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Executives

Jerry Turin – Chief Financial Officer

Analysts

Kevin J. Dennean – Citigroup Inc.

Oclaro, Inc. (OCLR) U.S. Small/Mid Cap Conference Call November 15, 2011 1:55 AM ET

Kevin J. Dennean – Citigroup Inc.

[Call Starts Abruptly] Optical Equipment Analyst here at Citi. Thank you for joining us at Citi's 8th Annual Small and Mid-Cap Conference here in Las Vegas. We’re very happy to have with us today, Jerry Turin, CFO of Oclaro. Before we get started I just want to mention there are some disclosures for you up at the front desk. With that, I think what we’re going to do is turn it over to Jerry for a brief presentation. We’ll do a Q&A session afterwards. We do have mics in the room. I would ask you just to wait for the mic to reach you, as this presentation is being webcast.

With that, I’ll turn it over to Jerry.

Jerry Turin

Thanks, Kevin. Let me start with just a little overview on who Oclaro is, then I’ll get into some short-term dynamics that are probably more relevant at this time. Oclaro is a manufacturer of optical components everything from chip level products to sub-system servicing. We are largely the telecom equipment providers.

Over recent years, we’ve executed in the industry roll ups and this time last year, we’ve executed our 12 months merger targets from the profitability gross margin and gross point of view and since then, our sector and then the broad economy at large has slowed and suffered some setbacks, and just as we were hoping to get some traction towards the end of the year ourselves and a number of our peers suffered from a large contract manufacturer being exposed to the floods in Thailand. So a lot of those dynamics how this years transpired where we are at today. Some of the actions we’ve announced in our recent earnings call are probably what we’ll focus on in the slides and then perhaps in the questions with Kevin as well.

So we’ll go to the first slide, which is slide three for those on the webcast. The key messages that I’ll touch on are, that our September quarterly results was expected, and in fact, shows some early momentum in some operating efficiencies and cost improvements we’ve been working on.

New product momentum is accelerating. Large part of this year’s story is in anticipation of second half, new product introduction growth in some, what I’ll call headline product areas. What’s important is, as we continue to introduce and announce more products through the year so, the pipeline is anything but close and we think we’re all well positioned from that point of view.

The telephone market itself continuous to experience a little short-term uncertainty bad conditions aside, felt like traction was beginning to pick up, but with the macroeconomic conditions, I think our sector is not too different from an awful lot of areas where there is a little bit of tentativeness at this point in time.

One of our challenges in the last year was ramping our high-powered laser business after the transfer of the fab associated with one of our acquisition activities. We’ve recovered that business and had record revenues from that business this quarter, so that’s an important point to takeaway.

In response to the conditions I've talked about this year, we’ve stepped up to take actions to lower our break-even level. Earlier in the year, it looked like we are in a short-term inventory correction in our sector. As we got beyond the June quarter, it was clear that there was going to be some level of softness in the second half, and that we started taking actions to adopt our business model accordingly. In the mean time, a lot other things we’re talking about today reinforce our commitment to core value proposition including differentiation at the wafer and fab levels as well as others. We’re facing what looks like a short-term two-quarter challenge, because of the Thailand floods. We think we maybe positioned by even more stronger from the market position and from a product position coming out, but of course two quarters is quite a long time when you’re facing the responses and challenges that we and the peer group are facing in that regard.

And as we talked about during our conference call roughly a week ago, as more information arises we’re trying to keep (inaudible) investors well advice as far as progress and any changes from what we’re describing because it is circumstances that develop as we move along.

As far as some of the specifics in the September quarter, our revenues were in line with guidance and our gross margin to adjusted EBITDA works towards the high end of the range and so achieving that when we start the market softness and some exposure in both of those areas that shows some underlying traction in some of the changed management programs that we’ve been working hard on through the year.

From a new product point of view, our 40-gig continues very strong and in fact, this is the first quarter where we shipped significant commercial lines volumes of 40-gig coherent, and we believe we are the first component supplier with coherent solution of 40-gig and that’s really exciting.

Strong position in 10-gig and transponders pluggable, shipping commercial volumes of tunable XFP to one of the top two OEMs in our space as well as one of the top internet service providers, and with that basis we extend the qualification to one customer at a time and we see significant potential in this business.

