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Ciena Corporation (CIEN)

F2Q07 Earnings Call

May 31, 2007 8:30 am ET

Executives

Suzanne DuLong - CCO

Gary Smith - President & CEO

Joe Chinnici - CFO

Steve Alexander - CTO

Analysts

Paul Silverstein - Credit Suisse

Michael Genovese - Citigroup

Mark Sue - RBC Capital Markets

Nikos Theodosopoulos - UBS

Cobb Sadler - Deutsche Bank

Brantley Thompson - Goldman Sachs

Simon Leopold - Morgan Keegan

Marcus Kupferschmidt - Lehman Brothers

John Marchetti - Morgan Stanley

Hasan Imam - Thomas Weisel Partners

Tim Savageaux - Merriman

George Notter - Jefferies & Co.

Tiim Daubenspeck - Pacific Crest Securities

Ehud Gelblum - J.P. Morgan

Presentation

Operator

Good day, everyone and welcome to the Ciena Corporation Second Quarter 2007 Result Conference Call. Today's call is being recorded.

At this time, for opening remarks and introductions, I would like to turn the call over to the Chief Communications Officer, Ms. Suzanne DuLong. Please go ahead.

Suzanne DuLong

Thanks, Alicia. Good morning, and welcome, everyone. I am pleased to have with me Gary Smith, Ciena CEO and President; and Joe Chinnici, our CFO. In addition, Steve Alexander, our Chief Technology Officer will be with us for the Q&A portion of today's call.

Our call this morning will be presented in four segments. Gary will provide some brief introductory comments; Joe will review the financial results for the second quarter; Gary will then discuss the business in the quarter and our outlook for Q3. Joe will wrap up our prepared remarks with our guidance. We'll then open the call to questions from the sell-side analysts.

To ensure we answer questions from as many participants as possible, we ask that the sell-siders limit themselves to one question. This mornings press release is available on National Business Wire and First Call, and also 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 some forward-looking statements. Such statements are based on current expectations, forecasts, and assumptions of 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 2nd, 2007. We have until June 7, to file our 10-Q for this quarter and we expect to do so by then or before. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events, or otherwise. Gary?

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Gary Smith

Thanks, Suzanne and good morning, everyone. On balance, this was a solid quarter. Convergence maybe an overused word but it's real and it's happening now. Several years ago we embarked on a strategy designed to position us to benefit from the network transition and convergence that we're seeing emerge today as a reality.

We believe our execution of that strategy, our efforts to specialize in an Ethernet-focused portfolio has articulated in our FlexSelect Architecture and vision has put us in a market sweet spot and enabled us to outperform our revenue expectations.

Based on our order pipeline and overall market dynamics, we're also optimistic about what our positioning means for our growth potential going forward. This quarter we faced some further challenges in our services business, which put pressure on our gross margin.

Notwithstanding this short-term issue, we still believe that going forward we can deliver an overall gross margin in the mid-40s range. In addition, we're confident in our ability to generate operating leverage going forward.

I'll talk to our business in the quarter and our outlook for the remainder of the year after Joe reviews our Q2 results. Joe?

Joe Chinnici

Thanks, Gary and good morning, everyone. This morning we reported second quarter revenue totaling $193.5 million. This represents an increase of 17.2% sequentially and 47.5% year-over-year.

Similar to last quarter, three 10% plus customers combined to represent 42.8% of total sales in the second quarter. All three are North American customers and two of the three were also 10 percenters in the first quarter of this year. Sales from international customers remain steady with international sales representing approximately 28%.

Moving now to talk about the quarterly revenue contribution across our portfolio. As we've mentioned previously, we've been working toward adjusting our product revenue commentary to provide more meaningful data and to better reflect the growing significance of application-specific scenarios and other factors as they relate to our financial performance.

From this point forward, we'll be talking to three major categories. First, converged Ethernet infrastructure. This group will incorporate all products currently in our optical networking and data networking groups.

The second category will be Ethernet access, which will incorporate all of our broadband access as well as revenue from our recently announced CN 3000 Series. And last, global network services encompassing our service-related offerings.

From time-to-time, when the detail would be meaningful, we may choose to talk to specific product lines which within each of these categories. Revenue from our converged Ethernet infrastructure products totaled $160 million in the second quarter, representing 83% of the quarter's total revenue.

On a percentage basis, this is consistent with the first quarter when revenue from this group totaled $137 million. Revenue from our Ethernet Access products increased from $9 million in the first quarter to $13 million in the second quarter.

And finally, our global networking services business increased slightly from $19 million in the first quarter to $20 million in the second quarter and represented 10% of the second quarter's total revenue.

Turning now to gross margin. Q2's overall gross margin of 42.3% decreased from the first quarter's level of 44.6% and moved outside of our target mid-40s range, primarily as a result of lower-than-anticipated services gross margin.

Our product gross margin remains strong at 47.3%. We had a slight loss on our services revenue. And Gary will talk more about the reasons for this performance in his comments. In the remainder of my comments today, I'll speak to both the GAAP results and to what the results would have been if we excluded those items detailed in the press release.

On a GAAP basis, our operating expenses in the second quarter totaled $79.1 million, up as expected from the first quarter. Adjusted for non-operating or non-recurring charges detailed in the press release, our R&D, sales and marketing, and G&A expenses for the quarter would have been $68.5 million.

This is up $6.3 million from the first quarter. The single largest driver of this step function increase was head count. In total we added 95 employees in the second quarter. We're not only ramping CN India, but we are addressing resources -- I'm sorry, we are added resources in all other key areas as well.

For instance, we are also augmenting our sales and marketing resources to provide additional market coverage. A portion of the increase is also attributable to increased sales commissions.

Our income from operations on an as-adjusted basis totaled $13.9 million, representing an operating profit of 7.2%. Our second quarter GAAP net income of $13 million or $0.14 per diluted share compares to a GAAP net income of $11.1 million or $0.12 per diluted share in the first quarter.

