Ciena's (CIEN) CEO Gary Smith on Q1 2015 Results - Earnings Call Transcript

Ciena Corporation (NYSE:CIEN) Q1 2015 Earnings Conference Call March 5, 2015 8:30 AM ET

Executives

Gregg Lampf - VP, IR
Gary B. Smith - President and CEO
James E. Moylan, Jr. - SVP, Finance and CFO
Thomas Mock - SVP, Corporate Marketing and Communications

Analysts

Amitabh Passi - UBS
Jess Lubert - Wells Fargo
Simon Leopold - Raymond James
Kent Schofield - Goldman Sachs
Natarajan Subrahmanyan - The Juda Group
Vijay Bhagavath - Deutsche Bank
Mark Sue - RBC Capital Markets
Paul Silverstein - Cowen and Company

Operator

Welcome to the Ciena Corporation’s First Quarter 2015 Earnings Conference Call. My name is John and I’ll be your operator for today’s call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that the conference is being recorded.

I would now turn the call over to Gregg Lampf.

Gregg Lampf

Thanks, John. Good morning, and welcome to Ciena’s 2015 first quarter review. Before we get started, I just want to let everyone know that due to the snowstorm here in Maryland we’re holding this call in a hotel. We apologize for any background noise you may hear from some adjacent meetings. With me today is Gary Smith, CEO and President, Jim Moylan, CFO, and Tom Mock, Senior Vice President, Corporate Communications. Steve Alexander is at Mobile World Congress in Barcelona so he won’t be joining us this morning.

This morning’s press release is available on national business wire and ciena.com. We have also posted to the investor section of ciena.com an accompanying investor presentation, including certain highlighted items from this quarter being discussed today, as well as our historical results.

In our prepared remarks today, Gary will discuss management’s view on the market and our progress and Jim will provide some color on our results and provide guidance. We will then open up the call to questions from sell-side analysts, taking one question per person with follow-ups as time allows.

Before turning the call over to Gary I’ll remind you that during this call we would 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 most recent 10-Q filing.

Our 10-K is required to be filed with the SEC by March 12, 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 operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today’s press release available on ciena.com. This call is being recorded and will be available for replay from the investor section of our website. Gary?

Gary B. Smith

Thank you, Gregg and good morning, everyone. Thanks for joining us today. Before getting into the quarter, I think it’s probably an appropriate point in the development of the business to step back and provide a little context. When we first set out to transform the business we specifically designed Ciena to become the leading specialist in open on-demand software driven networks for a much broader and more diverse set of buyers.

We built the business to deliver more consistent results and greater operating leverage. We are executing well on this model I think as reflected in our strong Q1 results. Results that position us well to meet our profitability goals for fiscal 2015. Although order timing and foreign exchange headwinds impacted revenue in the quarter, we were able to deliver excellent operating profit and EPS.

With the strong performance across all other operating metrics, we are now consistently delivering on our business model, with improving operating leverage and profitability. Jim will provide more detail behind these results, but I do want to comment briefly on our financial performance.

Revenue in the quarter was lower than expected due to a significant strengthening of the US dollar as well as the timing of the orders from the U.S. government sector that we expected to turn to revenue in the quarter. We now expect to receive these orders in the current quarter with revenue recognized over Q2 and Q3.

While our bottom-line is not immune to volatility and foreign exchange rates, operating income was largely unaffected by FX this quarter as a result of offsetting effects on the revenue and expense elements of our business as well as more favorable gross margins. We continue to see robust demand from a broader set of customers. This is inline with our expectations coming into the year. Order flow in the quarter was strong across a diverse range of customers.

This is primarily due to customers' critical and growing need for on demand networking capabilities in the cloud. And as we’ve said before the need for on-demand network resources is redefining traditional domains to a simpler topology that reflects more cloud centric usage. Connecting users to their data which we refer to as content to user and connecting datacenters together, which we refer to as content to content. And we believe that truly building an open and global on-demand environment requires a leading position with both the web scale players and the global tier 1 service providers as their roles are becoming increasing interdependent as they connect content-to-content and content-to-users in real time.

Last quarter, we shared our leadership position in the web scale market and we continue to make progress in this area. For example, we’ve been selected by Digital Reality the world’s largest wholesale datacenter provider to connect datacenters and carriers within their digital network ecosystem. Our 6500 will allow Digital Reality to offer new on-demand services that combine virtual servers, storage and networking resources. And as was the case in Q4, our second largest customer in the quarter was again a major web-scale player. The web-scale opportunity continues to grow and we are uniquely positioned to address the needs of this market, and that includes both direct sales to web-scale players and new projects with tier I service providers who are building out network services to support specific web-scale customers.

In addition to our progress with web-scale buyers, in Q1 we also further strengthened our leadership position with service providers especially in the critical metro segment of this market. With full year 2014 figures just coming out, research firm DeLauro show Ciena gaining 3 percentage points of metro share worldwide.

We had a very strong quarter for metro in Europe including deployments with three of the largest service providers in the region positioning us well for future growth in the most strategic parts of these European networks. And in Kala we are deploying what we believe is the largest nationwide metro project in Brazil. And in North America we are pleased to announce that we’ve been selected by Windstream to deliver a next generation packet-optical metro solution as central part of their new next gen metro strategy.

