Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

CIENA (NYSE:CIEN)

Q2 2011 Earnings Call

June 08, 2011 8:30 am ET

Executives

Thomas Mock - Senior Vice President of Corporate Marketing & Communications

Gregg Lampf - Assistant Vice President of Shareholder Relations

James Moylan - Chief Financial Officer and Senior Vice President of Finance

Gary Smith - Chief Executive Officer, President and Director

Analysts

Tal Liani - BofA Merrill Lynch

Nikos Theodosopoulos - UBS Investment Bank

Mark Sue - RBC Capital Markets, LLC

Alex Henderson - Miller Tabak + Co., LLC

Jess Lubert - Wells Fargo Securities, LLC

Rod Hall - JP Morgan Chase & Co

Jeffrey Kvaal - Barclays Capital

Michael Genovese - MKM Partners LLC

Ehud Gelblum - Morgan Stanley

Paul Silverstein - Crédit Suisse AG

Operator

Good day, ladies and gentlemen, and welcome to Ciena's Fiscal Second Quarter 2011 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Gregg Lampf. Please go ahead.

Gregg Lampf

Thank you. Good morning, everyone, and welcome to Ciena's Second Quarter 2011 Review. With me today is Gary Smith, CEO and President; and Jim Moylan, CFO. In addition, Tom Mock, Senior Vice President, Corporate Marketing and Communications, is here.

This morning's remarks will be presented in 2 segments. Gary will discuss our recent progress and provide our views of the current market trends and environment. Jim will then detail our Q2 financial results and provide our guidance for Q3 2011, as well as comment on our progress toward achieving our target operating margin goal. We'll then open the call to questions from the sell-side analysts.

For this call and going forward, in order to be fair, we will provide for one question per analyst. We will come back for follow-up questions should time allow. This morning's press release is available on National Business Wire and on Ciena's website at ciena.com.

Before I turn the call over to Gary, I'll remind you that during this call, we will be making certain forward-looking statements. Such statements are based on current expectations, forecasts and assumptions regarding the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in the context of the risk factors detailed in our 10-Q filed with the SEC on March 10, 2011. Our 10-Q is required to be filed with the SEC by June 9, and we expect to file by that date. 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 its operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's press release available on our website at ciena.com. Also, I want to highlight that we will be hosting our Analyst Day in New York next Wednesday, June 15. We look forward to seeing many of you there. For those who cannot join us, the half day event, which begins at 9:00 a.m. Eastern, will be webcast. As a reminder, this call is being recorded and will be available for replay from the Investors portion of our website. Gary?

Gary Smith

Thanks, Gregg, and good morning, everyone. We continued to make good progress in all aspects of our business and operations. We have great momentum, as evidenced by our robust customer engagement levels, additional design wins and strong order flow. Overall, we are essentially where we expected to be at this stage in the evolution of the combined businesses. Going forward, we expect the traction we are experiencing in 40G and 100G coherent transport, the industry's transition to OTN and the strong alignment of our solutions to customer priorities to drive future growth and operating leverage. In fact, in calendar Q1, Ciena gained market share globally in all key optical segments, switching, long-haul transport and metro transport. And let me tell you why we are so well-positioned.

While we've been successfully executing on our large-scale integration, we've also spent the last 15 months investing heavily in major new platforms in each of our 4 segments. These developments include: coherent 100G, the market's largest OTN switch; an expanded Carrier Ethernet product family; and a completely re-architected network management platform.

We've also invested in entering multiple new geographies and vertical segments, as well as in expanding our footprint in our traditional customer base. All of these investments have been carefully selected to take advantage of market opportunity and our clear technology leadership.

While we anticipated and planned for these investments, the costs have impacted and are continuing to impact a number of financial and operational metrics, including margin, OpEx and cash flows. However, I would like to stress that even with these dynamics, we've been able to demonstrate solid progress.

Going forward, there are clearly lots of moving parts. So progress may not always be linear, and the timing is difficult to predict. But we absolutely expect improving financial performance overtime as we begin to reap the benefits of these investments.

With our successful completion of critical integration milestones combined with these investments in our business, we've created a solid foundation for growth with multiple positive indicators. We can now confidently move to the next phase of the company's evolution, one focused on optimization to gain additional operating leverage as we continue to drive towards sustained profitability.

As part of our moving to the next phase, we announced today several key leadership changes. And we are fortunate to have a strong and stable global leadership team, and we have both world-class customer facing and product teams in place. Today's leadership changes are intended to drive even greater cross-functional alignment of these 2 key organizations and direct greater emphasis to an important market vertical for Ciena.

Effective August 1, the beginning of our fiscal fourth quarter, Mike Aquino, currently Head of our Global Field Organization, will assume the newly created role of General Manager of our expanding Global Government Solutions Group. We are uniquely positioned to address government requirements, and we feel it is critical to have strong executive focus on this major opportunity for Ciena.

Philippe Morin, who currently leads our Product Global Group (sic) [Global Products Group], will now lead the Global Field Organization. And Francois Locoh-Donou, who has been running our EMEA operations for the last 6 years, will become head of our Global Products Group. These changes have been contemplated for some time, and as we move from integration to optimization for continued growth, we believe it is an opportune time to make these transitions and look forward to the continued contribution from these key leaders.