Adjusted for the unusual or non-operating items detailed in our press release, including 123R-related compensation expense, our second quarter net income would have been $24.1 million or as-adjusted net income of $0.26 per diluted share.

As a reminder, since the first quarter of this year, we are using GAAP taxes in our as-adjusted net income presentation. In the past, we had used a 35% rate for this calculation. Turning now to the balance sheet.

First, we achieved another significant milestone. We were cash flow positive in the quarter, generating $44.6 million in cash from operations. This was due to $31.4 million in cash from net income and $13.2 million net increase in cash resulting from changes in working capital.

For the first six months of 2007, we have generated $33.3 million in cash from operating activities. Cash, short-term, and long-term investments at the end of the second quarter totaled $1.2 billion.

In addition, you'll notice $542.3 million in convertible notes payable moved into current liabilities. This is the 3 and 3.75 convertible notes due in February of 2008. As expected, our accounts receivable balance at the end of the quarter increased from $139.4 million at the end of the first quarter to $145.5 million in the second quarter.

Day sales outstanding in the second quarter was 68, down from 76 in the first quarter. Going forward, however, we still expect our DSO range to increase to between 75 and 85 days as a result of our increasing international business and longer payment terms.

Inventory levels ended the second quarter at $118 million, up as expected from the first quarter level of $103.5 million. The increase is driven by our need to ramp to meet identified demand requirements.

The inventory breakdown for the quarter was as follows. Raw materials, $34.2 million; work in process, $7.5 million; finished goods, $100.8 million; and a reserve for excess obsolescence of $23.8 million. Product inventory turns improved from 2.9 in the first quarter to 3.1 in the second quarter.

Finally, head count. As I mentioned previously, we added 95 employees in the quarter, bringing our worldwide head count to 1,683.

And now, I'll turn the call back over to Gary.

Gary Smith

Thanks, Joe. I'll orient the remainder of my comments today around three key performance levers, revenue, gross margin, and operating profit. Firstly, gross margin. Given our Q2 gross margin came in lower than expected, I want to address that first up.

Our product gross margin was down slightly sequentially as a result of a less favorable product mix in Q2 versus Q1, but a 47.3% our product gross margin is generally strong. Like last quarter, our most significant gross margin challenge came in our services business.

Our Q2 services gross margin was lower than we anticipated as a result of a combination of three things, essentially. Number one was costs associated with our investments in additional services resources to support large customer installations, particularly in Europe.

Number two is our higher-than-expected mix of lower margin installment-related revenue, and the most significant factor in the quarter. Lastly was deployment cost overruns incurred in assisting a customer of a very large network build.

We've taken steps to address these factors going forward. First, we are working with the customer to reduce the likelihood of future cost overruns. We are also working with them to reduce the potential for variation within the mix of our installation projects in any given period. And finally, we will gain efficiencies as we scale.

I'm confident that we're taking the necessary steps to improve our services gross margins. However, even if we see a worst-case scenario and our services gross margin remains at roughly breakeven, based on the visibility we have into what's expected to be a very favorable product mix in Q3 overall, we still expect to deliver gross margin in our target mid-40s range. To the extent we're able to improve our services gross margin therefore, there could be upside potential in our margins.

Now let me talk about revenue. Our business has been strong enough to enable us to consistently meet or overachieve revenue expectations for many quarters now. Our revenue growth is coming from two important demand trends. Number one is increasing capacity requirements. This one's pretty straightforward. Bandwidth needs are going up so more capacity is required.

But we're also seeing demand across our portfolio driven by the transition from multiple disparate networks to a converged multipurpose network infrastructure that at its heart is significantly more packet-friendly and therefore better suited to handle video.

Several years ago we placed some strategic bets that our customers' networks would head in this direction. The result was our FlexSelect Architecture and vision and thus far it looks like our bets are beginning to pay off.

In addition, we're capturing share, selling more to customers in more market segments, and the combination is fueling growth across our portfolio. Joe already spoke to the sequential increase in our Ethernet access group.

In Q2, however, our growth was most noticeable in our converged Ethernet infrastructure product grouping. At $74 million long haul core transport related revenue was the largest revenue contributor in the quarter, growing more than 50% sequentially. Core transport demand is being driven not only by pure bandwidth requirements, but also by the transition to a multipurpose network infrastructure.

The adoption of Ethernet in network infrastructure is also driving strong growth for CoreDirector, our intelligent core switch, which at $46 million core switching related revenues grew 18%, sequentially. The last growth driver within this group I'll call out at this point is our CN 4200 Advanced Services Platform.

We continue to see strong acceptance of this product across our customer base and while revenue declined sequentially to $20 million, demand remained strong with shipments in fact, of more than 1.5 times revenue in the quarter.

I'll caution, however, though we've posted sequential revenue growth now for 13 straight quarters, because of the nature of our customers, the way they roll out projects and revenue recognition criteria, we continue to see the potential for revenue fluctuation quarter-to-quarter.

Overall, however, we expect the combination of capacity needs and new infrastructure builds will continue to drive demand across our product portfolio and we believe we can deliver up to 36% annual growth in 2007.

Finally, on operating profit, we told you last quarter that on an as-adjusted basis, our operating expenses were going to increase in absolute terms in Q2 and in his commentary earlier on, I think Joe reviewed some of the contributors to the increase in Q1.

Let me spend a few minutes talking about what we're actually investing in. Beyond people and sales commissions, we're also focused on driving product cycles. Our R&D spend and emphasis is split between next generation enhancements to existing platforms and strategic forward-looking projects that will help further the success of our FlexSelect Architecture and broaden our reach in new market segments.

Firstly, on the enhancement side, we're focused on advancing Ethernet capabilities across all of our platforms. In addition, we're furthering implementation of our FlexSelect Architecture across our portfolio.

