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Executives

Jerry S. Rawls - Chairman of the Board and Co-Principal Executive Officer

Kurt Adzema - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Finance

Eitan Gertel - Chief Executive Officer and Director

Analysts

Alexander B. Henderson - Needham & Company, LLC, Research Division

William H. Choi - Janney Montgomery Scott LLC, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

James M. Kisner - Jefferies LLC, Research Division

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Joseph Wolf - Barclays Capital, Research Division

Natarajan Subrahmanyan - The Juda Group, Research Division

Michael Genovese - MKM Partners LLC, Research Division

Rob Richardson - Stifel, Nicolaus & Co., Inc., Research Division

Troy D. Jensen - Piper Jaffray Companies, Research Division

Dave Kang - B. Riley Caris, Research Division

Richard C. Shannon - Craig-Hallum Capital Group LLC, Research Division

Finisar (FNSR) Q2 2014 Earnings Call December 5, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Finisar Corporation Announces Second Quarter Results Conference Call. Just a quick reminder, today's conference is being recorded. And now at this time, I'll turn things over to Jerry Rawls, Executive Chairman.

Jerry S. Rawls

Thank you, Jessica, and good afternoon, everyone. We appreciate your taking the time to listen to our conference call today. A replay of this call should appear on our website within 8 hours. An audio replay will be available for 2 weeks by calling area code (888) 203-1112 for domestic or area code (719) 457-0820 for international, then enter the ID number 5981213.

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

We have prepared some slides for today's earnings call. You can access them by connecting to the Investor Relations page of our website at finisar.com, click on Investors, then scroll down to Webcast Archives and click. You'll see a listing for today's second quarter 2014 earnings call.

I am pleased to report second quarter revenues were $290.7 million, a new all-time record for Finisar. Revenues increased by $24.7 million or 9.3% over the first quarter and by $58.7 million or 25.3% over the second quarter of the prior fiscal year.

Our revenues increased for the fifth consecutive quarter. This quarter's revenue growth came from both datacom and telecom products. As a result of these higher revenues, a favorable product mix and our operating leverage, we were able to achieve non-GAAP gross margin of 37.1% and earnings per diluted share of $0.43. You may remember that we had guided to gross margin of approximately 36% and EPS of $0.37 to $0.41.

Now I'll let Kurt review the rest of the numbers. Kurt?

Kurt Adzema

Thanks, Jerry. Revenue for products for data communications was $204.3 million, an increase of 10.7% from Q1, primarily driven by increased sales of 10Gig and above Ethernet transceivers. Revenue for telecommunication products was $86.5 million, an increase of 5.9% from Q1, primarily driven by increased sales of wavelength selective switches and ROADM line cards.

In the second quarter we had one 10% or greater customer. Our top 10 customers represented 61.4% of total revenues compared to 59.7% in the preceding quarter.

Non-GAAP gross margin was 37.1% compared to 35.1% in the preceding quarter, primarily a result of higher revenues, a favorable product mix and operating leverage.

Non-GAAP operating expenses were $63.2 million, an increase of $2.3 million over the prior quarter. This increase was primarily driven by higher compensation expenses. Non-GAAP operating income increased to $44.8 million or 15.4% of revenues compared to $32.4 million or 12.2% in the preceding quarter. This was primarily driven by revenue growth and improvement in gross margins.

Non-GAAP income was $43.8 million or $0.43 per diluted share, compared to $31.3 million or $0.31 in the preceding quarter.

Average diluted shares for non-GAAP purposes totaled 103.7 million. This includes the impact of converting the principal amount of our outstanding convertible notes to equity for the purpose of calculating EPS. Therefore, you need to add back $539,000 of interest expense and other costs associated with the convertible notes to calculate diluted EPS.

Non-GAAP taxes are estimated at approximately 3% for the remainder of fiscal 2014. Weighted average fully diluted shares for fiscal third quarter are expected to be approximately 104.5 million for non-GAAP purposes.

Second fiscal quarter capital expenditures totaled $29.7 million. Capital expenditures are expected to be approximately 32 point -- $32 million in fiscal third quarter, primarily driven by the starting of construction on the shell of the second building of our new Wuxi, China production site. We expect the shell of the building to be complete by fall of 2014 and will be fitted out a floor at a time as needed to accommodate growth and migration of manufacturing to lower-labor-cost regions.

Cash and cash equivalents increased $28.1 million over the prior quarter to $316.5 million at the end of the second quarter. There are a number of noncash or infrequently occurring charges and benefits which we exclude from our non-GAAP results. These totaled $13.8 million last quarter. If you include all these items as required under GAAP, we generated net income of $30 million or $0.29 per diluted share compared to $26 million or $0.26 per diluted share in the preceding quarter.

