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Ciena Corporation (NYSE:CIEN)

F1Q10 Earnings Call

March 4, 2010 8:30 am ET

Executives

[Robin Weinberg] – Investor Relations Consultant

Gary Smith - CEO and President

Jim Moylan – CFO

Tom Mock – Senior Vice President of Strategic Planning

Analysts

Mark Sue – RBC Capital Markets

Subu Subrahmanyan – Sanders Morris

George Notter – Jefferies

Paul Silverstein – Credit Suisse

Nikos Theodosopoulos – UBS

Sanjiv Wadhwani – Stifel Nicolaus

Vivek Arya – Bank of America/Merrill Lynch

Jeff Kvaal – Barclays Capital

Mike Genovese – Soleil Securities

Blair King – Avondale Partners

Simon Leopold – Morgan Keegan

[Shubal Gush] – Thomas Weisel

Douglas Ireland – JMP Securities

Operator

(Operator Instructions) Welcome to the Ciena Corporation Fiscal First Quarter 2010 Results Conference Call. At this time for opening remarks and introductions, I’d like to turn the conference over to the Ciena’s Investor Relations Consultant, Ms. [Robin Weinberg].

[Robin Weinberg]

I am pleased to have with me Gary Smith, Ciena's CEO and President, and Jim Moylan, CFO. In addition, Tom Mock, our SVP Strategic Planning will be with us for the Q&A portion of today’s call.

This morning’s prepared remarks will be presented in three segments. Gary will review our financial performance in the first quarter, discuss our view of the market environment, and provide an update on the integration planning around our pending acquisition of the Optical Networking and Carrier Ethernet assets of Nortel’s MEN business. Jim will then detail our Q1 financial results, speak with you about expected financial metrics for the combined organization, and provide our guidance for Q2. We’ll then open the call to questions from the sell side analysts. This morning’s press release is available on National Business Wire and on Ciena's website at www.Ciena.com.

Before I turn the call over to Gary, I’ll remind you that during this call we will be making some forward looking statements. Such statements are based on current expectations, forecasts, and assumptions of the company that could 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 December 22, 2009.

We will file our first quarter 10-Q on or before March 11th. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events or otherwise. Today’s discussion includes certain adjusted or non-GAAP measures of Ciena’s results of operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today’s results release available on our website at www.Ciena.com.

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

Gary Smith

At $175.9 million our fiscal first quarter came in relatively flat which was somewhat lower then we’d previously anticipated. The primary reason for the lower reported sales was revenue recognition delays associated with initial deployments of new platforms with certain customers. Despite that, our strong order flow in Q1 continues to give us confidence that the market environment is in fact improving. Our Q1 adjusted gross margin was within our mid to high 40’s target range of 46.4% and our non-GAAP operating expense remained essentially flat with our fiscal fourth quarter.

We also generated $4.5 million in cash from operations during the quarter. In fact, if we excluded the $11.4 million of cash spent on acquisition and integration related costs, we would have generated nearly $16 million in cash from operations during the quarter.

I’d like to talk briefly about our current view of the macro economic environment and provide an update on our integration planning related to the Nortel transaction. We’re thinking about the current market environment essentially in three ways:

While global market conditions still indicate some uncertainty, we see signs of improvement, particularly in North America. This improvement has manifested itself in the form of more positive sentiment amongst our customer base, an increase in overall levels of activity, and a growing pipeline of opportunities.

As you’ve heard me say before, and as validated in public statements by a number of our customers, the fundamental demand drivers of our business remain in tact. Demand for network optimization is strong and we appear to be in the early stages of an industry wide optical upgrade cycle. Our customers are facing new service demands on their networks and traffic growth continues to pressure existing infrastructure, something that can no longer be ignored. The growth of data traffic on wireless networks alone is a clear evidence of this trend. As a result, we’re starting to see increased spending in selected areas to address these challenges. We’re encouraged by recent announcements from service providers that they plan to increase their CapEx budgets somewhat this year.

This is a view clearly more specific to the current Ciena stand alone business, we’re bringing several new solutions to market, including new switching platforms, carrier ethernet service delivery platforms, and carrier managed service solutions. By continuing to invest in our portfolio during the recent challenging market conditions, we’re able to bring new solutions to market in the near term to more quickly address the areas of concern in our customer’s networks. We will continue that balanced and disciplined approach to investing in the months ahead.

While the reality is that a recovery will not happen overnight, and we’re likely to experience some turbulence as we come out of a global recession, we believe that we are well positioned to be among the beneficiaries of an improving environment.

As a stand alone company, Ciena has enjoyed a unique position to service customers with the solutions and support required to enable true next generation network models. Following the close of the Nortel transaction, Ciena becomes the leading global equipment provider, exclusively focused on the foundations of these networks, converged optical ethernet.

That leads me to our pending acquisition of the Nortel assets, a topic I know people want to hear more about. I can tell you that we remain on track to close the Nortel transaction later this month. We’re working diligently to ensure a smooth transition of the business for the benefit of both our customers and employees. We’re pleased with the progress of our integration planning efforts which have been driven by a team comprised of dedicated internal resources from both companies and third party experts.