We're looking at Next Generation ROADM capabilities, as well as technology improvements to drive down the cost of carrying bandwidth longer distances. Finally, we're adding VDSL2 and ADSL2+ and IP feature sets to subscriber facing products to better enable delivery of video and IP Telephony services.

Looking further out, we've begun investment in a number of strategic projects, which include 100-gig transport and switching, next generation 40-gig transport and switching, and hybrid integrated transport and switching technologies to drive further platform convergence.

While we're likely to see a slight increase in actual OpEx dollars from Q2 to Q3, we believe we're now at the point where we'll start to leverage our operating model. Not only did we make a substantial investment to accelerate some key projects in Q2, but with more than 180 Ciena India employees, we will start to see the payback of the investment and training that we've undertaken in that region.

As noted in the press release, assuming we successfully achieve our revenue and gross margin goals, we would be on track to deliver 10% income from operations on an as-adjusted basis, as soon as our fiscal third quarter 2007. 10% clearly will be a big achievement, but it is not our end goal.

There is additional leverage in our model, but as we've said for some time now, let's get to 10% and from there we'll assess the market and our business and determine what our ultimate target should be going forward.

Our overall goal remains finding the right balance between investing strategically in our business to fuel longer-term revenue growth and maximizing short-term operating profit and net income.

In summary, we're benefiting now from the steps we've taken over the last several years to create an Ethernet optimized portfolio that is well aligned with market direction. Whereas a year ago when many of our customers were focused on simply adding bandwidth to their existing network infrastructure, we're now also seeing demand driven by the transition to Next Generation Ethernet-based architectures.

Importantly too, customers are focused on the total cost of network ownership and are looking for more than single point to point solutions. As a result of the direction our customers are headed and where we positioned our specialist portfolio, we continue to see a robust order pipeline and we're pleased with the product revenue visibility this is affording.

We've got some challenges in our services business, but I'm confident at this point that we've identified the issues and that we've taken the necessary steps to address them. With that, Joe, will you walk us through the guidance for Q3, please?

Joe Chinnici

Sure, Gary. Thanks. Before I begin to offer guidance, I'll remind everyone that the statements Gary just made and those that I'm about to make are forward looking. It's important to review the risk factors detailed in our most recent 10-Q in order to understand the factors that might cause actual results to differ materially from this guidance.

As stated in the press release, we'd expect to be able to increase our fiscal third quarter revenue sequentially by up to 5% from our fiscal second quarter revenue. On gross margin, as we've said in the past, gross margin is difficult for us to predict with accuracy and we expect to continue to fluctuate from quarter to quarter.

Our gross margin ultimately depends on a combination of factors, the prior ones being product and customer mix, but as was evident in this quarter, the second quarter, it can also be influenced by services revenue mix as well as volume, pricing, and the effects of ongoing product cost reductions.

As Gary said previously based on the visibility we have into expected product mix, we expect to deliver Q3 gross margin in a mid-40s range. We expect our Q3 as-adjusted operating expenses in real dollars could increase slightly from Q2, though as Gary noted, we expect as-adjusted OpEx to continue to decline as a percentage of revenue through the balance of the fiscal year.

As noted in the press release and as Gary discussed, if we successfully achieve our revenue and gross margin goals in Q3, we would be on track to achieve 10% income from operations on an as-adjusted basis as soon as the third quarter. We expect other income and expense in the third quarter will be income of approximately $9 million.

On our tax rate, as we've previously discussed, we are not likely to pay significant U.S. federal taxes for some time and on our GAAP profits, given our sizable NOL position. Accordingly, our quarterly income tax expense should represent primarily foreign taxes, which we expect in the third quarter will be approximately $500 million.

We estimate the third quarter's diluted share count at approximately $94 million total shares. As a reminder, because of our NOL position, our as-adjusted EPS calculation will not include any adjustments for taxes. In other words, we will use our GAAP taxes for that calculation.

At some point in the future, we will be required to release all or a portion of our NOL. We expect to be able to talk more about with a will happen, when it will happen, and how it may affect your model as we get closer to that event, but it's not likely that anything will change until sometime toward the middle of our fiscal '08 year.

Finally, we expect to remain cash flow positive in Q3, albeit not at the same level we saw in Q2. Now, operator, we'll take questions from the sell-side analysts. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) We'll go to Paul Silverstein of Credit Suisse.

Paul Silverstein - Credit Suisse

Thanks. First off just a clarification. Did I understand you correctly, Gary, that in the event of no improvement in services, you're still confident that you will get to your targets on gross and operating margin?

Gary Smith

Correct, Paul, yes.

Paul Silverstein - Credit Suisse

To the extent you have improvements there could be upside. What's the likelihood that you'll improve the situation?

Gary Smith

I think given our experience in the last couple of quarters there, I'm unlikely to go there, but I do think that we've addressed the issues in the services area. I think now it's a matter of timing to that. I wouldn't be prepared to commit to the upside, but I think we are confident about a range in the mid-40s, even if it's as bad as it has been in Q2.

Paul Silverstein - Credit Suisse

Gary, on the long haul side, given the strength that you're seeing, can you give us a little more insight where that's coming from? And is there any issue in terms of 40G, where the market's at, where you're at with respect to your products? Do you have a shippable 40G product today? Will you have a shippable product in time to hit the market? It seems like that's starting to happen.

Gary Smith

Paul, I'm going to let Steve take that.

Steve Alexander

So, Paul, what we've seen is that systems that are going out the door today are kind of the 10 gig systems upgradeable to 40. So we plan to have the 40 gig ready for that.

The RFPs that are on the street for the next generation builds, people are looking for 40 gigs upgradeable to 100. As Gary alluded to, we have technology development programs in place to put that into the market when it's needed.

Paul Silverstein - Credit Suisse

Steve, you don't feel like you're playing catch-up at this point?

Steve Alexander

No, I don't think we are.

