable higher gross margin over time.

In terms of operating expenses at $80 million and non-GAAP operating expenses were down 8% sequentially. Last quarter we talked about higher than anticipated prototype related expenses. Those expenses came in as expected in the third quarter but were offset by lower employee related expenses due in part to some headcount reductions.

Overall, 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. Like many of our customers, we have constrained our investment over the last year as a result of the environment. We have several new platforms coming to market over the next several quarters which is likely to drive R&D higher. We’ll continue to monitor the environment and our customer’s needs in assessing our operating expense levels. As the environment begins to show signs of strengthening our OpEx will have to increase to support these initiatives albeit not at the same rate as revenues.

Before I ask Jim to review the details of the quarter let me spend a few minutes discussing the environment and what we’re seeing and hearing from our customers. First, it’s reassuring to hear some of our large North American service providers publicly recommit to their stated CapEx targets for 2009. It’s also reassuring to hear customers say they intend to increase the pace of the spending in the second half of the calendar year.

However, we expect it may take a while for that sentiment to translate into real spending and recognized revenues. That said, in general our customers traffic levels have grown, their revenues have not significantly declined and CapEx to revenue rations remain at historical lows. As a result, we continue to believe that current levels of spending are unsustainable over time, particularly give the combination of traffic growth and new service demands on networks.

Perhaps even more so then even a year ago. Many of our customers are facing multiple critical network and business priorities from capacity crunches in the core and wireless backhaul to the need to deliver more cost effective high bandwidth enterprise type solutions.

One of the areas where we’ve seen a willingness to invest and where we are getting meaningful traction is managed service deployments, likely as a result of their immediate and direct link to revenue. We continue to prioritize our own development spend such that we remain on track and aligned with evolving market opportunities and customer concerns. At the highest level over the course of this year and early next we’re focused on bringing to market a series of products in transport, switching, and software, that together create a powerful toolkit to migrate today’s networks to more efficient, more capable OTN Ethernet.

Our four significant ongoing development efforts include:

Bringing out our market data optimize switching solutions and the evolution of our core director family.

Filling out our converged optical service delivery portfolio including 100G technologies and capabilities.

Expanding our Ethernet service delivery portfolio

Extending the value of software and unified network and service management across our portfolio.

I’ll touch briefly on each of these. First on our switching solutions, as you know one focus of our R&D efforts has been on bringing to market our data optimized switching solutions which is often equated to the evolution of our core director family. I can’t emphasize enough that this is not a core director replacement program. This simplest description of what we’re doing is that we’re building a family of switches to support next generation networks. We continue to make good progress on this and within the next few weeks we’ll be more forthcoming with some details.

In the meantime I’d like to talk a bit more about the nature of these development efforts. Specifically we’re doing two things. First we’re enhancing the current platform by migrating CN4200 technologies primarily Ethernet and OTM in a release of core director that includes new hardware and software features. And we’ll be introducing a new platform that will enable customers to increase capacity handled per network node, increase the number of switching nodes in a network and add packet switching capability to the whole family.

You can think of this like it is today. Core director is the industry leader at managing circuits. We’re going to take what core director does so well and apply it to managing Ethernet.

On our optical service deliver portfolio we continue to see strong interest on our 100G capabilities. We believe the broader commercial opportunity for 100G is likely to materialize in late 2011 or early 2012. In the meantime we’re active within the standard bodies and seeing opportunities for the capability in specialized applications, like our 100G win at the NYSC Euro Next.

On our carrier Ethernet service delivery portfolio or CESD we remain very excited about the opportunity for our CESD portfolio as evidenced by the strong traction this quarter. As I mentioned earlier we were pleased to see strong revenue in the quarter primarily from wireless backhaul type applications. In addition, although we’ve not recognized any revenue to date we are beginning to receive initial purchase orders for CESD products from AT&T in support of both their business services and wireless backhaul applications.

Finally software and unified network and service management, this is critical to optimizing or making the networks work. Network automation has a historically been our strength and we’re investing strongly in our software architecture to leverage and optimize that strength. We feel strongly that we’re in the midst of several important product cycles and we’re excited about the opportunities we believe they enable us to address.

In summary, our goal remains as it has for the last 12 months, balancing operating performance near term with a disciplined approach to strategic investment longer term. I believe we are seeing the early signs of market recovery but I cannot predict the shape or timeline of that recovery. In the meantime we remain confident that our current portfolio and future product cycles target the current and emerging critical network priorities of our customers.

Jim, with that will you talk to the details of our Q3 results.