Now I'd like to share our views on the current market trends and environment. And despite the continuing uncertainties of the global economy, end user demand remains strong. Today, people and businesses are using the network in significantly different ways, and they have higher expectations for their network experience.

As we anticipated, these changes are now forcing the deployment of new network architectures that are more intelligent, efficient, reliable and adaptable. We have been investing in our solutions and extending our technology leadership in areas that make this intelligent infrastructure easy to deploy and manage. We are now well-positioned to help our customers effectively address their end users' evolving needs and requirements.

These needs and requirements are being driven by a number of trends, including on the mobile front, nearly 6 million iPhones have been activated recently in the U.S. alone. Carriers around the world are reporting growth in virtually all smart categories, and a wave of connected devices is absolutely on the horizon. At the same time, pricing plans are being more aligned with usage, making the expansion of networks more viable. And consumer Internet shows no sign of slowing. The most recent example is Netflix's nearly 30% growth in the U.S. since just the fall.

Additionally, enterprises are increasing their dependence on communication services for applications like cloud computing, IT virtualization and data center connectivity. As a result, these services must be more dynamic and extremely reliable.

The most recent example of the momentum in this space is Apple's iCloud announcement this week, which shows how the cloud can be used in consumer, as well as the enterprise markets. We believe many of these trends have prompted several of the world's largest service providers to state recently they are maintaining, if not increasing, their overall CapEx spending targets for the year. More importantly, they are concentrating more of their investments on the next-generation technologies to support this evolution of end user behavior.

These trends require an intelligent infrastructure, which allows a network operators to scale capacity, properly allocate and manage that capacity between users and applications and turn that capacity into services or connectivity for enterprise applications. This intelligent architecture requires specific capabilities which align extremely well with Ciena's expertise and portfolio.

I'd like to spend a few minutes discussing these capabilities, including scaling capacity, allocating and managing the capacity and converting this capacity into services or connectivity for enterprise applications and describing briefly how we are addressing each of them.

Firstly, scaling capacity is a primary requirement for networks, and our WaveLogic-based coherent optical transport leads the industry. Demand increases are driving network backbone capacity upgrades, and many service providers are moving forward to satisfy this demand. In fact, the first 100-Gig coherent deployments in the U.S. are now well underway, and they are using our 6500 solution. More recently, we also won a major tier 1 European service provider's business for its multi-year core modernization effort. We've also been penetrating market segments beyond service providers. For example, we won multiple awards within government, research and education networks, including Internet2, SURFnet, NORDUnet and VERNet.

To sum up high-capacity coherent technology leadership, we have more than a dozen 100-Gig coherent customers around the world who are using our solutions to carry active, live commercial traffic for long-haul applications today. We are also experiencing success globally in 40-Gig coherent, with more than 75 customers deployed commercially. And in fact, almost half of our transport revenues now comes from 40-Gig and 100-Gig.

And our best in class leadership extends across our portfolio. In fact, allocating and managing the capacity created by coherent optics is a major challenge in networks today. OTN represents a technology inflection point as it is now widely recognized as the only way to manage capacity beyond 40-Gig. A recent independent global survey demonstrates this inflection point by showing that 3 out of 4 carriers prefer OTN for new switching deployments between now and 2014.

Ciena's experience with OTN and complementary technologies is uniquely strong. Ciena's OTN switching includes our proven control plane for automated mesh networking, which is the most widely deployed technology of its kind in the world. And we have embedded this technology into a range of commercially deployed platforms. Most notably, our CoreDirector switching family has been deployed successfully for many years. And our next-generation 5400 family, which includes the world's largest OTN switch, is able to scale to the capacities we're seeing in the core and automate the allocation of that capacity. In addition, the 5400 family is designed to address the broader OTN bandwidth management requirement, and it is therefore, addressing a much larger market than a traditional optical switch has historically.

We now have 6 customers for the 5400 family, two of which were not current CoreDirector customers. And I think this indicates the traction we are getting outside of our current switching customer base. Based on robust trial and engagement activity, we are confident that the combination of our technical leadership and deep customer engagement will enable us to capitalize on the projected demand for OTN solutions.

Lastly, all the capacity that has been created and allocated in these networks must be turned into services or connectivity for enterprise applications. As we've mentioned before, ethernet is the ideal technology to accomplish these tasks, and our CESD products have been leading in fiber-based ethernet access for some time now. A number of network operators are emphasizing ethernet access in their 2011 spending plans for fiber-to-the-home, enterprise connectivity and backhaul for 3G and 4G LTE wireless networks.

To date, we've deployed more than 200,000 CESD network elements, most of which have been used in wireless backhaul applications. Nevertheless, we've been optimistic about the emergence of business ethernet services as an additional driver in this space. Most recently, a large U.S. MSO selected our solutions to support their ethernet business service offering. We are also seeing demand resume with one of our large tier 1 customers for wireless backhaul applications as part of its multi-year program. As a broader data point relating to CESD, customer interest is strong globally, and our pipeline has grown sequentially in terms of customers, orders and revenues.