In addition to these areas that we’ve been talking about during through in the year and some of the existing WSS (inaudible) we’ve been talking about during the year and the re-ramp of the high-powered lasers, we continue to introduce new products and [real model] products about. To that we have noted here are our dual chip 980 pump. So putting two chips in one package, which is quite an innovation, and we believe that we’re the first sampling WSS with the high port account 1/23. And that’s were we’re focusing a lot of our resources, because that’s where we believe we have more differentiation and the opportunity to be first to market or at least hit the market as an incumbent, where as the existing WSS market we really acquired into relatively laid by acquiring to start up and we’re playing a little bit of chase-up, catchup in that regard it is a more challenging market dynamic. Also in the quarter, not here introduced 100-gig coherent receiver, and are beginning that sales of 40-gig and 100-gig external modulators as well.

In recent months we’ve taken a look at this market dynamic we based, net our significant cost base, we have a significant fixed cost base as part of our business model. We’ve established a goal of breaking even at from an EBITDA point of view this June and we’ve put actions in place to achieve that at a $110 million revenue level assumption. We’re working our R&D back towards 13%, so there is targeted reductions in that area nothing that impacts our key product introductions or our key value proposition. We’ll start transferring some back end production of our high-powered lasers from (inaudible). We have a long-term site consolidation strategy is a result of our history and acquisitions we have quite a dispersed footprint, and we see ways to continue improve efficiency there and we’re taking some of the next steps during this timeline.

And also very important is that through much of this year we’ve been looking at our long-term manufacturing strategy, long-term manufacturing footprint two, three, five years from now where we’re going to continue to have our own manufacturing in-house and we do about 60% of the back-end manufacturing in-house today. Do we build a second factory here as down the road, do we use more contract manufacturing partners, do we grow with the existing contract manufacturer we work with on roughly 30% to 35% of our other back-end business, and that process, which include our (inaudible) with many of the leading contract manufacturers led to are expanding the scope of that evaluation to consider selling our Shenzhen factory to a contract manufacturer and entering into a long-term supply agreement.

We're very close to signing a definitive agreement on that, working to finalize the key terms, and from that we’d anticipate $30 million to $40 million of net proceeds in the upcoming March quarter, that’s when we'd anticipate the deal closing. With more conditions, consideration down the future, linked to some real estate that we would sell as part of the deal and at this time, we wouldn't want to predict exactly the timing of that or the amount, but there is some additional economics in that.

So that comes in important, because one of the things in our September quarter while we showed a lot of momentum from the underlying business point of view. We took our CapEx down dramatically. We’ve lowered our flow of material indeed significantly. How we had a significant cash burn in September largely working capital associated and largely associated with the timing difference and bringing those expenditures down hard to realizing the benefit through the P&L and through direct cash flows. So, we do expect through the December quarter that even with some of the issues we’ve talked about in Thailand and with some of the market conditions that we expect to be close to cash flow break-even in December.

Our working capital is fairly well positioned going into the December. Our CapEx even including investments in re-ramping some production lines will be closer to what we spent in September with the $6 million range. Then what we spent in recent quarters for that, and I think the average of the pre-season three quarters was about $11 million a quarter. So our CapEx is in shape. We’ve lowered our material entities, our inventories are at healthy level, so we think we generated a little cash from that and of course, to the extent revenues are lower in December because of Thailand. It doesn’t really impact cash within that quarter, because we’re still collecting the revenues that we sold in the September quarter, but we do anticipate a bit of a (inaudible) building from a cash point of view and certainly the March quarter is when we’ll see the impact of the lower revenues in Thailand. While it’s important to look at this sort of cash in flow from a strategic move we’ve been considering for a long time.

As far as the flooding itself, I’m sure people have different levels of familiarity with the circumstances, but we use Fabrinet in Thailand two facilities. Primarily we use what’s called the Chokchai facility and we had about 60% of the square footage of that facility, and that’s a facility that was totally flooded and remains flooded and the product lines that we did in that facility have to be brought up essentially in a new location. And as of now, our plan is to restart these in the other Fabrinet facility, which was protected from the floods and seems to cure for the time being and the long-term at least as of the current evaluation.

