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Ciena (CIEN)

Q3 2006 Earnings Conference Call

August 31, 2006, 8:30 am ET

Executives

Gary B. Smith - President and CEO

Joseph R. Chinnici - CFO

Stephen Alexander - CTO

Suzanne DuLong - Chief Communications Officer

Analysts

Paul Silverstein - Credit Suisse

Cobb Sadler - Deutsche Bank

Ehud Geldblum - JP Morgan

Marcus Kupferschmidt - Lehman Brothers

Brantley Thompson - Goldman Sachs

Mike Jenneweave - Citigroup

Vivek Arya - Merrill Lynch

Jonathan Ferguson - JMP Securities

Tim Savageaux - Merriman Curhan Ford

Simon Leopold - Morgan Keegan

Natarajan Subrahmanyan - Sanders Morris Harris

Presentation

Operator

Good day everyone, and welcome to the Ciena Corporation Q3 2006 Results Conference Call. Today’s conference is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to the Chief Communications Officer, Ms. Suzanne DuLong. Please go ahead ma’am.

Suzanne DuLong - Chief Communications Officer

Thanks Cecilia. Good morning and welcome everyone. I’m pleased to have with me Gary Smith, Ciena’s CEO and President; and Joe Chinnichi our CFO, in addition Steve Alexander, our Chief Technology Officer, will be with us for the Q&A portion of today’s call. Our call this morning will be presented in four segments, Gary will provide some brief introductory comments, Joe will review the quarter’s financial results, Gary will then discuss the business in the quarter and our outlook for our fiscal fourth quarter, Joe will wrap up our prepared remarks with guidance for Q4. We’ll then open the call to questions from the sell side analysts. To ensure we answer questions from as many participants as possible, we ask that sell-siders limit themselves to one question.

This morning’s press release is available on national business wire and First Call and also our website at www.ciena.com. Seperatly from our result announcement today Ciena announce that its board of directors has approved a one-for-seven reverse split of its common stock to be effective as of 5 pm Eastern on September 22 2006. The Q3 result presented in our press release and in this conference call do not take into account the effect of that forthcoming reverse split.

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 1. We have until September 7 to file our 10-Q for our fiscal third quarter and we expected 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. Gary?

Gary B. Smith - President and CEO

Thanks Suzanne and good morning everyone. We are very pleased this morning to report our tenth sequential quarter revenue growth, which we believe is a result of our focused market positioning. In addition, this quarter’s results point to continued progress towards that goal of normalizing our business model. We are pleased with our progress thus far, and we continue to focus on driving operating performance improvements and future earnings growth over the long term. Overall, we remain encouraged by current market dynamics and the emerging trends, and we are confident that our portfolio is aligned to benefit from these improving conditions.

I will discuss our business this quarter and our outlook in more detail after Joe reviews the quarter’s results. Joe?

Joseph R. Chinnici - CFO

Thanks Gary, and good morning everyone. This morning we reported Q3 revenue totaling $152.5 million. This represents an increase of 16.3% sequentially and 38% year-over-year. There were three 10%+ customers in the third quarter that combined, represented 51.6% of total sales. All three 10% are North American customers; two were also 10% customer in the second quarter. The third is a long time Ciena customer purchasing primarily long haul capacity additions and has not contributed to the 10% category or more of revenue since our fiscal 2002 year.

International sales decreased sequentially as expected from 27.3% in the second quarter to 23.7% in the third quarter. For the second straight quarter we did recognize revenue from VT for both the 21 CN project as well as well as non-21 CN related deployments, though VT was not a 10% customer in the quarter.

Moving now to talk about quarterly revenue contribution across our portfolio. Revenue from our transport and switching products increased sequentially from $83.8 million in Q2 to $104.3 million in Q3, representing 68% of the quarter’s total revenue. Our transport and switching products consist of core transport and switching, multi-service access, metro transport and switching, Ethernet transport and switching, and storage extension solutions. Long haul optical transport related revenue grew sequentially and was the largest contributor within transport and switching. Long haul transport revenue increased from $19.7 million in Q2 to $52.1 million in Q3, primarily as a result of channel parts adds to particular customer’s core network.

Core switching related revenue decreased slightly sequentially from $22.8 million in Q2 to $17.9 million in Q3. Revenue from our metro optical transport products increased sequentially from $12.3 million in Q2 to $17.2 million in Q3. Revenue from our CN 4200 FlexSelect advanced services platform of $11.5 million was roughly flat sequentially although shipments of this product continued to ramp aggressively with Q3 shipments of more than two times revenue in the quarter. Revenue from our data networking products also improved slightly on a sequential basis growing from $11 million in Q2 to $12.8 million in Q3. Revenue from our broadband access products decreased slightly from $22.4 million in Q2 to $20.7 million in Q3. Finally, revenue from our global networking services increased slightly from $14 million in Q2 to $14.7 million in Q3.

Now lets turn to our quarterly operating results. The press release includes a GAAP-only presentation of our results as well as detailed information about the adjustments that as management we make to Ciena’s GAAP earnings in our analysis of Ciena’s ongoing business. In my comments today I’ll speak to both the GAAP results and to what the results would have been if we excluded those items detailed in the press release. With that background let’s start with the operating results.

The Q3 gross margin of 47% came in as expected slightly below the Q2 level of 48%. Our strong gross margin again this quarter was a result of our ongoing product and manufacturing related cost reduction efforts, as well as product mix in the quarter including a favorable chassis to channel product mix within our long haul transport revenue. Product gross margin decreased slightly from 49.7% in Q2 to 48.9% in Q3 as a result of product mix in the quarter. Services gross margin also decreased as expected from Q2’s level of 33.3% to 28.7% in Q3 as a result of services related revenue mix in the quarter. We continue to expect our global networking services related business to generally track closer to the 20% to 25% gross margin range. On a GAAP basis, our operating expenses in Q3 totaled $84.5 million. The quarter’s GAAP operating expenses reflects non-operating related or non-cash charges for FAS 123R related equity based compensation expenses, contingent legal and consulting fees upon litigation settlement, amortization of intangible assets, restructuring costs, and a recovery of doubtful accounts.