In summary, we are very encouraged about our growth prospects as we enter this next phase of the company's evolution. The market data and our overall progress since the MEN acquisition strongly supports Ciena's strategy, and we expect to see our market position continue to improve. At our Analyst Day next week, we'll talk further about these industry trends and our plans and milestones to enhance that technology and market leadership to continue improving our financial performance going forward.

Now I'd like to hand over to Jim who will take you through our Q2 results and Q3 guidance. Jim?

James Moylan

Thanks, Gary. Good morning, everyone. Over a year ago, we laid out our plans for the integration of the MEN business. And I can now report that to date, we have successfully completed the milestones we communicated at that time.

We are also very pleased that our integration has been seen as seamless by our customers, in their own words, by the way. Finally, I want to thank our employees for their hard work during this critical period for Ciena. And from a financial perspective, as Gary said, the business is progressing as expected. Now onto the results, and I'll start with revenue.

We reported second quarter revenue of $418 million, which was at the lower end of our guidance range. These results partly reflect the effects of our ERP system shutdown during the first 2 weeks of the second quarter in connection with completion of the back-office integration of the MEN business. This shutdown reduced our fulfillment and shipping capabilities during the quarter.

Our second quarter results followed higher-than-anticipated revenue in the first quarter. You will recall, we reported Q1 revenue of $433 million. In that quarter, approximately $10 million was pulled in from Q2 as a result of customer requests for accelerated fulfillment in anticipation of our ERP shutdown.

By the way, I'd like to point out that when both the first and second quarter revenues are combined, we actually overachieved against the aggregate of the midpoint of our guidance ranges for these 2 quarters, being higher in the range for Q1 and lower in the range for Q2.

Based on our revenue performance for the first half of the year and strong order flows in both the first and second quarters, we have increasing confidence in the strength of the business going forward. And just to complete our high-level revenue review, we had two 10%-plus customers in the second quarter, contributing 26% of total revenue. Revenue from outside the U.S. represented 45% of total revenue.

On a segment basis, the revenue contribution is as follows. First, our Packet-Optical Transport segment, which includes all of our optical transport platforms plus associated operating system software and embedded software features. This segment accounted for $273 million in revenue in Q2, representing 65% of total sales.

Our Packet-Optical Switching segment includes CoreDirector, CoreDirector FS and our 5430 OTN switch plus associated operating system software and embedded software features. This segment accounted for $31 million in revenue in Q2, or 8% of total sales.

Our third segment, Carrier Ethernet Service Delivery, or CESD, includes our service delivery and aggregation switches and broadband access products plus related operating system software and embedded software features. Sales of CESD increased 12% sequentially to $31 million, or 8% of total revenue in Q2. Finally, our Software and Services segment, which includes our integrated network and service management software, as well as all of our services-related offerings, was $83 million in Q2.

In the remainder of my comments today, I'll speak only to non-GAAP results. Please refer to our press release on our website for reconciliation to our GAAP results. Q2's overall gross margin was within guidance at 41.3%. OpEx came in at $186 million, which included approximately $3 million of upward FX pressure, primarily due to the appreciation of the Canadian dollar against the U.S. dollar.

Moving on to other income and expense, this includes a $2.2 million gain from foreign currency transactions and interest expense of $9.4 million. Our as-adjusted Q2 net loss was $22.4 million, or a loss of $0.24 per common share.

Now onto cash flow and the balance sheet. At April 30, 2011, we had approximately $557 million in cash and liquid investments. Let me update you on a metric that we've talked about in the past. We used $51.8 million in cash from operations during the second quarter. This includes a use of $41.4 million due to an increase in working capital and $13.9 million of integration and restructuring payments. Absent the working capital increase and integration payments, the operations of the business generated $3.5 million in cash during the quarter.

We continue to believe this is an important measure of our business, and we will continue to monitor it. As we move into the next phase for the company, however, we will be more focused on driving and monitoring free cash flow, which we define as cash from operations less capital expenditures.

At the end of Q2, our accounts receivable balance was $391 million from $370 million at the end of Q1. Day sales outstanding were 84 from 77 days in Q1. The increase in DSO was driven by revenue in the second quarter being back-end loaded, in part, due to the temporary ERP shutdown. And of course, when you're back-end loaded on revenue, you don't get a chance to collect as much of that receivable balance during the quarter as you might otherwise. Inventories totaled $286 million in Q2 from $267 million in Q1.

Product inventory turns were 2.8x in the quarter from 3.2x in Q1. The inventory breakdown for the quarter included raw materials of $40 million, work in progress of $9 million, finished goods of $267 million, and all of this was reduced by an accrued reserve for excess and obsolescence of $30 million. Finally, on headcount. As of April 30, 2011, our worldwide headcount was 4,301.

I'll now discuss guidance for the fiscal third quarter of 2011. Absent any significant changes in exchange rates, our guidance is as follows. We expect revenue to be in the range of $435 million to $455 million. We expect adjusted gross margin to be in the low 40 percentages and adjusted operating expenses to be below the levels we saw in Q2 in the low- to mid-$180 million range.

We project other income expense net in the second quarter will be an expense of roughly $9.4 million, all of which relates to the interest on our convertible notes. And finally, we expect our tax obligation for Q3 will continue to be related purely to foreign taxes.