The products we do there are tunable dispersion compensation; amplifiers and modulators, each are significant product lines. Tunable dispersion compensation we may have back online by the end of the quarter, very early next quarter. Current expectations or amplifiers are some time during the March quarter and the modulators are probably the long poll in the ‘10, probably more towards the end of March at this point in time and of course, all these evaluations are preliminary, and we are still in the stage of plugging equipments you know from the water, plugging it in and testing it out and our folks, and the Fabrinet folks making substantial progress there. As you can imagine, not only week by week, but day by day understanding exactly what to bring up in recovery front are continually being worked. The Pinehurst facility itself, the production was disrupted until recently; early efforts there are being made to bring production back up. Our high-powered lasers, part of our high-powered laser business is done there. And so, we see production starting over the next weak of so and we also have a little bit of a knock-on effect where some of our PCBA boards with some of our other products in other parts of the company are still with Fabrinet as supplier.

Similarly, those have started to be brought back up again, we may have some limited revenue with stretch and associate that in December, but that's baked into the high-level numbers we gave during our call last week where we expect to have $20 million to $30 million revenue impact in December, and a small part of that may be made the knock on effect of PCBAs, and right now we are thinking $10 million to $20 million in the March quarter and pretty much back on track in the June quarter. Again, I caution everyone that you now, there is a lot, lot going on, so what we want to do is over communicate that people should understand that these evaluations are going to be revised week by week by week.

Now, from a financial point of view, other than talking a little bit about the September quarter, in our recent call, we broke out our revenue category in a little bit more granularity than we have in the past, in order to give people a deeper understanding of the trend and the frame of reference for understanding strength of new products and where we have the moment. Telecom components, you can see it in December of last year, is really been impacted fairly significantly by the some of the inventory corrections and market conditions in our sector and particularly in Asia has slowed down significantly this year. With in transmission modules which includes 10-gig and 40-gig transponders, transceivers pluggable devices buried within those numbers is very significant strength in 40-gig which has grown from almost zero in the September quarter maybe a couple million to something in the order of half of those September revenues, but the mean time the 10-gig transponders also suffer similar to the telecom components and mostly due to the same market conditions.

In the short term, that’s had an outward impact on margins because those products all tend to be relying a lot of in-feeds from our own components that use our wafer fabs that are very high fixed overheads. So when those revenues go down, we have a disproportionate impact on margins, when Asia recovers and those revenues come back that’s part of the margin turnaround. Similarly if we go down the list of industrial and consumer which is where we had the record revenues this quarter that’s where early in the year we were struggling to get production back up and that tends to be higher than typical margins as well.

Within amplification, filtering and optical routing, tunable dispersion compensation which gets deployed in 40-gig solutions of our customers in China has been down for the same market negotiations with this components and essentially we held directed our business fairly consistent since the December timeframe.

I will go – bring up this slide just for visibility and to talk to the outlook in the bottom right corner. Right now, revenue guidance $75 million to $85 million obviously a steep haircut from the September quarter in the run rate as a result of that $20 million to $30 million impact we think we’re going to experience from Thailand, and really flowing that revenue change down to gross margin and adjusted EBITDA is exactly the story and those as well.

I’ll ramp up on that, and I will leave this key messages right up, I am very prudent to start with, I don’t think we need to reiterate at this point, but I am sure when we have questions from Kevin and the audience we made you know have opportunity to elaborate on some of these as and would be.

Kevin J. Dennean – Citigroup Inc.

We’re turning now to the floor for questions in just a minute but may be I will kick it of.

Jerry Turin

Sure.

Kevin J. Dennean – Citigroup Inc.

I think you’d left where the short-term issues on Fabrinet and you got technical happen with the cash burn in the quarter. Lets talk a little bit about the restructuring efforts, you know I think bring down R&D to about 13% or so, it’s not actually not follow up and we were fiscal. What I really want to horn in on is you know I think one of the tales of the prior story where you know something inherently the prior story is the strong manufacturing values that you have.

Now you are moving to a more variable base models particularly in the back end, how should we think about that impacting gross margin leverage going forward, once we get passed Fabrinet, once we get passed well I think by all accounts we are a largely passed, inventory correction of your customers. So I think you talked about the average back end cost has been about 8 million per quarter, if you can just walk us through what the puzzles of these back end.