That concludes my comments, and I'll turn it over to Eitan.

Eitan Gertel

Thanks, Kurt. In Q2, we continue to make significant advances in our product development activities, resulting in the delivery of a record number of new products to our customers. Demand for our 6-gigabit and 10-gigabit optical transceivers for wireless systems was strong due to a large number of global LTE deployment. Currently, our 10-gigabit SFP+ wireless is being designed into new systems by many of our customers.

We continued our 10-gigabit tunable SFP+ module -- sorry, we demonstrated our 10-gigabit SFP+ tunable module in September of ECOC show in London. We have begun shipping samples to our customers. Our industry-leading, low-power consumption of approximately 1.5 watts is due to our internal tunable laser, custom ICs and advanced packaging technology.

For 40 gigabit, we are continuing to add capacity for both QSFP SR4 using multimode fiber and LR4 using single-mode fiber. In addition to our QSFP transceivers, demand for our QSFP active optical cable for both 4 x 10 gigabit Ethernet and 4 x 14 gigabit InfiniBand SDR applications was strong.

For 100 gigabit, we are ramping production of our next-generation CFP LR4 and CFP2 LR4 modules, both of which use Finisar directly modulated laser that operates at 28-gigabit per second. They enable us to significantly reduce both our power consumption and cost. At ECOC show in London, we have demonstrated the industry's first 100 gigabit CFP4 module for short reach application. It represents another 50% size reduction and power reduction as compared to a CFP2. We are also making good progress with our CFP4 long reach application.

Our parallel optical engine module are now shipping at both 10-gigabit and 25-gigabit per channel. These modules are being designed into numerous supercomputers, high-end servers, Ethernet switches, routers and wireless systems.

Lastly, our single and 2-slot WSS solutions with our 2 x 1 x 20 and 2 x M x N next-generation WSS modules have been sampling to customers. We believe that due to our long experience using our unique LCoS technology, we will continue to offer the highest performance products available in the ROADM market. Our ROADM line card programs are also progressing well, and we had a nice revenue growth in Q2 as we started to ship production quantities to multiple customers.

Now I'll turn the call back to Jerry for final comments. Jerry?

Jerry S. Rawls

Thanks, Eitan. For the fiscal third quarter we expect revenue and operating income to increase again for the sixth consecutive quarter and to set new company records. We believe revenues for our third quarter will be in the range of $290 million to $305 million. We expect non-GAAP gross margin will be approximately 37%. This reflects leverage from higher volumes, partially offset by the impact of 1 month of the annual telecom price reductions that typically take effect on January 1.

Non-GAAP operating margin is expected to continue to improve to approximately 15.5%. Non-GAAP earnings per diluted share are expected to be in the range of $0.43 to $0.47 per share.

Finisar's revenue is driven primarily by growth in the world demand for bandwidth for the ever-increasing distribution and use of video, images and digital information. Another important trend that is benefiting us is the growth in cloud services, with larger data centers and increasing number of longer, higher-speed connections. This increases the optical content in data centers and creates more opportunities for Finisar products. Over time, both enterprise and carrier spending will continue to increase to provide more bandwidth capacity. We believe Finisar is uniquely positioned with our broad product line, extensive customer engagements, profitable vertically integrated business model and strong balance sheet to capitalize on these market opportunities.

And now with that, I'm going to turn it back over to Jessica, and open it up for questions. Jessica?

Question-and-Answer Session

Operator

[Operator Instructions] And we'll first go to Alex Henderson from Needham & Company.

Alexander B. Henderson - Needham & Company, LLC, Research Division

A couple of quick questions. One, was there any 10% customers in the quarter? Two, was the ROADM business up quarter-to-quarter? And then can you just talk a little bit about the gross margin outlook as we go into the seasonally weaker April quarter with the full price hit? I just want to calibrate on that a little bit so we don't make a mistake. And off of that, can you talk a little bit about whether you think you're kind of tapping out on the upside on gross margins?

Kurt Adzema

All right, Alex, I'll try to handle these. First of all, there was one 10% or greater customer. Your second question on the WSS, like we said, WSS and ROADM line cards was the primary driver for the growth in telecom. And in terms of gross margins, again, we said gross margins for this quarter are expected to be approximately 37%. And typically, like you said, there will be 3 months of price erosion in Q4 and gross margins tend to be a little bit lower in Q4 based on that. But obviously, it will depend on revenue growth and product mix as well.

Alexander B. Henderson - Needham & Company, LLC, Research Division

Just to follow up that last question, so are we starting to run out of room to push these gross margins up? I mean, you've had a hell of a run. And it started to get pretty rich on the gross margin. Are we starting to tap out on margin expansion there or no?