Jim Moylan

We reported third quarter revenue of $164.8 million representing a 14% sequential improvement. We had three 10% plus customers in the quarter that represented 37% of total sales. Two of the 10% customers are North American based and one was also a 10% customer in Q2. Sales from international customers represented 37% of total revenue in the quarter consistent with the 36% in Q2.

As you know, we break out our revenue into three major product groups. The first group; optical service delivery includes transport and switching products as well as legacy data networking products and related software, it accounted for $117 million in revenue representing 71% of total revenue for the quarter. Within optical service delivery our CN4200 advanced services platform was the largest contributor in the quarter at $43 million, up more then 30% from $32 million in Q2. Core switching contributed $38 million in the quarter down slightly from $43 million in Q2. Long haul transport added $27 million up sequentially from $23 million in Q2.

Our second product group carrier Ethernet service delivery or CESD includes service delivery and aggregation switches as well as Ethernet access products, broadband access products and the related software. As Gary noted, CESD had a strong quarter increasing more then 70% sequentially in Q3 and contributing $23 million or 14% of total revenue.

Finally our Ciena specialist services group which includes all of our services related offerings was $25 million in revenue flat with Q2.

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. First I’ll speak to gross margin. Q3 GAAP gross margin was 45% adjusted for share based compensation and amortization of intangibles Q3 gross margin was 46% which is generally consistent with the last several quarters normalized gross margin.

Our GAAP product gross margin for the quarter was 48% up from 45% in Q2. You’ll recall that Q2 product gross margin reflected the adverse effects of orders associated with loss contracts in that quarter. Our services gross margin was 31%, once again better then our target mid 20% range as a result of the mix of services revenue in the quarter.

On a GAAP basis Q3 operating expenses totaled $97.6 million. That included stock based compensation as well as $6 million in amortization of intangibles and $4 million in restructuring related costs. Excluding those items our adjusted operating expenses totaled $80 million which as Gary noted represented an 8% sequential decline from Q2 and represents the results of our efforts to control our costs as we were in the downturn.

Our Q3 GAAP net loss was $26.5 million or a loss of $0.29 per share. Adjusted for unusual and non-operating items discussed previously our third quarter net loss would have been $4.8 million or a loss of $0.05 per share.

Turning now to cash flow and the balance sheet. We continue to be pleased with our working capital management. Despite the GAAP loss in the quarter we generated $3.5 million in cash from operations. Our balance sheet remains strong with $1.1 billion in cash and short and long term investments at the end of the third quarter. For Q3 our accounts receivables balance was $120 million up slightly from $117 million in Q2. Our day sales outstanding were 66 down from Q2 73 days.

Given ongoing revenue uncertainties we continue to closely manage our inventory position. Inventories totaled $89 million in Q3 down a little from $91 million in Q2. Product inventory turns were 3.2 times in the quarter, up from 2.9 times in Q2. The inventory breakdown for the quarter was as follows: Raw materials $20 million, work in progress $0.8 million, finished goods $90 million, and a reserve for excess and obsolescence of $22 million.

With respect to headcount as of July 31, 2009, our worldwide headcount was 2,110.

I’ll conclude our prepared marks today by talking to guidance for Q4. Before doing so, however, I would like to caution that although we are providing some limited guidance for the upcoming quarter our visibility remains limited. We expect to deliver Q4 revenue roughly flat with Q3 revenue. 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.

We believe Q4 non-GAAP operating expenses will be in the low to mid $80 million range. We do expect the prototype expense will be higher in Q4. We expect other income expense net in the fourth quarter will be an excess of roughly $1 million. As for taxes, we expect our tax expense for Q4 will be related to foreign taxes. Depending upon your assumptions you may need our diluted share count or our basic share count. We estimate Q4 diluted share count at approximately 113 million shares. We estimate Q4 basic share count at approximately 92 million shares.

We’ll now take questions from the sell side analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from George Notter – Jeffries

George Notter – Jeffries

I wanted to better understand the trajectory of operating expenses going forward. I understand there’s a bit of a bulge here from and R&D perspective with new products coming out. As we get beyond that bulge any sense for how much reduction we can get in operating expenses in absolute terms would be great.

Gary Smith

With all these platforms coming out it’s a little bit lumpy in terms of both prototypes and also we’ve got some strategic hiring as well. We see the sentiment overall getting better. We want to make sure that we’re optimized around our resources and the platforms to market and the timeliness of that. I would say that we have continued to balance it very carefully as we come out of the downturn.

We’ve got clearly operating leverage in the business we’ve reduced operating expenses significantly and we’ll continue to be very disciplined around it. We talked about being up in Q4 with some prototypes and some additional strategic hiring in R&D as well particularly. We’re going to manage that very carefully going forward.

