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Executives

Gregg M. Lampf - Vice President of Investor Relations

Gary B. Smith - Chief Executive Officer, President and Director

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

Thomas Mock - Senior Vice President of Corporate Marketing & Communications

Analysts

Kevin J. Dennean - Citigroup Inc, Research Division

Jeffrey T. Kvaal - Barclays Capital, Research Division

Rod B. Hall - JP Morgan Chase & Co, Research Division

Tal Liani - BofA Merrill Lynch, Research Division

Victor W. Chiu - Morgan Keegan & Company, Inc., Research Division

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Paul Silverstein - Crédit Suisse AG, Research Division

Blair King - Avondale Partners, LLC, Research Division

Vijay Bhagavath - Deutsche Bank AG, Research Division

Tim Long - BMO Capital Markets U.S.

Ehud Gelblum - Morgan Stanley, Research Division

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Catharine Anne Trebnick - Northland Securities Inc., Research Division

Natarajan Subrahmanyan - TheJudaGroup, Research Division

CIENA (CIEN) Q1 2012 Earnings Call March 7, 2012 8:30 AM ET

Operator

Good day, everyone, and welcome to the Ciena Corporation Unaudited Fiscal First Quarter 2012 Conference Call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Ciena's Vice President of Investor Relations, Mr. Gregg Lampf. Mr. Lampf, please go ahead.

Gregg M. Lampf

Thank you, Ally. Good morning, and welcome to Ciena's First Quarter 2012 Review. With me today is Gary Smith, CEO and President; Jim Moylan, CFO; and Tom Mock, Senior Vice President, Corporate Communications.

This morning's press release is available on National Business Wire and ciena.com. In our prepared remarks, Gary will discuss management's view on the quarter, and Jim will offer some color on our Q1 results and provide guidance for Q2. We'll then open 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 will be making certain forward-looking statements. Such statements are based on current expectations, forecasts and assumptions regarding the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in the context of the risk factors detailed in our most recent 10-K filing.

Our 10-Q is required to be filed with the SEC by March 8, 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. As a reminder, this call is being recorded and will be available for replay from the Investor section of our website.

Gary?

Gary B. Smith

Thanks, Gregg, and good morning, everyone. As you've seen in this morning's press release, we reported revenue of $417 million for our fiscal first quarter. As we stated 2 weeks ago, the first quarter's lower revenue was primarily the result of timing issues, so I'd like to take a moment to provide some details on that.

As we've discussed in recent quarters, our business is becoming increasingly more solutions-based and more geographically diverse with multiple new customer wins. And I think it's important to note that all of these dynamics are quite positive and part of our deliberate strategy to drive greater diversification of the business.

But this is resulting in longer time frames for project deployments, achieving customer acceptance and, therefore, revenue recognition. Specifically in the first quarter, we experienced revenue recognition delays on a few solutions-orientated projects with new customers, especially in international markets. This had a more significant effect than previously anticipated and was intensified by the impact of the seasonality of our business and, really, the calendar timing of our fiscal first quarter.

In the meantime, I would stress that all demand indicators around the business remain strong. We are winning deals and taking market share. We are seeing no drop in customer interest or orders and no significant change from that, that we've already described before in the competitive landscape or in the markets where we're focused.

In fact, most of the business metrics in Q1 came in as expected or better. Order flow continued its momentum with product orders strongly year -- up strongly year-on-year. Our backlog continued to grow as adjusted operating expense came in lower than expected. We generated cash from operations, and we achieved positive free cash flow for the quarter.

The bottom line is that we see no change in our opportunity. And in fact, having just returned from Mobile World Congress, it is clear to me that the networks in general are playing an increasingly important role in the user experience, requiring intelligence and economics of scale to underpin that experience.

The proliferation of services, devices and applications requires networks to be both bigger and smarter, and that requirement is driving our network vision and product architecture. As the one supplier in the industry with both market-leading technology and deep experience in transport, switching and carrier Ethernet, we are leveraging that leadership by cross-pollinating our core technologies across our complete portfolio to deliver a truly automated and converged network infrastructure.

Specifically, in transport, we've just launched WaveLogic 3, our newest generation chipset for high-speed coherent optics and the industry's first software programmable processor system. This technology, again a first for the industry, is how Ciena is delivering against the need for bigger and smarter bandwidth as we continue to move the goalposts in coherent optical transport.

Scalable to 400 gigabits per second and beyond and offering longer reach and latency, WaveLogic 3 will extend our already sizable development lead in this space. The process's programmability also allows network operators to dynamically optimize bandwidth for metro, regional, long-haul and submarine applications in one platform.

We also continue to make progress in our switching business, which was up from Q4. We're encouraged by the variety of customer verticals adopting our Packet-Optical Switching solutions for a wide range of applications that we can now address. Our platforms are unique in that they provide a migration platform from SONET/SDH to OTN and, ultimately, to Packet all in a single platform.

As of the end of Q1, 17 customers have selected our 5400 platform, well over half of which are not CoreDirector customers, I think demonstrating that the market for our OTN switching solutions extends beyond our traditional optical switching market. During the quarter, we were awarded switching wins by a national U.S. carrier, as well as an Asian PTT who is building a global mesh network, again indicating the global nature of the expanding market for this type of architecture.