Metro is clearly a strategic segment to us as much of the overall market growth for at least the next three years is expected to be metro driven. In fact we believe metro represents the market opportunity that is at least two to three times larger than traditional long core.

But another reason why metro is so important is because it means for content to get to uses, its proximity to both the content and the user means next gen metro requires a higher degree of packet conversations and software to deliver an on-demand experience. Factors that lead us to expect metro applications to drive higher margins overtime and make our next gen metro solutions stickier than traditional transport.

So with continued gains in both the service provider and web-scale markets, we clearly are operating from a position of strength as we drive an open global network for the cloud, and we believe we are poised to extend that leadership. Last week, we introduced four new solutions as for the OPN open architecture to allow our customers to fully leverage web-scale principals across all kinds of networks. We expect these products and others to be launched over the course of the coming year to continue to expand our role in the network as well as our reach with new buyers.

The new solutions include Coherent Select, which is the first metro optimized implementation of coherent technology, simultaneously simplifying and bringing new levels of flexibility to metro aggregation networks. Our new WaveLogic 3 extreme chipset maximizes capacity no matter the distance from local interconnections to transoceanic submarine links. And WaveLogic 3 Nano targets application such as metro where maximum efficiency is more valuable than maximum capacity, providing up to 75% power savings and half the space of WaveLogic 3.

And finally we launched two new Ethernet platforms to bring Ciena’s automating provisioning capability to the small cell backhaul market. All of these innovations together with our ongoing market expansions are further diversifying our business. Our continued success in new verticals contributed to non-telco customers making up more than a third of our Q1 revenue and that’s compared to just 25% a couple of years ago.

Metro applications in Q1 represented also more than a third of our overall 100 gig shipments. And coincidentally about a third of our overall 100 gig shipments went directly to web-scale customers. And as you know, web scale growth is a major driver of submarine traffic and we continue to win in that market as well. Having announced three new submarine wins in the last quarter alone.

Despite foreign exchange headwinds, international customers represented 44% of Q1 revenue and we continue to see our relationship with Ericsson as a critical path to further international expansion. In fact, we have now shipped product to Ericsson for three tier 1 service providers, Telstra and two as of yet unannounced customers one in Europe and one in Asia. We’ve also since secured an additional European customer by partnering with Ericsson. And overall, we are on track to meet our expectations for that partnership in 2015.

So as I look back over Q1, it was a quarter highlighted by our continued diversification, our expanding portfolio and opportunity and most importantly our improved operating leverage and profitability. I think that our Q1 performance validates not only our strategy but also our ability to execute against it, and capitalize on our competitive advantages in the marketplace.

Before I turn the call over to Jim, I want to take a moment to thank Tom Mark for the last 18 years of dedicated service at Ciena. And despite our best efforts, Tom is insisting on retiring at the end of this month. So in effect this will be our last quarterly call with Tom on the line. As many of you have worked with Tom over the years I’m sure you’ll agree when I say that he will be truly missed and I want to thank him for his many contributions to Ciena and we wish him the very best in his retirement. Jim?

James E. Moylan, Jr.

Thank you, Gary good morning, everyone. Our first quarter results and the momentum we have in the market reflect the solid platform that we built over the past few years. Our portfolio and go-to-market investments are helping us win in critical segments of the market and we continue to diversify across verticals, regions and applications. We are expanding our role and our reach as we build a global on-demand environment for the cloud.

Our Q1 results indicate strong performance in nearly all of our operating metrics. We delivered a solid bottom-line and continued improvement in operating leverage. Before going into our Q1 results in more detail, I’d like to spend a moment on the effects of the movements in foreign exchange rates.

As you’ve seen from other companies both within and outside of our industry, our financial metrics were impacted by the rapid strengthening of the US dollar against a variety of foreign currencies, particularly in January. In our case, changes in FX rates particularly the Canadian dollar and the euro did affect virtually every income statement line in some way. But the net impact on Q1 adjusted operating income was minimal for reasons I will explain.

Against that backdrop, Q1 revenue came in lower than expected at $529 million. The strength of the US dollar was a factor in our revenue for the quarter, reducing revenue by approximately $10 million. Revenue also was affected by the timing of orders from the US government. As Gary mentioned, we now expect those orders in Q2 with revenue coming in Q2 and Q3. This is a perfect illustration of why we often say that you should view our results in fiscal halves or in full years to get the most accurate picture of the trends in our business.

As expected, Q1 gross margin recovered substantially from Q4’s 38% coming in at 44%. Last quarter, we said that we expect the gross margin to return to our more typical range in the first half of 2015. Q1 results bear that out and we were actually able to overachieve a little on gross margin this quarter, due to a combination of ongoing product cost reductions and a favorable product mix. This included increased software content and a greater proportion of higher margin line cards.

In addition gross margin was slightly affected by FX in the quarter through a reduction in cost of goods sold. Q1 operating expense was significantly lower than expected at $197 million. The strengthening dollar reduced OpEx by roughly $4 million. OpEx also was affected by the timing of certain real estate and R&D projects, which we now expect to occur in subsequent quarters. The combination of this lower OpEx and strong gross margins allowed us to over achieve on operating profitability despite this extreme volatility in the foreign exchange markets.