George Notter – Jeffries

In terms of the OpEx spend over the last two quarters now that you’ve brought it down the same time you’ve invested more aggressively. I’m still trying to parse the amount of OpEx reduction you had here against the amount of incremental R&D investment from all the prototypes and activity. I’m still trying to figure out exactly how much you could maybe come out as you get beyond this bulge, any numerical sense for that at all?

Gary Smith

I think we’ve got an environment that’s not got great visibility. We’re managing it very carefully on a short term basis and then we’ve reduced the underlying operating expenses. Perhaps this is a better way of looking at it, we’ve reduced them 17% in total over the last nine months and yet we’ve still been able to spend more on R&D then we did in 2008 and I think that really talks to prioritizing and optimizing our spend, things like G&A and some of the other expenses we’ve managed very carefully clearly compensation is always a big aspect of it and given the fact that the company is not profitable we’re not paying bonuses etc. and all of those things accumulate up and that’s enabled us to take the operating expenses down.

The other thing I would say is that we’ve now got a company that’s got a much more agile operating expense margin meaning we’re outsourced in terms of manufacturing; we’ve got some strategic outsourcing in terms of our service partnerships. We are able to flex those kinds of things when you get into a downturn. The last time we went through this in 2001, 2002 we didn’t have those kinds of flexibilities in our operating model.

Operator

Your next question comes from Jack Monte – UBS

Jack Monte – UBS

On the guidance, trying to understand some of the puts and takes to the flat quarter over quarter revenue guidance. Maybe you can help me understand if I’m thinking about this the right way. I’m thinking international is going to be weaker, domestic should outperform and then I’m trying to reconcile some of your key customer’s guidance commentary on CapEx with the flat outlook. AT&T is supposed to be up 30% plus in the second half and then we only have flat revenue guidance. What is the thought process there, what should I be thinking about?

Gary Smith

As we come out of this downturn I think its going to be a little lumpy anyway. The second thing I would say is in absolute terms we’ve just come off a quarter where we’ve delivered 14% revenue growth so effectively we’ve delivered above what was our Q4 consensus so we’ve delivered that in Q3 and we’re saying that we can do a similar kind of performance in Q4. I think the trajectory overall is positive and I think it’s consistent with some of the utterances you’ve seen from some of the North American carriers.

I think it just takes time for the increase in spending to filter through in terms of shipments, revenue recognition, and those kinds of things. I think overall it’s consistent with what I think most people are saying around an up tick. The trajectory of that is just difficult to predict.

Jack Monte – UBS

Am I thinking about it the right way that the international piece should under perform? If I take a step back if I think about the international piece this past quarter it was up 16% it outperformed versus the domestic piece so maybe that won’t continue and it will under perform with recovery being lagging internationally or how should we think about that?

Gary Smith

There are a couple of projects internationally that we’ve won with a couple of tier ones that will help sort of offset the overall feeling. I think its more Europe is sort of lagging then some of the other territories and that tends to be I think a general commentary that we’re seeing from other people too. How that manifests itself in quarterly quarter to quarter revenues again I think we’ll be a little bit lumpy. Overall Europe generally is lagging a little bit in terms of recovery. Internationally we’ve got some offset against that and a couple of decent sized projects that we’ve won.

Operator

Your next question comes from Samuel Wilson – JMP Securities

Samuel Wilson – JMP Securities

You talked a little bit about the disconnect between CapEx and actual revenue recognition at Ciena and I wanted you to fill in some of the details, is most of that behind customer acceptance and the issues around customer acceptance and sort of the accounting behind it or do you just think carriers at the front end are spending on some other things first and you’re a little bit later in the spending cycle?

Gary Smith

I would characterize it, it’s not specifically to Ciena but I can talk about what is specific to us. By the time you get order, particularly in the second half of the year carriers tend to place orders in the first half of the year for deployment in Q3 and early Q4, and don’t tend to deploy a lot around the holiday season from Thanksgiving to Christmas generally. Our revenue recognition is clearly driven by accounting policy and it varies by customer and if it’s a large turn key project.

The other thing I would point out as well is that when we talk about Q4 for us ends at the end of October. We have an earlier fiscal year close as well. I’ve just been mindful of that where most of our competitors and a lot of the common tree clearly talks to the full calendar year. That can be a little misleading as well.