In Carrier Ethernet Solutions, we continue to see opportunity for business Ethernet services despite the fact that the market is certainly developing slower than we anticipated. Furthermore, given the growth in mobile data and the emergence of LTE, we do expect continued growth in mobile backhaul.

In order to expand our addressable market in these areas, as well as in network infrastructure applications to Carrier Ethernet, we are further enhancing our current service delivery and aggregation portfolio. Specifically, we're adding larger switches to the product line so we can address applications deeper into the network, and we're adding features such as MPLS-TP that allow us to better interoperate with IP networks. I think, overall, we are laying a solid foundation that we believe will help us increase our addressable market in this area and grow our Carrier Ethernet business in the second half of the year.

In summary, we have significant technology leadership in carrier Ethernet, transport and switching, which we believe are even more powerful when they all work together. Therefore, we continue to converge our offerings and unify the portfolio with common control plan and network management software.

And in order to further facilitate the global need for network modernization and to take advantage of these solutions, we're also developing several new strategic service offerings. These consultative services are grounded in the deep insights we have into our customers' businesses, as a result of a highly collaborative engagement model and our growing solutions orientation. When combined with our technical leadership and ongoing convergence development, they create a truly unique competitive advantage for Ciena.

Now I'll hand it over to Jim to cover the Q1 financials and also the guidance for Q2.

James E. Moylan

Thanks, Gary. Good morning, everyone. I'll take a few minutes to provide some detail on the results that we published earlier today. As a reminder, I will be speaking only to non-GAAP results. Please refer to this morning's press release on our website for the reconciliations to our GAAP results.

While our lower-than-expected first quarter revenue kept us from delivering the operating margin we expected, our ongoing efforts to optimize the business and increase operating leverage were evidenced by positive results in other areas. Order flow remained strong, and our backlog grew. First quarter product order intake grew approximately 20% year-over-year, which is an encouraging indicator for future growth.

Adjusted gross margin came in at 42%, in line with our guidance for the quarter. Adjusted OpEx came in lower than expected at $175 million, driven primarily by lower expenses associated with prototypes for several large platforms coming to market this year. These development plans remain on track, however, and we expect these expenses to occur later in the year and primarily in Q2.

We generated $13 million in cash from operations in the quarter, and we achieved positive free cash flow again for this quarter. Our cash position is up by approximately $9 million as we ended the quarter with $601 million in cash and liquid investments.

We continue to feel strongly that we will have a very good year in 2012 as our portfolio is playing well in the market. We do expect to continue to win large-scale solutions-based projects going forward, so we believe we will continue to experience longer revenue-recognition cycles in future quarters.

The lumpiness that comes with these larger products creates additional uncertainties in predicting quarter-to-quarter revenue and mix. As you will see, we have widened the range of our revenue guidance this quarter in recognition of this. So as you consider these dynamics of our business, we believe that viewing first half results versus second half results provides a better view of the underlying trend in our business rather than focusing on one individual quarter.

That brings me to guidance for the fiscal second quarter of 2012. Absent any significant changes in exchange rates, our guidance is as follows. We expect revenue to be in the range of $435 million to $460 million. As for gross margin, we expect Q2's adjusted gross margin to be in the low 40s, and adjusted operating expense for Q2 is expected to be in the low 180s.

Although this does represent an increase over Q1, as I said before, there is some OpEx that we had expected in Q1, which we now believe will occur in Q2. We are on track to meet our first half expectations for adjusted OpEx, and we continue to believe that OpEx will be roughly flat for the full fiscal year as compared to 2011. As I said, we believe that 2012 will be a good year for Ciena, and we anticipate that our operating results for the second half of fiscal 2012 will be stronger than those of the first half.

To close, here are some other metrics for those looking to model earnings per share. With regard to other income and expense net in the second quarter, we project an expense of approximately $9.5 million related to the interest on our notes. We expect our tax obligation for Q2 will continue to be related solely to foreign taxes. As for share count, we estimate Q2's basic share count at approximately 99 million total shares. Diluted share count will vary depending upon your assumptions about our profitability.

That concludes our prepared remarks. And with that, we will move on to Q&A. [Operator Instructions] Ally, we'll now open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Kevin Dennean of Citi.

Kevin J. Dennean - Citigroup Inc, Research Division

Just wondering, Gary, if you could talk a little bit about the new customer momentum in your switching business. Little bit of a slowdown in the momentum with 17 customers in trial. Can you talk about what the pipeline looks on that, and where you think that number might progress through the year?

Gary B. Smith

Sure, Kevin. I mean, I think that the momentum continues to gather. I think when we talk about 17, that's actual sort of customers. That's orders placed, et cetera. They're all at varying degrees of maturity. Some of those are substantial Tier 1s. Some of which we've not got to revenue yet. But clearly will be substantial moving forward. So I think we're pleased with that. We're also getting a better understanding about the expansion of the market in terms of the market opportunity for this converged platform with OTN, and we're seeing multiple different applications for it. It's going to be lumpy. Clearly, we're talking about driving a new market with the convergence of OTN, control plane, et cetera. But I think so far -- and we saw this when we introduced CoreDirector all those years ago, and it's going to be a little bit lumpy as we go through this. But I think we're very pleased with the traction that we're seeing. And when you think about it, the revenues that we're seeing now are really without any of those major Tier 1s really kicking in, in terms of the revenues. And the timing of that, we think will be towards the end of the second half of 2012.