Our Q1 adjusted operating profits of $37 million represents an adjusted operating margin of 7%. Orders in the quarter were greater than revenue and thus our backlog grew. Adjusted earnings per share was $0.12 and we generated $23 million in cash from the business.

Now let me speak to guidance. We certainly continue to believe that 2015 is going to be a great year for Ciena. As you’ve heard us say again today demand is high, our leadership position is strong and our visibility remains good, but as you see in our Q1 results, we are not immune to volatility in FX rates. Given the dramatic effects that we saw in Q1 we want to help you understand the impact that the recent strengthening of the US dollars has on our expectations for the full fiscal year.

When we reported our Q4 results we said that we expected 2015 revenues growth to be in the range of 7% to 9% for the full year. If the US dollar had not strengthened as it did we would continue to expect our revenue to be in that same range for the year. However, we now expect that the current FX rates will reduce our 2015 revenue expectation by approximately $50 million to $60 million.

After considering this impact, we now expect an overall revenue growth rate in fiscal 2015 in the range of 5%, of course that expectation could change, depending impart on what happens to FX rates as we move through the year. That said, it’s important to note that we are taking market share and we continue to believe that we are growing faster than the market despite these FX rates effects.

In addition, spot rates FX will also reduce our operating expense this year such that we now expect that OpEx will average approximately $205 million per quarter for the full year. We also expect the change in FX to reduce our cost of goods sold for the year. When all these changes have taken together, we continue to expect that we will achieve our previous guidance of 8% to 9% in adjusted operating margin for fiscal 2015.

In fact when combined with our improved gross margin performance, we also believe that our adjusted operating income for 2015 will be inline with our previous expectations. We also continue to expect to generate in fiscal 2015 roughly double the cash from our business that we did in 2014, excluding any repayment that.

Turning now to our fiscal second quarter, we expect Q2 revenue to be in the range of $585 million to $615 million. If FX rates had not changed from the beginning of the year, both ends of this revenue range would have been higher by approximately $15 million. We expect Q2’s adjusted gross margin to be between 42% and 43%. We expect Q2 adjusted operating expense to be approximately $210. We do not expect significant cash generation from the business in this quarter, largely due to the fact that we payout our fiscal 2014 companywide incentive compensation during the quarter.

Finally, due to the cost of hedging, we again expect to charge another expense of about $4 million. I know all of this FX discussion has been a lot to absorb, but I do want to emphasize that even after the impact of the fluctuations in foreign currency exchange rates to-date we expect our bottom lines, both at the operating profit line and at the net income line to be about the same as the numbers we expected at the beginning of the year. In other words, FX changes to-date have affected the income statement at certain lines, but the net effect of all of these changes is minimal for the full fiscal year.

I’d like to close our prepared remarks by reiterating that we are committed to capitalizing on this platform we’ve build to deliver balanced, diversified growth and substantially increased profitability. As customers continue to adopt web scale principals Ciena is positioned to help all kinds of network operators transform their business through strategic, on-demand networking.

John we’ll now open the line for questions.

Question-and-Answer Session

Operator

Thank you we’ll now begin the question-and-answer session. [Operator Instructions] And our first question is from Amitabh Passi from UBS.

Amitabh Passi

Hi guys, good morning can you hear me?

Gary B. Smith

Yeah, we can hear you Amitabh.

Amitabh Passi

Hey, excellent. I just had a couple of questions, Jim first one for you and I apologize if I missed this. I think I heard you say 5% revenue growth for the full year, but you reiterated operating margin in 8% to 9% but I thought I also heard you say that in terms of operating profit dollars and net income dollars your expectation hasn’t changed. So I was little confused by that lower revenue same operating margin. How is that the operating profit and net income dollar expectations are still consistent with where they were?

James E. Moylan, Jr.

So there is only one way mathematically to get there, and that’s to assume that our gross margin is going to improve from our previous expectation.

Amitabh Passi

Okay, alright just wanted to clarify that.

James E. Moylan, Jr.

Amitabh you will get there, just pencil it out.

Amitabh Passi

Okay. And then Gary maybe just a broader question for you, you talked about several metro wins just the point of clarification where most of the ones you’ve highlighted in your commentary 100 gig wins. And then maybe just give us a sense of the demand and the competitive environment particularly vis-à-vis Cisco?

Gary B. Smith

Amitabh again most of those wins are referred to were 100 gig and most of the -- what we’d call next generation converged packet metro, which is really what we’re talking about not the legacy metro, most of those are 100 gig. We’ve invested very heavily in that space, we think we have leading capabilities more of which will deliver during the course of this year. So from a competitive point of view, obviously as we get closer to the end user it’s a slightly different set of competitors within that capability and Cisco is certainly a -- would be more of a competitor as we get to the metro space.

But it’s also a much, much larger opportunity, I think it's at least two to three times and I think it’s strategically important because it is so converged it’s really the point of service delivery to get content into users. It’s also the opportunity to put software applications and obviously a lot more packet capability on it as well. And overtime we think that will deliver more gross margins.