Depending upon your assumptions, you may need either our diluted share count or our basic share count. We estimate Q3's basic share count at approximately 97 million total shares. We estimate Q3's diluted share count at approximately 150 million total shares, assuming the conversion of all 4 issues of our convertible debt.

To close our prepared remarks today, I'd like to discuss our view with respect to Ciena's post-integration target operating model. In April 2010, we shared with you our post-integration target operating model, which included an operating margin target of 7% to 10% on an as-adjusted basis as we exited fiscal 2011. We have previously highlighted 3 assumptions that are critical to achieving this target range: growing revenue, controlling expenses and shifting product mix to higher margin products. Over the last 15 months, while successfully combining these 2 businesses, we have made significant progress in all 3 areas. Based upon this progress and given our strong foundation for growth, we now are projecting an operating margin approaching the low end of our target range for the full fourth quarter of fiscal 2011. At Analyst Day next week, I will take some time to review our efforts to date, as well as focus on what lies ahead with respect to further growth and optimization of our business model.

That concludes our prepared remarks. And with that, we will move into the Q&A portion of the call. As a reminder, in order to maintain fairness, we will be taking only one question per sell-side analyst with follow-ups as time allows. Tanisha, we'll now open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Rod Hall of JPMorgan.

Rod Hall - JP Morgan Chase & Co

I just wanted to ask, I guess, just one question, if you could characterize what the demand situation is looking like from carriers regionally? So if you can talk to us about what's going on in Europe specifically, as well as the US, just trying to get a better handle on why the guidance, the revenue guidance is a little bit weak, below at least what we thought it was going to be in the model?

Gary Smith

Yes, Rod. Why don't I talk the -- overall, we're seeing strong demand. And I think from a regional point of view, just thinking about your question here, we are seeing good demand in Europe despite some of the macroeconomic uncertainties in certain countries there that we don't really have exposure to. We're seeing pretty good demand in Europe. Clearly, Asia is not a large market for us, but we do have some strategic countries there. We're seeing good demand in Asia, Latin America and North America. So I really don't see much changes from region to region, Rod. We see pretty solid demand across the board globally.

Rod Hall - JP Morgan Chase & Co

So do you think the reason that -- I mean, the revenues are below street estimates for the guidance. I mean, do you think the reason for that is the street is just ahead of itself in terms of expectations? Or how would you explain the differential there, I guess?

James Moylan

Here’s what I'd say about that, Rod. We have a lot of wins, which are big complicated networks that require a long testing cycle, lab cycle, and are going to take a bit longer to get to revenue than we might have expected. Also, we are expanding outside the U.S., and it just is the case that rev rec cycles outside the U.S. are a bit longer than those in the U.S. But I would say, that with the projection that we've now given you for Q4, we do have to have a pretty nice uptick in both revenue and in margin to get to the levels that we're talking about. So we do see it coming for all the reasons that I've talked about. It's a little less than we expected today.

Rod Hall - JP Morgan Chase & Co

And Jim, Jim, should we take the big increase in DSOs as an indicator of that? I mean, that kind of pushed out some of these big deals. Or is that unrelated?

James Moylan

No, it's not really related to that. Really, it has to do with the fact that we were back-end loaded in the quarter. And as I said, when you're generating a higher proportion, a higher proportion than normal of your revenue in the last month of the quarter, you just don't get a chance to collect it before the end of the quarter. If you just translate that, that should relate to the fact that our receivables were unusually high at the end of the quarter. And if you looked through a quarter, they would move around, but they wouldn't be that high. One thing I would say, though, is that generally speaking, as you move outside of the U.S., you do get somewhat longer payment terms. It's just the way people do business. And so whereas we used to think in terms of day sales as being in the low 70s, my guess is, we're going to be in the high 70s or so going forward.

Operator

Our next question is from Jess Lubert of Wells Fargo.

Jess Lubert - Wells Fargo Securities, LLC

Question is on the gross margins. Your guidance is looking for a low 40% gross margin this next quarter, and I was hoping you can help us understand if we should be thinking of that as flat, up or down versus this past quarter. And then with respect to your comments about approaching the low end of the 7% to 10% operating margin range, is it still your expectation to exit the year with gross margins in the 43% to 44% range? And if you can help us understand how we get there, I think it would be helpful.

James Moylan

We believe that going to Q3, we'll be flattish from Q2. As we move forward in time, and as I said earlier, in order to get to the kind of target that we laid out there earlier, we do have to show both a growth in the top line and a margin expansion. I won't comment on the 43%, 44% per se, but I will say, it's going to have to be up from what we delivered in Q2. And there's a lot of ways to get to the numbers that we talked about and a lot of combinations of revenue and margin. Now with respect to how we see that margin developing, based on our pipeline of switching and CESD, we see, pretty clearly, a path to a higher proportion of our higher margin products in, particularly, the Q4 of this year. Secondly, we are doing a number of things to optimize our supply chain. And as that optimization continues, we should get a point or so from that work.

Jess Lubert - Wells Fargo Securities, LLC

So is it fair to assume that to get to the low end of that range, it will come from a combination of a greater mix of switching and CESD, as well as perhaps lower OpEx?