Operator

Our next question comes from Jeff Kvaal of Barclays.

Jeffrey T. Kvaal - Barclays Capital, Research Division

I guess I wanted to ask you about the lumpiness that's now seems to be embedded in your business. I think -- or I had anticipated that the Nortel merger would actually help eliminate some of the lumpiness as you have better customer product and geographic diversity. Now it seems as though the variability seems to be as high as ever, maybe even a little bit higher. What are some of the changes that are going on there that would help us square that circle?

Gary B. Smith

Yes. Jeff, that is a very good question. And I think overall, as I alluded to in some of my comments there, I think with the MEN acquisition, it should provide a more balanced business to us. About 50% of our business is international. We're able to provide more solutions orientation as we converge these platforms. And I think -- I do think this, over time, it will help in terms of predictability. I think the thing that we're dealing with is we're going into multiple new markets. The good news is it's opening up new market opportunities for us in things like submarine and other new geographies, et cetera. And I think we're going through the curve on that, as it will, around the initial deployments. The good news is we're winning a lot of new customers. But with that, comes some uncertainty around some of the timing, certainly of revenue recognition. Now I think we'll work through that. And I think as we get more and more orders and build more of a backlog, I think that will help in terms of the predictability. The other thing as well is I think -- and I think we're very conscious of this, we've got multiple new platforms coming into market, where we're leading with the technology and we're helping leading the development of those markets. And now we've got a number of them, and that should provide balance to the business. But there will be variability on a quarter-to-quarter basis as we look at all of those dynamics. So I think we'll work our way through it. But I think we're -- we are seeing good general progress if you look at the increase in orders, et cetera, and I think the revenues will clearly come as we work through that.

Jeffrey T. Kvaal - Barclays Capital, Research Division

Okay. So maybe another way to put that would be that you'll eventually get to better predictability, but during the process, where new products are ramping up, we're not quite there yet.

Gary B. Smith

Yes. I think that's a reasonable summary. The other thing that overlays that is the sort of the global economy, where this sort of network modernization cycle is -- we're seeing some stutters clearly with some of the things that are going on in Europe, et cetera. And I think that's also playing its part. But we're not really seeing any change in the environment over the last couple of quarters there. So yes, I do think this will flow through, and I think it's sort of an evolution process of both Ciena and the maturing of the market.

Operator

Our next question comes from Rod Hall of JPMorgan.

Rod B. Hall - JP Morgan Chase & Co, Research Division

I just wanted to ask about your visibility into the second half of the year. You've commented a couple of times you expect revenues to pick up in the second half of the year over the first half. Yet, with your own quarter-on-quarter progression, as well as a lot of other guys in the industry, it seems like visibility is worse, not better. So I just wanted to see if you could give us any more specific color on what gives you confidence there. I mean, are there specific contract discussions you're having or carriers telling you they're going to spend more? If you could just elaborate on that, that would be helpful.

James E. Moylan

Yes. Rod, the way we do our forecasting and projecting is entirely bottoms up coming from our sales force in their engagements with customers, and they project what they see as order flow from their customers. I think it's as good a source as we can have. There's always uncertainty about exactly what will come from each customer. But I think, overall, they've been pretty good in projecting their order flow. In going from order flow to revenue, you get into all of the things that we've talked about, full network completions, customer acceptance, customer behavior, out in the field, which can be harder to project than just their order flow, which is driven really by the network planners and then the operations folks. So I think we have good intelligence about what the customers are going to do with respect to their orders. Yes, it is uncertain, but that's really the basis for our confidence for the second half.

Rod B. Hall - JP Morgan Chase & Co, Research Division

Jim, do you guys have any -- just to follow up on that, any contracts that are kind of signed and sealed and that'll guarantee a portion of revenue in the second half of the year? Or is it pretty much all the pipeline and estimates based on the pipeline?

James E. Moylan

Well, it's basically based on contracts with customers. Now we don't have guaranteed volumes in those contracts. What we have is we have a contract. We have a plan by these customers which calls for deployment of our gear, and that's the basis for our projection. So it's -- there are certainly -- particularly in some of the shorter sales cycle businesses, such as the enterprise business, there's some expectation that we will continue to win new contracts. But for the big customers that we have, we have contracts in place with, I think, virtually all of them.

Operator

Our next question comes from Tal Liani of Bank of America Merrill Lynch.

Tal Liani - BofA Merrill Lynch, Research Division

A few questions. You mentioned order flow grew or product order intake, you mentioned it grew 20%. Is -- are these new things that you got this quarter, or was it kind of delay or push-out from the previous quarter? And is this indicative of a recovery in the order environment again or things that happened already in the past and that you just now see it? And the second point is, in the past, you mentioned that WaveLogic 3 will help to improve margins. Can you give us an update on where it is and when will products, the WaveLogic 3 hit the market and what could it do to margins and revenues?