Let me add some color on a few of the larger items. We have $2.4 million in 123R related equity based compensation expense. We also incurred $5.7 million in contingent legal and consulting fees upon litigation settlement. These were legal expenses specifically contingent fees paid to outside counsel and advisors connected with the settlement of our tax litigation with Nortel Networks. There was no money paid to Nortel as a result of the settlement. Of the $11 million in restructuring cost incurred in the quarter, roughly $10 million was a charge associated with a reduction in estimated future sub lease payments associated with our previously restructured unused facilities located in South Tennessee. A small remainder of the restructuring related costs were associated with other activities, including workforce reductions associated with Q2’s closing and our Shrewsbury New Jersey location. Adjusted for these and other non-operating or non-recurring charges detailed in the press release, our R&D sales and marketing and G&A expenses for the quarter exclusive of stock compensation costs would have been $59.2 million. This is down 6.6% from Q2’s $63.4 million as adjusted op-ex, despite the fact that it includes cost of approximately $2.9 million associated with reinstituting our short-term performance based employee bonus plan during the fiscal Q3. This marks the first time since Q1 of our fiscal year 2002 that we paid employee bonuses.

Our Q3 GAAP net loss of $4.3 million or a loss of one penny per share compares to a GAAP net loss of $51 million or a loss of $0.09 per share in the same year ago period. Prior period GAAP result do not include the impact of FAS 123R but do include share-based compensation expense recognized in accordance with APB25 as interpreted by FAS B interpretation number 44. Adjusted for the unusual are non-operating items I discussed earlier including 123R related compensation expense, and again on equity investments our Q3 net income would have been $20.6 million or $13.6 million if tax effected or as adjusted net income of $0.02 per share. This assumes of course due to the transition from as adjusted net loss to as adjusted net income, you use the higher fully diluted share is outstanding of $650.7 million versus the basic share count of $589.4 million. This is better than the per share guidance range we offered in comparison to as adjusted loss of $0.04 per share in the same period a year ago.

Turning to the balance sheet, cash, short-term and long-term investments at the end of the quarter totaled $1.2 billion. We used roughly $18.8 million in operating cash during the quarter, which is up as expected due to increased working capital needs. Turning to some other balance sheet items. Our accounts receivable balance at the end of the quarter increased as expected from $76.6 million at the end of Q2 to $89.6 million in Q3. Day sales outstanding in Q3 remained at 53 the lower our expected 65 to 70 day range. Inventory levels ended the Q3 at $95.8 million, up as expected from Q2’s level of $79.1 million as a result of purchases made to support anticipated demand.

The inventory for the quarter was as follows. Raw materials $29.4 million, work in process $5.5 million, finished goods $81.5 million, and a reserve for excess obsolescence of $20.5 million. The largest increase came in the area of finished goods, which was up 19.4% from Q2. Product inventory turned to a 2.9 in Q3 down slightly from 3.0 in Q2 as expected, given the increase in inventory. We expect Q4’s inventory levels to increase from Q3 as a result of additional purchases we’ll be making to support demand as a result of shipments on which revenue recognition will likely be waiting for customer acceptance beyond Q4. Deferred revenue decreased in the quarter from $58.8 million in Q2 to $42.6 million in Q3. Deferred revenue for Ciena generally consists of service related revenue for which we’ve been prepaid. However, occasionally, it will also contain equipment related to revenue from a customer who has paid us but from whom we do not yet have acceptance to trigger revenue recognition. This was the case in both Q2 and Q3 and this quarter like past we were able to recognize substantial portions of the equipment related deferred revenue due to timing of product acceptance and associated revenue recognition.

Finally, head count. Our worldwide head count at the end of the quarter totaled 1422, an increase of 34 from Q2 reflecting normal hiring and attrition as well as ramping our R&D facility in India where we now have roughly 80 employees. And now I will turn the call back over to Gary.

Gary B. Smith - President and CEO

Thanks Joe. Continued progress in the focused execution of our strategy is helping align our business model and enabling us to capitalize on the available market opportunity. At the macro level consumers and in part the enterprise market is driving business to our traditional Telco customers at an accelerating pace from the last several years. It’s no secret that following the protracted low and significant capital expenditure on network infrastructure, our customers particularly Telco carriers are opening up spending again to support the increase in demand on the networks. We’re finding that these capacity requirements have been generated both by broadband subscriber growth and an increased uptake in higher bandwidth optical services and end user applications, which is expected to continue.

In addition to near term success based spending trends we have also recently had conversations with customers, again the Telcos in particular about next generation network bills and Steve Alexander our Chief Technology Officer discussed with you last quarter, all network operators today have some mix of legacy WDM, TBM as well as new packet based networks. Our service providers face an increasingly competitive landscape and mounting end user demands for new high bandwidth applications, they are also realizing they must respond not just with the right services but at a much faster pace. So with they begin to change what they sell, they are increasingly looking to next generation solutions to help them do it faster and more efficiently. We are hearing from customers that as demand grows for broadband and IP services Ethernet combined with WDM for transport along with packet aggregation and switching are emerging as the most economical and efficient technologies for delivering and transporting services. In other words our FlexSelect vision and architecture is resonating. And in many of these conversations with customers we find ourselves revisiting several of the innovative technologies we talked about prior to the industry turndown, like 40 Gigabit Ethernet intelligent control plans among others.

Of course, we are cautious in our optimism about these conversations and recognize that these preliminary talks did not imply imminent business opportunities. We do however view these conversations as a positive indicator that the industry is focused on overall growth but is simply on cost reduction. Again we stress that our customers are still spending carefully and are only beginning to interpret the necessity of these next generation technologies in serving real customer needs. We are encouraged though by our conversations with these customers as well as commentary from industry observers. Several industry analyst firms report anticipation of a healthy next generation solutions market moving forward. We support that notion as networks are upgraded for today’s pure capacity needs and the service providers increasingly realized the inherent value and flexibility in next generation largely for net-based infrastructures.