James Moylan

Yes. Well, not so much lower OpEx. I think we're going to be low- to mid-OpEx. We have now exited all of the transition services, arrangements and our NBS payments are behind us. And the guidance that we've given reflects sort of the forward-looking view of OpEx.

Jess Lubert - Wells Fargo Securities, LLC

All right, so OpEx should be steady in the low $180 million range through the second half of the year?

James Moylan

That's what we think.

Operator

Our next question is from Paul Silverstein of Credit Suisse.

Paul Silverstein - Crédit Suisse AG

Gary, historically, you'd given us the number of trials on the optical switching on the new 5400. Can you give us an update on that? I know you said you had 2 new customers, 6 total. But how many trials are in progress right now?

Gary Smith

If I broaden it out, Paul, to trials and engagements that are serious engagements, we've got over 20 right now globally, which is...

Paul Silverstein - Crédit Suisse AG

That's trials plus customers?

Gary Smith

Yes, yes. So it's a combination of all the engagements that we have across the board with the major carriers. So pipeline continues to increase. The amount of prospects is increasing. We've got about 20-plus, what I would call very active engagements with carriers across the globe. And that includes various things around demonstrations, around lab systems. They have different requirements, so that continues to expand. We had 2 new wins in the quarter, and we expect multiple new wins in Q3 as well. And as Jim alluded to, we do expect revenues to be up in the second half, particularly into some of the timing of projects in Q4.

Paul Silverstein - Crédit Suisse AG

So Gary, on that issue, just in terms of the base, last quarter, you said the initial 4 customers you converted out of trial, only one was in revenue. That one was de minimis. Can you characterize the revenue contribution from the 6 in this quarter?

Gary Smith

Very small. It was very small.

Paul Silverstein - Crédit Suisse AG

Very small. So virtually all of it remains on the comp?

Gary Smith

Yes, it does. And it's the sort of nature of this thing. It always takes longer than we think, having gone through it when we introduced CoreDirector. But we're getting the design wins, we are getting the orders, the traction is good. It's all a matter of timing as they say, but I am very encouraged by what we're seeing, particularly with the broader OTN market. I think people are now beginning to realize, they go over 40 Gig. They've got to do something different. So I think it's opening up a much broader market than we've typically seen with the classic CoreDirector, for example.

Paul Silverstein - Crédit Suisse AG

And Gary, can you -- on the visibility question in terms of timing, the disappointment in the near term versus your far more optimistic commentary about the longer term, can you give a little bit more granular insight on the visibility, the basis of your confidence?

Gary Smith

Well, I mean, I think it's on the combination of all of these things. It's on orders, it's on design wins. It's on the customer engagements around what we're talking to them around RFPs and just straightforward engagements with the customers. We're seeing a growing demand for this kind of technology into the network and particularly, OTN. And I think we're growing increasingly confident around our position in that. And I think, if you look at our heritage with our mesh switching, control plane, a lot of that, the refresh of that technology combined with the new platforms, I think is being incredibly well received in the marketplace. So I think we will see progress as we've said in the second half. But I also think, as I look through to 2012, I think we are incredibly well positioned.

Gregg Lampf

Paul, we need to move on to the next question.

Operator

Our next question is from Ehud Gelblum of Morgan Stanley.

Ehud Gelblum - Morgan Stanley

A couple of questions if I could, guys. Gross margin, when you normalized last quarter for the boost that you had, Jim, gross margin actually went up this quarter to 41.3%. I think it was 40.2% when you normalized last quarter?

James Moylan

Yes.

Ehud Gelblum - Morgan Stanley

Yet, your mix seemed to go -- wasn't favorable in terms if you think of switching being the higher margin and transport being the lower margin. So if you can kind of explain what drove the higher gross margin, it would be helpful. And then when you look at your Q4 and your new target in the lower end of that 7% to 10% range, what is that mix that you are looking for? Can you give us a percentage range of mix that you are looking for between transport and put CESD and switching together? And is that just a Q4 mix that you hit? Or is that sustainable forever? So I'm wondering if once we hit that, call it, 7% or 7.5% range in Q4, does it stay there, both the mix and the operating margin in Q1 of next year and Q2? Or does it kind of lump around so we should not necessarily look at linear as that's the beginning of a move-up from there?

James Moylan

Huddy, I'm glad you qualified the forever, because I was going to have to say it probably isn't going to last forever. That's a good question. Let me tell you about how we're looking at this. First of all, in this quarter, CESD is up. And CESD is a good margin contributor. I'd also say that in our business, it's never quite as simple as looking at the mix between the individual product platforms. Because even within the various products or segments, you can see movement depending upon a number of things such as where are you in the deployment cycle of razors versus razor blades or commons versus card fills? Where are you terms of the competitive balance and sort of pricing pressures with respect to front-end pricing? We can get a bump in things like services margin as a result of the mix within services. And in fact, we did this quarter. So it's a -- the biggest single thing is CESD is up, switching is down but...

Ehud Gelblum - Morgan Stanley

But the net of that -- I mean, CESD was up 3%, I think, switching was down to 4%. So the net of those 2 is flat to down.