Gary B. Smith

Tal, why don’t I take the first one and Tom will talk about WaveLogic 3. We talked about 20% product increase year-on-year. Typically, Q1 is not a -- the seasonality of it has a number of impacts, not least of which it’s normally our lowest order quarter, given the fact that we straddle this November, December and January timing. But we actually saw good order flows in the quarter. So really, it's just an indication, I think, of the overall strength and momentum, if you will, of the business. And it was a mix of new customer wins, extensions of existing contracts. It was a good mix of business overall. And I think considering it was Q1, with all the other issues that normally associate with that, I think we take that as a good sign into the business. Tom, you want to say something?

Thomas Mock

Yes. From the WaveLogic 3 standpoint, as we said in the prepared remarks, we think it's a pretty significant step forward in terms of our capability there. It does allow us to create transceivers that are smaller footprint, lower power and also with fewer components. I mean, WaveLogic 3, as we've talked about, will be a single wavelength solution. It is something that we're bringing to market during the course of this year. In fact, we've announced a couple of applications that are requiring the kind of distances that WaveLogic 3 will bring to the table. And we think that longer distance and the overall better performance there allow us to extract a bit more value. But that said, we are in a competitive market in terms of optical transport, and we see it remaining competitive.

Tal Liani - BofA Merrill Lynch, Research Division

And, Tom, Alcatel announced a 400-gig chipset. It's just fascinating that the industry is going from 100 to -- 40 to 100 to 400 in such a short period of time. And the question is, what does it do? On one hand, WaveLogic 3 is supposed to improve margins, et cetera, through better technology basically, better integration. But what does it do to the industry that we're going from 100-gig deployment to 400-gig deployment within sight on -- over such a short period of time? What does it do to pricing and demand for equipment overall?

Thomas Mock

It does feel like a bit of a speed treadmill here. I think that the real issue that we're seeing there is customers wanting to see a path to future higher speeds. I think pretty much anyone you talk to in the industry would agree about the importance ultimately of 400G. But remember, we're still in the early days of 100G. I think what our customers really want to be able to see is a capacity path that will extend out over time, and the systems that they buy today can be upgraded to faster capacity. It doesn't mean they're going to go to 400G today nor in the near future. In fact, if you talk to the industry guys, the industry analysts, they'll tell you that they believe that when 100G really begins to capture a significant part of the market will be this year and next year. So I wouldn't read the emergence of 400G as the death of 100G, nor would I read it as a particularly short 100G cycle. I'd read it rather as our customers wanting some comfort about how they deal with continuing needs for higher capacity.

Operator

Our next question comes from Simon Leopold of Morgan Keegan.

Victor W. Chiu - Morgan Keegan & Company, Inc., Research Division

This is Victor Chiu in for Simon Leopold. I just wanted to ask you going back to your order flows and your backlogs. It seems like deferred revenues came down quite a bit this quarter, almost 18%. So this seems a little contradictory to your comments regarding the stronger order flows and backlog. So I'm just wondering if you could help us reconcile that?

James E. Moylan

Yes. Victor, the deferred revenue on our balance sheet is really a function of services. We get orders for services which extend over as much as a couple of years. And in many cases, we get paid for those services in advance. And that sets up the deferred revenue on the books. What that reduction in deferred revenue means is that we actually booked a bunch of that revenue that had been deferred in our maintenance business in the quarter. If you look at our inventory and you look at deferred cost of sales and finished goods, you'll see that the reason that our inventory is up is basically those 2 things, which is -- very much aligns with the fact that we are seeing longer revenue recognition cycles. We have -- in a lot of cases, that equipment is out there in the field awaiting either final acceptance or awaiting deployment.

Victor W. Chiu - Morgan Keegan & Company, Inc., Research Division

Okay, that's helpful. OpEx, I wanted to ask actually -- I'm sorry, can I ask you about the pricing of WDM at 10G and 40G? Are you seeing any pricing pressure from competitors in that product segment?

Thomas Mock

Victor, it's been a competitive market, and it continues to be a competitive market. I think we've also talked about on previous calls as customers begin to move to 40G and ultimately 100G, that probably exerts a negative downward pressure on 10G pricing. That said, I think when you look at total cost of ownership across the network, the fact that coherent 100G and coherent 40G don't require dispersion compensation and can operate over distances comparable to 10G. We're reaching a point here where, particularly on long-haul routes, the cost of 40G and 100G implementations is pretty close to that 10G implementations. And most of the service providers are of the mind today of why would I not go to these higher speeds if I indeed could.

Operator

Our next question comes from Nikos Theodosopoulos of UBS.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Can you give an update on the revenue recognition of the contract you won last year, the SEA-ME-WE 4 contract? I believe that was quite material. I don't think you have quite recognized that yet. I'm trying to understand if that's embedded in your guidance for the next quarter.

James E. Moylan

Yes. Nikos, that is a -- it's a complete network. As we've said, it's submarine network. We provided the switching to the network, and it's just taking a long time for the network to get to an operational status. And it has to be at that operational status before we can book revenue. We -- it is in the range of $20 million-plus. We -- at this point in time, we don't believe it's going to hit in the first quarter. We think it's going to be in the second -- I'm sorry, in the second quarter. We believe it's going to be a second half event. That, along with some other things, going back to the earlier question about confidence in the second half, is what -- when that hits, that's going to give us a bump in revenue in whichever quarter it hits. And that's one of the reasons why we feel confident in our second half results being better than the first half.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

All right, got it. And the revenue delays -- revenue-recognition delays that you experienced specifically in this first quarter, are those -- were those for 1 or 2 customers? Or would you say it was more broader than 1 or 2 larger particular contracts?