Kurt Adzema

Gross margins will always be driven by product mix and also by revenue growth. So I think it ultimately depends on those factors. Again, we don't provide any guidance beyond the near term on those factors, but we still feel like this quarter we're going to have healthy gross margins despite the 1 month price erosion.

Operator

We'll now go to Bill Choi from Janney Capital Markets.

William H. Choi - Janney Montgomery Scott LLC, Research Division

My question is largely oriented to understanding the sustainability of the strength in the datacom. I mean, when we look at it, there's kind of some various trends, some opposing. You have very positive ASP boost as you get to 10, 40 and 100 gigs. At the same time, units -- depending on which customers you sell to -- could be a little bit more challenged. And so I wanted to understand, how much of the strength we're seeing and strength you're anticipating is coming from ASPs versus units? Can you put some thought around that?

Jerry S. Rawls

Well, I would -- I think you're a little bit right in that the strength in the market is really in the higher speeds. And if you remember, what's really going on in data centers is a lot of 1-gigabit Ethernet connections are being replaced by 10 gigabit, 40 gigabit and in some extreme, in some cases 100 gigabit. And each one of those carries a higher price tag. But I think the most important thing is that many of these connections now in data centers, more and more are optical every quarter. Because it is -- copper connections are being converted to optical connections at higher speed. So I think fundamentally, that's what's driving our business.

William H. Choi - Janney Montgomery Scott LLC, Research Division

If you look at the units, and I kind of alluded to this a little bit, one of your largest customers gave a pretty tough outlook and just wanted to see how you were thinking about that part of the unit business when some of these customers have inventory hub pull systems and visibility is inherently limited, any thoughts on how you've kind of thought about units as you look out into the January quarter guidance?

Jerry S. Rawls

Well, we have -- in any quarter, we typically have about 1,000 customers. And they're spread all over the world. And so we always want all of our customers to do extremely well. But the good thing is, we got enough of them doing well that it's carrying our business forward.

William H. Choi - Janney Montgomery Scott LLC, Research Division

And then just in terms of the customers, there's -- you guys are in a good position to sell directly to large web companies that are building out major data centers. Can you compare and contrast some of the characteristics of how these customers differ from your traditional OEM customers when they're making vendor selections. How many providers they select? And what the rollout schedules look like and visibility you have to these things?

Jerry S. Rawls

Well, I would say that they differ. Every Web 2.0 data center operator is not the same as every other. They have different criteria. They have -- they run -- some of them build their data center architectures around different speeds, and their selection processes are different. So it's hard to generalize. I will say that many of these Web 2.0 companies have hired substantial technical staffs to be able to evaluate hardware like our optics so that they are able to procure it reliably from suppliers like ourselves. But I don't know that I could generalize and say, "Well, they're a lot different from selling to an OEM." I think they're becoming more like OEMs, actually.

William H. Choi - Janney Montgomery Scott LLC, Research Division

But are you getting more visibility out of these deployments? And how big were these customers in providing this strong current business trends, can you quantify that? And that's it for me.

Jerry S. Rawls

Well, I think to Web 2.0 in this quarter was more than 10% of our revenue. And it was up nicely from the quarter before. So I think that's a very encouraging trend from us. With respect to visibility, we don't maintain the same kind of inventory hubs or just-in-time hubs that we do for our OEM customers. So we do get purchase orders. We do have lead times. We do schedule deliveries. So in some cases, that means that probably lead times are maybe more visible with the Web 2.0 companies than they are with our OEMs.

Operator

And we'll now move to Kent Schofield from Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Could you comment on how telecom fared relative to your expectations? I think you were looking for Q-on-Q growth, kind of some of the put and takes relative to your expectations. And then maybe just a little bit more broadly, you've been talking about some better trends there on the telecom side of things. Does it continue with that trajectory?

Kurt Adzema

Well, I think the quarter came in for telecom about as we expected. The prior quarter had grown quarter-over-quarter 3-plus percent. We expected it to grow faster. It grew at 5-plus percent. So I'd say in general, I think the quarter from a telecom perspective generally came in as expected. For the next quarter, again, we expect some unit growth, but at the same time, we've got 1 month of the telecom price erosion. And so in general, I think, those will offset each other.

Kent Schofield - Goldman Sachs Group Inc., Research Division

And just more broadly and looking more into '14. Does it seem like things are getting better there still or is it still too early to tell?