James Moylan

Yes. But again, you have to look at the sort of inside-the-segment results. Now with respect to the going forward, as I said earlier, we do expect a bigger mix of CESD and switching in Q4 than we are seeing today. That's going to give us some amount of the margin improvement that we must get in order to get to the target we've put out there. As far as the continuation of that trend, we think that it does continue. Because as we've said and as Gary spoke about, we have an enormous amount of traction on our OTN platform. We're very early in the revenue cycle for that product, and we think that's going to grow over time and faster than transport. We also think the same about CESD. So my guess is, we're going to continue to see, at least on a trend line basis, the improvement in the mix. Now as you know, from past experience moving from quarter-to-quarter, you can see movements in all of our product groups. But we think that over time, CESD and switching are going to increase as a percentage of our revenue. The only other thing I'd say is -- I've talked earlier about manufacturing optimization, and we are going to -- we have in place a set of plans, which is going to drive improvements in our supply chain and higher margin as a result of that.

Ehud Gelblum - Morgan Stanley

So if we quantify, transport was 81% of revenue, I believe, and last quarter was 82%? Are you looking for that in Q4 and beyond to be more like 70% or 75%? Where is the point at which you think makes the numbers work?

James Moylan

I'm sorry, I missed the first part of the question, Huddy.

Ehud Gelblum - Morgan Stanley

The transport revenue was 81% of your product revenue. I'm leaving services out of this. Last quarter, it was 82% of your product revenue. Where did that have to fall -- what is that mix that you are looking at in Q4 and beyond? Does transport fall into 75% of product revenue or is it...

James Moylan

It's got to go into the 70s. There’s just so many ways you can get there, Huddy, that I certainly agree with the direction you're talking about. I just don't think it would be helpful to comment on the exact number.

Ehud Gelblum - Morgan Stanley

Okay, I appreciate it.

Operator

Our next question is from Mark Sue of RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC

Gary and Jim, is the order growth, which is giving you the confidence to see strong revenue growth in the fourth quarter, is that kind of broad-based? Is it regionally concentrated? And has the backlog been steadily increasing quarter-over-quarter to give us the added boost for the fourth quarter?

Gary Smith

That's a good question, Mark. I think, just to cast our minds back, one of the things that we've been doing since the MEN acquisition, since we acquired MEN, it basically came over with an extremely depleted backlog. So one of the things we've had to do over the course of the last 15 months is kind of build that back. And particularly, with some of the larger projects that we've won, as Jim articulated, they tend to be further out in time. And we are building our backlog back up again as appropriate for a business of this size. So some of that is happening as well. And I think from an order point of view, we're very encouraged by the order flows last quarter. It was the strongest order flows we've seen since the combination of the businesses. So it's all of those things that give us some more confidence around Q3 growth and Q4.

Mark Sue - RBC Capital Markets, LLC

Okay. And then if we look further out, how should we kind of see the sequence of the quarters considering that backlog, where it is, the order trends and the near-term revenue guidance, should we kind of see a big hockey stick in the October quarter and then down sequentially in January, meaningfully? Or should we kind of see more steady trends following a healthy fourth quarter?

James Moylan

I'd like to give you a crisp answer to that, Mark, but unfortunately, I can't. We've not operated this business through a seasonal cycle. And so we're not sure what the seasonal depiction of the company is. Let me just say how we've looked at it. If I look at the history of Ciena on a stand-alone basis, it's really hard to see seasonality in our revenues. We can, internally, see some seasonality in our order flow, with our Q2 and Q4 historically being the strongest orders quarters. But that never showed up in revenue. We took over the MEN business and recall, and I've said this before, but Nortel did not close their books on a monthly basis. They only closed them quarterly. And they were on a calendar-quarter basis. So they were not on the same calendar timing as we were. When we tried to take their historical results and convert them into Ciena fiscal quarters, it appeared that whatever seasonality had been in the MEN numbers went away. And so it didn't look to us as though there was going to be a lot of seasonality in the business. However, I caution anybody to take that as gospel, because we just don't know. We haven't given any word about 2012 yet. We'll speak to the future as we get to Analyst Day. But we are not prepared to talk about what's going to happen from Q4 to Q1.

Operator

Our next question is from Alex Henderson of Miller Tabak.

Alex Henderson - Miller Tabak + Co., LLC

So the primary question I want to address is, can you talk a little bit about the tone of transport between 10-Gig and 40/100-Gig? And particularly, what is going on relative to volume versus pricing within the mix? There is obviously quite weak conditions around 10-Gig as people start to anticipate the shift to 40-Gig. How much of a factor is the pricing pressure on the decline in the 10-Gig business. And were you surprised at that? And I know you've been talking about going after market share. How aggressively are you pricing to get this business to lock in the common equipment to get the future blade business down the line and the like?