James E. Moylan

Yes. It was a few new customers. It was not any of our big Tier 1s with whom we've had long-standing relationships and longstanding contracts. They were complete systems, and they were mostly international.

Operator

Our next question comes from Jess Lubert of Wells Fargo.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

A question on the CESD business. On the last call, you suggested that the CESD business would be up quarter-over-quarter. So I was hoping you could provide some additional details on the miss in this area. To what degree was it driven by a single customer? Do you expect to recapture that business during the April period? And are we nearing the point where we will see customers other than AT&T have a material impact on CESD going forward?

Gary B. Smith

So a couple of things, Jess, I mean, I think to answer your last question first, I think we're already seeing that. We've broadened out the customer base significantly. There's been a number of announcements around carrier Ethernet and wireless backhaul. I think the challenge is, particularly on the -- on the Ethernet business services, that just is taking longer than we'd anticipated, combination of issues around back office within the major carriers, getting it integrated in there, but it's certainly taking longer than we would think. Again, I think it's still a fairly emerging nascent market, and it's going to be lumpier along the way. We're expanding the capabilities of the portfolio, which I think should broaden out the market for us to give us a little more balance to the business. We're putting more intelligence on the -- on some of the software implementation with it. So I think, for example, a good example of the lumpiness we expect it to be up next quarter. I don't think we expected a good start to the year for it, for Q1, which I think the numbers were about what we thought. But we do expect that to be up in Q2 that we're coming into.

James E. Moylan

I believe -- Jess, I believe what we said, and I know I've said this, is that we expect both switching and CESD to be up nicely in 2012 as compared to 2011. And that is still true. We do think that both of those products are on growth trajectories. And over the long term, we expect those to grow faster than transport. And we stand by those comments today.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

And can you help us understand what will drive the better CESD growth in the second half? You seem to suggest we'd see that ramp in the second half of the fiscal year.

Gary B. Smith

I think it's the broadening of the portfolio, which we’ve got a number of new enhancements coming to market now, and also, visibility into some of these Ethernet business services that are going to -- they're going to get rolled out. We really haven't seen a lot of appreciable revenue for those services yet.

Operator

Our next question comes from Paul Silverstein of Crédit Suisse.

Paul Silverstein - Crédit Suisse AG, Research Division

Gary, Jim, if you could first just give us some numbers and then I've got a question for you. On the numbers, can you tell us -- I think I heard one of your execs say you now have 25 100-gig customers. But can you tell us what the customer count, as well as the revenue contribution from 100-gig and 40-gig, either in absolute or as a percentage of transport? Can you also tell us what the 5400 was, either in dollars as a percentage of switching? And then I've got a question for you.

Thomas Mock

Okay. Paul, I'll take the question on the coherent optic transport. So in terms of 100G customers today, we're at about 25 customers. That's up from last quarter. And in terms of how it is impacting our transport business, it's currently about 50% of our transport revenue, it's up a little bit as a percentage but relatively in line with what we've been seeing in the past. So total coherent customers, 40 and 100G is around 116.

Paul Silverstein - Crédit Suisse AG, Research Division

That was 116 total customers. And you said 100G itself is now 50% of transport?

Thomas Mock

No, no, no. 40 and 100G is 50% of transport, Paul.

Paul Silverstein - Crédit Suisse AG, Research Division

All right. And again, the total customer count is 116, that's 40 plus 100?

Thomas Mock

That's 40 plus 100.

Paul Silverstein - Crédit Suisse AG, Research Division

All right. In optical switching, either -- I'm sorry, your 5400, either in dollars or as a percentage of optical switching?

James E. Moylan

What I'd say there, Paul, is we have not yet started to see a rollout of 5400 on the part of the big Tier 1 wins that we have. So 5400 is not a high percentage of our switching revenue as of yet.

Paul Silverstein - Crédit Suisse AG, Research Division

Jim, do you have visibility to those rollouts or is it still too early?

James E. Moylan

We have plans from the customers. So we have reasonable visibility. Those plans can change.

Paul Silverstein - Crédit Suisse AG, Research Division

All right. And finally, you mentioned a number of projects that's contributing to lumpiness. Can you give us some sense, preferably in hard numbers, as to the nature and the number of opportunities you're looking at compared to 90 days ago, or a year ago, whatever reference point you want to give us in supporting your statement that you're seeing a pickup in activity?

Gary B. Smith

Paul, do you mean in the total business or in switching or...

Paul Silverstein - Crédit Suisse AG, Research Division

I guess I was speaking in total, but it'd be great if you actually gave us the breakdown. But I'm trying to get a sense, when you talk about lumpiness from -- relative to the order trends and better pipeline, can you help us quantify for us, give us some sense of what we're talking about proportionately?