We are confident that our specialist role position is to benefit from this trend as customers start to make the transition. In particular, we are encouraged by customer response to our FlexSelect vision; our approach to converge the Ethernet architectures and have the value about product portfolio notably the CN4200 family is resonating in the market. And well my comments thus far have been primarily telco centric we’re seeing this sentiment across our customer segments from telco to cable to government and also in some specific enterprise verticals like financial services. We are also seeing new fits for some of these solutions in nontraditional applications. For instance this quarter we secured two new MSO customers for our core directed platform and we are engaged with a number of US and European organizations in the research and education community where our innovation and technologies are congruent with advanced network research.

Turning to how these market dynamics are affecting our business. As I mentioned earlier this marks our 10th straight quarter of revenue growth and significant progress towards sustained profitability and in improving operating model and we are confident, that despite some expected variability in gross margin based on the timing a magnitude of our ongoing product and manufacturing related cost reductions, product mix, customer mix and volume, we can sustain a gross margin range in the mid 40s. In addition, this quarter’s results also point the continued focus on driving efficiencies across the company.

On the operation side we continue growing our India R&D facility where by this fall we should have more than hundred engineers onboard. At the cost of good sold level we have extended our work in Asia with suppliers and contract manufactures to continue improvements of our supply chain model and we have teams dedicated to improving back office systems and rationalizing associated processes. All these efforts are designed to enable us to scale our business without necessarily incremental costs and provide the underpinning for the growth of our business. As Suzanne noted, we’ve also announced today that our board of directors has approved a one-for-seven reverse stock split to be affected 5 pm. Eastern on September 22nd. We believe that affecting the reverse split will enhance the stock’s appeal to a broader range of investors and permit some more meaningful comparison of our results of operations in the future.

In summary, fiscal Q3 illustrates continued progress in the execution of our plan. With driving sequential revenue growth that is a result of sustained market strength and our position as a specialist the network transition. While we continue to expect quarter-to-quarter variation in our gross margin driven in large part by product and customer mix a game we’re increasingly confident that our business can sustain gross margins in the mid 40 range. Our focus on operating expenses remains persistent as we continue to implement efficiencies across the company to improve and normalize our business model. We’ve talked before about the challenges we’re facing growing and scaling our business, which are markedly different than those we endure during the industry slump.

We are making steady progress but we are not underestimating scope of the changes we have yet to make. For example, we continue to work to streamline many of our back office operations to improve the efficiency of those systems and processes and to enable us to more efficiently deal with projects that can range from wholesale network upgrades to spot capacity related additions. Positive sign to both renewed network investment fueled by growing demands of capacity as a result of greater broadband usage and wider mix of services and applications have us encouraged about the future. We expect our role of the network specialist will continue to provide us momentum and enable growth in our business as the need proliferates to transition networks for improved service delivery. We have the opportunity to discuss our progress and I will look in more detail at our upcoming analyst day planed for October 10th in New York City. More information about the event will be made available in the coming weeks including a detailed agenda. With those comments Joe, will you walk us through the guidance for Q4, please?

Joseph R. Chinnici - CFO

Certainly, thanks Gary. Before I begin to offer guidance I will remind everyone that the comments Gary just made, and those that I am about to make are forward looking. It is important to review the risk factors detailed in our 10-Q in order to understand the factors that may cause actual results to different material from this guidance.

As stated in the press release, we expect our fiscal Q4 revenue will trend up sequentially by as much as 5% from our fiscal Q3 revenue. As we said previously gross margin is difficult for us to predict with the accuracy as it ultimately depends on a combination of volume, product mix, customer mix, and the effects of our ongoing product cost reductions. While we continue to pursue additional product and manufacturing related cost reductions, we expect quarter-to-quarter variability in gross margin in large part depending upon product mix. Based on anticipated product mix, we expect the Q4’s gross margin will be down from the Q3’s and as we stated last quarter we expect that overall the next several quarters our gross margin will settle in the mid 40s.

We expect as adjusted operating expenses in the Q4 exclusive of any unusual or non-operating items will increase moderately from the Q3 reflecting the timing of some R&D related expenses. We expect the other income expense in Q4 will be flat to up slightly as a result of improving interest rates. We expect other income net of approximately $9 million. Adjusting for the one-for-seven reverse split announced today, we estimate Q4’s basic share account at approximately 84.7 million total shares. Again, adjusting for the one-for-seven reverse stock split announced today, we estimate Q4’s fully diluted share account at 93.4 million total shares.

On our tax rate as we stated last quarter, we have NOLs in excess of $2 billion, and as a result we are not like you to pay US Federal Taxes for sometime after we achieve GAAP profitability. However, to this point we have been using a 35% tax rate in the presentation of our as adjusted results. And we expect to continue to do so through the remainder of fiscal 2006 effectively one more quarter. We acknowledge that this presentation may not reflect what is like to be our actual tax obligation in near term and as such we expect to amend our as adjusted presentation to reflect the substantially lower tax obligations as we move into fiscal year ‘07. Adjusting for the one-for-seven reverse split announced today we expect that exclusive of unusual or non-operating items, and exclusives of share based payment expenses related to 123R, our adjusted Q4 net income will be in a range of $0.10 to $0.12 per share.

Finally on cash, we expect overall operating cash needs will increase slightly from the Q3’s $18.8 million as a result of general working capital needs including inventory and accounts receivable. In addition, because of the timing of the end of the Q3 the interest payments were both the 0.25% and our 3.75% convertible notes will fall in our fiscal Q4.

Operator, we will now take questions from the sell side analysts.

Question-and-Answer-Session

Operator

Thank you. [Operator Instruction]. We’ll go first to Paul Silverstein at Credit Suisse.