Paul Silverstein - Credit Suisse

Okay. On a personal note, I never do this, but Joe, you'll be sorely missed. I don't think anybody can replace you. Thanks, guys.

Joe Chinnici

Thanks.

Operator

We'll go next to Michael Genovese of Citigroup.

Michael Genovese - Citigroup

Great. Thanks a lot. Congratulations, Gary, Joe, and Steve on a very nice quarter.

Gary Smith

Thanks, Michael.

Michael Genovese - Citigroup

Business model is coming together. Now, I do want to ask as just a second question, I'll ask that first, what's the CFO search looking like if there's been any progress made there? But for my main question, on the service gross margins, it looks like one of the factors that impacted it was a large installation, which I guess would be for one of these top ten U.S. customers.

I'm positively surprised that the gross, product gross margin was as strong as it was given my assumption that you're building a large new long haul network for that customer. So my question is, is was there an impact, even with these 47% gross margins, was there an impact from a lot of new long haul chassis going out into the field, and excluding that, would product gross margin have been even higher?

Gary Smith

Michael, let me answer your second question first. If I follow your logic through what you're saying is because long haul was up there, newer builds given the installation profile on the services, that's a reasonable assumption.

We had some reasonably large builds that we were doing on the long haul side. And they tend to be more chassis-based, which tends to be lower margins. So, yes, the product mix was strong, even notwithstanding that. So I think your logic is essentially correct.

On the CFO side, I think as Paul alluded to earlier, I think though he's irreplaceable, I think we're optimistic about finding a successor in a timely manner. I think we're confident in the team that Joe's assembled as well. I think we're in a good position from that perspective.

Operator

We'll go next to Mark Sue of RBC Capital Markets.

Mark Sue - RBC Capital Markets

Thank you. Just trying to understand the reasoning behind the guidance of 5% considering you just did 17% sequential growth. Recognizing that the business is lumpy, are you expecting a pause at AT&T or are things winding down at BT? Is the business becoming more seasonal, or is it just continued conservatism?

Gary Smith

Mark, let me pick up on the last point of continued conserve -- we try and call it how we see it. There are a lot of moving parts to it, and as you rightly said, it's a lumpy business.

We've got a large amount -- I think we've got two-thirds of the Tier 1 carriers around the world, so we're able as one is digesting some of the builds, we've got others building.

We've been able to with the broad customer base that we've got deliver sequential revenue growth. For example, Q1 to Q2 wasn't a very large revenue increase. I think we had a strong increase from Q1 to Q2. I think we're just trying to call it as best we see it.

Mark Sue - RBC Capital Markets

Any thoughts on if the business is becoming somewhat seasonal or it's just still large project-based?

Gary Smith

Mark, I think it's large project-based. In the last couple of years, we've seen within the month of August I think some of the orders slow down. That's about the only seasonality that we've kind of noticed. So I'd loathe to say it's seasonal.

Mark Sue - RBC Capital Markets

Got it, that's helpful. Thank you, Gary, and good luck, Joe.

Operator

We'll go next to Nikos Theodosopoulos of UBS.

Nikos Theodosopoulos - UBS

Just a couple of quick ones. On the gross margin for the third quarter can you give a little bit more information on the mix shift that will help the gross margin -- the product gross margin? Is it kind of a line cards being shipped in the long haul market now that those chassis were shipping this quarter. Can you give any more color on that?

And can you -- I didn't hear any commentary -- or maybe I missed it, on the deferred revenue. It went up I believe, materially sequentially, can you comment on that whether it was product, services, or some combination? Thank you.

Joe Chinnici

Nikos, this Joe. Why don't I try and answer those two. In terms of the strength in the gross margin, it is product mix, you're right on. I wouldn't necessarily say it's line cards as opposed to chassis because we are deploying quite a few new chassis, either expanding footprint or rebuilding or building new networks for several customers.

I think it's just a lot of the hard work that's been done, it's a high content of 4200 potentially in Q3. Just things are going in the right direction. I hope that answers that question. In terms of the deferred revenue piece being up, in the quarter we got the third and final payment as it related to a legal settlement stemming from a resolution between Ciena and Broadwing and that was a big piece of it.

Nikos Theodosopoulos - UBS

So that final payment was the bulk of the increase?

Joe Chinnici

That's a big piece. We've structured some different payment terms with customers that are in foreign locations where they pay a little bit of money with either receipt of order or upon shipment and then they pay the rest of it upon revenue acceptance.

That was a little bit of it. Hopefully, we'll be able to talk about this in the future. We've landed a little bit of new business in certain parts of Asia that right now it's small, it's not significant, but hopefully it will grow into something bigger and better.

Nikos Theodosopoulos - UBS

And do you recognize that final payment in one quarter, or do you spread it out over the next four quarters?

Joe Chinnici

For the customer?

Nikos Theodosopoulos - UBS

No, no. That final payment from Broadwing, do you recognize it in revenue in one quarter, or is it spread out over four quarters?

Joe Chinnici

No, it will be spread, Nikos.

Nikos Theodosopoulos - UBS

Okay, thank you.

Operator

We'll go next to Cobb Sadler of Deutsche Bank.

Cobb Sadler - Deutsche Bank

Thanks a lot. I had a question on the services of gross margin. Is that business -- so I just want to make sure that it's on the cost side rather than the pricing side. Are you seeing any changes in pricing within services?

And you know, best case scenario, a couple years out or a year and a half out, could that gross margin go back to around 30%, you put up a little bit in excess of 30%…

Joe Chinnici

Hey, Cobb, we lost you.

Cobb Sadler - Deutsche Bank

Okay. Back on now?

Joe Chinnici

Yes.

Cobb Sadler - Deutsche Bank

Okay, great. I'll start over. Services gross margin, can they go back to 30% over a long period of time, let's say six to eight quarters?