Amitabh Passi

Okay, thank you. I’ll sit back in queue.

Gary B. Smith

Thanks, Amitabh.

Operator

Our next question is from Rod Hall from JPMorgan.

Unidentified Analyst

Yeah, hi thanks. This is Ashwin on behalf of Rod, first of all Tom congratulations on the retirement.

Thomas Mock

Thank you.

Unidentified Analyst

My question really is on competitive environment in general, can you talk about competition in metro maybe the Web 2.0 customers one of your competitor announced new products towards the end of last year. I’m just wondering how you see the competitive environment playing out this year. Also if you could talk about any metro RFPs in pipeline and potentially you could have one in Q1, which could probably help your revenue accelerate in second half of this year that will be helpful too.

Gary B. Smith

Okay, why don’t I take the first part of that? In terms of the competitive environment I think as I mentioned on the previous question to Amitabh. As you get closer to the edge it’s a slight different set of competitors emerging there and certainly Cisco is one more obvious one. But we think we are very well placed with our next generation platform, that’s specifically designed for the space and we’ve got increasing capabilities during the course of the year as we will announce.

The environment generally, I mean if you take the top North American opportunity as I mean and I think the other one you are referring to is the Verizon opportunity that’s been publicly talked about in the RFP. Should Ciena secure that and by the way we think we are very well placed for that, there is a very good fit both from a relationship point of view and credibility and also from a solution point of view should we win that we basically would have the top five facilities based carriers in North America will have already chosen Ciena to basically role out their next generation metro.

So I think you know those decisions have already been made, and so you know when we think the decision on Verizon will be announced shortly. On the product side, let me hand over to Tom.

Thomas Mock

Yeah. I would say on the things that’s interesting about the metro area and Gary sort of alluded to this is the fact that you are closer to the end user so there is more complexity in the devices, there is more conversion, there is package switching required, sometimes the end switching required. One of the reasons we’ve been so successful in that space is because we’ve been able to converge those into a box that actually fits the application very, very well.

There is also in the metro area quite a drive in terms of differences by the web scale providers and we’ve also seen some success in that market as well. So and it’s not just connecting users to content affecting that area that’s where some of the more complexity in some of the greater need for packet switching comes in, there is also a good market for being able to interconnect data centers that have been placed closer to the users and that’s one of the things that’s driven us to be ranked number two globally in metro WDM in 2014.

So we see it as a good growth engine for the company, we see it as a good fit with our technology and we also see it as a good fit with some things we are doing on the agility side to help service providers put more functionality closer to the user.

Unidentified Analyst

I have a follow up on Gary’s commentary on Verizon. So in your fiscal ‘15 guidance, are you already factoring in this win and how much of revenue are you expecting from this deal?

Gary B. Smith

We are not factoring any real revenue for this year by the time we get to the role out I think most of that will be beginning and there might be some late in 2015, but I think really would come online in 2016. So in the guidance that we’ve given we are not really factoring in any revenue that’s going to be a layered on opportunity as we go through ‘16. There is a lot of other metro wins as I said they are beginning to roll out of the major carriers in North America including AT&T, which is beginning to deploy 100 gig into the metro that was also strong in Q1, CenturyLink, Comcast, Bell Canada, Sprint, most of the North American players have made their choices and it’s the Ciena platform and that’s beginning to roll out in ‘15.

Unidentified Analyst

Okay. Thank you.

Operator

Our next question is from Jess Lubert from Wells Fargo.

Jess Lubert

Hi guys. Thanks for taking my question and Tom congratulations again. Couple of questions, first pricing of the big 100 gig metro opportunities you are working on and with the big U.S. opportunities should we be expecting concession similar to what we saw last year with your biggest customer?

Gary B. Smith

Remember when we talked about that deal we said that it’s a normal part of winning new positions to have a price discovery mechanism and to give discounts at the beginning. We also said that we don’t expect the kind of very significant in quarter effect for any deals in the future as we saw in Q4. So I’d say that the competition in all these metro deals is tough and we’re going to be having to get some price concession, but as of now, we don’t expect to kind of effect going forward in any deal that we saw in Q4.

Thomas Mock

One thing to keep in mind Jess is we also introduced some new chips that are going to help improve our cost point for metro and that’s going to allow us to remain competitive even if the prices go come down.

Gary B. Smith

Well also Jeff you have seen the strength of the gross margin in Q1 and we also develop the amount of metro shipments, which were substantial in the quarter was well and they actually helped the margin given the conversions on the platform.

Jess Lubert

Okay. So it sounds like you are not expecting a big step down function if you were to when that big opportunity upfront is that fair statement?

Gary B. Smith

Correct.

Jess Lubert

And then my second question I was hoping you could discuss what you are hearing from customers regarding the 8700 platform, how that’s going verse plan I didn’t hear that on the call and perhaps you can touch upon how impactful you believe some of your new web scale capabilities are likely to have with these accounts over the course of the year?

Thomas Mock

Yeah we’ve added some new customers to the 8700 roaster for the quarter we are at 12 customers now I think that’s up three from the last quarter. We see this as a good way for us to expand our reach inside networks for using our packet capability. So typically we’ve acted more close to edge of the network this will allow us to get more back into the metro infrastructure of the network.