Samuel Wilson – JMP Securities

You talk about the new core director platform. As you talk about a new platform and an expanded product portfolio and it’s not a replacement of the existing core director. Do you see this as a product where its going to take that traditional six months to one year sell cycle where your customers will feel like they’re have to go through lab trials to field trials to broader deployment or do you think that given the large install base of core director already it will be more of, we know this product, we’re ready, just put it in a few field trials and we’re deploying relatively rapidly?

Steve Alexander

You’re going to find there’s going to be a broad spectrum the way people approach it. The software between the various members of the family, what I want to emphasize here is that the family approach we’ve taken to this will be the same software we’ll run on different boxes and so you’ll have people that say okay I’m very comfortable with the operation of it I just want to check on the hardware side of it. Then there’s going to be other just on a policy basis they’re going to put it through a longer acceptance cycle regardless of their view of the platform. I think you’re going to find both.

Samuel Wilson – JMP Securities

Can you talk a little bit about Ethernet; Ethernet really showed a surge this quarter, it appears at least in the numbers show a surge. Has there really been, I know a lot of us call it a c-change but we’ve reached that point in the hockey stick where we’re seeing Ethernet sales really fundamentally take off here and that’s what carriers are putting their effort.

Steve Alexander

We’ve said in the past one of the things that we’re betting on is the emergence of Ethernet in particular the way we implement it with Ethernet and OTN combined as playing not only the role as service delivery but actually playing a role in infrastructure. It really lets the carriers optimize their total investment and we do see more interest then ever in Ethernet service delivery and Ethernet OTN as an infrastructure play and we think that’s going to continue.

Samuel Wilson – JMP Securities

What I’m asking though is based on the results of the quarter just reported did it surprise you to be upside in the sense that how much business you did there or you’d seen this coming for a while?

Steve Alexander

I think we had expected a transition away from the more conventional SONET/SHD world over to one that is much more Ethernet and Ethernet OTN centric. That’s the way that we have built the features into the portfolio, that’s the way that we’ve optimized the investments that we’ve made on the R&D side. I think we’re starting to see some of the benefits of that.

Jim Moylan

We have not seen any significant rev rec from AT&T in our CESD portfolio yet.

Operator

Your next question comes from Mark Sue – RBC Capital Markets

Mark Sue – RBC Capital Markets

As a clarification the higher then expected revenues that was not related to recognition of deals that slipped last quarter it was more the broader growth then carrier Ethernet is that the characteristic.

Jim Moylan

It’s really a result of slippage. Certainly there was some stuff that came into the quarter but at the end of every quarter there are some things that move around. No, I think it just reflects what we expected which was an improvement in our basic revenue situation.

Mark Sue – RBC Capital Markets

Your comments on CapEx linearity offset by the pace of spend that implies that after a flat October quarter we can potentially have a very strong sequential January quarter is that a reasonable assessment?

Gary Smith

I would hesitate to say that. We’re at nation stages of this recovery and I think its going to be lumpy. That would be a nice thought though.

Mark Sue – RBC Capital Markets

Can you say that quantified orders and quantified customer commitments are at the highest levels that you’ve seen in a while?

Gary Smith

Orders are one indication they’re not the only piece, it’s around sort of pipeline and book and bill and all of those things, its never particularly single dimension for us. Generally I would say that activity is certainly improving, sentiments definitely improving overall, certainly a lot better situation then we were six and nine months ago. I just think the size and shape of this recovery is going to be kind of difficult to predict.

As they said earlier I think we’ve got a situation where I think the CapEx to revenue ratio is unsustainable from a carrier point of view over the longer term which I think is encouraging for us. As Steve outlined, we’ve got a lot of very strong product cycles coming to market over the next 12 months.

Mark Sue – RBC Capital Markets

On CapEx ERN spending flush if you had to say one way or the other do you think the carriers are intent on spending at least a part of their remaining balance late this year?

Gary Smith

I think the carriers are feeling a little more optimistic around their spend but I think how that translates to revenues and orders, it takes a while for that stuff to filter through. If their intent is to spend more it takes a while for that get out. I think you’re more likely to see that in Q4 at the end of the fiscal year for vendors.

Operator

Your next question comes from Mike Genovese – Soleil Securities

Mike Genovese – Soleil Securities

You gave us an update on your 100G roadmap. I was wondering if you could maybe talk about 40G for a minute, where you are there with that roadmap is looking like. Secondly tangentially related there’s been a lot of speculation about these Nortel assets in the market. Any comments you could give us on what you think about the technology, what you think about it in terms of industry consolidation, what the sale of the Nortel assets could mean for the industry.