Gary Smith

Yes. Let me take that. I think it's unlikely to get up to 30%. I think a range for a healthy business there is above 20, certainly probably in the 20, 25 range. We think we can get back there and I think certainly prior to a few years out. I think some of the things we put in place should get us back there sooner.

Cobb Sadler - Deutsche Bank

But you can do mid-40s at 0%, basically, so any improvements take the gross margin up north of mid-40s?

Gary Smith

Certainly in the profile we're seeing in Q3. Let me answer the other question, which I thought was a good point and one we were perhaps not clear around.

It is not a pricing issue that we see in the services. We don't see anything particularly new on the pricing side. It's really a cost issue on the profiles we ramp up folks.

Cobb Sadler - Deutsche Bank

And OpEx, is Osmine -- is it still a decent portion of OpEx and is it flat or increasing, or down?

Gary Smith

Cobb, we spend on Osmine every quarter, it depends upon which releases and which product but it's a good chunk of the R&D budget.

Cobb Sadler - Deutsche Bank

Great. Thanks a lot.

Operator

We'll go to Brantley Thompson of Goldman Sachs.

Brantley Thompson - Goldman Sachs

Hi. I was wondering if you could talk a little bit about the visibility into '08 and is there some revenue level at which you think you could achieve a 15% operating margin when you think about the model longer term?

Is it $1 billion run rate for the year that puts you there as you look at the overall corporate model? And then also, just any comments on how we should think about the CapEx outlook? Thanks.

Gary Smith

Yes. Clearly, Brant, there is a number at which we would achieve from a revenue point of view significant operating profit. I think the thinking right now is that we don't want to get ahead of ourselves and we haven't got to 10% yet as an operating profit. And I think that's the next sort of milestone for us.

We're back into profits, we've generated cash, we've got the 10%, which we said could happen as soon as Q3. I think we're not in a position yet, I don't think, to share the visibility into '08.

I think we feel that we've got a lot of fuel in the tank from the investments that we've made on the R&D side and on the customer relationship side and I think we feel that we've got a lot of operating leverage in front of us. I think we would be getting ahead of ourselves to try and share timing and revenues that we view at this point.

But there are a lot of things, I think in the business that should start to help considerably. We touched on the India investments. We've invested significantly out there and that should start to pay off in terms of operating leverage.

Also on the sales side with partner relationship, et cetera as well and some of the large sales opportunities that we've been involved in over the last couple of years, so we're very focused now on operating leverage.

We think we've got the right kind of pieces in the company and the right kind of structure in place, so going forward that's what we're focused on.

Brantley Thompson - Goldman Sachs

And on the CapEx front?

Gary Smith

On the CapEx, generally, we're seeing sort of two kinds of demand. As I've alluded to, one within the customer is just bandwidth driven, fairly straight forward. And we see a good demand for purer bandwidth.

And than I think the second part of it is, how can we carry it more efficiently, that traffic. So I think you're seeing a shift in terms of where people are spending that CapEx.

I don't think CapEx is going to go up dramatically, it’s a personal view. I don't think it needs to, but it is shifting from just pure capacity to transitioning these networks to lower cost networks.

Brantley Thompson - Goldman Sachs

Thanks.

Operator

We'll go next to Simon Leopold of Morgan Keegan.

Simon Leopold - Morgan Keegan

Great, thanks. I wanted to see if I could get two quick clarifications and then more of a philosophical question here.

On the clarifications; first, just want to make sure, in the guidance it does look like the OpEx goes up on an absolute dollar basis by a small amount, that's the first one?

Second one is, process of elimination suggests that the legacy metro products, the old O&I that you've sold in the past, those seemed to have declined quite a bit. Just want to clarify that I've gotten that correct?

And then philosophically, if you could talk more about how your competitive landscape has changed from the perspective of your changing portfolio as well as newer or different competitors or old competitors too and how they may be changing the dynamics.

Specifically, we've got Infinera coming out and you're splitting the contract at BT with Huawei, your position there? And then Nortel, I think competed with in the past seems to be less of an entity from your position. If you could give us a little color on how things have changed for you from a competitive position? Thank you.

Joe Chinnici

Sure. We're all going to take a shot at your question, Simon. I'll go first, turn it other to Gary, and then he'll turn it over to Steve. In the OpEx one, the short answer is yes. You've got that right. We can confirm that. Gary?

Gary Smith

Legacy Metro was actually up slightly Simon in Q2. There are a number of other platforms in that grouping, some of which are older platforms, but the actual online Metro was actually up slightly in the quarter.

Steve Alexander

One thing you should also know about the Metro, is we've architected a transition plan where you can effectively use what we call a flexishelf, which puts 4,200 and the online Metro systems together.

The other question you had I think was about the competitive landscape and the emergence of new players.

Clearly, we've competed on the world stage for many years. We're pretty much used to the competitive nature. We've seen the Chinese suppliers emerge and they've set the global cost points. We expect to be able to compete successfully going into the future. There's nothing in the offing that we're aware of that would change that.

Simon Leopold - Morgan Keegan

Maybe what I'm getting at is what might be different now than a year ago?

Steve Alexander

From the competitive nature?

Simon Leopold - Morgan Keegan

Yes.

Steve Alexander

I think you've seen -- Huawei has made some inroads in a couple of places. They are setting some of the cost points out there for what you might call the low entry costs and such.

I think we still have the ability to differentiate the products from a features and services and total cost of ownership point of view. I don't think anything has changed that way in the last year.

Simon Leopold - Morgan Keegan

And how about the legacy guys, the likes of Ericsson, Nortel, Alcatel Lucent?

Steve Alexander

Many of those have either had opportunities in rationalizing their own portfolios or have not invested in the correct trajectory for, let's call it the transport, transmission business.

I think with the changes that we made in the portfolio and the approaches that we sought to producing with effectively the Multihaul systems out of Core Stream and the 4200 systems, I think is much better aligned actually with where the market is going.