This is also boxes optimized to packed traffic in the 100g plus which was nice step with some of the other things we are doing on the infrastructure side. It’s also a device that’s larger in scale and more software intensive and those kinds of trends tend to make it a higher margin product for the business. So we are seeing good traction with the product with customer so far it’s been on the market for a little over quarter now and we’ve already got 12 customers for it. And those are customers from various parts around the world not just in the United States.

Jess Lubert

Thanks, Jeff.

Operator

The next question is from Simon Leopold from Raymond James.

Gary B. Smith

Hey, Simon.

Operator

One moment. Alright Simon go ahead with your question.

Simon Leopold

Sorry do you hear me, okay?

Gary B. Smith

Yes, we can do.

Simon Leopold

Okay sorry about that. It was my fault, nonetheless Tom I wanted to congratulate you on your next phase, it’s been a long time. So we will miss you hear, so good luck with whatever you are doing next. Nonetheless let’s go into the questions, I was hoping you could talk about two things, one is what’s going on with the mix, in terms of this quarter it looks like most of the delta within converged packet versus what we were expecting, so just wondering how you are thinking about the mix of your segments’ going forward?

And then Gary you talked about metro margins being better and I was kind of surprised and you’ve answered that in part to Tom’s comment on some other new chips sets, but I am wondering if you could help us understand how this compares historically because, I generally thought that long haul has been a better margin market then metro and we also seem to see more competition in metro than long haul so I am a bit surprised regarding this idea that metro margin improved? So if you could help us with that aspect. Thank you.

James E. Moylan, Jr.

Let me speak to the growth rate just for a moment Simon. As you can see we’ve seen growth across just about all of our segments expect for optical transport, which are our older platforms and we expect to see that overtime, if I were to look and speculate on where the higher growth will be I think you are going to see higher growth overtime in packet networking and higher growth overtime in our software business that’s where we are going to see higher growth. But we expect everything other than optical transport to grow overtime.

Simon Leopold

But in the April quarter do you expect the most sequential growth in converged packet relative to where it was this quarter versus October?

James E. Moylan, Jr.

Most likely as you know though we can always fool by serial movements in any number in our income statement, but yes that’s what we would expect.

Thomas Mock

And Simon to your margin question, the cost reduction does play a factor in that, but an equal important factor is the fact that most of these applications we’re seeing are requiring somewhat of switching an entire level of functionality gives us an opportunity and to put more value into the network. I think that’s one of the reasons that we’ve been able to do better than some of our competitors is because we’ve done a better job with integrating some of those technologies into the platform, easier to put in their networks, easier to integrate with their existing long haul facilities and more capable helping them delivering new service is faster to their end users.

Simon Leopold

Great thank you for taking my questions good luck Tom.

Thomas Mock

Thanks.

Operator

And our next question is from Ken Schofield from Goldman Sachs.

Kent Schofield

Great, thank you. First off congratulations to you Tom. On the data center interconnect market we have seen a lot of thought of launches there, so I was wondering if you could do a little bit of dive in terms of competitive environment for those platforms what you’re seeing and how you see that evolving going forward?

Thomas Mock

Yeah I’ll start with that and Gary or Jim add some color commentary as you see fit. Today that market is largely dominated by simple point to point transport and as we’ve seen in the longer haul parts of the data center interconnect market as time goes on the needs get more sophisticated, in some cases it needs switching capabilities, in some cases they want to go longer distances at higher capacities. So one of the things that we’ve been working on is how can we get them the most capacity on a fiber over a metro distance to be able to connect data centers within to these. We also believe that overtime there is the ability to add some traffic management to that, there is the ability to add some automated protection to that and there’s the ability also to run software applications that will allow the platforms have got to better interconnect with the stuff that’s going on inside the data center.

You may recall about six months ago we talked about some work we’ve been doing with Brocade that allowed us to have the software they have running in the data center actually controls some of that behavior of the networking in order to setup and tear down capacity, because one of the things that’s happening here is even though a lot of these initial deployments are fairly static over the longer term as people start to migrate applications between data centers we’ll see that connectivity become more dynamic. So the initial entrance in the market have made special purpose products to go into that space have largely been very simple, optical transport platforms that simply get capacity from one place to another and don’t necessarily allow the interaction with software applications that would allow you to make that more dynamic. We see that’s really going to be a more important part of the data center interconnect market.

Kent Schofield

And one quick follow-up. With the second largest customer on the web scale side of things is that the same customer as last quarter?

Gary B. Smith

Yes I believe it is, Kent.

Kent Schofield

Okay, thanks so much.

Thomas Mock

Thanks, Kent.

Operator

And our next question is from Subu Subrahmanyan from The Juda Group.

Natarajan Subrahmanyan

Thank you. My first question was on the metro Market, you told us what it was as a percentage of 100 gig port so wondering if you can talk about what it represented as a percentage of revenues and what ASPs are compared to long haul? The other question was you now have more cost optimized platforms, but last year were you selling more of what would traditionally be a long haul platform into metro, which could have depressed margins and as you add more packet functionality and lower cost components it improves metro gross margin going forward?