Steve Alexander

I’ll take the first part of it on the 40 and 100 gig. As we said in the past we think ultimately the high ground, if you will, in all of the transport is going to be 100 gigabit Ethernet. We’ve seen the emergence of the 10 gig world, 40 gig remains what we think is an important but it’s a stepping stone ultimately to the 100 gig. We’ve clearly placed the majority of our investment dollars in the 100 gig world and I think you’re starting to see some of the first benefits of that with the announcement with the New York Stock Exchange, Euro Next the deal that we’ve got.

It clearly is intended to optimize the performance of networks that are latency sensitive. That’s essentially why you go down that path. We believe 40 gig is important but it is a stepping stone that we see going to the 100 gig world.

Gary Smith

In terms of the industry structure etc. generally speaking consolidation is generally helpful. Whatever those assets end up I think that will be helpful from an industry point of view.

Operator

Your next question comes from Alex Henderson - Miller Tabak

Alex Henderson - Miller Tabak

Can we go back to the R&D line for a second, obviously with these new products getting ready to launch the prototyping costs should fall back out, can you give us a little bit more clarity on what the size of these slug of R&D that are associated with prototypes will be over the next quarter or two and when you might expect those to actually drop back out?

Jim Moylan

Typically prototype expense is going to come up as we bring products to market and then for those products at least, prototype expense will fall down. What we said in the third quarter was we didn’t bring a lot to market immediately so we had lower prototypes then sort of our run rate was in the second quarter. We also said that we expect coming into the fourth quarter because as we said we’re bringing some things to market, we’re going to spend more on prototypes. That’s about as far out as I’ll be able to speak to it. I guess you could try to optimize our prototype expense to match the timing of products coming to market.

Alex Henderson - Miller Tabak

Are we talking about $3 to $5 million slug in the R&D line as a result of that?

Jim Moylan

I think you can get sort of a guess at it by our language. We said that we did just under $80 million in the third quarter and we said that we’d be in the low to mid $80’s million in the fourth quarter.

Alex Henderson - Miller Tabak

It sounds like the design of the core director family that you’re coming out with is targeting the fine grooming/direct attack on what the [Empenera] might want to do down the line. Certainly [Empenera’s] grooming functionality is highly limited versus what you guys can do. Is this somewhat of a preemption of them coming into the marketplace putting in digital nodes, improving flexibility of the network using the core director as a way to obviate that need. If that’s the case, can you talk a little bit about how the cost differential of the core director might look versus one of their digital nodes in a similar scale unit?

Steve Alexander

I’m not sure we would say that we designed it as a preemption. I think we’ve approached the core director family from really three directions in terms of scalability. You want to increase effectively the capacity on each one of the nodes, you want to increase the number of connections that each node can manage and you want to basically increase the total number of nodes that are available in the network. This falls along the lines of what we’re trying to do with connectivity managing circuits managing connections all in an Ethernet waver going forward.

I agree with your observations, we thinks it’s a much better solution then some of the alternatives that are out there, both from a connections management as well as an availability point of view. The core director family is really optimized around providing very resilient connections and network. These initially started as TDM connections and over the next few years they’re all going to migrate to become Ethernet connections. We basically want to do for Ethernet the same thing that we did for TDM, we want to provision faster then anybody else, we want to make them more reliable, more available then anybody else can. In terms of cost points I think you’ll find it’s competitive and arguably we think it will be market leading.

Alex Henderson - Miller Tabak

Can you give us some sense on the fine grooming of sub-landers of traffic, what type of degree of fine grooming we should anticipate?

Steve Alexander

I’ll go back to emphasizing the family piece of this. You do a family approach to optimize what is effectively the carriers operations. The smaller box at the edge of the network would be able to groom or process finer grain flows. You wouldn’t necessarily want to be doing megabit minute elations on a 100 gigabit core switch. Obviously you optimize the grooming throughout the network.

Alex Henderson - Miller Tabak

On a related subject, when you talk to your carriers on the optical Ethernet people think about it on the sell side and buy side of as an optical market but in fact it looks like a lot of the decision process that’s being made isn’t being driven by the optical market at all but rather by the router market. The router overlay in particular.

Can you talk to a little bit about how much capital substitution you see shifting money from putting money into the router footprint as they shift traffic off the router using router bypass as well as deliver off the routers for Ethernet service delivery. How much do you see this carrier shifting the CapEx off the router piece down into the service and transport piece in the optical layer? It seems like the router problem is driving decisions to put money into optical as opposed to optical economics per se.