Gary B. Smith

Paul, I mean -- I think probably one of the best indicators is the order flow, which was up on product 20% year-on-year, particularly into the sort of Q1, which is normally a fairly weak order flow for us, and that was pretty strong. That's one very good indicator. It's not an absolute, but that's a good indicator. We're also looking at good flows so far this quarter as well, and the projections are pretty good for this quarter. So we've continued to build backlog over the last few -- multiple quarters, and that's probably about as strongest trend as we can see in terms of the strength of the business. The overall pipeline continues to grow for our opportunities, so we're encouraged by that. Those are the kind of metrics that we look at.

Operator

Our next question comes from Blair King of Avondale Partners.

Blair King - Avondale Partners, LLC, Research Division

It's a question that really revolves around the product transition to the new silicon. And if you could help us understand how that transition went from your first-generation to second-generation WaveLogic version and then what your expectations might be in the transport segment as you move to the third-generation in the second half of this year. And I guess what I'm really trying to get at is, would you expect to see any sort of product purchasing delays given the introduction of WaveLogic 3?

Thomas Mock

From our past experience, Blair, I wouldn't think that you would see that. And the reason I say that is because we've pretty carefully designed the different generations of these so that they can be installed in the same shells. So while the future generations give you better stand designs, they still fit into existing systems just fine. I do think that the thing that's going to be important as we look to WaveLogic 3 is it really lets us put 100G in the same kind of stand designs that people put 10G in today. So it makes that migration from 10G even easier and over a broader base of customers. So I think that's really the dynamic you would see rather than any particular pause as a result of a shift in technology. As far as the end user is concerned, WaveLogic 3 occupies the same kind of bandwidth on the fiber as WaveLogic 2 does. So they can go in the same sorts of shells, fit in the same channel plans. Now there are some advantages for WaveLogic 3 in terms of greater density and power consumption, but that shouldn't slow down in the existing deployment of 100G.

Operator

Our next question comes from Brian Modoff of Deutsche Bank.

Vijay Bhagavath - Deutsche Bank AG, Research Division

Gary, Jim, this is Vijay Bhagavath speaking on behalf of Brian. Yes. So I mean, just a quick question and a follow-up. The question is around -- I mean, our research is telling us that you had to give discounts in order to win some of the transport business. Do you think some of those management discounts kind of trend to fade away as we get towards the later half of this year?

James E. Moylan

Yes. What we're seeing is in the early stages of a deployment of a platform, you have the normal sort of chassis deployments, lightly loaded chassis deployments at lower margin and then cards at higher margin, and we're seeing that definitely. In addition, because of the competitive environment, as Tom mentioned, we've been competing against other competitors on 40- and 100-gig for a while even though they haven't had product in market. We have -- in the interest of winning longer-term, strategic contracts, we have given some discounts. We're still engaged in a very competitive market. Ultimately, those discounts are going to roll off, but what I can't say is how many new deals we're going to sign and have to play competitively in those. I guess the one thing I'd say is that we've been able to hold our margin very nicely through this period of very intense competition on transport. As the needs for higher speeds increase, I think you're going to see -- over time, you're going to see fewer people being able to keep up with the needs for these very advanced and rapid transportation platforms. So I think over time, that, combined with the new features that we're adding to transport, we're going to see some relief on transport margins. But I'm not sure you're going to see it this year.

Vijay Bhagavath - Deutsche Bank AG, Research Division

Certainly. And then a quick follow-up would be around kind of your thoughts on Carrier Ethernet and software and services. I mean, obviously this helped improve margins, et cetera. So any thoughts on how you're looking at Carrier Ethernet software and services from a sales push point of view versus you think the ramp of these 2 categories are pretty much a function of customer pull-through versus sales push?

Gary B. Smith

I think it's a number of things, Vijay. It's also about the evolution of the portfolio. We're getting to the point this year where we will be truly converging some of the capabilities across the portfolio, and that gives us the opportunity putting control plane on 6500 with all of the capabilities. That gives us the opportunity to bundle some of the software packages and capabilities and add additional value-add to that. The other thing I would say is -- and I think what's significant around the WaveLogic 3 is that the programmability on that also allows us to sell various software applications on it as well. So this whole thing around putting more intelligence on the network really fits very well into our portfolio. And so I think, over time, as Jim indicated, as we put more intelligence on this, this should take our overall target margin to the mid-40s. But I don't think that's going to happen this year. But it has enabled us to -- even in this very intense competitive environment where we're winning a lot of new initial deals on transport, we've still been able to keep the margin in a reasonable range.

Operator

Our next question comes from Tim Long of Bank of Montreal.

Tim Long - BMO Capital Markets U.S.

Yes. If you could just, Jim and Gary, qualify for a little bit what the better operating results in the second half, what does that mean specifically? I mean, clearly revenues are going to be higher given the growing backlog. Are you implying much better growth? How much better growth? And then is there any implication on the gross margin side as an operating result? Will that -- are you expecting that, that will be better in the second half? And then just related to the gross margin, if you can just -- it sounds like a lot of the push-out or delayed deals are on the international side. What do you think the gross margin implication for that will be as those turn into revenues over the next few quarters?