As we’ve said before, the Nortel assets allow us to accelerate the execution of our strategy and increase our ability to compete more effectively. In particular, the combination results in greater scale in both R&D and customer breadth and gives us stronger operating leverage. However, we’re realistic about the challenges and risks associated with such a complex integration process but we’re confident in our ability to achieve success and are highly motivated and excited, particularly given the continued endorsements from our customers and our employees.

With that in mind, I’d like to update you on the milestones we outlined last quarter and they include: establishing the leadership structure of the combined enterprise, determining our combined product portfolio, establishing our go to market strategy and field alignment, and describing our revised target operating model.

With the caveat that this is all subject to the closing of the transaction, I’ll start with the organization and leadership of the combined company. I’m pleased to tell you that we’ve chosen our senior management and extended leadership teams and defined their areas of responsibility and accountability. And we have already identified, confirmed, and aligned substantially all of the entire organizational structure. Much of what remains to be completed in the organization is the result of our need to comply with local legal requirements, particularly in Europe. We expect to have resolution on the remainder of the organization shortly after the deal close.

We’ve structured the company around two elements that are essential to our success; quite simply the product portfolio and our customers. Firstly on the product side, Philippe Morin, President of Nortel’s MEN business will serve as our Senior Vice President of our Global Product’s Group. In this role he will drive all aspects of Ciena’s products and will report directly to me as a member of the executive team.

Philippe will build on the combined company’s history of innovation and quality to lead the end to end development and delivery of products, software, and solutions. Working closely with Steve Alexander, our Chief Technology Officer, Philippe will own a number of functions including R&D and product management and product introduction. Philippe will also oversee supply chain management.

On the customer side, Mike Aquino, currently Head of our Global Field Organization will continue serving in his role to drive clarity, accountability, and agility in satisfying our global customer’s requirements. Essentially this group is aligned around the end to end responsibility for the customer’s experience, including account management, channel sales, field systems engineering, and industry channel and field marketing as well as customer service.

We’ve been diligent in our process to fill key positions and retain critical talent to ensure that we assemble a world class team comprised of employees from both companies to lead us forward. I think we’re succeeding at this goal. To date, virtually 100% of the employment offers we’ve extended to Nortel employees have been accepted. With the leadership in place, and the resources of both organization aligned to this structure, we’re ready to execute once the transaction closes.

I might just mention, the product portfolio is one of the key elements of the combined organization. We’re bringing together two complementary technology bases to build a portfolio with greater depth and we think customer relevance. To that end, we’ve made excellent progress defining the combined solution set and we’ll be ready to announce our portfolio when the transaction actually closes.

Our progress in defining the portfolio ensures that at deal close our engineering and field teams can move forward with clarity and our customers are afforded the assurance they seek in Ciena as a strategic partner. We understand that our customer’s and partner’s want Ciena to be decisive and swift in this critical piece of integration planning.

We’ve already gathered critical input and validation through consultation with customer’s of both companies. I have to say that response to our portfolio vision has been overwhelmingly positive. We also have clear plans for ensuring continuity of supply at deal close; in fact, we’ve already successfully managed the transition of the vast majority of Nortel supply contracts. You’ll hear more about the specifics of our combined portfolio once the deal closes.

For now, I can tell you that Ciena will be the only company exclusively focused on converged optical ethernet, which really rests on three key areas of expertise: maximizing the capacity, scalability, and reliability of our customer’s networks essentially through optical technology, and maximizing the flexibility, efficiency and economics of their networks through ubiquitous ethernet technology, and pulling and uniting those capabilities together with the industry leading control playing and management software.

This leads me to the second element of our combined company, our customers. We’ve aligned our field operations to fit the capabilities and strengths of the combined company. In simple terms, the go to market strategy of the combined company is framed around five major regions: the US, Canada, EMEA, CALA, and Asia/Pacific. Within these markets the global field organization will be focused on driving sales into Tier 1, Tier 2 wireline, wireless, and MSO service providers, as well as government and enterprise markets. And we will leverage the combined strength of our partner relationships to enhance that market coverage where appropriate.

We’ve built our organization to ensure tight alignment between Ciena’s global functions and those local and regional teams to better facilitate rapid customer response. With the exception of certain regions such as EMEA, Central Europe, which remains subject to information and consultation processes, the leadership and organization structure of the combined global field operations team has already been established around this model and is ready to move forward at the time of closing.

We’re firmly committed to ensuring a seamless transition for our customer’s and for our partner’s and to this end we’ve established a dedicated customer experience team focused on facilitating effective customer engagement throughout the transition process. In addition, to ensure Nortel customer’s will be able to do business with Ciena immediately after the deal closes, we are well along in the process of successfully managing the transition of the majority of Nortel’s customer contracts.

Given our progress to date in these three critical areas, organizational structure, product portfolio, and the go to market strategy, combined with some resource alignment that is already undertaken at Nortel and separately at Ciena in preparation of the close, we’re very pleased with where things stand on the transaction and the integration planning, including the ability to secure operational efficiencies moving forward.