Gary B. Smith

Subu let me take that, roughing out on the revenue it’s about half as well, the rough correlation exist between the ports and the revenues. The point I would make about metro is what we’re talking about in these new rollouts is really a next generation metro that’s highly converged platforms that require a lot of switching, OTN, control plain, a lot of packet convergence and when I talk about what we’re rolling out at AT&T and CenturyLink et cetera and hopefully with Verizon as we go through 2016 these are based on these kinds of platforms highly converged platforms not simple transport as Tom was saying.

Natarajan Subrahmanyan

Understood. And then two quick clarifications, could you tell us what web scale represented as a percent of revenue? And Tim you mentioned I think was an earlier [ph] question, we have lower revenues and same level of operating profit dollars should operating margin percents actually be higher in the quarter?

James E. Moylan, Jr.

Yeah on the web scale percent of revenue, we haven’t disclosed that precisely it’s still probably as a direct number under 10% but it’s our fastest growing vertical. Although if you include it the sales that we make to tier 1 operators who are building capacity to serve the web scale set of customers, it would be in excess of 10%. And we believe that we’re number one in chair on just the direct sales if you add the indirect sales that are specifically for web scale customers we’re clearly number one in terms of market share.

With respect to the FX discussion, I just want to remind everyone of the numbers, so you understand how it all works. We said that revenue is going to be affected for the year and reduced by about $50 million to $60 million. We said that if you parse through the language that we used to that OpEx that’s about a $20 million reduction in OpEx. We also say that our operating income number is going to be about the same as we ahead earlier in the year. So that difference obviously is made up in the COGS line. And in order for our operating margin to be roughly the same I’m sorry in that same range and the same number based on a lower revenue number the operating margin percent by definition does have to go up.

Natarajan Subrahmanyan

Okay. I just wanted to clarify that. Thank you.

Gregg Lampf

Thanks, Subu.

Operator

Our next question is from Brian Modoff from Deutsche Bank

Vijay Bhagavath

Yeah, thanks guys Vijay on behalf of Brian. Hi Gary, hi Jim.

Gary B. Smith

Hello, Vijay.

Vijay Bhagavath

Yes so if I may the way I look at the company and the stock, the three fundamental catalysts one is the 100 gig metro opportunity at the U.S. telcos and in Europe et cetera, and then the 100 gig long haul build out at AT&T, and then the third is continuing strengthen Web 2.0, so I’d like to understand from you when you look at your web scale datacenter opportunity give us some numbers in terms of year-on-year revenue growth in terms of percentage contribution would it be approximately 10% of revenues currently from web scale datacenters and would it would be 2X of the revenue growth you’re seeing from telcos in terms of how we should look at Web 2.0? That would be the first part of the question. Thanks.

Gary B. Smith

Let me kind of answer it generally and try and get down to some specifics to you. I think what’s driving the whole on-demand environment right now is really the content. I mean that’s what’s driving the networks. The web scale folks are building clearly content-to-content, datacenter-to-datacenter. And they are building out in many cases direct capacity for that and also obviously from content-to-users some of them are building specific in collaboration with the tier 1s around the world those kinds of dedicated capacity. And we’re involved in all of that because we’re strong in all the global tier 1s for the web scale folks.

So I’d answer it in sort of specific in number of ways. One, our non-telco revenues have gone up from about 25% couple of years ago to we had a milestone in Q1 of over a third of our revenues now come from non-telco infrastructure revenues. And that includes the web scale guys. Directly they’re about approximately 10% of our total figures. But if you also put in the collaboration where we put dedicated capacity in the tier 1s it’s a very strong driver of our overall growth and that number is substantially more than the direct amount of business that we’re doing.

So if you put those things together its 20% to 30% of our total revenues come from those folks that we can actually identify from the web scale and we see that increasing. And we see other opportunities with emerging web scale players that we’re not currently with and we expect to secure some of those during the course of this year as well, increasingly our portfolio is geared to support them both directly and with the sort of global web scale features as per the number of additions to the portfolio we announced the other week.

So I think, if you think about it in those terms obviously 100 gig content-to-content we are also seeing them build out metro as well where they want to get catching closer to their end users.

Vijay Bhagavath

Yeah, thanks Gary. And then quick follow on would be, Infinera seeing strength with web scale data centers, so on deal-by-deal basis in the field would you have to compete quite aggressively versus Infinera or is it a positive some game there is enough of opportunity for both of you help us understand the competitive dynamics in web scale data centers?

Gary B. Smith

Well I mean, if you think about the metro opportunities to-date with the tier 1s it’s probably more on a global basis Alcatel and Cisco that we would compete with. If you talk specifically about some of the simpler applications around data centers then there are number of small players in that, but by the time we roll out complete portfolio I think we will be very well positioned. And so we’ve got lots of different capabilities we can deploy the scale from simple point-to-point data center environment that just looking for pure transport all the way up through fully converged packet with switching and OTN and of very high density where we’ve got specialist wave logic technology being deployed. So I think as we go through the course of this year it will become clear so we’ve got absolutely comprehensive portfolio that will scale right the way from the simpler transport point-to-point all the way through to fully converged high density software enabled metro applications.