Paul Silverstein - Credit Suisse

All right two questions, my first on British Telecom. Can you give us some more insight in terms of what your expectations are going forward, its been less than 10%, but the bulk of it is still to come, can you give us any insight, Gary and Joe on the timing as well as perhaps the magnitude and other sensitivity to particular account?

Gary B. Smith

Sure Paul, we recognize revenue in Q3 and we see for both 21CN and some non-related 21CN deployments were not 10% customers as we said. We continue to see orders from BT relating to networks outside of the 21CN billed, which in quarter to quarter could be as much or if not more than some of the 21CN business generally appears on track. So it’s a large program, from our perspective and you know it’s going to spread out over a couple of years as was originally planned.

Paul Silverstein - Credit Suisse

That’s Gary on the on-track comment; you haven’t seen any evidence of the slowdown particular expected 20% we billed up for optical.

Gary B. Smith

You know I can’t talk BT and I certainly wouldn’t want to but from our perspective it appears on track, it’s a big project and we are beginning to take revenues from it, it’s going to fluctuate quarter to quarter, from our perspective but it appears on track.

Paul Silverstein - Credit Suisse

Okay and secondly on the competitive landscape, in particular -- but in general, can you give some commentary what you are seeing out there in both material and long haul?

Gary B. Smith

Steve, do you want to?

Stephen Alexander - CTO

So, with regards to all of -- you have to take any kind of competition seriously. You see competition coming from the local suppliers, overseas in particular from the Chinese suppliers and you see that folks like Infenaro who are, I think going after kind of a tier-two and tier-three carriers where they kind of focus mostly on some of the short-term CapEx, in general we take all competition seriously I think, fortunately the innovations that we put in was FlexSelect and FlexiCore and the ability to migrate networks from the SONET/SDH, TDM world over to Ethernet are playing out very well in the marketplace.

Paul Silverstein - Credit Suisse

Gary, have to had to respond to the pricing in any situation assuming -- vis-à-vis -- etc?

Gary B. Smith

You know I think value proposition is different from those guys so and I don’t think, you know we certainly wouldn’t compete with the Chinese guys on price that’s not the market that we are after and that’s not -- Steve said with the FlexSelect architecture and the rest of it, that’s not really the market we are going after.

Paul Silverstein - Credit Suisse

Thanks a lot.

Operator

I will go next to Cobb Sadler at Deutsche Bank.

Cobb Sadler - Deutsche Bank

Thanks a lot. I just want to drill down a little bit on the gross margin, you got it write down quarter to quarter, but it sounds like BT will continue to increase and a lot of that revenue up to half, I understand is that the CN4200. So are you just kind of low on margins a little bit been conservative or are you seeing something out there that, in the pricing front?

Gary B. Smith

Cobb, surprised --that, but I can understand the perception. Now I think -- in all seriousness a lot of moving parts to that gross margin is a lot things that can effect it and we do expect the season variability. I think you know we have strong gross margins in Q3 primarily at the result of increase cards versus chassis on the long haul. BT was not the biggest factor -- you know it was less than 10% quarter and it’s not going to be the biggest factor in product mix on a whole, generally looking at role of the moving parts to that our genuine perspective is that it’s going to be in the mid-40’s range.

Cobb Sadler - Deutsche Bank

Okay great and, Joe, could you give me the raw material number again?

Joseph R. Chinnici

Sure, Cobb give a couple of second.

Cobb Sadler - Deutsche Bank

Okay great and -- but the finished goods was like about -- it’s up about $13 million quarter-over-quarter and when -- I’m assuming a lot of that is product you’ve already shipped into a carrier network or about to ship. You know, but your guidance is only up roughly 5% so I’m just wondering if you shipped a lot of product, would you expect to recognize that an out quarter or how should we look at that?

Joseph R. Chinnici

Okay Cobb, this is Joe. You asked for the raw material number, correct?

Cobb Sadler - Deutsche Bank

That’s right.

Joseph R. Chinnici

29.4.

Cobb Sadler - Deutsche Bank

Got it.

Joseph R. Chinnici

All right, now what you are also asking about is some clarification on the finished goods space. Like every other quarter a big of piece of that finished goods is sitting offside but basically waiting for revenue recognition. What we’ve also done as we’ve started to move some other stocks closer to the customers and that’s why you are seeing the finished goods go up as well, more from a customer service level and being able to shorten lead times for our customers because a lot of this business is success based, and you got to be able to response very-very quickly.

Cobb Sadler - Deutsche Bank

Got it, okay, thanks a lot.

Operator

We’ll go next to Ehud Geldblum at JP Morgan.

Ehud Geldblum - JP Morgan

Hi, thank you very much. Looking at the earnings guidance that you guys have revenue is up and clearly gross margin seems to be coming down a little bit from the, the shift I am guessing from the long haul card sales that you are selling. I’m assuming that’s into that third 10% you have announced since 2002. The EPS number, that was down from this quarter $0.10 to $0.12 I’m looking you basically did around $0.15 when you assume kind of adjust for the trajectory, I’m sorry for the reverse stock split. How should we be looking therefore, I mean you had a bunch of quarters of earnings going up, how should we be kind of thinking about the earnings and why would it be going down next quarter is really kind of -- was this a one-time nature that you had this kind of -- one-time kind of purchase from this 10% customer that you don’t expect to repeat, just trying to clearly how we should be thinking about the down earnings guidance for next quarter?

Joseph R. Chinnici

Sure, hi, Ehud, this is Joe. It’s a good point, good observation, I am glad you hit it head on right upfront, again a lot of it is driven by the customer mix. If we go back to the guidance -- I feel like a broken record that we talked about how difficult it is to forecast the gross margin but it is really difficult with regard to channel, the chassis and we don’t know when they are going to want some of this stuff, like we do, going forward again gross margin will be a big piece. The op ex as likely some of it has to do with the timing that’s impacting your observation and what the earnings are doing, but going forward as we move the revenue line consistently upward the leverage of that will be -- we’ll drive through to the bottom line is just that we can’t give it to you in this particular quarter.