While we recognize the scale of this integration and the scope of work we face in the coming months, we remain confident in our ability to implement and execute our integration plan decisively and with transparency and deliver on the operating leverage and value of the combination.

With that I’d like to hand over to Jim, who will take you through the details of our Q1 results.

Jim Moylan

As Gary said earlier we reported first quarter revenue of $175.9 million representing a 5% improvement over the same period a year ago. Sequentially, Q1 revenue was roughly flat with Q4 $176.3 million. We had one 10% plus customer in the quarter that represented 24% of total sales. This customer is North American based and was also a 10% customer in Q4. Sales from international customers represented 30% of total revenue in the quarter, roughly flat with Q4.

Turning to our three major product groups, the first, Optical Service Delivery which includes transport and switching platforms as well as legacy data networking products and related software, accounted for $108.6 million in revenue representing 62% of total revenue for the quarter. Within Optical Service Delivery our CN4200 platform was again the largest contributor in the quarter at $55 million. Core Switching contributed $23.4 million and Long Haul Transport added $23 million in the quarter.

Our second product group, Carrier Ethernet Service Delivery or CESD includes our service delivery and aggregation switches, broadband access products, and related software. CESD had another strong quarter increasing more than 33% sequentially from Q4, contributed $40.4 million or 23% of total revenue in the first quarter. As with last quarter a large majority of Q1 CESD revenue came from our Ethernet service delivery aggregation and access platforms. We remain very pleased with the prospects for continued future growth of this product set, which as you know, stems from our acquisition of World Wide Packets.

Finally, our Ciena Specialist Services Group which includes all of our services related offerings reported $26.8 million in revenue in Q1 essentially flat with $27 million in Q4.

In the remainder of my comments today I’ll speak both to the GAAP results and to what the results would have been if we excluded those items which we detail in our press release. On gross margin Q1 GAAP gross margin was 45.6%, adjusted for share based compensation and amortization of intangibles, Q1 non-GAAP gross margin was 46.4%.

Q1 non-GAAP gross margin included a $3.3 million benefit as a result of an out of period adjustment to our accrued warranty liability. Our GAAP product gross margin for the quarter was 48.6% and our GAAP services gross margin was 29% once again better than our target mid 20’s range as a result of the mix of services revenue in the quarter.

On a GAAP basis, Q1 operating expenses totaled $130 million. This total includes acquisition and integration related costs of $27 million, stock based compensation of $7.4 million, and $6 million in amortization of intangibles. Excluding those items, Q1 adjusted operating expenses totaled $89.6 million roughly flat with Q4 and aligned to our guidance.

Our Q1 GAAP net loss was $53.3 million a loss of $0.58 per share. Adjusted for the unusual and/or non-operating items detailed in our press release, our first quarter net loss would have been $11.4 million a loss of $0.12 per share.

With respect to cash flow and the balance sheet, we continue to be pleased with our working capital management and we continue to be cash flow positive. We generated $4.5 million in cash from operations during the quarter, a sequential increase from the $1.9 million we generated in Q4. That takes into account $11.4 million of cash expended on acquisition and integration related costs during the quarter.

At January 31, 2010, we had approximately $1 billion in cash, short term, and long term investments. During Q1 we paid a cash deposit of $38 million for the Nortel acquisition. When we close, as a result of the aggregate consideration to be paid on the Nortel transaction, we’ll be reducing our cash position by approximately another $492 million and we will be issuing $239 million in convertible notes to Nortel.

I should note that the purchase agreement provides for a reduction of the cash consideration to be paid based on the amount of working capital which will be transferred to us at closing. The actual cash paid at closing will likely be less than the $492 million which I quoted earlier.

As we previously disclosed, Ciena may elect to replace some or all of those convertible notes with cash equal to 102% of the face amount for the notes if replaced prior to the closing of the transaction.

For Q1 our accounts receivable balance was $105 million down from $118 million in Q4. Day sales outstanding were 54 down from 60 days in Q4 as a result of good collection work. Inventories totaled $95.4 million in Q1 up slightly from $88 million in Q4. Product inventory turns were 3.4 times for the quarter slightly down from 3.7 times for Q4. Inventory breakdown for the quarter was roughly aligned to that in Q4. Raw materials totaled $18.3 million, work in progress $2.2 million, finished goods $98.2 million, finally we have accrued reserve for excess an obsolescence of $23.3 million. On headcount as of January 31, 2010, our worldwide headcount was 2,197 people.

Before I talk about Q2 guidance, let me add some additional color to Gary’s comments on the Nortel integration planning. I’m sure you can appreciate that because we’ve not yet closed the deal our ability to provide detail on the combined company’s financial metrics is limited. However, as we move forward, we are committed to giving you the information you need to evaluate the performance of the combined company. It is our goal to provide additional detail on that at our analyst day in April, if not before.

At this early stage I can tell you that our current thinking is to describe the business in the following broad areas; transport, switching, carrier ethernet service delivery, and software and services. We plan to be aligned to your interested in giving you enough detail to understand our performance on an as adjusted basis before any acquisition and integration related costs and before the typical items we adjust for that are described in our press release.