Jerry Turin

Sure, let me address that two ways, I think there is two parts of the question. The first is your outsourcing the back end and that the contract manufacturer get the margin on that, is there by definition a lower margin profile from that. And the answer is, the key principle in our negotiation is a principle of cost neutrality coming of the gate. So obviously the agreement is not final, there is supply agreement and share purchase agreement are not signed in final, but that’s part of the value proposition is here to maintain that almost immediately and to see potential upside in the future. The other part of the question, which is very relevant and interesting part of the question is, the scalability of our margin, in fact I talked a little bit about when I was talking about our product revenues, which products in particular benefit from our fixed overhead when we grow and they have high incremental margin.

And so the question is, if we move away from that model, do we have left margin leverage when we expand, and the answer is, very little of that leverage was in the back-end of Shenzhen facility, it was about a third of our fixed cost. But it probably had a higher variable element than the rest of our business and the Shenzhen factory probably was getting to the 85%, 90% capacity range, I mean we have to build those some additional square footage, some additional screen room space et cetera for Shenzhen facility long-term growth.

On contract with our fabs in Europe that probably range between 40% and 65% or 70% capacity, and where the capacity can be increased quite significantly with a few point of equipment. So that’s really the wafer fabs that we really have that margin expansion, that potential from the fixed cost base. And that's also where we really have differentiation in terms of the quality of the wafer fabs, the level of photonic integration that can be done whether it's putting different functionality under one ship, reducing number of components, whether it’s a concept of laser technologies and so forth.

And that's where we think we have the chance to really differentiate our higher-level products too not just from the cost point of view, but from a performance point of view. So everything we're talking about today really reinforces our focus on that part of our leverage story. And in fact, we think we have further upside in the long-term by concentrating our back-end operations model on the investing clouds and managing contract manufacturers.

There were certain advantages to be in a high-grid. They're having 30%, 35% contract manufacturers, 60% in-house. But one of the downsize to just to be a master of well discipline so to speak and then we think by concentrating our team and really building out the resources to be a world-class partner with contract manufacturers, is also a more efficient approach.

Kevin J. Dennean – Citigroup Inc.

Great, thank you. I guess, just couple questions on the new product front. On your ROADM efforts in your Xtellus business you were trying to go into the market, I think it’s fair to say is, try to pass-through second source positions given incumbency of JDS, market leader of JDS (inaudible) that was probably made more difficult by the inventory correction. So can you talk about within the WSS component market, where are you focusing. Historically, it's been kind of a 1/8 market. We’re seeing folks moving to a very low core account to go into the kind of access portion as in that work. And we’re also starting to see some interest in very high core account WSS ROADM components more in the course. Can you talk about what the plans are on that front?

Jerry Turin

Sure, so we look at WSS ROADM is almost street to street markets, or at least street to street markets from the point of view of our value proposition, and where we think we have the best, the best chance to succeed, the best opportunities. In lot of the existing core accounts, 1/2, 1/4, 1/9, 50 gigahertz, 100 gigahertz, since acquiring Xtellus, that’s where we’ve been pushing the products into pushing qualifications, getting qualifications across a number of those categories, but coming in into the second source to incumbents coming into the late, that was coming in having to qualify to be minute characteristics of a competitor that customers got used to, and coming from a weaker market position, that’s always a challenge while we continue to survey, we’ll continue to see revenues move up modestly, but that’s not going to be where we change the world, right and that’s where we focus on two things. One is the very high [port] counts which will kind of would be the next way where we think number one, that our technology itself has been inherent advantages at high port count that our peers don’t have, and also just from the time to market point of view, the opportunity to come in as a leader incumbent so playing with a winning head rather than chasing after existing slots and that’s where the point about us being the first one sampling 1/23 is important. So that’s certainly a night and day starting point from where we got into WSS originally. It’s a long way from being the first one sampling to say you’re the winner in this space, but it’s also a night and day starting point.