James E. Moylan

Yes. Tim, I would say that what we have said consistently over the past couple of years is that in order for us to get to our goals in terms of operating margin and operating leverage, really, 3 things had to happen. We had to grow our top line, and we believe that we're going to grow our top line nicely in the second half. We believe that we should continue to gain market share given our technological position. So that's the first element, and we feel very good about that. The second thing we've said that we have to do is that we have to grow our gross margin percentage. And we said that there were 2 or 3 things that are going to do that for us. One is the mix is going to get richer toward more switching, more CESD and hopefully more software. And the second thing is that we have to continue to execute our plans with respect to our supply chain. And we believe -- we're very comfortable in the fact that we are executing our supply chain plans, and we're going to see a benefit from that. We believe that switching and CESD are going to be up nicely in the second half. So generally, we think we're going to see better margins in the second half. That's just a guess today. And we've said we've got to maintain our OpEx. We've got to sort of hold that flat as we grow our top line and grow our gross margin. And we've said today, again, that we expect overall OpEx to be roughly flat for the full year as compared to 2011. So those are the 3 things that are going to have to happen to get to our goal.

Operator

Our next question comes from the line of Ehud Gelblum of Morgan Stanley.

Ehud Gelblum - Morgan Stanley, Research Division

A couple of clarifications and some real questions. First of all, clarifications. Jim, what was the diluted share count? What would that diluted share count be if we assume in our model that EPS is positive? Then...

James E. Moylan

Each of the 4 tranches of converts becomes dilutive at a different level of profitability. At a $5.9 million number, I think the first tranche comes in and then it goes up to, I don't know, something like $25 million or so, all of them are dilutive. Ehud, if you'd like, Gregg can send you a schedule that'll lay all that out for you. You really, first, have to get to an assumption or projection of our profitability and then derive the number of shares with full share count.

Ehud Gelblum - Morgan Stanley, Research Division

Okay. I have one of those, but I wanted to see if it was correct. But I can do that off-line. I appreciate that. Gary, you said that orders were up 20% year-over-year. I'm wondering if they were up quarter-over-quarter. So how did orders -- clearly, backlog was up quarter-over-quarter because of deferred revenue recognition, but I was wondering if orders were up quarter-over-quarter as well. And then I wanted to explore the -- again, the comment you’d made that the 5400 was still -- it sounds like a very, very small percentage of switching right now and is not going to your larger customers. I was under the impression that it was at much larger customers and so, therefore, it is that, that is what is sitting in finished goods inventory, a lot of 5400, and is sitting in a lot of your backlog or has it not even approached the inventory and backlog stage?

Gary B. Smith

So I'll answer your first question. In terms of Q1, even though the orders were strong there, we had a very strong Q4 as well. So they were down sequentially and then that is very normal. In fact, it wasn't down as much as in previous quarters into Q1, which is typically our weakest quarter given it's November, December, January. So again, it was encouraging from that point of view but it was down from Q4, which was totally expected, and we've seen that ever since we've been, I think, as a public company. 5400, still relatively small in terms of the overall mix of things. But I would say that when we talk about the Tier 1s, it's actually out there with the Tier 1s, and we've got about -- I think of the total of the 17, you could classify about 10 of them as Tier 1s. So that's people who have placed orders and have product. I think the issue is the actual rollout of all of that and the adoption of that on a meaningful basis. Whilst they have -- many of them have plans to do that, that's not until towards the end of this year before I think it'll be a sort of meaningful impact. So that's the -- the context of that is we've got and secured a number of strategic Tier 1 wins with 5400, but it's not into meaningful revenue yet. And that expectation is towards the end of this year.

Ehud Gelblum - Morgan Stanley, Research Division

But is that in inventory or backlog?

James E. Moylan

Well, the -- it's definitely in backlog. Now what I'd say is we talked about one specific project, SEA-ME-WE 4, which has been awaiting final network completion. And that is actually in our deferred cost of sales. So that's a pretty big number in our deferred cost of sales.

Ehud Gelblum - Morgan Stanley, Research Division

Of your general Tier 1, the other 10, I'm trying to -- what I'm trying to discern is do they just have test equipment, a couple of 5400s that...

Gary B. Smith

Some of them we've taken to small amounts of revenue already or -- so that is not meaningful in terms of deferred. The real issue is orders on hand and the actual rollout plan for them.

Ehud Gelblum - Morgan Stanley, Research Division

So it's not in -- so it's correct to say that this is not in your inventory of finished goods?

Gary B. Smith

Not in a meaningful way, no.

Ehud Gelblum - Morgan Stanley, Research Division

But -- I think the large numbers are in backlog.

Gary B. Smith

Yes.

Operator

Our next question comes from Sanjiv Wadhwani of Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Just 2 quick questions. Jim, of the shortfalls from Q1, are you expecting most of them to be recognized in Q2 or some of them spill into the second half? And then, Gary, general question for you. When you look into the visibility that you have into the second half, is that mostly coming from outside of the U.S.? I'm trying to sort of get a picture of what you're expecting North American CapEx to do this year.

James E. Moylan

Yes. To the first one, Sanjiv, a good bit of that Q1 stuff will drop into Q2. On the other hand, we do -- we expect to continue to see these longer revenue recognition cycles. So for example, you shouldn't take whatever number you have for Q2 and add the shortfall in Q1 to it. But we do think a fair number of those will drop into Q2.