We also plan to report separately on deal related costs so you can follow the progress of the back office integration. We also plan to describe our target operating model and our timeline for achievement of certain milestones including expected operational synergies. Also, for the next several quarters, we’ll describe separately the revenue contribution for the Ciena and Nortel product sets so you can track their individual performances.

I’ll close our prepared remarks today by talking to our guidance for Q2 2010. As noted in the press release, our guidance comments today and likely in the answers to any questions about forward looking results will be limited to our expectations of Ciena’s performance as a stand alone company. They will not reflect the addition of any revenue, margin, or expense associated with the acquisition of Nortel.

We currently anticipate fiscal second quarter revenue to be in the range of $185 to $195 million. Based on current expectations and product mix we also believe that adjusted gross margin will be within our target range of mid to high 40’s. We believe Q2 non-GAAP operating expenses will be roughly flat with Q1. We expect other income and expense net in the second quarter will be an expense of roughly $2 million. As for taxes, we expect our tax obligation for Q2 will be related to foreign taxes.

Depending upon your assumptions you may need either our diluted share count or our basic share count. We estimate Q2 basic share count at approximately 93 million total shares. We estimate Q2 diluted share count at approximately 114 million total shares.

We’ll now take questions from sell side analysts.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Sue – RBC Capital Markets

Mark Sue – RBC Capital Markets

The deal does that all get recognized in the current quarter and are there any specific features that the customer’s are waiting for Ciena? As we look at the pending combination of Nortel and Ciena, do you feel that there will be more product rationalization, less rationalization, any thoughts on how the combination from a product point of view?

Gary Smith

On the rev rec, the items that we weren’t able to recognize I’d characterize them, there were two or three of them, all really relating to new platform introduction of one sort or another. The thinking around Q2 is we’re not necessarily expecting all of those deals to come through in Q2 but rather over the course of the next couple of quarters. When we look at the 2Q guidance we’ve kind of blended that and an assessment of risk and likelihood of other things. That’s how we clearly, when we look at guiding for future quarters we take those things into account. I’d sort of characterize it overall as really putting new platforms out there and the revenue recognition challenges associated with those.

In terms of the product integration and alignment with the Nortel platforms, I think that’s going extremely well. I would highlight that clearly some of the high capacity transport technology that Nortel have we’re looking at parlaying that across the portfolio. I think from an alignment around the portfolio perspective I think we feel better about it now than we did last quarter, than we did when we first started the due diligence on the acquisition. The more we get into it and the synergies that we see in terms of cross selling, in terms of parlaying the technologies across the portfolio, I think its fair to say we feel better about that now than we did

Mark Sue – RBC Capital Markets

Should we take that $798 million annualized and your comment we don’t really need to reduce anything there, I guess your comments on optical upgrade cycle also apply not only to Ciena but also the Nortel business.

Gary Smith

The portfolio that we’ve bringing to market around converged optical ethernet I think the timing of that looks to be very favorable given what we’re seeing admittedly in the early stages, given the capacity demands in terms of upgrade requirements across the board I think the timing for that is very good.

Operator

Your next question comes from Subu Subrahmanyan – Sanders Morris

Subu Subrahmanyan – Sanders Morris

Could you touch on what particular platforms were impacted by rev rec, clearly Core Director revenues declined pretty substantially, how was the upgrade to FS if you could talk about a little bit more? My other question was in terms of impact on gross margin of what we’ve seen in terms of the mix shift and how you expect that going forward as you get more of the rev rec from the Core Director platforms?

Gary Smith

Because we’ve got a number of new platforms coming to market it was across the board we had CESD platforms that we’d anticipated to take in revenue on a first office application. We had some of our high capacity optical transport components that we couldn’t complete the complete delivery of the system. We had a few component supply issues so we couldn’t take revenue on that.

The other one, to your point, was around a software upgrade that wasn’t completed in time. I think really it was across the board, I think particularly relating to Core Director FS we do see good traction with that. I think this is probably the low watermark as it were if you could describe that for Core Director.

I think based on the traction that we have and the order profile we really do think that we’re going to see a strong second half improvement in Core Director and Core Director FS. We began at the end of the year to take revenue for the 5430 as well. We’ve secured about four new customers for Core Director, Core Director FS recently and we haven’t taken revenues on any of those yet. Again, that gives us some comfort around the second half ramp.

Subu Subrahmanyan – Sanders Morris

Gross margin impact of the mix shift?

Gary Smith

We’ve hovered around this mid 40’s with some elements coming in and out affecting that. I would expect given that visibility and the changing profile of some of these other more software oriented platforms, I would expect overall that the gross margins to improve. I think they’ll still be in the range but I would anticipate an improvement in gross margin all other things being equal.

Operator

Your next question comes from George Notter – Jefferies

George Notter – Jefferies

I wanted to know about the integration costs, I think coming out of the announcement of the deal you guys are talking about $180 million in cash integration costs. I know you have to replicate the IT infrastructure on the Nortel side. Can you talk about that; is that still a fair estimate going forward?