Ehud Geldblum - JP Morgan

Okay, so the main difference is -- the discrepancy between the revenue going up next quarter and the earnings going down is primarily the gross margin, it’s not really the op ex and that has to do with the mix shift coming back, do you think?

Joseph R. Chinnici

You know, it is really you know, if you put it simply it’s gross margin, we’re forecasting down little, op ex slightly up, you put those two things together and even with you know, our revenue’s forecast up, that get you to the operating performance. I think the important thing is that we have got good operating leverage in the business it’s going to continue to improve our operating model. It just with even with revenues up we are looking at it, we the gross margin began little Opex slight likely and that’s the end result for it.

Ehud Geldblum - JP Morgan

Right, one last thing to add into that, you said before that your run rate of 4,200 if that was going to get to $40 million a quarter here $11 million second straight quarter. Each of these shipments will double that so another $11 million I guess is that the increase in finish goods that fitting up in the field while you recognize -- are we still on pace to get to $40 million in revenue not just shipments per quarter by the middle of ‘07.

Joseph R. Chinnici

Let me qualify something, my $40 million number I’ve been talking about the past couple of quarters with supply chain, which is stuff here and stuff on the way. We are very much well on our way to that, indicate that what we are doing is the shipments are very, very strong in -- very, very strong in Q3 and they are expected to be very, very strong again in Q4. I’m worried about that I could tackle quite, certain about it. The big piece they are -- to bridge with the GAAP is predominantly nothing but rev reg and getting those expect the certificates.

Ehud Geldblum - JP Morgan

Okay, by a very strong Q4 you mean even stronger than the $22 million in Q3?

Joseph R. Chinnici

I can’t go there, but you know because we get into more qualification over forward-looking guide here, but we are comfortable at what we say.

Ehud Geldblum - JP Morgan

Thanks so much guys.

Operator

And we’ll go next to Marcus Kupferschmidt at Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Hi, good morning everyone.

Joseph R. Chinnici

Good morning Marcus.

Marcus Kupferschmidt - Lehman Brothers

Couple of -- could you comment about 4200 revenue recognition delays versus the big shipment this quarter. Is that spread across a bunch of customers or is that highly concentrated into any individual accounts and I have a couple of follow-ups.

Gary B. Smith

It’s across the number of customers.

Joseph R. Chinnici

Yeah Marcus I would also point out that it’s not delay so don’t get me wrong here. I don’t want to cause any issues. It’s just the normal sequence of shipping something, installing it and getting the ref reg.

Marcus Kupferschmidt - Lehman Brothers

Understood, now when you think you can support $40 million a quarter run rate it’s you know shipment rate would that be a pretty diverse shipment across many customers or do you think there will be any real you know concentration of those roughly $40 million a quarter shipments?

Gary B. Smith

Well the design of the supply chain -- has put in place is basically to be able to service any customer.

Marcus Kupferschmidt - Lehman Brothers

All right but did you think about your goal for you know let’s say mid-fiscal year ‘07.

Joseph R. Chinnici

Marcus let me answer this. We have very broad customer uptake of the platform right from the you know more traditional Telcos right way through you know MSOs into the enterprise base, into the R&A community. So it’s a lot of customers you know there has been some concentration during that for sure, but it’s a lot of customers making up those numbers we had 16 customers in Q3, for example.

Marcus Kupferschmidt - Lehman Brothers

That’s great, for shipments and revenues.

Joseph R. Chinnici

That was for actual revenues so you know that $11 million we recognized you know from those amount of customers. So I will give you some kind of view about --

Marcus Kupferschmidt - Lehman Brothers

What about your -- a customer of yours is returning this quarter for a lot of long haul. Do you think that’s the kind of near term shipment blip or a lot of catch up words that may give you a sense that kind of activity can continue over the next couple of quarters because they have got some bigger projects, how should we think about that?

Joseph R. Chinnici

I think I have sense you know without getting specific about the customers let me talk sort of generalities, I mean I think we have seen it across the board of ongoing activity you know from time to time you will get folks playing sort of catch up with not having invested over the last few years but I think that’s largely settling down and I think its real demand driver it’s success base that putting it on for real customer demand. And I think you know, you’ll see blend of that going forward but I think you know, I think we are encouraged by you know, ongoing activity there.

Marcus Kupferschmidt - Lehman Brothers

Thank you

Operator

And next we’ll go to Nikos Theodosopoulos at UBS.

Amitabh Passi

Hi, this is Amitabh Passi on behalf of Nikos. Just a couple of questions on the data networking business, you had another sequential uptake in the quarter, should we expect the strength to continue or do you think we might see you know, sort of revenues drop off in the next couple of quarters.

Gary B. Smith

You know, I think yeah you are going to see some fluctuation quarter-to-quarter across the portfolio you know, Steve, do you want to talk about some of the things we see there?

Stephen Alexander

Again one of the trends that we’ve talked about in the past that we are doing with the portfolios is moving some of the core competencies and the contributions around, so a lot of the feature set that in the past we would have just said okay because it only shows up on the VN series for example is now moving over to show up on the 4200 series, on the CoreDirector, on the Core Stream. So the way we talk about the portfolio have to change as well, al right, we are moving Ethernet features on the world of platforms now, but pretty much every platform that we have in market have Ethernet features on it. And so you are going to find those technologies are distributed throughout the entire feature offset, the whole portfolio feature set.

Amitabh Passi

Okay, and if I may, just one quick follow up question. Last quarter one of your international channel partners was quite a significant customer, should we consider that’s sort of a one-time event like last quarter or do we expect this customer to again be fairly significant down the road?

Gary B. Smith

You know, again I think you may see fluctuation there I mean, it’s ongoing business with them you know, it’s going to be fluctuate from time to time we have little bit of pens up rev rec because we articulated in Q2 so it might not be as large as that, but you know, we do up ongoing relationships with a number of partners. You are going to see a sort of you know, steady business problem.

Amitabh Passi

Okay thanks, Gary.