Simon Leopold - Morgan Keegan

Great. Thank you.

Operator

We'll go next to Marcus Kupferschmidt of Lehman Brothers.

Marcus Kupferschmidt - Lehman Brothers

Hi, good morning guys.

Gary Smith

Hi, Marcus.

Marcus Kupferschmidt - Lehman Brothers

Two things. I want to talk about services and the tax commentary. In terms of services, I guess what I was wondering is, isn't a large part of this just you're investing more up-front and, therefore, as the revenues come in, you should leverage your fixed costs? I would think that would be the biggest variable here, and just getting ahead of adding more people every quarter?

Gary Smith

Marcus, that basically, if you were to summarize it, that's basically it. It's a timing issue around it and we think that will, we've got enough of the controls around it and I think we understand the dynamic with it.

Marcus Kupferschmidt - Lehman Brothers

And, therefore, are you implying there's risk that you have to just keep adding more people as the activity goes up and then it's tough to get ahead of the…?

Gary Smith

No, I thing it's really a kind of step function that we've had in the last couple of quarters. We are not hiring more, we don't need to hire more people now. We can start to get revenue for the folks that we've actually hired and so the fixed costs get attributed across greater revenues and your margins go up. And I think we're at that point.

And I think if you were to characterize it, it's the sort of transition from going from almost entirely third party to having some in-house resources and a combination of that. And we're almost in the ugly duckling stage of that until we optimize that model, but scale will pull us through that.

Marcus Kupferschmidt - Lehman Brothers

Okay, good. And then on the tax commentary, I guess just to clarify, are you implying that we would get an updated tax guidance in fiscal year '08, or are you thinking potentially mid-fiscal year '08 you are starting to accrue U.S. GAAP taxes on a non-cash basis because of some NOL reversal? Just a little clarity into that would be very helpful.

Joe Chinnici

So about the only clarity, this is Joe, Marcus. The only clarity I can give you is that things are going to change, that's a definite. We think they're going to change sometime in the mid-'08 timeframe. I can't give you much more guidance than that, it's going to be worked on the latter half of this year and as soon as we formulate and know what we're going to do, we'll communicate it to you. That's the best can I go right now.

Marcus Kupferschmidt - Lehman Brothers

All right. Thank you.

Operator

We'll go next to John Marchetti of Morgan Stanley.

John Marchetti - Morgan Stanley

Hi, thank you. Last quarter guys, you talked a little bit about the install revenue within services that the pipeline you had, you could see that continuing for a few more quarters going forward. Just curious if that's still the case or we got a little bit more of that this quarter than you had originally anticipated and it sort of shortens that window?

And then secondly, just on the gross margin guidance that you're giving, you're talking about in third quarter being able to offset even a flat services gross margin. Should we expect that the product gross margin in general now is moving higher to where even if that was sustained over the next couple of quarters, we could continue to see that, or are you just essentially saying, that's kind of the visibility you have in 3Q and that's it there? Thank you.

Gary Smith

John, let me take both of those. First of all, the install pipeline looks good. That's, as we sort of talked about earlier, that's sort of part of the scaling of the revenues, which will help in terms of margin for services. So that's good news.

Really, in terms of the gross margin guidance, it's really just around the visibility in Q3 and the particular product mix there is very strong. Although looking further out, we still have a perspective that it's in that mid-40s range.

John Marchetti - Morgan Stanley

Thank you.

Operator

We'll go next to Hasan Imam of Thomas Weisel Partners.

Hasan Imam - Thomas Weisel Partners

Yeah, thanks. I just had a couple of quick ones. First, on the OpEx front, I think you guys had talked in the past about ramping headcount further to maybe 200 or so by year-end. So the OpEx going up only slightly in the third quarter, does that imply that in the fourth quarter we could see a bigger ramp?

And then in terms of the OpEx again, are we at a point where we're starting to see the OpEx trajectory basically flatten out, or it's just going to grow, but grow less than revenues?

Gary Smith

Hasan, this is Gary. I think you're right in the latter part of your commentary there. I would expect to see OpEx flatten out from here. I mean, it may fluctuate a little bit quarter-to-quarter and we expect a slight increase in Q4, but we would expect it to flatten out from here.

Hasan Imam - Thomas Weisel Partners

Great. And then on the product front, I just had one question. Given the type of capacity upgrades you're seeing in the long haul, do you guys need a bigger CoreDirector in terms of switching capacity? And the ROADM product, does that cannibalize the smaller CoreDirector-related revenues? Thank you.

Steve Alexander

This is Steve. I would say it would be probably sensible for us to be looking at a bigger switching capability. That would make sense given what we see going on in the marketplace right now.

And the ROADM does not rally cannibalize the CoreDirector piece of it. They're used in different applications in most cases.

Operator

Yes, sir, did you have a follow-up?

Hasan Imam - Thomas Weisel Partners

No, I'm good. Thank you.

Operator

Thank you. We'll go to Tim Savageaux of Merriman.

Tim Savageaux - Merriman

Hi. Good morning, guys.

Gary Smith

Hi, Tim.

Tim Savageaux - Merriman

And congratulations on what really is a breakout quarter. It wasn't that long ago we were arguing about growing 20%. Anyway, I hope you enjoy it. And a couple questions real quickly. And I want to rephrase the competitive question. If I do my math correctly, it looks like your Optical business growing on a year-over-year basis certainly above 50 and maybe closer to 100%, somewhere in the high double digits.

That's obviously far in excess of any sort of market growth rates that you yourself have talked about historically, Gary. And I wonder if you, as an aside to this question, want to sort of update your view on overall levels of market growth versus Ciena share gain?

But in this competitive environment where we've got various start-ups running around making noise and lots of other guys, I'd say looking over the past year, that doesn't seem to be affecting you very much, if at all.