Steve Alexander

You’ve touched on a number of topics there. I think the carriers are always trying to optimize the way their networks operate. They’ve got a number of choices now and in many cases our role in life is to give them as many choices so they can optimize the best possible way. They can manage circuit flows on an optical level which people would typically put wave lengths, they can optimize their networks using containers so we speak of OTN as kind of being the containerize freight model for the carriers that carries anything they want, it can carry IT services, it can carry Ethernet, it can carry storage, it can carry hi def video.

We think that there’s a broad market for the approach that we’ve taken. Some of it you would describe as maybe router off load, honestly some of its just going to be described as point to point connectivity. Maybe from hi def signals going forward. We see things changing in the way that carriers can build their infrastructure and again the use of OTN I’ll go back to the containerized freight model you look at what that did for the shipping business you expect similar things to happen in the transport space its something the carriers almost anything they can imagine and it changes modality very easily.

You can move things across boxes using OTN in a much more efficient way then you can using a lot of other technologies. Its all around how to optimize the spend.

Alex Henderson - Miller Tabak

To point to the question, do you see spending shifting off the router plane into the optical plane?

Steve Alexander

I think we see it continuing in all the layers of the network, there’s going to be spend and layers euro which is wave length spend in the layer one space on OTN, lots of spend in layer two in Ethernet and there’s going to be continuing spend above that with the routers. I think its going to be in all the areas of the network. We think there’s lot of opportunities to do more in layers euro one and two then ever before.

Operator

Your next question comes from John Marchetti – Cowen and Company

John Marchetti – Cowen and Company

Getting back to the CESD line for a second here, obviously a big switch up this quarter at least on a sequential basis. A lot of that, if I understood your comments, seems to have come from the one big North American customer. As we look into 4Q and maybe beyond there do you think now we’re at this higher run rate for the business, like you said, AT&T still hasn’t come in here. Can we expect that we can see this sort of level of revenue obviously with some variation going forward or is this a one off very lumpy deal and we’ll have to wait and see how this turns out of the next several quarters?

Gary Smith

Overall I would expect this to be one of the families of the platforms. I would think that CESD would be a driver of revenues going forward along with 4200 and the core director family. It’s going to be a bit lumpy and an ascent market but I think overall we’ve got since the acquisition of World Wide Packets we’re now over 50 new customers. They vary in size but we’ve got a number of tier ones that we’ve been able to secure that are beginning to roll out, one large one you just touched on which we haven’t really even taken any revenue for yet.

I’m very optimistic about that space I think its taken a little bit longer then we’d anticipated we were a little, I think overly optimistic around that and some of it was the overall environment probably a combination of both. I think we feel pretty good around the broad base of activity with CESD now.

John Marchetti – Cowen and Company

You talked about revenue and 4Q being relatively flat. Should we expect that that is how the way you’re two major segments play out on the product side? Last quarter we talked about everything being sort of up sequentially. Should we think are there any big variations in there or do you expect that as a whole the business will sort of move flat sequentially as we go into fiscal 4Q.

Gary Smith

There’s always a bit of a change in the mix. I would say broadly a similar kind of mix I would expect in Q4 and similar kind of profile around the gross margins, etc.

John Marchetti – Cowen and Company

Last quarter you booked the two new long haul contracts, you took some of the losses up front. Did either of those contribute to revenue in this quarter?

Gary Smith

I don’t believe they did.

John Moylan

Not in any material way. One of them might have contributed a minor amount but not any material way.

Operator

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

Tal Liani – Bank of America/Merrill Lynch

I have questions on the P&L margins and expenses. On the gross margin side you’re now at about, if I look at it correctly you’re now at about 46%. The question is how much more up side do you see in the long run. What I’m trying to understand is whether from absolute expenses OpEx you’ve maxxed out the declines you can deliver. Then on the gross margin side same question whether you’ve maxxed out on the increases you can deliver. Understand whether the story going forward is more about revenue growth or it’s also about additional declines in absolute dollars and expenses.

Gary Smith

In this kind of an environment we’ve been able to maintain our margins in the mid to high 40’s range and I think that talks to the strength of our value proposition. Our intent in terms of what we’re investing in and a key motivator for the portfolio investment that we’re making. You’d summarize it in simple terms in terms of software that is embedded on the platforms and across the architecture and generally speaking that’s higher gross margin.

We still have ambitions driven by the investments that we’re making to increase that margin over time. I think we’ve talked previously around those margins in the over a period of time getting closer to 50 and beyond. In the short term from what we can see right now we’re in that mid 40’s type range.

Jim Moylan

With respect to OpEx we have signaled that our OpEx will be up a little in Q4. We’re not prepared to speak beyond Q4 at this point in time. I guess what I would say is I’d point out that we were able to take OpEx down 17% from the end of last year to the Q3 of this year. We did that by a very disciplined approach to our expenses but were able to increase our R&D expense. It’s that balance that we’re able to strike and that we intend to keep striking going forward.