Gary B. Smith

Sanjiv, on the North American CapEx, we're seeing pretty solid performance from North America. When we're -- we're seeing pretty positive indicators for the rest of the year into North American CapEx. I think the issue with this whole CapEx piece really ties into sort of network modernization, et cetera, and putting real intelligence out on these networks. And I think it's an issue of not total CapEx but what are they spending it on and are they really making that shift to these next-generation architectures. And I think we're seeing a pretty solid perspective around both of those issues, in terms of their overall CapEx being reasonable for the year, and probably more importantly for us, what they're going to spend it on. It's really around the convergence and the 6500 and the 5400 platforms going forward.

Operator

Our next question comes from Catharine Trebnick of Northland Securities.

Catharine Anne Trebnick - Northland Securities Inc., Research Division

Can we go back to deferred revenue for a minute? Jim, you had mentioned that it was up 20% on the product year-over-year. Is there any way to look at that and say that there's a rule of thumb that some of this will come in second quarter, third quarter or fourth quarter?

James E. Moylan

Yes. What we said, Catharine, was that product order intake was up 20%. We did say that our deferred cost of sales and finished goods is the main reason for our increase in our inventory levels. And what that is indicative of is these longer revenue-recognition cycles. With respect to the question of rules of thumb, it's one of the reasons why we have had some difficulty in projecting our revenue is that some of these rules of thumb are changing as our business is changing. And whereas before, we might have had a business that was heavily rev rec’d upon delivery of the gear, now it's based upon full network deployment and acceptance by the customer in a much larger way. So we're gaining intelligence about the way our business is working, but it is changing. So there's no way really I can tell you how much is in Q2, Q3 or Q4. We used to think that most of our orders in a given quarter are going to turn to revenue within a quarter or a quarter and a half. That's not the case anymore.

Catharine Anne Trebnick - Northland Securities Inc., Research Division

And one other quick question. On the 5400s, is there a way to look at that as how many might be for submarine applications versus metro deployments?

James E. Moylan

You're talking about our revenue or our backlog?

Catharine Anne Trebnick - Northland Securities Inc., Research Division

Just in terms of the application for the 5400.

Thomas Mock

I'd say, Catharine, that most of the applications are in the Tier 1 carrier space, but we actually have pretty good application diversity there. In addition to submarine, we're also seeing them in government applications. We're seeing them in Tier 2 network applications. So it's a pretty broad base of applications into which we put it.

Operator

Our final question comes from the line of Subu Subrahmanyan of TheJudaGroup.

Natarajan Subrahmanyan - TheJudaGroup, Research Division

I have 2 questions. First, on the topic of carrier release of budgets, that's something that's been speculated about a lot. So, Gary, curious for your perspective of Tier 1 U.S. carriers, how they release their budgets, what you see from them from budget perspective. Then, Jim, on gross margin. Given that mix actually weighted more towards switching versus transport being down, the gross margin was down sequentially, can you talk a little bit about that and what trend we should expect there?

Gary B. Smith

Okay. In terms of -- Subu, in terms of North American -- the Tier 1 carriers, we've actually seen a pretty solid performance from North American carriers, both coming through Q4 and into Q1. And I think we have a reasonable view for calendar 2012. It's pretty positive. And as I said earlier, really, it's around the shift of spending and not just the total CapEx amount. So whilst that's interesting, and I mean broadly, I think what people are seeing is budgets are broadly sort of flattish with 2011. But from our point of view, we're actually seeing more opportunity because they're shifting it towards next-generation architectures, and we're very well placed with a number of those Tier 1 carriers. So we actually think -- our view right now is U.S. Tier 1 carriers budget's pretty solid for 2012, from where we're sitting anyway.

James E. Moylan

And with respect to margin, Subu, the mix of switching and, to some extent, CESD is always going to be a important indicator of our margin. Those products are more complicated. The competitive intensity in those products is just not quite as severe as it is in transport. So that's going to be a primary driver. But another thing that's changed about our business is that that's really not the only thing that's affecting our margin, particularly in transport. We still sell a number of platforms. We still sell CoreStream 4200, the 3000 series from the MEN line. And because those products are older, because the mix of what we sell tends to be more heavily card-weighted as opposed to commons-weighted, we can -- we're going to experience generally higher margins on those older platforms. And the mix within transport is going to be important to us and can move our margin a point or more. So without speculating what next quarter's margin is going to be, because I can tell you it's going to depend upon a lot of things, we are comfortable that it's going to be in that low 40s range. We do think that, over time, as our mix of the more complex products grows and as we add features and intelligence to our transport platforms, we are going to see better margins in the transport space but we don't see that as a near-term phenomenon. We don't think it's going to be in the next couple of quarters. [indiscernible] looking at 40s margin.

Natarajan Subrahmanyan - TheJudaGroup, Research Division

Just like to follow up. But for January itself, is it fair to say that it was more of a negative mix impact on transport even though absolute transport revenues were down sequentially and the percentage of revenue?

James E. Moylan

That is definitely true in this quarter, yes.

Gregg M. Lampf

Thanks, Subu, and thanks everyone for joining us this morning. We appreciate your taking the time, and please stop by our booth at OFC.

James E. Moylan

Thanks, everybody.

Gary B. Smith

Thanks, folks.

Operator

Ladies and gentlemen, this does conclude today's conference. You may all disconnect and have a wonderful day.

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