So maybe you could take another swing at that competitive environment in light of sort of a market growth versus market share gain perspective and give us your updated thoughts on how quickly your market is growing, whether you're seeing it accelerate and to what extent your growth, if indeed those numbers are correct are driven by share gain?

Gary Smith

Tim, I think one of the things that we're trying to get our arms around here is I think the market in some degrees sort of fragmenting and you've got this new market appearing, let's just call it for want of a better description a converged Ethernet. And I think you are seeing a separation out of folks who are exposed to that space broadly are enjoying lets just say greater growth than others.

I think as Steve mentioned earlier on, there's a bunch of folks who are either focused on or have only invested in, what I would call the more traditional point-to-point optical transport piece. And I think that market is not growing as quickly.

And I think you are seeing this shift over towards a compression of the layers, if you will, from layer zero to call it 2.5. And that's really where we've placed a lot of our bets, things like the 4200, the enhancements to CoreDirector, the FlexSelect Architecture on the transport side. And I think those pieces talk to a much higher growth in that area.

Now I think we're at the fairly early stages of that and so there's no real kind of market data around it or say differently Tim, I still think we're measuring it in the older markets, i.e., Metro Optical, Long Haul Optical, Regional Optical, and I think it's moved on us and I think what we're struggling to do is get our arms around the new market, which is a combination of switching, transport, Ethernet layer 2, layer 2.5.

But, if you ask me personally why we're growing faster than the overall market, it's because of the bets we have placed in that space. If we’d have just stayed as a pure transport player on a point-to-point basis, then I do not think we'd be showing anywhere near the kind of growth that we're showing right now. I just do not think that.

While some of the point-to-point transport products are used in those solutions and FlexSelect what it's been driven by is the overall architecture and solution that we're able to provide. I'm loathe to sort of talk about numbers in that space.

But I think the overall optical market if you pin me against the wall is probably growing at something like north of 10%. I mean it's fairly modest growth year on year. I think the much faster growth is in converged Ethernet.

Tim Savageaux - Merriman

Okay. Well, I guess it would be helpful to try and come up with some metrics before the next drama at the analyst day to try and figure out exactly what -- if there's a new breed of market that combines the Ethernet markets and the Optical markets.

You're right, I think that's sort of 10% growth and a lot of your peers are growing in the 20s is less and less useful in trying to measure how we should look at your longer-term growth rates which clearly seem to be in excess of those levels. I'll throw that out there for future considerations and congratulations once again.

Gary Smith

Thanks, Tim. Appreciate it.

Operator

We'll go to George Notter of Jefferies.

George Notter - Jefferies & Co.

Thanks, guys. Let me add my congratulations on the quarter. Another question on the services business on margins. I guess I was trying to figure out what exactly is it that you see driving the change in margin structure there? I understand your commentary earlier about scale, but it seems to me that you've got to expect a change in the mix there as well to get to a 20 or 25% margin level there.

Is that implying that you'd see this bulge in installation revenue at some point kind of snapping back to some more normal mixture of businesses and services, or what exactly are you looking for there? Thanks.

Gary Smith

Yes, George, I think it's a combination of a couple of things that sort of came together, if you will sort of in the perfect storm for the services margin in Q2. You've got cost overruns with a particular customer, you've got a product mix.

It's really a services mix, i.e. pretty simply you make less money installing certain products than others and we skewed strongly towards an area where we do not make much money on EF&I and it was just a combination of those things that resulted in the fairly dramatic gross margin impact to it.

But it's really an issue of cost and us really going through a phase where we're making the transition from almost a complete outsourced model, where we're building up our own resources and so I think going forward you get a more optimized model, that I'm pretty confident that will take us back to a services gross margin that's in the 20s.

And I think we're pretty confident of that looking at the profile of the products. It's an issue of timing. It will take a while to work this piece through.

George Notter - Jefferies & Co.

Would it be fair to say that the biggest component of the improvement then would be eliminating some of these cost overruns or the change in mix away from EF&I? Or how would you parse out the…?

Gary Smith

Cost overruns, George. That is the biggest issue to it. In some ways that's the good news, that's the easiest thing for us to control. So cost overruns, if you were to take one thing away from it, it's cost overruns and clearly that's within our control.

George Notter - Jefferies & Co.

Great, thanks.

Operator

We'll go next to Tim Daubenspeck of Pacific Crest Securities.

Tiim Daubenspeck - Pacific Crest Securities

First one, just clarification. Joe, going back to the guidance last quarter on the other income line, you said $9 million is probably the net number, some upside to that. Yet you're guiding again to $9 million for the July quarter. Just looking for some of the gives and takes on that line and why we're going back to $9 million.

And then the main question is, 4200 revs, how much of this is building backlog in terms kind of the down sequential? And can you talk a little bit about customer concentration within that 4200, specifically? Thanks.

Joe Chinnici

Okay, Tim. How are you? On the other income line, yes, we did post a little bit better, but that again was tied to that, a legal settlement. We're not only getting some cash for some of it, it pertains to a licensing agreement thing and that's where it shows up geographically on the P&L and you won't have that recurring going forward, that's why we're sticking to that $9 million number.

In terms of the 4200 backlog, Gary, and the customer concentration, in the case of backlog, we don't normally talk about that. But we are building the book of business, it is growing. Since a lot of customers knew you get tied up into longer rev rec criteria, if it wasn't for that, that number would have been a lot stronger too.

I think Gary in his prepared remarks talked about the order flow being greater than 100% of the revenue in the quarter, which is a good thing, but then I think I just kind of talked about a book-to-bill there, indirectly, which we don't normally do.

Customer concentration, there are one or two big ones, but I would say we're approaching, we're closer to triple digits in terms of customers that we've shipped that product to, but again there are some big customers in that mix as well.

Tiim Daubenspeck - Pacific Crest Securities

Does that mean, is most of that revenue still largely European?