We believe that there will be operating leverage in this business going forward. We’re not prepared to talk about when that’s going to occur but it will occur.

Tal Liani – Bank of America/Merrill Lynch

If you look at your expenses R&D on a year over year basis is slightly lower but the majority of the declines are sales and marketing and G&A. If you separate the two and you say R&D is related to the business it’s more variable do you think that sales and marketing which is also variable do you think it will start going up in absolute terms or are there more cuts that you could deliver within sales and marketing?

Jim Moylan

As of right now we don’t have any plans in that regard. The sales and marketing has a naturally variable component because there is a commission component of that cost tied to orders. As orders increase that expense will go up, if orders went down that expense will go down. We don’t expect the latter of course.

Tal Liani – Bank of America/Merrill Lynch

The last component of the OpEx is the G&A it was down quite substantially on a year over year basis percentage wise. Are there any structural changes you could make that would further reduced G&A or do you think on the G&A side it is $9 million roughly a quarter it’s the bottom and from here it really depends on the business.

Gary Smith

The overall approach to the business was to invest more in R&D in the downturn because we think that will give us strategic advantage going up and to stay cash flow positive. Those were the two design criteria’s we went into this downturn with. I think we’ve structured our operating expenses around that where we thought that might be and broadly speaking that’s proven about right, we’ll be cash flow positive for the year we believe. From that point of view we’re not really looking to take more costs out of the business frankly.

We think we’ve sized it about right in terms of; in fact we’ve aligned and optimized some of the sales expenditures so that we’ve gone into some new territories in this downturn. That I think will help us as it comes out. The overall point that I would make is that going forward as we see a recovery here OpEx won’t grow at the same rate as the revenue but it will grow. As Jim said there is operating leverage there. We feel that we’ve got the structure about right and that we can get good operating leverage going forward as the market recovers.

Tal Liani – Bank of America/Merrill Lynch

What about pricing pressure, most layers I’m speaking with are noting increased activity of [Wawey]. Long term I’m not talking about one quarter or impact but longer term increased activity of [Wawey] and more pretense outside of even Europe so into the US and European markets. Did you start noticing [Wawey], do you have any direct competition and second any impact on margins because of competition?

Gary Smith

I’d go back to the point that we talked about earlier that we’ve been able to sustain our margins in the mid 40’s type range which I think is testament to our value proposition. Our value proposition is really we don’t sell on price it’s really around the overall solution and the value that we bring to the customers. People like [Wawey] and other low cost vendors are more of a threat I think to price focused vendors. I think the solution that we’ve got to market is less sensitive to that.

We’ve seen them, we do compete with them particularly in the transport space, particularly in Europe we’ve seen them in places like BP. We are able to compete with them and get decent margins. We understand how to compete with them. They’re just going to be a fact of life and I do think they will be in North America and I think it’s really more of a threat I think to venders who are just focused on price.

Operator

Your next question comes from Sanjiv Wadhwani – Stifel Nicolaus

Sanjiv Wadhwani – Stifel Nicolaus

I’m guessing that AT&T you’re probably going to recognize revenues in this October quarter.

Gary Smith

You’re referring to this CESD portfolio specifically?

Sanjiv Wadhwani – Stifel Nicolaus

Yes.

Gary Smith

Not sure but possibly. Yes, possibly we’d recognize some.

Sanjiv Wadhwani – Stifel Nicolaus

Any color on the timing and adoption of the new core director family of products by your largest customers, any color over there?

Steve Alexander

We expect they’ll be in customer’s hands at the end of this year. That begins the lab trial portions of it and the rest. Again you’ll see a broad spectrum of how people approach this thing. Some will want it as it comes out of the shoot because they’re very familiar with the box and they just want to get additional features in. others will put it through a much longer acceptance cycle.

Sanjiv Wadhwani – Stifel Nicolaus

It looks like at the end of this calendar year it should be in customer hands?

Steve Alexander

Yes, that should be the beginning.

Sanjiv Wadhwani – Stifel Nicolaus

The two wins from the April quarter where you took some pricing action looks like revenue contribution this quarter was very minimal. Does that spike up a little bit in the October quarter, any sort of flavor over there?

Jim Moylan

The biggest piece of it actually will come early next year, the biggest chunk of it.

Sanjiv Wadhwani – Stifel Nicolaus

From both the customers?

Jim Moylan

Yes.