Then we also look at it in terms of the line card level, the ROADM line card level. So we think of WSS as a component that’s critical that you can sell all vertically integrated into your ROADM line card solution. We think more and more customers are really going to be looking at that as the from factor that they are order from the optical components guide. Our customers are not in a business of buying a bunch of optical components, amplifiers, WSS, a lot of the integration skills in doing line cards. So they are looking to folks like us to do that where long historical incumbent to the line card level and now that we have WSS, which is probably in the 30% of the building material range, just to give you a sense of the rest of the optical componentary on the board. We believe we come in as much more of an incumbent these tend to be a long-term design wins and long term co-design efforts with customers, so you are not going to be – see quarter by quarter wave of new wins and revenues ramping, but we are shipping one product under one program, and we think that over the upcoming years that’s where we can get a significant traction as well and really deliver long-term value proposition.

So when we think in terms of focusing our resources, we think of very high port count and we think of supporting our own vertical play where we think we have a strong incumbent position and a strong reputation as a provider of subsystems in line cards.

Kevin J. Dennean – Citigroup Inc.

Let me just follow-up on the ROADM line card question and then we’ll check in with the floor for questions. You mentioned that the WSS is about 30% of the pump just for the line cards. Is it right to say that the other two critical components are optical channel [owners] cards and then, can you quantify what percentage of pumps those might be?

Jerry Turin

Well, first, I’d look at the 30% a very rough number.

Kevin J. Dennean – Citigroup Inc.

Sure.

Jerry Turin

So very much we look down, in the amplifier content probably more than that, in channel monitoring probably less than that. We’re a long-term leaders amplifiers or probably the leaders in amplifiers and then, the key component within amplifier is laser pumps and probably the second of the amplifiers is JDSU and each of us are vertically integrated at the laser pump area. So when you talked about vertical integration, we talked earlier about the manufacturing strategy point of view. But its also very important for us from a product point of view where we can take our chip level products all the way up to the food chain and control even more the (inaudible) materials and more of the differentiation and WSS is interesting because it’s just not taking the chip level into a subsystem or module level like an amplifier, but then its taking amplifier WSS and channel monitoring as well as the long legacy of the software integration skills and some standard development platforms that we have in place that they really create a vertical play, and you can play without having all of those elements. But if you have all of those elements it certainly strengthens your position.

Kevin J. Dennean – Citigroup Inc.

One last follow-up on ROADM. So on ROADM line card, what should we think about potential gross margin of that product things?

Jerry Turin

So I would say that there is the potential to be rate around what our long-term gross margin target is with 35% sort of range, I think 30% to 40% is the potential hopefully well within that line cards.

Kevin J. Dennean – Citigroup Inc.

Yeah. Let’s see if we have any questions from the audience?

Question-and-Answer Session

Unidentified Analyst

(Inaudible)

Jerry Turin

So yeah, the question was pent-up demands created by the Thailand situation and with regard due to the competitive dynamics, and I think there was probably a short-term and the long-term element to that question. So long-term and long-term being, if we come out of this in June, so the thesis if customers and their customers aren’t getting their demand fully satisfied and if everything is back on track in June, do you actually get a real tailwind, because of that pent-up demand? It could be. It's very early to say. I mean that's a thesis. I mean there’s a certain logic to it. But I'd hesitate to say that, everything (inaudible) suddenly is back on track, I think that’s our current expectation, but it is possible.

And then in the short-term, the question is based on which peers have limitations coming out of Thailand or indirectly out of Thailand, if they rely on a sub-component. Does that be a market share opportunity or a market share risk? So in tunable dispersion I mentioned the three products in Chokchai. So there's limited competition in tunable dispersion compensation although, we've seen some competitors rise in China, and we resolved first in that for a long time, so I would have expected to gradually move to some of that (inaudible) share as they came on line anyway. Amplifier as we’re leaders on, a lot of the amplifiers are, there are significant amplifier products are very much core development program, kind of long-term product lines with customers. There can be short-term changes in shares, but I don't think there is any long-term disruption. External modulators is somewhere where we probably lose a little bit of an opportunity for our peers, because they’re ramping 40 gig and a 100 gig, that's what we are really try and push production on as quick as possible, but that’s where we may lose some, that I am sure in the short term.

As far as other areas, it is down WSS, ROADM, we will continue to meet our same production levels, but again, we are not going to change the world and all the sudden customers are going to switch dramatically to us. It’s one of the big incumbent on the short-term problem. So this is not going to work that way.