Operator

Next Brantley Thompson at Goldman Sachs.

Brantley Thompson - Goldman Sachs

Hi guys, two questions. Could you give us a little bit more color in terms of what type of tax rate you know, we can expect to see you know, going forward in terms of the company, like where is your cash tax now and is that how you are thinking about presenting results going forward, and then I got a follow up.

Gary B. Smith

So, Brantley, what you are really asking for is some guidance going into ‘07 I’d say let’s hold off for that and maybe we can add that one of the things when we talk about when we get to the Analyst’s Day, because that’s going to be a little complicated and we should leave it for that rather than for on this call.

Brantley Thompson - Goldman Sachs

Okay, and any -- but indication can kind of where cash taxes have been running on a quarterly basis?

Gary B. Smith

It’s very, very small probably you know, for a yearly thing, annually and well less than million-plus.

Brantley Thompson - Goldman Sachs

Well less than million per year, okay.

Gary B. Smith

Yes.

Brantley Thompson - Goldman Sachs

And then in terms of the gross margin in the mixed impact you are seeing, can you talk -- I know you’ve given an indication for the next quarter but you can you just talk you about the mix, what you see is kind of the predominate mix trends over the next, say you know, three quarters or so and then who we should be -- you know, how we should thinking about that, clearly 4200 is going to continue to ramp as a percentage of overall sales you know, what do you see kind of for long haul in some of the other businesses?

Gary B. Smith

What I’m trying to, Bran, I mean it’s hard to predict the sort of mix, though we are encouraged by what we’re seeing on the 4200, I think the Core switching and core transport, as well as you know, we were beginning to see a good cadence rate on that. So I mean I think we are going to see fluctuations on that, and that’s what leading us to -- with all the other moving parts predict to gross margins sort of in the mid 40’s range but, you know, I think we are encouraged by the DM what we were saying their as well, but you know, to Steve’s point from a portfolio point of view you are seeing this really converging is actually become a reality across the portfolio and so you are looking at some of the functionality and application that we’re shipping products for and as you know, we ship in 4200 or some -- and transport applications that are really what you call sort of regional transport. So you are really beginning to see you know, a convergence across the portfolio.

Brantley Thompson - Goldman Sachs

Okay, thanks.

Gary B. Smith

Thanks Brant.

Operator

Next Mike Jenneweave from Citigroup.

Mike Jenneweave - Citigroup

Great, thanks a lot, hi guys.

Gary B. Smith

Hi Mike.

Mike Jenneweave - Citigroup

So everyone with a fiber oriented access business, I know if your business is more copper oriented, but practically every vendor that sells access equipment or here that support fiber to vx access project has recently seen a weakening of demand and forecasts both in North America and Europe. So my question to you guys is first of all what do you seeing are given that you have a copper oriented access business, and secondly what are your thoughts about fiber access as a demand driver for optical capacity in the metro, and the core and the network. Are you worried about some of these slowdowns and delays in fiber access eventually having a follow on impact in the capacity market? Thanks.

Gary B. Smith

Steve do you want to -

Stephen Alexander

Sure, so you know, again I think it’s import we kind of play ring behind the first point of aggregation on the fiber fix side as you pointed out we do a piece on the copper and the copper we expect is going to fluctuate around with different bills and different demand rates, in general the expand which demands on the networks continue to increase you know, especially as some of the first video services are stating to turn up and newer application show up on the internet. So, we see a continuous increase if you will in demand for capacity and bandwidth and you know what that is fueling the mood from you know, 2.5 gig transport up to 10 gig transport up to 40 gig transport. So, we were comfortable people are going to continue to use you know, the network capacity going forward.

Mike Jenneweave - Citigroup

the follow up. Do you think that the capacity that’s been put in today is being putting into support today’s growing traffic demand say network traffic is going in well and excess of 50%. Are you putting into support the services that are on the network today or you are seeing customers pre-building capacity for their planned video service architectures sales over the next 3 to 5 years and sort of things, look we need so much capacity over the next 5 years, so we better start planning it today because the video is this huge demand?

Gary B. Smith

No, that I think as Steve said, you know, that might be the case in some of the access places, but not well worse it Mike we manage really kind of at classified as success based you know, and the other driver that as you know, well as things like IPTV have got a lot of publicity you know, you won’t stand that broadband generally still increasing, what you said yourself, you know, the copper based continues to stuff continues to rollout, we have also got enterprises with huge amounts of increasing data requirements driven by compliance and the businesses you got new models with maturing along the internet, you got the advent of music and video etc., driving all of that. So, I think the macro we were comfortable the stage set above the ongoing drivers of demand you know, including IPTV, but Mike I would say that what we’re seeing right now is success price bills.

Mike Jenneweave - Citigroup

Thanks Gary.

Operator

Next, Tal Liani with Merrill Lynch.

Vivek Arya - Merrill Lynch

Thank you, it’s Vivek Arya on Tal’s behalf. In the last few quarters you have benefited quite a lot from channel cards sales and I just wanted to understand typically what is your visibility into that like do you already know how many channel cards you will sell in the next two quarters and I’m just trying to basically gauge how sustainable that business is because that has implications on both your top line as well as your gross margins?

Gary B. Smith

Vivek it’s a good question you know channel card visibility, the answer to that is probably not a lot of visibility -- you know success bags. You know, and I would say it was -- we’re pointing to that clearly you know as one of the big factors with a strong gross margin performance and Q3 if we look back at some of the other improving in gross margins and sort of Q2 wasn’t really channel cards mix in Q2 that got us to 48% gross margin. It was a mix of other products and though the customers mix is there as well. So I think you know that whole -- one of the strategy we put in place with rebuilding the company is to get a broader base portfolio across the broader customer base so that you know as one or two trends and fluctuations within the quarter might be negative or positive you know that has moves us over you know the broader customer base and product base and I think that’s what we are beginning to see. So you know whereas I think the Q3 gross margins were pointed to the channel cards, in Q2 it was a different mixed of products and customers.