Jim Moylan

Yes, it is a good estimate going forward. To clarify, the $180 million is really transaction and integration costs and includes the cost arising from the transaction itself such as professional fees, bankers and lawyers and related costs. Yes, the $180 million is what we think it’ll cost. We’re well along in our planning; we focused of course on day one which will be the close date to ensure that we can seamlessly operate the business at that point and doing some planning for day two which will be the day that we remove our reliance on the NBS business and actually have our own IT infrastructure in place.

George Notter – Jefferies

To be clear, how much of that $180 million do think was spent thus far?

Jim Moylan

We’ve expensed $27 million.

Operator

Your next question comes from Paul Silverstein – Credit Suisse

Paul Silverstein – Credit Suisse

Did you quantify the revenue recognition, the revenue that was subject to those four items that you called out?

Gary Smith

We didn’t quantify it. If you look at the higher end of our range when we went into this we anticipated revenues up as much as 5% which would have taken us to that $185 million. Any kind of combination of these rev rec ones would have taken us toward the high end of that range.

Paul Silverstein – Credit Suisse

The translation is there was somewhere in the order of $10 million?

Gary Smith

Slightly shy of that, varied in size, that’s a reasonable view.

Paul Silverstein – Credit Suisse

The four items you called out, I don’t recall hearing anything about Core Director, and so they were either transport or the World Wide Packet ethernet stuff?

Gary Smith

There was a software release that we didn’t recognize. It wasn’t Core Director.

Paul Silverstein – Credit Suisse

The 5400 platforms, that family of products that comes out second half of the year?

Gary Smith

Its out in limited release right now, it’s in a number of Tier 1 labs receiving certification. We would expect it to be shipping GA towards the end of the year certainly. I would expect us to begin to take some small revenues at the end of this fiscal year.

Paul Silverstein – Credit Suisse

Can you help us understand the difference between the 5400 platforms and Core Director FS?

Tom Mock

The biggest issue is size of the platforms. The Core Director platform is basically a 640 gigabit platform but the 5430 can scale all the way up to over 7 terabit. The other thing to keep in mind too is that the 5430 platform has the capability of doing a hybrid switching fabric so it can do TDM switching at sonic, TDM switching as OTN or also packet switching. We’re really looking at that as the way of helping service providers transition to a next generation packet based architecture.

Paul Silverstein – Credit Suisse

You’re expecting GA into this year?

Tom Mock

That’s correct.

Paul Silverstein – Credit Suisse

To address ARPUs like the Verizon RFP, the packet optimal, how big a deal is it to integrate the Nortel optics, I assume that’s what you’ll do to integrate the 100 gig and the 40 gig into those platforms. How big a deal is that in terms of getting that product commercial?

Tom Mock

We’ve done that sort of integration in products before. You may recall that we actually did that kind of integration on the original Core Director platform a few years back. As Gary mentioned, we’re looking to take the Nortel 40G and ultimately 100G technology and push it across our platforms so that’s definitely something that’s in the plans for us.

Paul Silverstein – Credit Suisse

You referenced strong order book, can you give any quantification or any additional insight on that?

Gary Smith

We had a very good quarter last quarter in terms of order flow in Q4. Q1 is normally a low watermark for us given that it straddles a bunch of holidays and end of year stuff from an order point of view right through to the end of January. We were considerably up on this time last year.

Operator

Your next question comes from Nikos Theodosopoulos – UBS

Nikos Theodosopoulos – UBS

Can you elaborate a little bit on the $3 million adjustment to gross margin, why that was taken in the quarter and do you anticipate other meaningful adjustments like this for the remainder of this fiscal year?

Jim Moylan

The warranty reserve is one of several estimates that we make as part of our financial closing process. Looking at the calculation this quarter we decided that a new methodology better estimates the reserve. I’ll note that we’ve had several minor adjustments that we’ve reported to you in earlier quarters such as the higher excess and obsolescence provision that we made last year. Right now I don’t anticipate any more for the rest of the year but these things do happen from time to time.

Nikos Theodosopoulos – UBS

This new method took place in this fiscal year?

Jim Moylan

Yes, this first quarter. I’d mention also that this adjustment is not going to have any affect on our target gross margin at Ciena stand alone.

Nikos Theodosopoulos – UBS

The integration and restructuring costs this quarter about $11 million of the $27 million sounded like they were cash related. Can you remind me what the total cash portion will be for the $180 million? I had thought it was going to be a higher percentage would be cash but this quarter was less than 50%.

Jim Moylan

The $180 million is essentially all cash, some of which is capital in nature. The reason why we only spent $11 million in cash during this quarter was that we had previously spent around $12 million or so.

Nikos Theodosopoulos – UBS

We should still look at the vast majority of the $180 million being cash related?

Jim Moylan

That’s right, $180 million is cash.

Nikos Theodosopoulos – UBS

When I look at the portfolio clearly there are a couple areas where I’m just wondering what the company is going to do. If I look at the 4200 versus the Nortel 5200 and 6500 those seem to be fairly competitive products and I’m curious do you anticipate keeping and investing in both products post the deal or do you envision favoring one of those two portfolios?