Vijay Bhagavath

Thanks. Final question for Jim if I may, anything Jim on the operational side, the way I mean is with the web scale data centers you have to turn the purchase order around quicker versus how you would respond to a telco bid, am I thinking this correctly in terms of the how your operational processes would be different to respond to Web 2.0 order versus one of your traditional telcos? Thanks

James E. Moylan, Jr.

I would say generally you are correct, I would say that the tier 1s are sensitively times but they do often give us orders far in advance and we do have time to react at least they can give us a plan for a year or a quarter where we will have some idea what they are going to do. Whereas the web scale guys do tend to move pretty quickly. And yeah so we have adjusted operating processes we did last year you’ll recall we did change some of our supply chain behaviors, we brought in some finished goods 100 gig cards to be able to generated lead times and we brought those lead times down to a very short period. And so we are very much able to serve the needs of web scale and it’s not just the web scale by the way in the enterprise on success based opportunities the lead time is critical and we can win or lose deals based on our lead time. So we have done the things in our supply chain to enable us to hit those lead terms.

Gregg Lampf

Thanks, Vijay. We got to take the next questioner.

Operator

And our next question is from Ehud Gelblum from Citibank.

Unidentified Analyst

Thanks everyone its Stan -- dialing in for Ehud, thanks for taking the question. I just wanted to ask little bit about the U.S. business, obviously we know what the AT&T numbers and it seems like with government weak the non-AT&T part of the business fell about $55 million in the quarter, I just wanted to understand what portion of that was related to the fed versus non-fed? And then also just back to the strong gross margin can you help us understand where exactly the concentration of line cards that you shipping that helped you on the margin side is coming in is that actually just from AT&T and can you sight maybe more specific projects or is that with web scale? I just wanted to understand the phases you are in of some of those deployments and beyond the cost side of things on the chips being lower and the FX where you are getting that improvement in gross margin just from a mix stand point on the line cards? Thank you.

Gary B. Smith

Let me talk to the first part of that Stan. In the U.S. the government sector order that we would expect to get rolled out of that were about $15 million to $20 million approximately. We expect overall the North America to rebound strongly into Q2. So I wouldn’t read too much into that from a trending point of view on a quarter-to-quarter basis, about close to half of that was just a government sector in terms of timing. And then you got enterprise and tier 2 et cetera that we think are going to come on strong for the Q2 and Q3.

In terms of the margin expansion, it’s really, it’s not just simple line cards it’s really was a greater preponderance of software, a greater preponderance of certain kinds of metro where you’ve got high packet and switching capabilities built into the platform. So they helped drive gross margins in addition to some of the cost reductions and just to be clear some of the new chips we announced the other week, while as we were shipping one of those chips we really haven’t received a lot of benefit of that cost reduction yet either. So that’s all in front of us as we roll out 100 gig both in long core and in metro.

In terms of the line card specifically, we had a lot of wins over the last three to four years particularly internationally, where we’ve put in essence a lot of chassis out there, we are now beginning to get a steady cadence of growth in terms of those channel adds, which tend to be at higher margins that’s also playing the role as well in our improved margin position.

James E. Moylan, Jr.

And just to add a little bit to that comment about the U.S. in the first quarter. We said over and over again that you can't really look at quarter-to-quarter performance as a trend you have to look over longer periods of time. We expect a very, very strong year in our U.S. business this year it will be higher than last year overall. And so you will see stronger performance in the subsequent quarters.

Unidentified Analyst

Thank you.

Operator

And our next question is from Mark Sue from RBC Capital Markets.

Mark Sue

Thank you. Good morning, gentlemen. There is a lot of positive things going away for Ciena this year, if I consider your comments that Ciena is not in a better position of strength and also combined here with all hard work you have done with COGS improvement in more software are you now able to price your products more of value and less on mark up on cost, operationally things are moving in the right way, so are you -- can we start having the strategic discussion with your customers to kind of pay more for value for that value that you add? Thank you.

Gary B. Smith

Mark, I think that’s a good point, there is two comments I’d make to it. First of all you’ve got a more converged solutions you’ve got a lot more capability been delivered and importantly it’s really about service creation to your point you are closer to the end user. And so it’s less of a capital expenditure it’s more around investing where they are actually getting revenues from their customers. And so it changed the dynamic of engagement, we spend as much time with the product marketing people at some of the major carriers around the world as we do with the infrastructure folks. And as you get closer to the services piece it’s much more success space and that tends to be more software orientated and therefore higher gross margin. So that’s why we are so focused on this broad metro space, because that’s where we see the opportunity to really amplify that and get the margins where we want them to be, which is consistently in the mid-40s.

Mark Sue

That’s helpful. And then maybe just a quick follow-up, there is a big focus to double your cash generation this year maybe how we should think about that, is that mostly a function of increasing net income or is it just improvement in the working capital as well? Jim maybe your thoughts on how we could continue to improve the cash flow generation? Thank you.

James E. Moylan, Jr.