Thomas Mock

A couple of things I've start with, Alex, and one of them is -- I think there is a tendency to look at this transition from 10-Gig to 40-Gig to 100-Gig in just the long-haul arena. And it definitely is happening there. And I think, as Gary commented, you can see that more than half of our WDM transport revenues today, or not more than half but approaching half, are coming from 40G and 100G. But remember, that's a combination of metro and long-haul. In the metro area, because a lot of the service providers are still delivering services at 10G and rates below, there is still a market for that there. So I wouldn't say that overall we've seen a lot of tremendous downward pricing pressure on 10G that hasn't been there for quite some time now anyway. We've reached a point now where, particularly in long-haul applications, 40G is becoming more economical. And we've also seen, in terms of the things I'd say we've been surprised by, we've seen stronger demand for 100G earlier than I think we thought we would have done. I think we all thought that that transition would take a bit longer. Now we still believe that the, what I would call the volume deployment, big nationwide deployments are going to be happening a little bit later in time. But as Gary mentioned, we've actually begun real deployments here in the U.S. for 100G. So we're pretty encouraged about its prospects at this point. So I don't I'd change our view on either what the pricing looks like or the timing, particularly, other than to say that 100G may be happening a bit sooner than we thought, although it's very early days.

Alex Henderson - Miller Tabak + Co., LLC

And so the pricing pressure is evidence in the marketplace, and the weak conditions in the optical component space is not a function of an aggression in pricing or a collapse in pricing on any of the 10-Gig products then?

James Moylan

I wouldn't say collapse, but I would say this: we have a leadership position in 40-Gig and 100-Gig transport, which is very attractive to our customers. Our competitors don't have a stronger position in 40-Gig and 100-Gig. In some cases, they are actually discounting their 10-Gig in order to try to be attractive to our customers. So you are seeing some pressure there. Just as a point, I'm not sure how that reflects back into the component supply chain. But definitely, we're seeing that effect from our competitors.

Thomas Mock

Yes, I think Jim's point is a good one because in competitors they can't really offer a 40G solution today. Most of the customers out there, if they don't have -- most of the customers out there, even if they're not looking at deploying 40G immediately, they want a 40G capable solution. So trying to convince them to buy a solution that's only 10G capable, requires a certain incentive as they say.

Alex Henderson - Miller Tabak + Co., LLC

And one last question on the mix and on transport. Can you talk a little bit about what you are seeing in terms of demand for coherent versus non-coherent in the marketplace and whether that has any impact on your ability to penetrate the market and to what extent upgradability to 100-Gig is being viewed as a critical driver?

Thomas Mock

I'd say, pretty much every service provider we talked to is looking at upgrading to 100G. And there really isn't a realistic non-coherent solution for 100G that will work over any reasonable distance. So coherent truly is becoming the currency of choice in transport networks moving forward. And we feel pretty confident today because at this point, we have over 90% market share in the coherent space.

Alex Henderson - Miller Tabak + Co., LLC

And how do you see the price delta between coherent and non-coherent? Last question, and I'll see the floor.

Thomas Mock

What was the question, Alex?

Alex Henderson - Miller Tabak + Co., LLC

What's the pricing delta between coherent 40-Gig and non-coherent 40-Gig?

Thomas Mock

The pricing for non-coherent 40-Gig is definitely lower. But the cautionary note I'd put on that is non-coherent 40-Gig has to be regenerated more often. So the overall system cost probably isn't that much different.

Operator

Our next question is from Michael Genovese of MKM Partners.

Michael Genovese - MKM Partners LLC

I wanted to ask about the deferred revenues, almost $20 million sequential increase in deferred. Can you tell us how much was products and how much was services?

James Moylan

It's mostly services, and it relates to annual maintenance contracts which we've signed during the quarter.

Michael Genovese - MKM Partners LLC

Okay, so there's not a significant piece of, say, 5430 within that deferred revenue?

James Moylan

Not really, no. Remember, we've talked about 80-1, the new accounting that we've done this year. And what that does is it’s, over time, it's going to significantly reduce the amount of deferred product revenue which sits on our balance sheet. And it enables us to recognize product revenue more quickly than the previous accounting standard.

Michael Genovese - MKM Partners LLC

Okay, and then the two 10% customers, 26% of revenue, I think that's a little lower than they normally are. They'd probably more usually be in the 30% to 35% range. Is there anything notable there?

James Moylan

That's about flat with Q1, Michael, nothing notable there. They are 2 great customers, by the way.

Operator

Our next question is from Jeff Kvaal of Barclays Capital

Jeffrey Kvaal - Barclays Capital

I'd like to ask about the strength of the strength of the turnaround in CESD. I think one of the customers that you've had that has done well and then not so well for you is AT&T, and it seems to be coming back a little bit from your comments. I am wondering if I am reading too much into that, for one thing. And then for another thing, how sustainable is that given, I think, AT&T says they will be in this 70% complete with their fiber backhaul plans by the end of the year?

Gary Smith

So let me talk about it broadly without getting too focused on a particular customer. But we are seeing, I think, the shift, Jeff, or the addition to probably a better description around most of the stuff that's out there right now is the wireless backhaul. And what we are seeing now, we announced a new MSO that we secured last quarter, and we are seeing a couple of our larger customers come back, one in particular. We believe that's a multi-year program, so we think that's very sustainable. And we've seen layered on top of that, finally, this business services gaining traction, which was the initial, our initial view of the rollout of CESD that got kind of hijacked by all this imperative around wireless backhaul. So I think we are seeing very encouraging signs around business services. And the point about that, Jeff, which is I think is to your sustainability, that's much more of a sustained business build out and relationship with the customers. So I'm pleased with the blend that I think we're beginning to see within CESD. So I think it's sustainable, and we think that CESD revenues will sequentially be up in Q3 as well.