Eitan Gertel

We think so. If you look at the telecom market for us, as we said before, with the contribution for our revenue are going to come from 2 areas. One is growth in market share and the other one is growth in addressable markets. So we still think that the combination of both of those will be beneficial for us through 2014. And as we go into that, the more deployment, the more metro business will be addressed towards the end of '14, we think it's going to be even better. But for us, it's a contribution of both those areas, the expanded market share and the growth in the addressable market.

Operator

And we'll now go to James Kisner from Jefferies.

James M. Kisner - Jefferies LLC, Research Division

So my favorite question, 100 gig. Could you comment on just the tracking, the relative growth of 100 gig versus 10 gig? I mean, is 100 gig kind of maturing a little bit? Or you still see CFP adoption pretty strong?

Jerry S. Rawls

We actually -- in our quarter, 10 gig actually was stronger than 100 gig.

Kurt Adzema

But 40 was the strongest, I would say, out of the 3.

Jerry S. Rawls

Right.

James M. Kisner - Jefferies LLC, Research Division

Is the 100 gig still growing sequentially or is it flattening? How do we think about the trajectory of that, CFP1, excluding CFP2 and CFP4.

Jerry S. Rawls

Well, at least for right now, CFP is -- the growth rate has -- what's the right word? The slope has flattened out. But one of the things you got to remember is, we're now shipping CFP2 to a lot of customers. So the focus that was on CFP has now shifted to CFP2. And as we pointed out in the call, we shipped -- we have actually supplied samples of our first CFP4 products to initial customers. So 100 gig is still alive and well.

James M. Kisner - Jefferies LLC, Research Division

Okay. Great. Great. Separately, just want to drill down on -- there's been some concerns -- I guess, conceptually, can you just talk about this on a non-customer-specific basis. So when a company has a wait-for effect on a new platform, I mean, is it logical for you to ever see any of that? I mean, wouldn't it sort of make sense for people to just keep buying transceivers for the old platform? Or do you occasionally see kind of a wait-for effect when a platform -- there's a platform wait-for effect at a customer? And I guess, sort of also relatedly, internationally, I'm assuming that you're not seeing any fallout from security concerns. You have physical layer technology. There's no intelligence really in it, so I wouldn't think that you'd have, for example, Chinese folks would not choose to work with you. I assume that your the best cost. They buy the best cost, best product quality. Just can you comment on those 2 trends? And I'll pass.

Jerry S. Rawls

I don't recall having seen a wait-for effect on our sales, but I'm sure it must have happened. I mean, if there is a new system about to be introduced and somebody has announced it, I'm sure there's a delay by the end users of purchasing the previous model and waiting for the new model. And in some sense that, you don't -- if there's a slowdown in the shipment of systems, that will slow down the shipment of optics as well. So I'm sure we've seen it. But I can't -- I couldn't specifically recall where that really had a meaningful impact on our business in any quarter, I don't know, in history, honestly. With respect to China, no, we don't have any intelligence. I mean, we have a processor and memory in almost all of our devices that we ship. There is firmware and software, but we are not monitoring the bits as they flow across the link. And we're really looking at physical layer properties. We're looking at the optical power. We're looking at voltages and temperatures and physical layer sort of properties. So there hasn't been an issue in China and, in fact, we just received an award from the government of China as the largest optical supplier in China. So it's, I think we're doing fine over there.

Operator

We'll now move to Simon Leopold from Raymond James.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

I had a couple of questions. Let me start with probably the easiest one of the night. Your G&A expenses in October took a little bit bigger jump than we were expecting. Just want to get a little bit more color on what caused that jump and how to think about that. And then moving on, I wanted to see if you could comment on 2 trends. One is, the pricing environment, particularly on 10 gig in the datacom world. And the other one is, if you could give us some perspective on the conversion of metallic media to optical media in the data center, presumably that's one of the big growth drivers here is the adoption of optics replacing copper metallic media. So if you could give us a sense of where you think the industry is and what that transition might look like over several quarters or a couple of years?

Kurt Adzema

So yes, so I'll start with the G&A question. So I think the increase in G&A was a combination of 2 things. I think first of all, it was increased legal costs, which tend to be lumpy quarter-to-quarter. And then there was just some increased compensation expenses associated with the higher level of profitability.

Jerry S. Rawls

10 gig pricing, I would say, was quite normal in the quarter. Most of our products, especially if they're reasonably mature products, we expect the prices to come down over time at some reasonable rate. And generally, the datacom prices are doing exactly that. So I don't -- we didn't see anything surprising in 10 gig pricing. And the conversion of copper to optical in data centers and in the equipment for data centers, is mostly about a conversion from 1-gigabit transmission to 10-gigabit transmission. And this trend is going to continue for a very long time because many of the server connections today that are in a rack -- that are very short -- they can be a foot or 2. Those are still direct attached copper in many of the data centers. But in the next generation, as those go from 10 gig to 40 gig, a lot of those connections are now going to become optical. So we're going to see, in my lifetime, a time when data centers are virtually all optical. But it's going to take, I don't know, 5 years for us to get there.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Do you have a sense of where we are today as to what percentage of ports today are metallic versus optical?