Operator

Your next question comes from Jeff Kvaal – Barclays

Jeff Kvaal – Barclays

I was wondering if we could delve a little bit more into the 40 gig story. Obviously you folks have clarified where you put your own investment. Has there been any sift in the way that carriers think about the migration from 10 to 40 to 100 over the past six to nine months?

Steve Alexander

I haven’t detected a major shift. I would say maybe two or three years back what you would get were RFX activities around a 10 gig network that was upgradeable to 40 and so then there was an upgrade cycle that went in place. I think what you’re now seeing are similar the RFX around 40 gig deployments that are upgradeable to 100 gig. I think that’s been the change over the last couple years. I haven’t seen anything or notice anything specific in a change in the 40 gig marketplace per se.

Jeff Kvaal – Barclays

How do you folks wrestle with migration plans if people want 40 gig and then go to 100 gig?

Steve Alexander

We design products in the beginning to be upgradeable. Even as back to the core stream system which has been in the market for quite a while it started as 2.5 gig waves is upgradeable to 40. With the 4200 that’s the platform that has 100 gig on it. That again started as a 2.7 gig platform. Our design philosophy from the beginning has always been to allow for basically a straightforward upgrade process.

Jeff Kvaal – Barclays

On linearity through the October quarter one I guess could make a reasonable assertion that the order patterns in August might not be as strong as they would be later in the quarter. I’m wondering how you folks have baked that into your outlook statement.

Gary Smith

We saw an improvement in sentiment in the March/April time and it’s been fairly steady since that. There are some holiday fluctuations in terms of flow of orders and stuff but generally speaking it’s been pretty steady since then. We’re seeing a fair amount of activity.

Jeff Kvaal – Barclays

Would it be fair to say that you are expecting that level of activity to become flattish through the quarter then not see any major spikes in linearity?

Gary Smith

Not particularly. You’re going to see some lumpiness in orders and clearly generally speaking September and October are better order months then August as you say. That’s only one part of the input when we look at what we’re going to do in the quarter. We look at backlog, revenue recognition and all of those things combined. A broader answer to your question is we take into account all of those things.

Operator

Your last question comes from Simon Leopold – Morgan Keegan

Simon Leopold – Morgan Keegan

On the AT&T business with the Ethernet products I’m wondering how much of the obstacles are within your control and how much is really internal to the customer, the typical network management issues versus your requirements to deliver some features?

Gary Smith

Are you talking about the Ethernet stuff, without getting too customer specific these kind of markets we think are nascent. It takes a while for large tier one carriers to get it integrated into their systems and software management etc. It always takes a while I don’t think we’ve seen anything unusual about these slower start on the project. The other question you’ve got to ask I guess is how much of the environmental stuff plays through that as well, it’s difficult to tell.

Simon Leopold – Morgan Keegan

What you can answer is in terms of what you control. Are there features that you’re still developing and work you still need to do internally to meet requirements or is it more or less in your customers hands?

Gary Smith

We’ve met all of our timeframes perfectly. There are some more ongoing things of new platforms where we’re going through and all the rest of it but that’s on a scheduled roadmap. We’ve met all of our deliverables.

Simon Leopold – Morgan Keegan

On the 10% customer list I believe one of them was international. I wasn’t sure whether you mentioned if that was new. If you can give us a little bit more color over description of what type of carrier it is, what they’re buying so we can try to guess who it might be?

Jim Moylan

I can tell you its EMEA based.

Gary Smith

It wasn’t a new customer.

Jim Moylan

It has been 10% previously.

Simon Leopold – Morgan Keegan

I think you’ve made some references to refreshing your long haul product line by essentially evolving the 4200 as sort of the next generation from the core stream. Could you update us on where that is?

Steve Alexander

You’re basically correct. The 4200 was a platform that was designed around multi-service delivery using OTN. Over the last year or so we’ve added a number of features to it to increase channel count, increase distance, you can expect the same thing to happen going forward is we’ll continue to evolve that platform.

Simon Leopold – Morgan Keegan

Is that like a 2010 transition?

Steve Alexander

Some of what will be coming to market that Jim’s alluded to in terms of additional prototype spend is associated with additional features on 4200 it will be rolling throughout the next several quarters.

Operator

That does conclude our question and answer session. I would now like to turn the conference back over to Mr. Gary Smith for any closing or additional comments.

Gary Smith

Thank everyone for their time this morning and for your continued support. We look forward to seeing many of you at Super Com in Chicago in late October.

Operator

That does conclude today’s conference. We thank you for your participation.

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Source: Ciena Corporation F3Q09 (Qtr End 07/31/09) Earnings Call Transcript
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