Tom Mock

As we said before, we’re going to give more details about our portfolio when we close the deal. A couple things probably bear mentioning there, particularly around the 6500 and 4200. If you look at where a lot of the R&D investment around 6500 has been spent its really been spent around making long distance high capacity pipes possible in the network and being able to manage that traffic appropriately. We focus 4200 is more around short distance metro applications and enterprise and carry managed service applications. There’s probably less overlap there then you might think.

Operator

Your next question comes from Sanjiv Wadhwani – Stifel Nicolaus

Sanjiv Wadhwani – Stifel Nicolaus

Switching was down it looks like around 40% or so sequentially, can you give some color around what might have happened over there? Second question, worldwide packets obviously very strong, is this a lot related to wireless backhaul mostly or are you seeing a lot of business ethernet services also, and any thoughts on AT&T and Clearwire for the rest of 2010?

Gary Smith

Core Director by its nature we’ve seen in the past it can be very lumpy. You’ve got existing customers that deploy this in sort of waves. The forecast from those customers is very positive for the second half of the year and we’ve seen that historically as well. I think we have a high degree of confidence around the install base, continuing to have an up tick in the second half.

Also, we’ve put a lot of new features and functionality in there in terms of the Core Director FS which is really things like OTN capability which really link that then into the 5430 and beyond. We’re going through some of the transition I think possibly with that as that gets certified in labs, etc. as they begin that upgrade.

We’ve also won with that platform about four new customers very recently for that that we haven’t taken revenue too yet either. We’ll recognize those in the second half so that gives us some comfort around that as well. The pipeline and activity around Core Director FS and particularly toward the end capabilities we’re very encouraged by. I think as we step back from it and look at that I think we feel pretty confident around the second half of the year for Core Director.

In terms of the CESD which resulted really from the World Wide Packet acquisition, we’re very pleased now with the traction that that’s taking. I would say that while its backhaul clearly features very prominently in terms of the applications there. I would say that we’re beginning to ship now to some of the business ethernet stuff as well, that does take longer in terms of integrating into OSF systems and into the marketing and sales constituents around the front end of these large carriers. We are starting to see that, it’s somewhat success based. We now have a broad range of carriers that are using the CESD platform to deliver ethernet based business services.

Sanjiv Wadhwani – Stifel Nicolaus

AT&T and Clearwire for the rest of 2010?

Gary Smith

We see continued strength.

Operator

Your next question comes from Vivek Arya – Bank of America/Merrill Lynch

Vivek Arya – Bank of America/Merrill Lynch

On Nortel’s $800 million or so in revenue recognition for nine months, can you give us a sense of what the corresponding order rates were? I believe in the past Nortel had large deferred revenues.

Gary Smith

That’s not something we can talk to you, to be honest. The plan, Jim outlined the framework for how we’re going to discuss all of that. I think we’re looking to give a very robust set of facts out on milestones as we go forward so you can see the information that you need. We’re not really in a position to do that right now.

Vivek Arya – Bank of America/Merrill Lynch

Conceptually on the full portfolio integration issue, I know there’s been a lot of discussion on the optical side. What about overlap on the ethernet switch side, will you need to rationalize motive there platforms just because of your own CESD platforms are newer and I believe doing so well. I think the past Nortel had about a $200 million or so annual run rate in its Metro Ethernet products.

Gary Smith

Clearly we’ll give detail of this at close. What I would offer you is if you look Ciena’s strengths its really in sort of world class switching, software integration. I would also say our carrier ethernet services as well. You can see the traction for yourselves. Those are the things that we would focus on and then the high capacity 1400 gig transport from MEN.

Vivek Arya – Bank of America/Merrill Lynch

Services gross margins declined a lot sequentially, any specific reason for that?

Jim Moylan

As with our products, our set of services that we offer there’s a range of margins which we experienced based on I’d say the complexity of the service offering. Our margin can move around on services just as it can on products depending upon the mix, so there’s no trend to be taken from that, it was better than we had thought and hope it’ll continue to be good.

Vivek Arya – Bank of America/Merrill Lynch

What’s your view on the balance sheet after you pay for the Nortel assets? I believe you’re planning to pay more cash, at least considering paying more cash than you thought before.

Jim Moylan

I’m not sure what the reference is to more cash, this is the cash that we negotiated during the auction, and it is the amount we’ve been talking about for a while. We will issue a $239 million convertible at the close and we have the right to take that out if we so chose but I can’t comment any further than that.

Vivek Arya – Bank of America/Merrill Lynch

That’s what I was referring to; instead of issuing notes that you could perhaps considering paying cash instead of issuing additional notes.

Jim Moylan

I misunderstood your question, yes we can substitute cash for the convert if we so choose.

Vivek Arya – Bank of America/Merrill Lynch

Are you comfortable with the balance sheet after all these cash payments?

Jim Moylan

I didn’t way we’re going to substitute cash for the convert I said that we have the right to do it if we so choose.

Operator

Your next question comes from Jeff Kvaal – Barclays Capital

Jeff Kvaal – Barclays Capital

On the revenue recognition delays or revenue deferral, when we are thinking about modeling the balance of the year should we think that the April quarter is particularly high and therefore not really gone from that. I’m trying to get a sense of how we should look at the progression, is there is a big lump that is in the April quarter that would come out again in July?