Jerry S. Rawls

Well, it sort of depends on where you look. If you look at switches, you'll see that a large percentage of the 10 gig connections in switches are optical. But if you look at servers, you'll find that a large percentage of the connectivity -- 10 gig connectivity for servers is in fact direct attached copper. And another -- but the server connections are very large volumes in data centers, and those are the ones that we see future conversions.

Operator

And we'll now go to Joseph Wolf from Barclays.

Joseph Wolf - Barclays Capital, Research Division

I think along the lines of the last question, Eitan mentioned some strength in the -- seems like high-performance compute market, which has been overall kind of weak this year. But you had strength in Ethernet and InfiniBand. I guess, just in that market itself at the high end, on the server side, can you talk about the fiber versus copper? And then, are you seeing the InfiniBand product move from the high-performance compute into other data center applications? Or does that remain a pretty niche market for you guys?

Jerry S. Rawls

That's a Mellanox question, I think. Mellanox would say that a lot of their storage system and switches are being sold in lots of applications besides high-performance computing. And I don't have a really good insight into that. Eitan, do you have?

Eitan Gertel

No.

Jerry S. Rawls

I mean, this is -- I guess, I would -- I'd have to refer you to Mellanox and talk to them. I know that one of the things for us for high-performance computing -- the reason that we talk about it is that we have a number of companies who are in that market, and we've never really had any exposure at all to high-performance computing. Yes, some of the storage and some of the connections were in fact optical, but an awful lot of them were parallel optics, really high-speed interconnects. And those were products that we did not make. And we have only entered that parallel optics market in the last couple of years. But our market share is growing rapidly, and the number of new designs that we are engaged in with high-performance computing systems companies, as well as many, many other segments of the IT industry is really, really encouraging to us.

Joseph Wolf - Barclays Capital, Research Division

So I guess just -- and I didn't mean that to be a Mellanox question, I was really focusing on that mix shift within high-performance compute and some of that. If you look at those different markets, are there different rates of conversion where we could be looking for faster deployment of optical versus copper?

Jerry S. Rawls

Sure. No question that high-performance computing uses more optics than a commercial data center serving a commercial establishment.

Eitan Gertel

I think we've mentioned the high-performance computing in 2 segments: One is in the active optical cable, the other one is our board-mounted optics, which is our new application for us as people are building supercomputers. So the combination of both is a market growth for us and market share expansion.

Operator

Subu Subrahmanyan has our next question, and he's from Juda Company.

Natarajan Subrahmanyan - The Juda Group, Research Division

Could you talk about -- within datacom 10, 40, 100 approximately sizing for how big they are as part of datacom? And I know you don't want to talk too much specifically about individual customers, but I'm just wondering, given Cisco's guidance in general for datacom if you're building in some measure of buffer given VMI makes it hard to predict some of the trends until the pulls actually happen.

Jerry S. Rawls

We are predicting growth this next quarter in datacom, and we are predicting that our telecom business will be relatively flat. And we think that 10-gigabit sales in datacom are going to continue to grow. 40 gig is going to continue to grow. And 100 gig is going to grow at a slower rate. So I mean, that's our outlook.

Natarajan Subrahmanyan - The Juda Group, Research Division

And could you size those different elements within datacom 40 [indiscernible]?

Jerry S. Rawls

Well, 10 gig is our largest segment. But 100 gig is not too far behind. It's not -- honestly, isn't our second largest segment, but it is not too far behind. And then 40 gig is sort of the newer entrée for us. But 40 gig is growing very rapidly right now. And as Kurt mentioned earlier, the 40-gig products and data centers were our -- was our -- on a percentage basis, was our fastest-growing product last quarter.

Natarajan Subrahmanyan - The Juda Group, Research Division

And from an order trend perspective, Jerry, can you just talk about how the quarter played out and the last few weeks have played out as you think about guidance?

Jerry S. Rawls

Well, I don't think there was anything extraordinary about last quarter. That was a pretty linear quarter for us. Remember, datacom is 70% of our revenue. Datacom sales come from just-in-time inventory pulls. We have a few customers who are on the same quarter that we're on that ended in October, but most of the quarters ended in September, and we didn't -- so we saw some August-September activity, we saw some September-October activity, but nothing -- we didn't see anything that was unusual. It was pretty linear.