Yeah, it’s both this year, we will have higher net income and we will do a little balance sheet cleaning. So it’s both and we expect that to continue going forward. As our net income grows our cash flow grow that sort of dollar for dollar, on the working capital line remember that we have been attacking internationally in areas where we have been doing big projects where typically we don't get acceptance until we complete the project and that begins the cash collection cycle.

So many of these projects have been on our balance sheet for longer than our normal business in the U.S. We are still going to be attacking in many of these areas, but the percentage of our business that these big projects represents will go down. And so I look for our working capital as a percentage of our revenue to decline over the next several years which will be another source of cash. So I think we’re going to generate good cash this year and assuming that the world continues the way it is now for the next several years.

Gregg Lampf

Thanks, Mark we’ll take one more.

Mark Sue

Thank you, gentlemen.

Gregg Lampf

Thanks Mark.

Operator

Our next question is from Paul Silverstein from Cowen and Company.

Paul Silverstein

Thanks, guys. Can you hear me okay?

Gary B. Smith

Yes, we can hear you Paul.

Paul Silverstein

Great. [indiscernible]. In terms of pricing I think the pricing the rate of decline hasn’t changed?

Gary B. Smith

We don’t see much change in the pricing environment and obviously with the cost reduction that we’re doing and getting closer to the metro and the end user we see the ability is much to deliver value.

Paul Silverstein

Okay. So Jim or Gary relatively I guess to follow up on margins that you just put up some very strong numbers up here I would say one quarter doesn’t trend make relative to the concern a lot of investors have that what AT&T did a quarter or two ago every carriers in the world is going to do to one extent or another at some point if not immediately is there again I know the numbers were strong and the comments around mix and pricings that is all strong. But anything incremental you could say relative to that concern? And then I have one follow up if I may.

Gary B. Smith

I think what was different around what happened in Q4 was it was very concentrated it’s how we structure the deal, which is very unusual for some very specific reasons we decided to structure it that way and take it in the quarter. What I said now I said then which was really this is no different than the stuff that goes on, on a regular basis with all of the major carriers except normally it’s extrapolated out through the course of the year and we are able to manage it accordingly.

And I also think Paul to your point we had a very strong quarter in Q1 with AT&T, particularly as they begin to deploy more and more of their metro and they’re just at the beginning of that starting to deploy their 100 gig. So and you can see from a gross margin point of view in Q3 of last year we were 44%, in Q1 of this year we are 44% really the decline in Q4 was attributable to one particular negotiation. We do not seeing that being repeated again in the foreseeable future with any of the tier 1 carriers.

Paul Silverstein

Okay. And then I recognize and sort of predict the future in your business little low one quarter little low year or two out, but relative to concerns about the extent of this upcoming cycle and there is not a lot of history I think we have had 1.5 upgrade cycle in the last 15 years if I recall. I recognize it’s not the late 90s in terms of the underpinning of the cycle the help of the customers. But what are the data points you can sight that suggest that this would be measures in years from now as oppose to there is a handful of quarters left? It seems like we’re at the beginning of metro, but the simple question is what are the data points that would indicate this is a multi-year as oppose to multi-quarters upgrade from here?

Gary B. Smith

Yeah I mean having leaved through the various cycles over the last sort of 20-30 years I’d say what’s different about this is I think first of all it’s grounded in real business model of people making money, real applications and that it demanding massive amounts of capacity. And I just don’t see that changing I mean we’re at the fairly early stages of that when you think about machine-to-machine is not really started yet in any appreciable way.

I think all of the -- and it’s very broad based. It’s not just the few large carriers building infrastructure, very often we’re delivering capacity right into the front end of the networks that go straight into usage by the content folks. And just the enormous amount of demand that’s being driven by those is unprecedented and the way they are building the networks it’s much simpler, it’s content-to-content and data center to data center connectivity I think that’s going to be a massive requirement for the next 5 to 10 years. If you think about then getting that content out to the users and that could in their mobile devices, into their machines we’re at the fairly early stages of that. So while it will have its ups and downs I think the underpinnings of the demand of fundamentally difference than we’ve seen in the telecom infrastructure world to-date.

Paul Silverstein

And here you see no trail off in the number of our peers and the other leading indicators that speak to that.

Gary B. Smith

Yeah, I mean we see increasing pipeline, increasing demand. Said simply, it’s a broader set of customers that are now driving demand for converged packet optical, it’s enterprise, research education, government sector, web scale content providers, web scale, datacenter, neutral providers a wider ray of customer base. And I think that makes for a much more balanced business, which I think is the whole point. We don’t want to see these large cyclical short-term movements and I think we’re beginning to get very confident that we can deliver consistent profitability and improve our operating leverage over a long period of time.

James E. Moylan, Jr.

I’d also say Paul that we believe that we can continue to take market share. We think with our solutions, our set of engagements with customers with expanding our role and reach that we’re going to continue to take market share. So if you look at us, in particular we see a nice future ahead of us.

Paul Silverstein

Thanks, Jim, thanks, Gary.

Gary B. Smith

Thanks, Paul.

Gregg Lampf

Appreciate you calling in Paul from overseas and everyone else and we look forward connecting with you again next quarter and during follow-ups. Thanks everybody.

Operator

Thank you ladies and gentlemen, this concludes today’s conference. Thank you for participating. You may now disconnect.