Joe Chinnici

Yes, it is. I hesitate and I struggle to go too far with that because we're starting to see North America really pick up in many different places. You've got to think of it a little bit differently in terms of say vertical markets, whether it's the financial sector, it's the health care sector, or it's the retail sector, but it's beginning to really take hold now.

The other thing that's a bit difficult to do, which is why we've changed our product discussion is that you've got to remember, when we pitch a piece of business because somebody wants to build a network and they want to build a link. And in order to get the best possible price for them and the best possible margin for us, we basically take a combination of the portfolio to build that network.

So 4200 could be combined in with long haul or it could be combined in with regional, right. And that's kind of tough to parse that dialogue to get that point across properly.

Tiim Daubenspeck - Pacific Crest Securities

Great, thank you.

Operator

We'll go next to Ehud Gelblum of J.P. Morgan.

Ehud Gelblum - J.P. Morgan

Hi, thank you very much for getting me in. A couple questions, if I could. First of all, when you take your 36% growth rate for the year and you back into Q4, it looks kind of flattish with your new Q3 guidance, up like 1% or so.

How does that fit in with some of the other things we looked at, which is, I think your deferred revenue is up large, clearly demand is strong, and why do you think Q4 slows down as much as it does and how do we gauge that, one?

Another question, when you -- Gary, you'd mentioned that the gross margin next quarter going back to the mid-40s is primarily a function of the mix becoming favorable for you, that way you don't have to rely on the services gross margin.

In future quarters, you won’t necessarily have that favorable gross margin mix on the product side. Does that mean that if services gross margin does not come up in the near term, then future quarters we could see gross margin fall back down to 42 as the mix sort of normalizes on the product side?

And if that's the case, I just want to understand that the 10% operating margin that you're forecasting or guiding to for as early as Q3, that we don't fall back into the single digits after that, that you're expecting once we hit 10%, then it's 10% or higher from there on. Just want to understand that. Thanks.

Gary Smith

Okay. Let me take the first part of your question and Joe will take the operating margin piece. I think really we just want to give people a perspective, our best perspective in terms of the total year right now and that's what we're endeavoring to do as we get closer.

As we get finished with Q3, we'll then be in a better position to guide into Q4 that gives you a rough view right now. We thought it was appropriate. It's still 36% growth in the year delivered across the four quarters, it's going to be lumpy from quarter to quarter, but we'll then start looking at '08 from when we get to Q4.

Ehud Gelblum - J.P. Morgan

I'm actually looking at Q4 '08, so 30% is phenomenal.

Gary Smith

You mean Q4 '07?

Ehud Gelblum - J.P. Morgan

Correct. It's flat. I'm wondering if you actually constructed that flat number to come up with Q4 to give you the 30% for the year or is it more of a placeholder?

Joe Chinnici

What do you know, this is Joe. No, we didn't construct that. I mean it's the way we see the ship dates, and the delivery dates, the RSF dates, whatever terminology you want to use by customer and the delivery schedule and the installation schedule, so, no, that's not a manufactured number.

I'm going to take the second part of your question, which talked, about the gross margin. The mix in the third quarter is strong, that's why we can give you the gross margin in the mid-40s while we still fix this services problem that we experienced in this particular quarter.

I think the other part of your question was if we don't fix the services thing, could the margins go back down to the 42 range?

Ehud Gelblum - J.P. Morgan

In future quarters.

Joe Chinnici

I'm sorry?

Ehud Gelblum - J.P. Morgan

In future quarters, the favorable mix in Q3 doesn't necessarily repeat forever?

Joe Chinnici

Yes, you're right. You could drop down to a 42, 43ish if we don't fix the services piece, but we'll fix it, it's just a question of how long will it take us.

In terms of -- your real question is targeted at the product gross margins. How long do we -- what's the permanency, or how long lived is that strength going to be?

Ehud Gelblum - J.P. Morgan

It actually is the operating margin, Joe, it actually was the translation down to the operating margin of 10% that you're getting next quarter off the favorable gross margin in product, could that revert to a single digit operating margin if gross margin reverts back, or are we safely above 10%?

Joe Chinnici

Let's get to the 10% and then we'll discuss that next quarter, but it's -- I don't want to count my chickens before they hatch, but it's looking pretty good right now.

Ehud Gelblum - J.P. Morgan

Okay. Two quick other things, if I could get in there. One is the favorable gross margin, does that have anything to do with the pickup in broadband access in Catina relying on AT&T coming back? Are you relying on that at all? Because Catina was a very high gross margin.

And then if you can comment on the accounts payable, it looks like you basically said if no one's paying me, I'm not paying anyone else and your accounts payable went up and gave you a huge inflow of cash. Is that a sustainable thing? Or how should we look at that?

Gary Smith

Let me take the first part of that. The product mix looks like it's good. The broadband access piece is not a significant. It's helpful in that regard, it's not a significant contributor or material to that. There are some other 4200, some of the new features on CoreDirector et cetera, some of the other Ethernet stuff that's helping on the gross margin side.

Joe Chinnici

On the AP question, I think it's -- I would under the heading of good working capital management, I'd say that's a piece of it. I would like to take credit for it, but a lot of has to do too, when the inventory's received in-house more than anything else.

Ehud Gelblum - J.P. Morgan

Okay. It's not just taking some purchase orders off the fax machine and hiding them some place until later?

Joe Chinnici

That's the second one of those questions you've asked on this call, no.

Ehud Gelblum - J.P. Morgan

Sorry about that. Good job. Thank you.

Operator

And due to time constraints, that concludes today's question-and-answer session. At this time I'll turn the conference back to Mr. Smith for any additional remarks.

Gary Smith

Thanks for everyone's time this morning and we really appreciate your continued support. We look forward to seeing many of you in June at NextCom in Chicago. Thank you.

Operator

That concludes today's conference call. We do thank you for your participation.

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Source: Ciena F2Q07 (Qtr End 4/30/07) Earnings Call Transcript
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