Operator

Our next question comes from Michael Genovese from MKM Partners.

Michael Genovese - MKM Partners LLC, Research Division

Just to explicitly clarify, are you looking for both telecom and datacom to be roughly flat to up 5% sequentially in January?

Kurt Adzema

So I think what we said was that we think telecom will be relatively flat given the fact that units will grow, but will have the 1 month of the price erosion. And that we expect the growth to come from datacom.

Michael Genovese - MKM Partners LLC, Research Division

Got it. Okay. And then in datacom, I guess it's not just the Web 2.0 guys that are building data centers, I think the U.S. government is also pretty aggressive there. So are you starting to see any U.S. agencies as meaningful customers for your datacom business?

Jerry S. Rawls

No. We don't sell directly to -- I mean, that's not fair. I mean, does any branch of the U.S. government ever buy optics from us? Sure they do. Is it a huge -- is it a big customer? No, not usually, unless it's something special, but usually not. Usually, we sell to the OEMs, who, in fact, ship their boxes to the data centers that are operated by the government. Or we ship to VARs, and the VARs ship the products, so.

Michael Genovese - MKM Partners LLC, Research Division

Got it. And then finally, can you just, in general terms, characterize where you think the state of Chinese demand and network builds are right now both for wireless and for core optical networks? Just there's been a lot of conflicting data points on China. How would you sort of characterize where we are right now?

Jerry S. Rawls

I'd say the Chinese market is really strong right now. Wireless build-outs are strong. 100 gig long-haul build-outs are also strong. I mean, I think that infrastructure spending on communications is going to be a focus for China for quite some time. So things have definitely picked up over there.

Operator

Our next question comes from Patrick Newton from Stifel.

Rob Richardson - Stifel, Nicolaus & Co., Inc., Research Division

It's actually Rob in for Patrick today. First off, congrats on a good quarter. I wanted to kind of follow-up on China, just this week we saw some kind of announcements that some of the service providers there had received licenses to begin operating the TD-LTE network. Just wanted to get your kind of thoughts, comments on what kind of an impact do you think that is for you and the timeframe that maybe that could start to impact your business?

Eitan Gertel

Well, I mean, we don't work directly with the operators in China. The demand from China we've been getting from our OEM customers. And as Jerry was mentioning and we talked on the call is that there's a great demand for wireless connectivity in China to connect new towers. And we think all those announcements are positive for us. But we cannot sit here and time it. We just -- we're waiting for it to happen. But all of those announcements seems to be -- will be positive for revenue growth.

Rob Richardson - Stifel, Nicolaus & Co., Inc., Research Division

Great. And kind of just in general, we've seen pretty strong trends in datacom for the last couple of quarters, I wanted to get some thoughts on where you think you are in that cycle? And I guess, how sustainable those trends can be going forward?

Jerry S. Rawls

Well, I don't view it necessarily as a cycle. I view this as really just the evolution of data centers in the world. And it is, as the speeds get faster, as the data centers get larger, they have to use more optics. And the physics are in our favor. And I think that's a great trend. But it's not a cycle. It's a trend that's going to go on for years, decades.

Rob Richardson - Stifel, Nicolaus & Co., Inc., Research Division

Great. And then I guess one last question for Kurt. So for year-over-year comparisons, can you tell us what kind of contribution Ignis had last year just to kind of compare what the difference was, the growth between this year and last year?

Kurt Adzema

I don't have those numbers in front of me. I mean, candidly, as we've talked about, we've divested 2 of those businesses. But the stuff that's been divested is not material. So I wouldn't really factor that into the growth. Obviously, we've had healthy growth even year-over-year after divesting those 2 smaller businesses.

Jerry S. Rawls

And we had nothing from Ignis in this past quarter, did we?

Kurt Adzema

For the businesses that we've kept, yes. But again it's...

Jerry S. Rawls

Ignis, not the ones that we sold.

Kurt Adzema

Right, but the ones we've kept, there is a small amount of revenue, but it's immaterial to us.

Eitan Gertel

I mean, the main reason we bought Ignis was not for revenue. We bought it for the technology. And that's what's embedded in our product. And that's where you'll see the impact.

Operator

Our next question comes from Troy Jensen from Piper Jaffray.

Troy D. Jensen - Piper Jaffray Companies, Research Division

So a quick question for Kurt. Just kind of following up on margins, I guess, everybody knows that telco margins are lower than datacom margins, but can you talk about contribution margins? And if we get a higher mix of telco sales, will that actually be accretive to the gross margin line because of the better contribution margins there?