On transmission products, tunable lasers, laser pumps, transponders, pluggable transceiver, that we satisfy all the Shenzhen that have limited PCBA shortages, there might be potential to squeeze out a little bit of share there, certainly not been in the short-term because they are going to be constrained as well in the December quarter, but perhaps if we gain in certain areas, but that maybe where that opportunity is. But right now there is a kind of academic discussions about where we are positioned, peers are going to be positioned in certain ways. I don't think it changes the competitor dynamic over – during a dramatic long-term way, but I think it does create a few opportunities.

Kevin J. Dennean – Citigroup Inc.

Any other question from the audience?

I’ll jump back and respond. Just going back to new products, can you talk about tunable XFPs and where you’re planning there, is it the 300-pin transponder replacement market.

Jerry Turin

So tunable XFP sales, it’s a pluggable tunable device, where JDF has just come out for roughly the last year with real significant commercial ramps, we’ll pay off the fact that it invested heavily in this for many years and we’re selling tunable XFP in commercial volume as I mentioned during the presentation, one of the two leading OEMs as well as the leading internet service provider. There is two applications for tunable XFP, right replacing fixed labeling (inaudible) devices and also the 300-pin transponders, tunable transponder market will evolve towards the tunable XFP as well.

There is a characteristic of tunable XFP called chirp and negative chirp is the characteristic of products that’s being sold today and that criteria is satisfactory for replacement of the existing (inaudible) market in for some of the 300-pin market. Characteristic called zero chirp is required for the remainder of the 300-pin market. So, we’re selling negative chirp and we’re sampling and we believe we are the first one sampling zero chirp.

And so, we think that again, we come to market even in the negative chirp with a strong position JDS is established in an incumbency position, but because of our vertical integration of the integrated chip and coming second, there maybe other peers that come in about the same time as us, but we think we come in as a fairly strong market position, and we come in potentially as the leader in zero chirp based on our understanding of sampling at this time.

Kevin J. Dennean – Citigroup Inc.

On the fixed wavelength replacement market, do you think that represents market share opportunity, because I don’t think that acquires the leader in fixed rate, but they could that there is going to be significantly fewer material suppliers.

Jerry Turin

Correct. We don’t sell fixed wavelengths on the excess fees. So that’s Greenfield market and in addition, whether its Oclaro or whether its peer group there are significant customer base potential within tunable XFP or the data center people, the Internet service providers. We’re looking to manage their own networks using what's traditionally been more of a telecom product. So, it kind of opens up the customer base from the traditional telecom guys reached in this particular product area.

Kevin J. Dennean – Citigroup Inc.

And Jerry, just from a real follow-up on tunable XFPs. I mean, you talked a little bit about it with ROADM that meets your own billing materials if you really want to drive margin, and my view on optical components has been that vertical integration is real key?

Jerry Turin

Yeah.

Kevin J. Dennean – Citigroup Inc.

With tunable’s, the overall transceiver market is fragmented. Can you talk about the supply dynamics there? It seems to me like there's really not a lot of suppliers of tunable lasers, we kept in sorry, acquire – I think specifically for that? Talk about how, I guess, first discussed am I right that there's a significantly smaller supplier base, the key element of light source and how you can fact that only impacts the long-term supplier share dynamics?

Jerry Turin

Sure. Tunable XFP is a great case study and what we think our value proposition is. First of all, there is a five to eight number of suppliers of tunable lasers and a number of suppliers capable of doing the sort of photonic integration that we have in our tunable XFPs and credits, where credits do where we believe JDS types in their tunable XFPs, the integration of the laser and modulator, which are typically two separate devices in the one chip. So, when you think about the size reduction that's going from a transponder to a pluggable device, when you think about requirement for fewer components, lower power consumption, more green aspect is more desirable. The ability to put more components into one chip is a significant competitive advantage, and being a supplier of tunable lasers isn’t enough. I mean, you have to have a sort of deep legacy and process technology and an [IC] that we’re able to translate into that level of photonic integration and I am not sure that the guys of these smaller suppliers of tunable lasers have that capability, as talking now to the best of our knowledge anyway.

Operator

Thank you gentlemen, that’s all the time we have for questions today.

Kevin J. Dennean – Citigroup Inc.

Thanks

Jerry Turin

Thank you.

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