Gary Smith

I wouldn’t describe it as a big lump. From time to time we get this, we have a lot of, and I think there are two things I would talk to. One is it’s a lumpy business anyway and I think when you’re coming out of a recession you can get some anomalies, we’ve seen this before. This is somewhat compounded by the fact that we’re bringing in a number of new platforms to market. Whilst that’s good news overall it can create some challenges and we clearly saw that in Q1. I would think as those platforms get to a degree of maturity and adoption and the revenue recognition gets more compacted then I think you’d start to see a more regular cadence of the business.

What we’ve seen so far as we’ve dug out of the recession I guess our low point was Q2 was $144 million. We then went to $164 million, we spiked to $176, and we’re flat this quarter. From what we’re seeing in terms of our overall pipeline and activity I would expect to see an up tick for the remainder of the year.

Jeff Kvaal – Barclays Capital

On the Nortel integration, to be clear, should we expect to hear about synergies for you on the close when that’s announced in March or at your analyst day in late April?

Gary Smith

I would say it’s more likely to be the analyst day in April, it gives us a chance to get our keys to the door and finalize our pieces there and the intent here is to share our model and the milestones along that so that we can collectively measure our progress.

Operator

Your next question comes from Mike Genovese – Soleil Securities

Mike Genovese – Soleil Securities

More on the revenue deferral issue, short and long term deferred revenues look like they went up $5 million quarter over quarter. You were talking about these deferrals being closer to the $10 million range. Could you speak to that? I would assume some of these orders that you got did not meet the qualifications to go into deferred revenues for the quarter, is that right?

Jim Moylan

There’s a fairly high correlation between the growth in our inventory balance this quarter and the revenue which we did not recognize. The fact that our revenue grew was because we had, in some cases it’s actually at customer locations. We just couldn’t get the rev rec, that’s how I’d answer that question.

Mike Genovese – Soleil Securities

Would you describe this weakness in Core Director in the quarter, do you think the transition and the fact that Core Director FS is right on the horizon, the 5410 is probably out, the 5430 is coming. Do you think that’s freezing in short term customers ordering what we call Core Director I because they’re anticipating these new products coming?

Gary Smith

I can certainly point to some examples where some customers are certifying the Core Director FS so they can upgrade their existing Core Director. Though I think there are some examples of that I wouldn’t classify widespread but I think that’s certainly a factor in it. I think it is more just the lumpy nature of that, quite frankly.

Mike Genovese – Soleil Securities

I don’t know if you can comment on this at all, can you make any comments, do you care to make any comments about the current status of domain vendor selection at your largest customer?

Gary Smith

I would choose not to at this time. I think there’s enough speculation in the market.

Mike Genovese – Soleil Securities

This is the second quarter in a row where you’ve guided diluted share count up significantly but this quarter it didn’t happen. Can you talk about why would the share count jump from 93 to 114 and why didn’t it happen this quarter?

Jim Moylan

It didn’t happen this quarter because there’s a calculation under which you derive diluted earnings per share. It so happens that when we’re in a loss position you don’t make that calculation so that your basic share count is exactly the same as you diluted share count. I just gave you the diluted share count in case someone’s model depicted a considerable profit for next quarter.

Operator

Your next question comes from Blair King – Avondale Partners

Blair King – Avondale Partners

I wanted to circle back on the working capital contribution out of the cash payment to Nortel. You’ve addressed this in the past but I just want to make sure that I’m clear; the $492 million in cash that you’ll pay would be adjusted out of the Nortel working capital contribution. I’m wondering do you have an update on what that might be.

Jim Moylan

Let me just give you the basic situation. The purchase agreement calls for our getting the working capital that we need to operate the business. We’ve estimated that to be about $167 million. We’re not getting some elements of working capital, that’s part of the agreement. To the extent that the elements of working capital that we get at close are less than that $167 million there will be an adjustment to the purchase price based on the difference between $167 million and whatever comes over. We really haven’t spoken to that difference at any point in time so I won’t comment any farther. I would expect that we’ll actually not put out $492 million in cash at closing.

Blair King – Avondale Partners

Could you give us a sense as to what thought process you might go through that would substitute the convert into equity, or cash?

Jim Moylan

I’m not going to be able to answer that one. Thanks for the question.

Blair King – Avondale Partners

On the SG&A there was an $11.4 million in the quarter that was attributed to the acquisition and integrated related costs. Is it fair to say that that $11.2 million is within the SG&A line this quarter?

Jim Moylan

Remember, we’re reporting these items as adjusted without it. You’re asking the question do the GAAP results include the $11.4 million.

Operator

Your next question comes from Simon Leopold – Morgan Keegan

Simon Leopold – Morgan Keegan

I wanted to get back to another question but asked a different way, particularly around the area of backhaul. I presume that you’ve multiple products participating in backhaul initiatives that I would include the 4200. I want to know does that make sense and then if you could frame what percentage of your sales come from that application?