Kurt Adzema

Well, again, I think you need to understand that there's differences between products even inside of datacom and telecom. So I think it's going to depend on which products grow. But again, overall revenue growth is good for us, whether it's datacom or telecom volume is good for us. Especially to the extent that, that volume is for production capacity that we already have. So in general, we're very happy to see last quarter that both the datacom and the telecom grew. And obviously in CY '14, we hope that telecom grows overall for that year.

Troy D. Jensen - Piper Jaffray Companies, Research Division

And then on the telco side, is the growth really dependent on metro? Because -- or metro in the U.S. I would guess? Because it sounds like China is strong and -- but this quarter here, it was ROADMs really drove the telco strength and so it's more of a share gain versus kind of market growth, and you're talking about kind of flat sales for next quarter. So what's the big driver? And when do we start to see this better kind of telco sales, maybe for Eitan.

Eitan Gertel

Well, Troy, I think the way to look at it -- what I said about metro is that's another aspect to actually going to accelerate growth in telco, but that's probably at the end of '14, beginning of '15. But growth in telco, as we see it right now, comes from addressing whether it's a long-haul application, an existing application we have. And our growth is driven by 2 aspects: One is growth of market share and the second thing is the addressable market. But we think the combination of both is looking good for us. Now you had another question. You asked me something else?

Troy D. Jensen - Piper Jaffray Companies, Research Division

It was just at the -- ROADMs drove the strength this quarter, and you're talking about kind of flat telco so. I mean, when are we going to see the rest of the telco bucket start to grow is what I was trying to get to.

Eitan Gertel

I think when you see it, when you look at ROADMs specifically, the ROADM grew and line card grew. But I think our comment for the Q3 is, you have the combination of the yearly price reduction, which impacts 1 month or 1/3 of the quarter, and then you have the -- running against the growth. So the combination of both, we say it's somewhat flat total revenue. But we still think that the trend continues for our overall telco business.

Operator

And we'll now go to Dave Kang from B. Riley.

Dave Kang - B. Riley Caris, Research Division

Just wanted to, Kurt, clarify for CapEx. Was it $27 million or $28 million last quarter?

Kurt Adzema

I think it was actually $29 million and change.

Dave Kang - B. Riley Caris, Research Division

Okay. And then tunable XFP, how did tunable XFP do last quarter? And is it going to be kind of flattish this quarter as well?

Eitan Gertel

Well, we're not breaking down to that level of revenue, but we think in general you can look at tunable XFP is doing well as we expected. And we have completed a number of qualifications. And we are doing as we talked about the last conference call that we will be substantially done with every work to be qualified that we can see by the end of this calendar year.

Dave Kang - B. Riley Caris, Research Division

Okay. And then regarding the upcoming telecom price adjustment, any kind of early indication? What to expect?

Eitan Gertel

In general, I would look at it and say that it's within the range of the prior year. That's the way -- that's probably an easy way to look at it.

Dave Kang - B. Riley Caris, Research Division

So nothing extraordinary then? Go ahead.

Eitan Gertel

Either way.

Dave Kang - B. Riley Caris, Research Division

Okay. Got it. And then regarding lead times, I mean, any kind of a stretching in lead times for any of the products?

Eitan Gertel

I don't think there's anything substantial. I mean, we have a few products -- I mean, we have a slightly longer lead time, but in general, our lead times are pretty much on average.

Dave Kang - B. Riley Caris, Research Division

Got it. Got it. And lastly, just going back to China, I mean, when -- you said, it's strong. So when did you see the pickup? And I was wondering if you can just quantify that a little bit. And how large can it get, especially with this 4G activity starting to get going?

Eitan Gertel

I think, it was the strength continues like pretty linear across the quarter. And how strong, how big can it be? We don't know. I mean, right now, we see some trends that we like. And predicting exactly what's going to happen in China is hard for us. But we like the trend. So we will continue to address the opportunities and take advantage of it, but we see the opportunity continue to grow. And as we said, opportunity in wireless for us was also very good. 100G coherent is growing. And we think that, for us, will be more meaningful towards the end of '14.

Dave Kang - B. Riley Caris, Research Division

So with that trend, maybe sometime next year, should we expect Huawei to become your 10% customer once again or?

Eitan Gertel

I can't predict to that point, but it'd be nice if it will be so.

Dave Kang - B. Riley Caris, Research Division

Sure. Just the last question is that, so how big is China for you right now? Just the direct, excluding any kind of CM stuff, just the direct customers. How big is it? Is it like 10%, 15%?

Kurt Adzema

Again, it's hard for us to break out things by geography because, obviously, we don't know. We ship into OEMs, and then OEMs ship -- can ship into the country or they can ship out of the country. So it's really difficult for us to kind of break that down. But I think, as Eitan alluded to, especially on the wireless side, we did see a pickup in China.