Vivek Arya - Merrill Lynch

Got it and when you look at the question on operating expenses as you look into the next few quarters do you see plans in place, do you have the leverage in place to lower Opex or do you expect it to remain steady or do you think that is the way to perhaps get it down to the low at mid-50s?

Gary B. Smith

You know I wouldn’t go with the numbers to that you know but I would say clearly that we’ve got more rooms continue to drive efficiencies and to work leverage across our operating model and that include you know, all aspects. So I wouldn’t necessarily point to just the Opex line you know as talk in the commentary you know we’ve got India ramping up and that will help drive operating efficiencies as well. So you know we’ve got some engineering expenses that will likely to take in Q3 which is why we are forecasting Opex slight up, but it is going to fluctuate. I would not say that it would you know continue to go down.

Vivek Arya - Merrill Lynch

Got it, one last question the broadband actually screwed. Do you still view it as a growth opportunity or is that -- this is going to be stable in this $20 million to $25 million range for the next few quarters at least?

Gary B. Smith

Well we do say it’s a growth opportunity you know we are looking at other developments and investments that we’ve made during the last few years and new features that are driving that. We still see you know copper deployments has been you know a good tool and the carrier’s armory of getting broadband out there can be very, very cost effective. We’ll continue to invest in that space and we have some new platforms coming out there. So we think that you know it will be a growth opportunity all the time.

Vivek Arya - Merrill Lynch

Okay, thank you.

Operator

We’ll go next to Samuel Wilson from JMP Securities.

Jonathan Ferguson - JMP Securities

Surprise, this is Jonathan Ferguson for Sam. Just a question, how would you characterize the performance in the quarter -- obviously you know with a strong growth and in which shipment for 4200 and where it looks like good sales to possibly AT&T. If you look at the company’s performance outside of those two areas, how would you characterize quarter-on-quarter?

Gary B. Smith

You know I think you know I’ll classify you know if you look across the portfolio I would say was strong. I would also say across you know the diversified customer base it was strong as well.

Jonathan Ferguson - JMP Securities

Okay, and then you do well Avaiva in the marketplace obviously you know they use price as a part of advantage. What is the reason the customers go with you behind its stock base, especially in a new bill?

Gary B. Smith

We don’t see Avaiva that much, you know because we really don’t focus on the low cost or the commodity areas where they are plying quite frankly and then we see them from time to time and some European belts, where we win against then is where the customer really valued, the value proposition that we have, which is not about just being the cheapest point piece of transport. So you know we don’t see them that often, you know sometimes they are included RFPs, somewhat as a strategic stocking cost by the purchasing departments, but when you really get down to it, you know and the application requires you know real innovation and they are looking at the total life costs of the products and they are looking at operating expenses etc. We, you know more often than not we will win.

Jonathan Ferguson - JMP Securities

Okay and then when you look at how your headcount breakdown will look over the next four quarters, obviously you are continuing to add headcount in India, you know US versus international headcount and R&D. How would that look over the next four quarters?

Gary B. Smith

Steve you want to --

Stephen Alexander

So the North American headcount and R&D will be roughly flat and growth will be offshore besides the India facility handles a total of 300.

Jonathan Ferguson - JMP Securities

Got it, thank you.

Operator

We are going next to Tim Savageaux with Merriman.

Tim Savageaux - Merriman Curhan Ford

Hi, good morning.

Gary B. Smith

Hi Tim.

Tim Savageaux - Merriman Curhan Ford

Congratulations on lovely quarter.

Gary B. Smith

Thank you.

Tim Savageaux - Merriman Curhan Ford

A couple of questions, first regarding your guidance and this kind of follows on to the chain of hard and visibility question. To what degree does that guidance include or not include any assumptions regarding seasonality of capital spending among your customers or you know kind of typical late year uptakes that we see them looking at last year when things were nearly as wonderful for you guys and you’re up 7% sequentially. So you know I would imagine with limited visibility it wouldn’t include much in terms of assumptions of a broad seasonal uptake, but that’s question number one. And then question number two is, there has been a lot of comments about sort of slightly kind of moderately Opex and we didn’t get just a tad more granular on that you know you did 59 which is great you got below the $60 million I think for the first time. I assume you are going to come above that, but may be not too much you’re sort of in the 62-ish area the first couple of quarters. Can you give us a little more kind of specificity with that?

Gary B. Smith

Okay, Tim I’ll take the first question and Joe will address the opex question. You know, typically we have not at the business scene too much seasonality. I think we did make the comment last August where we sort of particularly low order and I think at the time of the call, you know we want to articulate that because that’s what we were seeing. We are really not seeing that this year and think we are, you know we’re making judgments and our overall visibility based on you know backlog and customer interactions. You know the some assumptions about some, you know run rate guidance of channels and thing, but I wouldn’t say that place is a large part and you know we’re certainly not you know accounting on some end of year, you know uptake in it. So I think we have you know pretty good solid visibility and for the forecasting for the next quarter also. Joe, do you want to --?

Joseph R. Chinnici

Sure. Tim, before I answer your question let me qualify my answer a little bit. A lot of what this is driven a lot by the R&D side and the project that Steve is working on with a lot of variable spending related stuff, like an oz mine or prototype or stuff like that. It’s big, there are big numbers that we haven’t being brief probably about with what Steve’s working on, quite a few new things. In terms of innovation those guys are really prinking and they really got the machine going. So as it relates to that, I’d say it could possibly go up a few million dollars on the map side.

Tim Savageaux - Merriman Curhan Ford

Okay, thanks very much.

Operator

And we’ll go next to Simon Leopold, Morgan Keegan.

Simon Leopold - Morgan Keegan

Thanks, I wanted to ask you maybe a bit more of a philosophical question. If you could to talk to two different scenarios, one is Alcatel and Lucent agree to merge, how that affects the competitive landscape for you, and then the second scenario is that if their merger gets voted down what that does to competitive environment for Ciena. Thanks.