Tom Mock

Your assertions is in fact true, 4200 in addition to some of the carrier ethernet stuff does participate in that. I think in the past we’ve talked a lot about 4G and WiMax but we’re also seeing some of our products now go into 3G wireless upgrades. With respect to the percentage of that that’s around 4200 its really hard to tell because once the traffic arrives at the cell sight and gets down on a combined network its just hard to separate it out.

Simon Leopold – Morgan Keegan

Maybe asked a little bit differently, of your total revenue maybe a range that you think of as attributable to backhaul projects.

Tom Mock

I don’t know that we’ve really gone there. One measure you can make of the growth of it is as Gary mentioned earlier a good bit of the CESD revenue is coming from wireless backhaul so that’ll give you some color as to where that might fit. For us to be able to break that out is really hard just simply because we don’t always know what our customers use the equipment for.

Simon Leopold – Morgan Keegan

I want to get a little bit of better understanding about what kind of product mix you’re anticipating for the April quarter because you’ve got a decent improvement in revenue and I’d like to get a sense of how concentrated it is or broad based that might be.

Gary Smith

Depending on the final mix, I would expect to see most of the platforms up across the board for the 4200, CESD and Core Director.

Simon Leopold – Morgan Keegan

Proportionately all the same, really where I’m going is I’m wondering if we should anticipate maybe a pop in Core Director given the degree of weakness this quarter?

Gary Smith

I would probably be more inclined towards the second half in terms of the Core Director. I think we’ll see it bottom out Q1 and Q2 and then the profile we’re looking at right now things can change, the profile right now is that strong Q3 and Q4.

Simon Leopold – Morgan Keegan

Around the gross margin, we’ve seen a pretty big volume shift from the World Wide Packets products and I’m just wondering, I assume that the gross margin contribution in the past has been near the corporate average and I’m wondering if on the higher volume that’s now above the corporate average if we could get some sense of the gross margin contribution there?

Gary Smith

As we continue to roll out enhancements to that platform around the software then that tends to be more in the higher range. If you look at the new platforms that we’re rolling out as part of CESD some of which we didn’t recognize this quarter, that tends to be in the higher range as its more aggregation and switching.

Operator

Your next question comes from [Shubal Gush] – Thomas Weisel

[Shubal Gush] – Thomas Weisel

Going back to the $180 million transaction cost, you mentioned $27 million was recognized and I see all of it was in the GAAP measure. Is there any likelihood going forward that part of this is not going to be in the GAAP and actually flow down to the adjusted number?

Jim Moylan

The $180 million does include some capital expenditures and so they won’t show up immediately in our financial results, they’ll show up as depreciation or amortization over future periods. With respect to whether we’ll be able to break all of those costs out and show them separately from our as adjusted, I think there’s a possibility that some of those amounts we just won’t be able to in following the rules around as adjusted results totally break them out of our as adjusted results. However, if that is the case we’ll point out to you where those numbers are so that you can get a clear picture of what our business is doing without any transaction and integration costs.

[Shubal Gush] – Thomas Weisel

On the competent supply issues that led to the rev rec delays, is this because of a sole supplier or is it because huge up tick in demand that cannot be met on a timely basis or some other reason?

Gary Smith

This was very specific to some high capacity expensive components. I wouldn’t describe them as single supply but there aren’t that many people in the world that can supply them, you’re probably looking at a couple. We’re experiencing some lengthening of lead times across the board but nothing significant. I think that’s also talks to an overall uptick.

Operator

Your last question comes from Douglas Ireland – JMP Securities

Douglas Ireland – JMP Securities

I think we’re about a year into the access cycle now and I was wondering if you have any thoughts about how much longer you expect your carrier CapEx to be focused on the access layer and when you expect to see the sort of 100 gig core cycle revenue begin to ramp?

Tom Mock

The access impact on our business is really more in additional traffic in aggregate hitting the network because most of our equipment goes in the metro part of the network or the core part of the network. We would probably benefit from a rise in access traffic more than we’d benefit from increased investment in and access part of the network. With respect to 100G we’ve seen a lot of trends in the network now that are causing capacity growth. Mobile backhaul we’ve talked about a good bit because of the increased use of wireless data, greater use of video and in fact greater use of high definition video, more real time video content I think are all things that are contributing to that.

In terms of when that’s going to drive 100G to market there are a number of different elements that impact that. You’re starting to see 40G beginning to be pretty widely deployed in networks in response to that. We believe that it’ll be a time yet before 100G becomes the common currency of bandwidth in networks. One of the things that we’re confident about is that the technology that Nortel has brought to the table around 40G and its ability to be able to upgrade networks easily from 2.5G and 10G to 40G is equally applicable to at 100G. We think we’re actually in a pretty good position to benefit from that when it does happen.

Operator

That does conclude the question and answer session for today. At this time, Mr. Gary Smith, I would like to turn the conference back over to you for any additional or closing remarks.

Gary Smith

Thanks for everybody’s time this morning, it’s very much appreciated for your continued support. We look forward to seeing everyone hopefully at our analyst day in April in New York.

Operator

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

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Source: Ciena Corporation F1Q10 (Qtr End 01/31/10) Earnings Call Transcript
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