Operator

[Operator Instructions] And we'll go to Alex Henderson with Needham & Company.

Alexander B. Henderson - Needham & Company, LLC, Research Division

A couple of quick questions. One, can you just talk to the SAN side of your business quickly?

Jerry S. Rawls

Talk to the SAN. We like SAN. It's a traditional product for us. And it's sort of where we, as a company, got started actually. So actually for us, it's doing quite well. It's -- today, it's mostly shipments of 8-gig and 16-gig Fibre Channel.

Alexander B. Henderson - Needham & Company, LLC, Research Division

Is it still growing?

Jerry S. Rawls

It's still growing.

Alexander B. Henderson - Needham & Company, LLC, Research Division

And the second question, on your tunable XFP, I've been hearing some positive comments about it gaining some real traction. Can you just give us a quick update on that?

Eitan Gertel

I mean, it's tough to comment on specific customers, but I would say, in general, we were in qualification for a long time, and we see majority of qualifications being done by the end of this calendar year. So we think we're in good position. And we're not happy at the rate that it happened. But we're happy where we are, and we think it's going to be a -- continue to be a growth for us in '14.

Jerry S. Rawls

Now to get qualified at all these customers, it just took longer than we expected. And maybe that's to be -- maybe we should have anticipated that given that we're coming in second in the market or, in some cases, third in the market. But 2014 looks like it's going to be a really good year for us for our tunable XFP product because we've got -- we're on the AVL now at virtually every big user of that product.

Alexander B. Henderson - Needham & Company, LLC, Research Division

And then a quick question on the light engine product, are you starting to see some ramp in that product and have you adjusted that software issue that was holding it back a little bit?

Jerry S. Rawls

Well, the software product was customer-specific, and it was -- it's a function that in the IC set that we use. And we are -- it's a matter of, we were buying a commercially available IC. We are now designing our own custom ASIC. We're designing it internally. And that will replace the commercially purchased IC and will provide additional functionality, which solves that problem. But it's not a problem with every customer. And I mean, if you were at the Supercomputer show in Denver here, what, 2 weeks ago, you would've seen our optical engine built into systems, into switching systems on display. It was by the system builders. So it's -- right now, I couldn't claim that we have huge volume, but we are clearly shipping megabucks of optical engines, and we think the market for these things is actually really big.

Operator

And we'll now go to Richard Shannon from Craig-Hallum.

Richard C. Shannon - Craig-Hallum Capital Group LLC, Research Division

Just a couple of questions for me. First of all, on the gross margins, following-up an earlier question, Kurt. As you try to optimize for utilization and you get more output from your new factory in China, kind of curious where gross margins could grow, assuming you're kind of controlling for mix. I mean, is this something that you could approach or achieve 40% at some point? Can you give us any thoughts on how we might think about that and extrapolate that?

Kurt Adzema

Well, I think, it all comes down to revenue growth. I think that's the primary driver. And so depending on what revenue growth exists in calendar '14, I think that will be a big driver. But obviously, we've seen some dramatic improvement on our gross margins in the last couple of quarters. But as you can see, that was -- revenue growth also was very high. So I think we feel good where we're at right now. In the near term, obviously, we've got a little bit of headwind just associated with the normal course of the annual telecom price reductions. But again, I feel like -- we feel very good about where we are in terms of our business model and our gross margins.

Jerry S. Rawls

We've commented for a long time when people ask about gross margins that we thought gross margins could be above 35%. But it was difficult for us to imagine that we could sustain gross margins as high as 40%. So I think we're in a very healthy range for our company right now.

Richard C. Shannon - Craig-Hallum Capital Group LLC, Research Division

Okay. Fair enough. One other question from me, guys. On wireless, you've talked about that for a few quarters being quite nice for you and associated that with 4G and LTE, which is obviously very early stage here. Can you kind of characterize or size that business relative to the rest of your datacom business and where it might be able to go in 1 or 2 years?

Eitan Gertel

It's relatively small compared to the overall datacom business. But we think it has a strong growth aspect to it. So we think it can be a substantial part of our business. But if you compare it to the overall revenue from datacom, you can't look at it as a major part of the datacom.

Operator

And there are no further questions. I'll turn the conference back over to our presenters for any additional or closing remarks.

Jerry S. Rawls

Well, listen, thank you very much. And for all of you that tuned in today, we really appreciate you taking the time to be with us on this call. And we hope you're able to join us again 3 months from today. Have a good day.

Operator

This concludes today's presentation. Thank you for your participation.

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