Joseph R. Chinnici

It’s an interesting philosophical question, Simon. I think generally speaking you know, I think it’s good for the industry you know, the consolidation there I think you know that certainly it’s going to be a challenging integration for them. You know, and I think if you were to summarize it any confusion is good for us. About the -- you know, if they were to merge you know, this is only probably going to be the good degree of confusion going on with the best life plans. And if they don’t that’s going to be confusing too because I think you know, what we are not focused -- started planning on the basis of the merger. So you know, all confusion amongst that competitive is a good thing for us to grab market share. And you know, I think you got lot of customers saying you know, if the merger does happen, this potentially opens up a landing slot, to use an airline parlance, where they want some diversification of customer base.

Simon Leopold - Morgan Keegan

But is it fair to say that what's in Ciena’s best interest is for the merger to complete?

Joseph R. Chinnici

You know, Simon, I wouldn’t sort of -- you know, I wouldn’t conclude that. I’d say you know, genuinely in the big picture of things not hugely impactfully the way but you know, our ongoing consolidation I think is generally good for the industry you know, having said that if you want to really get philosophical about it I think that’s -- I think is a good thing.

Simon Leopold - Morgan Keegan

Okay, thank you very much.

Operator

And we’ll take our next question from Subu Subrahmanyan - with Sanders Morris.

Natarajan Subrahmanyan - Sanders Morris Harris

Thank you, my question is regarding the deferred revenue Joe had talked about you know, CN4200 shipments being very strong but some revenue recognition going from pervious line card -- channel cards, could you just give us a sense of overall what's going on with deferred revenues given the pieces that are incoming in and out, and is that CN4200 higher shipment all in that the current deferred revenue?

Joseph R. Chinnici

Now, Subu, let me start at the back and work my way forward on your question. In terms of deferred revenue there isn’t a lot of 4200 in that classification per se, okay. So the 4200 is more tied to offside inventory than it is deferred revenue. The deferred revenue, we got some older contracts with a bunch of stuff that are tied to services where people have the right to do some -- what's the good word, a soak -- which is a little bit different than an FLA application but they pay you for. In the case of the 4200 it’s newer, it’s more success based, its kind of a new business paradigm were you got to get it, you got to get it installed and they will pay to that average.

Natarajan Subrahmanyan - Sanders Morris Harris

I got it, so just line card and channel card business and the customers, they kind of came back was that the piece that led to our significant revenue recognition and lowered differ revenues this quarter?

Joseph R. Chinnici

That’s hard to say Subu.

Natarajan Subrahmanyan - Sanders Morris Harris

Got it, all right thank you.

Operator

Next (inaudible) Partners.

Unidentified Participant

Thank you, I just want to go with the deferred revenues in different way. Can you differentiate for us how much of that deferred revenue was longer type billed that are now getting recognized as opposed to products that has to be reconfigured, first specific classifications of the customer. The changes in this classification and also in the finished goods inventory has there been a change in demo units for say in the finished goods or if some of that build up related to a change in shipping methods from aero plane to shipping overseas by boat?

Gary B. Smith

Okay, so let me try to -- those are complex ones, do you know -- deferred revenue, none of it has to do with changing a -- customers changing specs. I don’t ever recall getting having to deal with anything like that -- that I have been here, so hopefully nails that question. On the finished good side, I guess your question is more originated to as we change our supply chain and move in to cheaper cost location aided, we have a lot of stuff on a boat instead of plane the answer is no. So that wouldn’t account for any growth and in finished goods inventory as it relates to the demos, we have had no change in what we do or how we do on that front as well.

Unidentified Participant

Okay, so then as your success with optical switches is -- as I understand it has been very strong in overseas markets and as you move into the US markets with the new products, does that effect your mix between chassis and line cards and is that a factor in your -- or your different guidance for the next, for the Q4 for gross margin.

Gary B. Smith

Simplistically I have to say no, again the mix driven by channels and line cards impact the margin, sometimes we do know about and sometimes we don’t, in the case of the 4200 it gets shipped out as a box then it’s very different than the days of old with the century with the agility in that, you don’t have a whole lot of channel card adds to 4200 because the product was constructed that way, the 4200 right now is more a product that is, grown feverishly in Europe as oppose to North America, although North America is doing very well in the enterprise space MSO space. Bu it’s grown gone crazy in Europe.

Unidentified Participant

Okay, so is there, has there been a change in the ratio of flat in over -- broad deal in your products between the natural Internet products and the bigger switches and between that ratio of sale cost in European sales versus US sales. So in other words, is there more room in the boxes to be filled with interface switch cards as your -- as you see the market in the US?

Gary B. Smith

Dana, this is Gary, let me try and help you with that. The 4200 basically is preconfigured, so you know it doesn’t -- its not the same dynamic as Joe was saying from a channel line cost. Now with that business continues to ramp and becomes a bigger percentage of our business, overall the dynamic around the channel card becomes lesser by relevant one over a period of time for us. That said, we still got of lot of chassis out there both within the optical switching space and within the CoreStream Agility space as well, its good.

Joseph R. Chinnici

Dana, just so you get the full picture. One of the innovations around the 4200 platform is that you can stack them and so it’s a little bit of a different model in the past you filled a large chassis that you would add channel cards to the 4200 against the, one of the innovations in the way it was architectured. Whether you can actually stack them up.

Unidentified Participant

Great thank you.

Gary B. Smith

Thank you.

Operator

That concludes the question and answers session today ladies and gentleman. At this time Mr. Smith, I will turn the conference back over to you for any additional or closing remarks.

Gary B. Smith

Thank you and thanks everyone for your time this morning, for your continued support. We look forward to seeing many of you at the upcoming financial conferences during the next several of weeks and our Analysts Day on October the 10. Thank you.

Operator

That does conclude today’s conference ladies and gentleman. We thank you for your participation and everyone may now disconnect.

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Source: Ciena F3Q06 (Qtr End 7/31/06) Earnings Call Transcript (CIEN)
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