Jeffrey Kvaal - Barclays Capital

Does that suggest that the backhaul imperative is winding down, Gary?

Gary Smith

No. I think that's going to continue. I think that's a multi-year program, both with the large carrier we talked about and with some of the other carriers. I think the demand as they go to 4G and LTE and all the machine-to-machine stuff you're starting to see on mobile, I just think that's going to continue.

Operator

Our next question is from Nikos Theodosopoulos of UBS.

Nikos Theodosopoulos - UBS Investment Bank

Two questions, I hope you have time for both. On headcount, you have added about 45 people each in the last 2 quarters. Do you expect that to continue? And if so, can you still keep OpEx flat the next quarter as you do that? And then the second question, on OTN switching, your competitors are moving towards embedding OTN switching into their WDM platforms and seem to be not pushing as much a standalone large OTN switch. What is Ciena's perspective on these moves by Huawei and Alcatel?

Gary Smith

Let me take the first part of that, Nikos. I'd describe it as sort of strategic hiring. And over the last couple of quarters and when we look at the guidance, we take that into account as well. So we absolutely think we can hold the OpEx. In fact, we think it will be down sequentially in Q3. And I think that kind of low 180 is a number I think we'd also view into Q4.

Thomas Mock

Yes, on the combination of OTN switching into the transport platforms, we absolutely believe that that is a trend that's going to happen. But I don't think that eliminates the need for a large core switch. I think one of the reasons you're seeing the traction in 5430 is because of its capability to handle the kinds of capacity that 100G backbone might actually create. Now as you get closer to the edge of the network, it absolutely makes sense to begin embedding OTN switching in the transport platforms, and that's something we've been talking about for a while now on 6500 in particular. And it's something we've been doing on 4200 for a number of years now. So I wouldn't say I quarrel with the trend. I will say though, that it doesn't eliminate the need for a core OTN switch. And I think the real key is going to be how well you can make those core OTN switches interoperate with the smaller switches near the edge of the network. And that's really something on which we focus a lot of attention.

Operator

Our final question is from Tal Liani of Bank of America Merrill Lynch.

Tal Liani - BofA Merrill Lynch

I have 2 questions. First one is you are guiding to a 7% margin towards the end of the year at the low end of your prior target. Is this sustainable? What I'm referring here is whether this is seasonal, because there is year-end spending for you or push on the sell-side and then margins get to this level and then decline. Or are these -- is this level a reflection of processes that just come to fruition and as a result, the margins go up and stay up for the following year? And I know you're not giving guidance for the following year, I'm just trying to understand the reasons behind the increase.

James Moylan

First thing I'd say, I just want to emphasize that the words I use, we are projecting our margin that approaches the low end of the target range. And people can translate that how they want to. I just wanted to make clear what I said. Secondly, with respect to the sustainability, we can't speak to 2012 today. But I can say that we, as I said earlier in response to Mark's question, we don't necessarily see a lot of seasonality in our business as we look at it today. Now we'll know better as we get to the end of this year and as we see what Q1 looks like. And so maybe I'll have to speak about seasonality when I get to Q1. But I'd be sort of disappointed if we got up to the range we are talking about now and fell back. That would be disappointing. One thing I'd say though, going back to something that Gary said that's going on in our business right now, we have -- we're in a very high period of new product introduction. And that puts a lot of strain and stress on a lot of our financial metrics that you've seen as we've come through here. We end up having to put gear into our own labs. We have to put out demo equipment which costs us in OpEx. We have customer acquisition costs. All these things are affecting our income statement. We think that we're going to move out of this phase over the next few quarters, and we're going to see improvement in many of our financial metrics, just in moving out of this phase. Now one might say we are always going to be introducing new products. Yes, we are. But we are in a particularly heavy phase of that introducing significant products in each of our segments and spending a lot of money on network management software.

Tal Liani - BofA Merrill Lynch

Second question, Packet-Optical Transport is basically the cause for the sequential decline. Can you refer to CN 4200 versus the 6500, Nortel 6500? What I'm trying to understand is if any of this decline is related to some transition out of the CN 4200, or it's more for spending issue?

Gary Smith

I would say it's just an artifact of the dynamic that Jim went through with the -- only having 11 weeks of capacity, if you will, to ship. I wouldn't read too much into the product stuff. In fact, we don't call out 4200 because we're 15 months on from the integration. But it's actually doing fine. I mean, it's doing -- it's pretty flat quarter-to-quarter, just looking at the numbers here. So I couldn't really point to that, Tal, and say that was a particular dynamic.

Gregg Lampf

Thanks, everyone, for your time this morning and for the continued support. We look forward to seeing everyone at Analyst Day next week. As a reminder, please call or email me directly with any questions at glampf@ciena.com or call me at (410) 694-3169, and I'll respond as soon as possible. Thanks for your time today.

Operator

Ladies and gentlemen, thank you for your participation. That concludes the conference. You may disconnect and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: CIENA's CEO Discusses Q2 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts