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Finisar Corp.(NASDAQ:FNSR)

F3Q08 (Qtr End 01/27/07) Earnings Call

March 03, 2008 5:00 pm ET

Executives

Jerry Rawls - President and CEO

Steve Workman - CFO

Analysts

Ajit Pai - Thomas Weisel

Paul Bonenfant - Morgan Keegan

Cobb Saddler - Deutsche Bank

Subu Subrahmanyan - Sanders Morris Harris Group

Patrick Callery - Piper Jaffray

Sam Dubinsky - Oppenheimer

John Harmon - Needham

Andrew Schmidt - Nyquist Capital

Operator

I'd like to welcome everyone to the Finisar Third Quarter Financial Results Conference Call. Jerry Rawls, President and Chief Executive Officer for Finisar; and Steve Workman, Chief Financial Officer, will be hosting this call. All lines have been placed on a listen-only mode to prevent any background noise. After the speakers' remarks there will be a question and answer session and questions will be taken from analysts who follow the company. (Operator Instructions)

Mr. Rawls and Mr. Workman, you may begin your conference.

Jerry Rawls

Good. Thank you Joe, and good afternoon, everyone. We appreciate your interest in our company and your taking the time to listen to our conference call today. A replay of this call should appear on our website within eight hours, an audio replay will be available for two weeks by calling 877-660-6853 for domestic or 201-612-7415 for international, enter 2791 for the account number and 276001 for the conference ID number.

I need to remind all of you that any forward-looking statements in today's discussion are subject to risks and uncertainties, which are discussed at length in our 10-K and quarterly 10-Q SEC filings.

Before we discuss our second quarter results, I want to point out that we have posted all of our GAAP and non-GAAP financial statements for the last several quarters on the investor page of our website, Finisar.com. Today, we'll focus on results from the second quarter of fiscal year 2008 but may reference some numbers from those previous quarters. Actual events and results can differ materially from these forward-looking statements.

As a reminder, we break down our revenues primarily by distance and networks applications. For example, products designed with common technology such as VSCEL lasers for short distance LAN or SAN applications. Distance of less than 500 meters are designated as LAN/SAN.

The rest of our optics products are designated as Metro. Within Metro we break out products designed for SONET/SDH applications, referring to those as Telecom. Telecom is an emerging market for us with a distinct set of customers, although both Metro and Telecom are common technologies to transmit data at distances up to 120 kilometers. More recently we have demonstrated new technologies that can cost effectively extend those distances up to several hundred kilometers, using advanced signal processing and novel optical packaging technology recently acquired from AZNA and Kodeos. So, while today our "long haul" sales are very small, we expect to introduce several new products for "long haul" in 2008 and 2009.

As we pre-announced a couple of weeks ago, revenues for the third quarter were stronger than we had originally anticipated. Total revenues of $112.7 million were up $12 million or 12% from $100.7 million in the previous quarter. This is a new record for the company, which we hope to eclipse several times in 2008 and 2009. We will talk more about this later in the call. Higher revenues in the quarter were fueled by growth in optics, particularly for our 10 gig and 40 gig products, which also reached an all-time record.

To summarize: total optics revenues of $103 million were up $12 million or 13% from $90.9 million last quarter. Total revenues for LAN/SAN applications were $55.3 million, up $4.6 million or 9% from $50.7 million last quarter. Metro revenues of $18.7 million were up $3.2 million or 19% from $16.7 million last quarter. Telecom revenues of $24.9 million were up $4.3 million or 21% from $20.6 million last quarter. Finally, revenues from Network Tools totaled $9.8 million in the third quarter, the same as the second quarter.

Revenues for 10 gig and 40 gig applications totaled $29.1 million, up $10.9 million or 60% from $18.2 million last quarter. You will recall that revenues for 10 and 40 gig products in Q2 '08 were hindered by the inability to ship certain products due to a number of firmware changes which had to be made. However, only about $2 million of the previous quarter's revenue miss was covered by a firm purchase order that rolled into Q3.

Of the $29.1 million in10 and 40 gig revenues, revenues from products designed for short distance LAN applications including the X2 SR, XFP SR, and SFP+ totaled $9.9 million, up $4.7 million from the $5.2 million last quarter. Revenues for 10 gig Metro applications, consisting of mostly of XFP transceivers, totaled $3.1 million, up $1.4 million from $1.7 million last quarter.

Finally, revenues for 10 gig Telecom applications totaled $16.1 million in the quarter. That was up $4.8 million, or 43%, from $11.3 million last quarter. Again, these Telecom sales were mostly XFP transceivers.

Other than our growth and revenues from 10 and 40 gig applications, one of the pleasant surprises coming out of this quarter's results was higher revenues for 1 through 8 gig LAN/SAN products. 8 gig revenues, in fact, surpassed $2 million this quarter and, combined with an increased demand for 8 gig test equipment out of our network tools division, leads us to believe that the SAN business may be surprisingly strong in 2008.

We also believe that the growing adoption of virtualization and data centers will increase the demand for high-speed optics in the SAN market. Out of $9.8 million in network tools revenues, test equipment for 8 gig applications nearly doubled in the quarter. Again, this quarter we had only one 10% customer.

Our top three customers accounted for 38% of total revenue compared to 28% last quarter. All three customers were up sequentially. Our top 10 customers represented 63% of total revenues versus 50% last quarter. Of course, last quarter results could be considered an anomaly.

Our top 10 customers had historically accounted for about 60% of our total revenues in any given quarter.

A breakdown of our revenues by market segment as well as for our 10 and 40 gig products can be found on the Investor Relations page of our website under the heading "Fundamentals".

I'll discuss our outlook for next quarter and beyond in a moment, but first I'll have Steve walk you through the rest of the P&L statement and the balance sheet. Steve?

Steve Workman

Thank you, Jerry. First, let me address the charges that are not included in our non-GAAP results. The largest of these is a charge of $7.4 million relating to finalizing all aspects of the option investigation and that includes $3.1 million for the actual cost of the investigation itself, an accrual of $3.9 million to adequately address any payroll tax liabilities that might arise as a result, and a non-cash charge of $400,000 related to the tender offer that was completed last quarter- to eliminate any tax issues going forward. Also, excluded is a non-cash charge of $3.3 million for stock compensation expense, a non-cash charge of $2.2 million related to the amortization of acquired developed technology and intangibles from previous acquisitions, and a non-cash charge of $1.6 million for slow moving and obsolete inventory reserves.

There was an accrual, also excluded, of $1.1 million related to an incentive payment, which was agreed to as part of the acquisitions of AZNA; a non-cash charge of $1.3 million tied to the discount on the issuance of a convertible note in 2003; and a non-cash charge of $700,000 related to tax differences.

So all these charges totaled approximately $17.3 million of which about $8 million are cash related. And of the cash charges, we already dispersed a portion of that in the last quarter. We have about $5 million remaining that will likely be dispersed over the next two quarters.

Excluding these non-cash or non-recurring items, non-GAAP gross margins improved to 38.2%, up from 37% last quarter. That improvement reflects a richer product mix with more 10 gig revenues in the quarter, even though 43% of the increase in 10 gig was in fact for shortwave products.

Operating expenses came in at $34.6 million on a non-GAAP basis. That's up $1.9 million from $32.7% last quarter. And if we look at R&D expense compared to last quarter, R&D this quarter was $17.6 million. That's up $1 million from $16.6 million last quarter. That reflects an increase in staffing and project spending related primarily to IC development activity.

And when you look at R&D expense on a year-over-year basis, which is up almost $2 million- again, non-GAAP- most of that increase is actually related to the acquisitions of AZNA and Kodeos, which didn't began hitting our results until the fourth quarter of last fiscal year. Both of those acquisitions have yet to generate a significant amount of incremental revenue, but the introduction of a number of new products toward the end of this calendar year should start to correct that situation.

G&A expense increased to $8.2 million in the quarter up $800,000 from $7.4 million the previous quarter primarily due to increased litigation expense associated with law suits involving the 505 patent for which our jury award is currently under appeal. There is in fact a total of $1.8 million in litigation expense related to this matter in these non-GAAP results. And it also accounts for the vast, vast majority of the $1.4 million year-over-year increase in G&A spending.

At this level of OpEx non-GAAP operating profit totaled $8.5 million or 7.5% of revenue. That is up from $4.5 million or 4.5% of revenue last quarter, although comparisons with last quarter are somewhat distorted due to the shipment issues related to firmware changes.

So, if we compare to the quarter before, these results are up from $5.7 million, or 5.4 % of operating margins two quarters ago. Compared to the prior year, the operating margins are down from 12.4%. Then, we saw higher gross margins of 41% and lower R&D expense.

With $1.7 million in net interest and other expenses in the quarter, pretax income and net income was about $6.8 million and $6.7 million respectively, or about $0.02 per share. And that compares to net income of $2.5 million or $0.01 per share last quarter and $0.04 per share one year ago.

Basic Shares Outstanding totaled $309 million at the end of the quarter and averaged about the same for the entire quarter. Including the dilutive effect of Options Outstanding, Diluted Shares Outstanding totaled approximately $312 million in the quarter.

Total depreciation and amortization of $6.8 million in the third quarter means we saw a non-GAAP EBITDA of $15.2 million where we spent approximately $6.7 million in CapEx.

Our cash balance at the end of January, represented by cash and short-terms investments as well as certain long-term debt securities which can be readily converted in to cash, increased to $122.4 million- up $7.5 million from $114.9 million last quarter, even as inventory increased by $4.7, mostly due to finished goods. And also this was in the face of disbursing approximately $3.9 million in the quarter for items related to the options matter.

Inventory turns were at 3.3. Compared to a year ago, inventory levels are up almost $20 million and about $8 million of that is related to more inventory being carried in the customer hubs. And despite the trend to holding more finished goods at customer's sites, we are targeting to get to four turns over the next four quarters.

In light of all the news about the subprime mortgage crisis and auction rate securities, which in many cases are becoming liquid, we undertook a review of all our investments last quarter. Our investment guidelines were developed with safety as the highest priority. We, in fact, do not own any auction rate securities and own only the highest grade of mortgage-backed securities, of which there is only a balance of about a million at the end of January. In addition, we also do not see any indications of impairment with respect to any of our money market investment, so I think we're in good shape in this regard.

Some of you may note that our cash balance in total hasn't moved that much over the last few quarters. Keep in mind that over the past year, we have spent approximately $13.9 million of our cash on two acquisitions (in Q4 '07) and over $12 million related to the total cost of the options matter, a total of $26 million. We think our ability to generate cash, even at current levels of business, should enable us to handle any maturity of the 5.25% convertible note at the end of October, but just to make sure we are in the process of finalizing the extension of our credit facility with Silicon Valley Bank to $70 million, of which we currently use very little, and that credit facility should officially be in place by the end of this week.

As we look forward, we believe OpEx should be no higher than current levels through next fiscal year and may actually decline a bit as smaller increases in R&D expense should be more than offset by lower G&A.

As for what litigation expense will be two or three quarters out, that will all depend on the final outcome of the DirecTV appeal and the challenge to our patent. However, we are recently confident that the level of activity last quarter was unusually high and it's not likely to be repeated over the next few quarters.

Now I'll let Jerry provide any further color on the top and bottom line in his final comments. Jerry?

Jerry Rawls

Thank you, Steve. On the operational side of things, we haven't talked much about China, but it's probably worth mentioning. Our Shanghai operation provides a number of passive optical components, which are used in our long wavelength transceivers. But in addition they sell passive components to the merchant market, including an interleaver for telecom DWDM applications. The total amount of merchant business exceeded $2 million in the last quarter and at the end of January there were over 500 employees working there, which is approximately 1/8th of our total worldwide workforce.

In May this year we will start to move that operation into a larger facility that has three times the square footage of our current facility. That additional space will allow us to handle the additional volume of production for AZNA transmitter [subway centers].

Regarding our outlook, in spite of questions being raised about the health of the US economy, we do not yet subscribe to the 'sky is falling' theory. In fact, we are far from it. It's not because we believe we are immune from any economic softness, but rather that we haven't seen any softness yet and most of our customers continue to be very optimistic in their outlook.

We previously predicted that our Q4 revenues would be from $110 million to $115 million. This takes into account that our third quarter may have benefited from our inability to ship approximately $2 million in 40 gig products in Q2.

Total revenue from the sale of optics should range from $100 million to $105 million with another $10 million from network tools. Within optics, revenue for 10 and 40 gig applications should increase from $29.1 million this last quarter to $30 million to $35 million next quarter, comprising most of the growth revenue.

Assuming those revenue levels for Q4 '08, we expect gross margin similar to Q3, while operating margins should improve a bit from 7.5% in Q3 to 7.5% to 8.5% in Q4. Of course, with our shares outstanding it's difficult to move the EPS very far, so we will have to stick with $0.02 a share as our EPS estimate for the quarter.

We think revenues for Q1 '09 ending in July should be between $113 and $120 million. We predict that our short wavelength SAN business will be strong that quarter with additional 10 gig revenues. We feel confident that we can continue to grow revenues in each quarter beyond Q1 '09, especially when we consider some of the trends at work in this industry in calendar year '08 and calendar year '09.

The Telecom sector: I think it is safe to assume that competitive carrier networks will continue to build in the face of stiff competition from the CATT industry. This is an addition to increase network loads driven by internet and video traffic that continue to be pulled across broadband networks.

Fiber-to-the-home deployments are expected to be robust in Europe in 2008, while at least one operator here in the US is poised to announce the winner of a recent RFP for deployments, to begin later this year.

I would point out that the opportunity for growth for us in the telecom sector has been limited by our lack of long-haul products. For the consulting firm Light Counting, the market for 10 gigabit telecom transceivers and transponders totaled $440 million in calendar year '07 and is expected to grow to over $500 million in calendar year '08.

Most of our sales in this market are XFP transceivers for Metro high-speed client-side applications. Our revenues for this market in calendar year '07 were approximately $42 million. While that's up 145% from just $16 million the year before, that's still a relatively small portion of the overall market.

And while the smaller XFP form factor is increasingly being adopted by telecom equipment suppliers, the market for the 10 gig 300 pin tunable transponder remained strong. Out of a $500 million market for 10 gig telecom products in calendar year '08, we estimate that the XFP form factor represents only about 25% of the market.

We are working hard to increase our exposure to this market opportunity through the introduction of a small form factor 300 pin transponder or 10 gig tunable applications that is based on reliable CML technology from AZNA. The technology from AZNA that helps to facilitate longer distance transmitters is the Chirp Managed Laser or CML. CML reduces the size and cost of the components needed for longer distance transmission, while reducing the power consumption.

We demonstrated this technology in two new products, at last weeks Optical Fiber Conference in San Diego. One was the first narrowly tunable 200 kilometer 10 gigabit per second DWDM XFP transceiver, or OC-192 and 10 Gigabit Ethernet applications. Second, was a 10 Gigabit per second SFP+ transceiver and operated over 50 kilometers of fiber while using less than 1.5 watts of power.

In addition to the 10 gig telecom market, we have not had any exposure as yet to the market for transceivers for fiber-to-the-home applications. We introduced a GPON transceiver for gigabit applications for this market last year and are engaged with several customers in qualifying the product.

The total market for fiber-to-the-home transceivers per Light Counting totaled over $300 million in calendar year of '07 and was expected to grow to $350 million in calendar year '08. The GPON portion of that market totaled just $27 million in CY '07, but is expected to grow to over $60 million in calendar '08 and over $100 million in calendar year '09.

While this has been a very competitive part of the telecom sector, we believe we can achieve reasonable gross margins that are comparable to our 1 gig to 8 gig LAN/SAN margins. Offering these products is very much in line with our objective to become a strategic supplier to the telecom equipment manufacturers by offering them a broader product line. To summarize, we are very excited about the prospects for growth in the telecom portion of our business both on a near-term and longer-term.

Moving to the Datacom sector, which consists of products designed for 1 Gigabit and 10 Gigabit Ethernet LAN applications, and 2, 4 and 8 Gigabit SAN applications. Our revenues for all these non-telecom applications totaled $78 million in Q3 '08, up $8 million from $70 million in the prior quarter. This is the one sector driven by enterprise spending. You might conclude that it is more susceptible to an economic slowdown.

However, let’s examine what has happened with the global supply chain that feeds this market over the last couple of years. I would point out that a substantial amount of business is now conducted through inventory hubs, whereby demand is triggered upon pulling products on a just-in-time basis from our inventory at the customer site. We are not just staring over boxes of customer-owned inventory on the shelves, as we did when the internet bubble collapsed in 2001.

More than half of our optics business is conducted through these just-in-time vendor-managed inventory hubs. While you can argue that visibility is compromised as a result of not having quite as much backlog, I think you will agree that it is probably a much healthier way of doing business. In addition, it is forcing all of us to stay closer to our customers to understand their expectations for the future. While it may fluctuate from one quarter to the next, we do not expect to see any big inventory corrections.

Our success in the datacom market has been constrained by our lack of 10-gigabit Ethernet products. The total datacom market for 10-gigabit applications alone was estimated to total $320 million in calendar year ‘08, up from a little over $250 million calendar year ‘07.

Our revenues from this space, in comparison, totaled a little over $30 million in ’07, with $13 million of that coming in just the last quarter. Whereas we had historically focused on the XFP form factor for these applications, about $10 million of our revenue in the last quarter comes from products we had just introduced and qualified in the last couple of quarters, namely X2-SR, XFP-SR and more recently the SFP+, all for short distance 10-gigabit data center applications.

There are several products, we will qualify to gain a competitive exposure to this portion of datacom market. These include the X2 LRM, for transmission of 10-gigabit signals up 220 meters over multimode fiber, which is typically found inside buildings. And the X2LR and ZR for longer distance metro applications. We will be working hard to qualify our products in the next couple of quarters. Outside of 10-Gigabits, our revenues from products for the LAN-SAN and metro applications totaled $65 million in the quarter and have a decided SAN flavor to the product mix.

This is the market that is at its beginning stages of transitioning from 4 Gigabits to 8 Gigabits. There are several factors that will have an influence on the demand for optical transceivers for this market in the future. Businesses will need to assess the impact of any slowdown with respect to their spending plans or if there is some compelling reasons to consider the deployment of new technologies to reduce the CapEx and Op Ex of data centers. And particularly, we've been trying to understand the impact of deploying virtualization in the data center, as it relates to the demand for optical transceivers.

Virtualization enables a single file server to deliver multiple applications to users at the same time, thereby increasing the utilization of that file server's CPU, which in most cases, is vastly underutilized, and increasing the utilization of bulk storage.

We are just completing a study of the impact of deploying virtualization in our own data center here in Sunnyvale, and if concluded, there will be a large increase in the number of optical ports as a result of virtualization. The reasons for this are related to the fact that virtualization wants storage to exist within a switched storage network whereas a substantial portion of a company's datacenter infrastructure is still comprised of file servers led by direct-attached storage. It turns out that most of these file servers in fact are connected to the network using copper connections. Remember that the number of copper gigabit ports sold each year in fact far surpasses the number of optical ports sold by a factor of ten.

Thus it's true that the elimination of file servers results in a drastic reduction in the number of ports, that they are mostly copper. At the same time the creation of new SANs to consolidate the storage requires more high-speed optical I/O.

In the case of our own datacenter, we found that through virtualization, we will be able to reduce the number of file servers by a factor of about 10. And in terms of ports we expect to see an 85% reduction in the number of copper ports. While the number of optical ports actually increases by 100% if we use rack servers, and 50% if we use blade servers.

Last week we announced a small minority investment in Nistica, a company which makes reconfigurable optical add/drop multiplexers or ROADMs based on MIMS technology. We also announced a sales and marketing agreement with Nistica for the sale of their ROADMs. With the majority of service providers planning to integrate ROADMs into their Metro networks, this has become an important product offering for Telecom equipment manufacturers. It's a market that already exceeds $100 million and is expected to grow 33% to 50% per year for the next several years and according to DellOro could reach $750 million by 2011.

With Nistica's full fledge ROADM scheduled for introduction later this fall, equipment manufacturers will be able to offer the capability of adding or dropping any arbitrate grouping of up to 48 channels, contiguous or not, in Metro edge and Metro core DWDM networks. With the help of our sales and distribution channel, we believe Nistica is poised to make a very successful foray into this portion of Telecom business.

Overall, our customer demand remains strong. We think 2008 and our fiscal '09 will be a better year than 2007 and our fiscal '08.

At this time, I would like to turn the microphone back over to Joe and we will entertain questions. Joe?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Ajit Pai from Thomas Weisel. Please go ahead with your question.

Ajit Pai - Thomas Weisel

Yeah. Good afternoon.

Jerry Rawls

Good afternoon, Ajit.

Ajit Pai - Thomas Weisel

Couple of quick questions, I think the first one is about the margin environment, both on the Short Reach application as well as some of the Metro and longer ones that you're targeting. Could you give us some color as to what the pricing environment is? Whether it's accelerated, declined to accelerate or relatively stable with what is happening last year?

Jerry Rawls

In our markets, almost all of it makes no difference where we are. Prices come down continuously and just a way of life of being a component supplier. And in the shortwave business, our margins have -- they continue to asymptotically approach some level that they are not there yet, but they continue to decline. But they are declining at a percentage rate that is less than it was a couple years ago. So, it's not pleasant to have your prices decline, but on the other hand the challenge for us in order to improve our overall gross margins is to make sure that we can reduce our manufacturing cost at rates that equal to or faster than the price declines and so far we've been able to do that.

Ajit Pai - Thomas Weisel

Right. And then when you're looking at the competitor dynamics, you're entering markets being much more active in telecom, but there are already some significant entrenched players that have share there. Can you give your strategy of being able to penetrate that market and also the ROADM market that you've just mentioned about through your minority investment, how aggressive do you intend to be in that market right now?

Jerry Rawls

Well, we try to be aggressive in every market that we enter. If I think about our telecom strategy overall, what our plan there is to try to enter the market with products that have higher levels of performance. We'd like to be able to longer use our CML technology from AZNA for example to be able to transmit longer distances and compete with lithium niobate external modulators. So, we'd have a cost advantage, a size advantage and a power advantage.

And I don't think that's any different than what we do in most markets that we enter is that we're always trying to introduce products that have some performance edge or performance advantage.

Ajit Pai - Thomas Weisel

Right.

Jerry Rawls

And with respect to the ROADMs, yes, we expect to be aggressive there. It's a new market for us. Our sales force is learning about the market. These are new products. There is the need for engagement with the service providers as well as with the telecom equipment companies. But I think it's an area that all of our sales guys are excited about because they view it as one of the rapid growths.

Ajit Pai - Thomas Weisel

Right. And you are going to move so far, when you're moving into telecom as well as other areas have been both inorganic and organic, is there any reason to believe that pattern will change over the next 12 to 18 months?

Steve Workman

No. I suspect those are the only two ways I think we're going to grow.

Ajit Pai - Thomas Weisel

Yeah. But it's going to be a combination of the two in a similar manner that you've been executing over the past maybe three years?

Steve Workman

Yeah. It will be difficult for me to predict where we're in organic growth at this point. But for sure, we'll consider acquisitions as well as developing products inside the company.

Ajit Pai - Thomas Weisel

Got it. Thank you so much.

Steve Workman

Thank you, Ajit.

Operator

Our next question is from Paul Bonenfant with Morgan Keegan. Please go ahead with your question.

Paul Bonenfant - Morgan Keegan

Yes. Hi, thank you. I was wondering if I could start with a housekeeping question. Your top customer, did you disclose what percentage of revenue that was this quarter?

Steve Workman

We do not. We normally don't. It's included in our 10-K every year. But we've had some requests in the past by customers, who ask us not to disclose customer names in our quarterly reports because it enables people to track their business or raised other questions that they weren't comfortable with. So, in deference to our customers we've said we just don't disclose customers in the quarterly reports.

Paul Bonenfant - Morgan Keegan

Okay, fair enough. And regarding your typical top customer and commentary from the CEO that there has been softening in the enterprise. It seems like your visibility has improved, you're rather bullish about your future here even with regard to the enterprise and many of us, who are scratching our heads because there seems to be disconnect there? Can you help us connect the lines?

Steve Workman

Well, we sell a lot of products to our largest customer many of which go into enterprise switching applications. But the fastest growing part of that is 10-gigabit, and so though there may be some slowing in the area, the explosive growth of their 10-gigabit business is very impressive. And but all the rest of the business including storage, including routers and etcetera all seem to be doing pretty well.

Paul Bonenfant - Morgan Keegan

Okay and your inventory, the charge that you took this quarter, I was wondering if you could define, and again I apologize if I missed it, what you mean by slow moving, which segment this refers to and maybe if you could give us some mix of products?

Jerry Rawls

That is based on a historical twelve month trailing view of the usage of these parts; it does not take any consideration what may happen going forward. So it is kind of a [pulp of many] a thing on a balance of the $80 million in inventory that we took a charge of $1.6 million. That does not mean we actually threw it away. We set aside a reserve and said, for our policy that if it is -- based on the historical usage if we have an amount that could last longer than twelve months, so reserve is part of that. Historically the actual amount of the churn we churn away have been quite a bit less than what we have set up as a reserve.

Paul Bonenfant - Morgan Keegan

So there is no precipitous decline in any particular segment?

Jerry Rawls

No, no, no. This is an arithmetic calculation. It is done in conjunction with Ernst & Young at the end of every quarter. I mean, it literally simply looks back twelve months and says if you have this resistor or that laser or something in stock and the products in which it was used you have more than twelve months looking back of product available. Then you have to take an excess of obsolescence charge or everything in excess of twelve months. On the other hand if it happens to be in a growing segment and in the next year you expect that segment of your business to grow rapidly, they clearly are not things that we're going to throw away but you would still have to take the charge based on formula of this arithmetic formulae.

Paul Bonenfant - Morgan Keegan

I understand. Okay, and one last question if I may, with regard to your operating model, your long-term targets, I'm wondering if you have any updates there in particular to the individual targets for gross margin, operating margin and what the run-rate might need to be to get there?

Steve Workman

Well. I think we talked in the past about an ultimate target of 15% operating margins and I think Jerry mentioned in the last earnings call that it would take somewhere around $140 million to do that. As we think about it, we think that's still kind of the right way of thinking about order magnitude, what it is going to take to get there. I think the current pricing environment might make it a little more difficult to do that this, in this coming year, but will certainly see double-digits in fiscal '09.

Paul Bonenfant - Morgan Keegan

Okay. Thank you for taking my questions.

Jerry Rawls

Thank you Paul.

Operator

The next question is from Cobb Saddler with Deutsche Bank. Please go ahead with your question.

Cobb Saddler - Deutsche Bank

Thanks a lot. Just had a couple of questions. First on the DIRECTV litigation, both on the award site as well as the expense, I mean, you mentioned there may be a couple of quarters out that could reduce some. And I guess that would be, are you pointing some sort of end in the process two quarters out, just give us a general update there? Thanks a lot.

Jerry Rawls

Well. We hope that we are getting close to the end of the process. The Federal Circuit Court heard the DIRECTTV appeal. I think it was January the 7th, was the date. And its interesting that one other case that was heard on the same day as ours received-- I think it was last week a written opinion. So we are optimistic that over the next few weeks, month or two. We would expect to see PIN in and ours and we're optimistic that it would be in our favor, but that's about all I can report; that we're waiting for the verdict.

Cobb Saddler - Deutsche Bank

Can you remind us what the expense associated per quarter with the litigation is roughly and it would fully go away?

Steve Workman

It was actually $1.8 million in this last quarter, which accounted for most of the uptick. I think the activity was particularly strong because there were actually two law suits that were very active this past quarter unrelated to DirecTV, but regarding to 505 patent, we just don't think that level of activity is going to reoccur in the near future.

Cobb Saddler - Deutsche Bank

Okay, great. Then a business question, SFP+, could you comment on roughly how the market is developing, it's developing faster than you thought. How are you positioned there? And then I'll have a follow up. Thanks a lot.

Steve Workman

Well, SFP+ for me anyway, I think its developing faster than I expected. Revenues have grown very, very nicely with a number of customers both for 10 gigabit Ethernet and for 8 gigabit Fiber Channel. So, we expect that it's going to be a mainstream product because it offers really excellent density and low power so.

Cobb Saddler - Deutsche Bank

And how do you feel about the -- at the major customers, I guess there's been one player, which already has been qualified. They haven't had their own VCSEL. Do you think the fact that you do have your VCSEL positions you better to be SFP+ at the major vendors and/or what do you think the time of that may be. And I guess the final question is how many you think overall vendors will be qualified for SFP+. Thanks a lot.

Jerry Rawls

Well, we have been qualified at several places with SFP+, at several major OEMs. And everywhere we submitted products, we didn't qualify so far. So I'm very optimistic about that. We have a good product. And how many suppliers will get qualified and most of the major OEMs you will see either two or three, but how many total in the industry might you see worldwide, I couldn't even venture a guess.

Cobb Saddler - Deutsche Bank

Of the $5 million increase in 10 gig WAN, whether [sneak] a portion of that SFP + this quarter, or do you breakout that if you have in front of you, if you don't I'll follow-up with you later?

Jerry Rawls

I don't have it broken out, but it was a significant portion of that.

Cobb Saddler - Deutsche Bank

Great, thanks a lot.

Jerry Rawls

Thanks, Cobb

Operator

The next question is from Subu Subrahmanyan. Please go ahead with your question.

Subu Subrahmanyan - Sanders Morris Harris Group

Thank you. My question was on Cisco specifically. They're coming in Modular switch arrangements; your exposure has been significantly traditional on the 1 gig side. You're gaining share on 10 gig and I was wondering how those two you expect to offset each other and then given the storage 10 gig and 40 gig are growing and your guidance is just relatively flat revenues. I'm wondering if you are expecting some weakness on the 1 gig side?

Jerry Rawls

I just have to say Subu, I think I agree with your premise that Enterprise Ethernet switching I mean if our largest customers say that, it's likely to be weak then I will not disagree with them, it's likely to be weak. But on the other hand, I also know that as I pointed out earlier that 10 Gigabit market is still growing very rapidly and I'm very hopeful that will offset any decline in the 1 Gigabit Ethernet market.

Jerry Rawls

Just a little more color there. If you take this quarter's result and back out telecom, back out 10 gig, you've an optics revenue of about $65 million. About $8 million-ish or so is associated with 1 gig products but the substantial -- there is a lot more that I think is tied to the SAN industry.

Subu Subrahmanyan -Sanders Morris Harris Group

Good. And just a follow-up question on your comments on Kodeos and AZNA, are you expecting revenues from those to start contributing in kind of the end of calendar '08 timeframe, and did I hear you right, Jerry that after the 1Q guidance you provided for fiscal '09, you expect sequential growth through the course of fiscal '09 offered that 1Q number?

Jerry Rawls

The answer is yes, and yes. We're optimistic. We think we'll have revenues from products based on AZNA's Chirp Managed Lasers in the second half of calendar year '08 and we expect sequential growth as far as the horizon as we can see.

Subu Subrahmanyan -Sanders Morris Harris Group

Great, thank you very much.

Jerry Rawls

Thank you.

Operator

The next question is from Patrick Callery with Piper Jaffray. Please go ahead with your question.

Patrick Callery - Piper Jaffray

Hey guys thanks for taking my call. Wondered if I could get you to talk a little bit more about the Nistica agreement, in terms of what that means for you as far as margins going is it a pure reselling thing.

Jerry Rawls

It's a pure reselling agreement. So, we're selling their products into the telecom space on a distribution margin basis and for us we generate margin but we also generate exposure understanding and the opportunity to get involved with not only the telecom OEMs but also with the service providers. So I think it's an important way for us to get our feet wet and also to develop a close relationship with Nistica, who we think as up and coming company in this area.

Patrick Callery - Piper Jaffray

Right. And so further to that kind of what's your outlook on that market. I mean it's obviously a market that a lot of your competitors have been jumping into. What's your feel on the competitive situation and where do you guys have a compelling sales strategy with respect to this company's product?

Jerry Rawls

Well, I think there are a lot of good companies that have ROADM products and a lot of them were just emerging and the market is just emerging, the market is starting to take off. But I think, like any telecom market it's driven by performance and cost. And I think one of the things that the Nistica team offers is excellent performance levels and defined by all respects that the industry has. But with costs point that I think they will be very competitive. So, I think they are going to be a very competitive offering.

Patrick Callery - Piper Jaffray

Okay, great. Then if I could also touch in on another one of the new products you've the GPON transceivers coming out obviously those have been working for you in call for a few months now. Any idea when you might start seeing those, ramp up and maybe some comments on the competitive situation of that market?

Jerry Rawls

We expect that we'll see GPON revenues in the second half of calendar year '08. It's possible it could happen earlier. But right now I think that's expected. It's a new area for us and we've to make sure that our GPON offering interoperates with every other GPON offering that any particular customer currently uses. So there is a lot of, not only it is just your optics torture testing that we have to go through where you heat them and burn them and shake them and do all that, but there is also this interoperability systems testing that goes on which has a lot to do with software and firmware and interesting exchanges that occur when it normally takes place.

But anyway, but we are working on it aggressively and it takes a while to go through it. But we are very optimistic. We are going to start substantial revenues in the second half. I believe our hope is anyway that margins are going to turn out to be better than we expected. The only way this is going to happen is that we are going to able to build these things more effectively, higher yields and lower total cost of manufacturing than what we may we have originally expected. But we are really, we are feeling pretty good about it right now that our margins are going to be about like our LAN/SAN margins are and I mean that is at the lower end of our total margin spectrum. But nevertheless nicely profitable and the volume will contribute to all parts of the business.

Patrick Callery - Piper Jaffray

Great. Thanks, Jerry. And then if I could just one more on this same theme, you guys have been, have introduced the Chirp Managed Laser technology for long reach. Comment a little bit about, since this kind of a new technology, what is then the reception you guys have had as far as the customer base and potential for implementing that or adopting it?

Jerry Rawls

Well customer response has been very enthusiastic because customers always like any way that they can get higher performance at lower cost and lower power and smaller packages. So that is what CML is all about and we had a lot of interest at OFC and our demonstrations there. We have a number of engagements with the customers where in sharing our roadmaps, one of the things that you do these days as you become a “strategic supplier” for the industry, the big OEMs all want to match your roadmap, for your products, to the roadmap they have for their products and to make sure that you are compatible souls and that you are supporting their product development. And there is lots of interesting enthusiasm watching our CML products come out later this year in to end in the next. We feel good about it.

Patrick Callery - Piper Jaffray

Great, thanks very much.

Jerry Rawls

Thanks Patrick

Operator

The next question is from Sam Dubinsky with Oppenheimer. Please go ahead with the question.

Sam Dubinsky - Oppenheimer

Hi guys. Just have a couple of quick questions. Could you just comment on the lead time environment and visibility and sort of what gives you confidence that you have some growth renewed in the July quarter and then I've a quick follow-up?

Jerry Rawls

Well, lead times are relatively short in the industry sort of in all areas; we run factories that have really short cycle times. So, three to four weeks, we run things through there. And most lead times in the industry today are sure less than eight weeks. But if you look at a lot of the lead times, if you look at that the segment of the LAN/SAN business mostly, that's where we have the majority of this just-in-time inventory hubs. You can argue there that the lead time is zero, and its -- on a date they need it, they pull it, and now, we get notified that that product has been pulled from the inventory and then we replenish it back into -- and replenish the hub to its minimum level and off we go. So, this is an area right now we are -- you can argue about these hubs is that, we don't have as much visibility as we used to have at some levels because we don't have much backlog for all that business that now goes through hubs we have virtually no backlog. But on the other hand we do have a lot of information that comes from our customers with respect to their forecast and their production plans.

Sam Dubinsky - Oppenheimer

Okay great. Thank you. And a follow up, now that 8 gig Fiber Channel is expected to ramp in this year and next. Is the Storage business becoming more strategic to you or is it still not strategic and also have you guys evaluated the profitability of the business and maybe can comment on that?

Jerry Rawls

Well, the Storage business is strategic for us because we're the number one in market share in that business and it would be hard for us to not define it is being strategic for us.

Sam Dubinsky - Oppenheimer

The test business I mean.

Jerry Rawls

Okay.

Sam Dubinsky - Oppenheimer

I'm sorry the test business.

Jerry Rawls

That's the one word that was lead to.

Sam Dubinsky - Oppenheimer

Yes, my apology.

Jerry Rawls

That's alright. 8 gig test is actually doing quite well and as we indicated in the call, it was the largest segment of revenue in the network, in our network tool segment last quarter. So, we feel pretty good about it. We feel that we're likely to see some growth over this next fiscal year.

We're not going to beat on the table and claim any victories in advance because it's one of these places, where we have we thought we were going to create growth last year and our business was flat throughout the year. So, we have a number of new product introductions both in 8 gigabit Fiber Channel, 6 gigabit SAS and SATA, PCI Express. There's a number of storage protocols that for which we will have new protocol analyzers, data generators, programmed air insertion systems and we think that the combination of all that will give us an opportunity to grow that business.

And the business is strategic to us in a sense that as part of the storage industry, we engaged with our customers earlier in the Test business, when they are designing new products, then we do in the Optics business. So, in the theory that it is always good to touch your customers and as in many places as you can being able to get engaged with the Test business early in the cycle, in their product cycles and then with optics later in the product cycles and stay engaged, I think overall has got to be positive for us. So, as long as we can maintain hope that we can grow that business, I think we're going to think it's very strategic.

Sam Dubinsky - Oppenheimer

What were the impediments, this is my last question, what were the impediments to growth in the past, so just you have the full product portfolio that is issue of a not the biggest sales force of channel and just maybe discuss how that is different when we go to 8 gigabit?

Jerry Rawls

We had very focused product line. It was focused on Fiber Channel and the SAN. Yes, we were number one in market share in that business, but most of our growth came on technology introduction cycle. And so as 1 gigabit SANs were maturing and 2 gigabit was taking over -- we were selling new equipment, equipped the labs with 2 gigabits and the 2 gigabit was declining and 4 gigabit was ramping. It was the same story and now its 4 to 8.

But on the other hand, we really didn't have products in much of any other area. And the thing we have been trying to do here over the last year or two is being able to design products that are useful for some of our storage customers in other areas in the SAS, all these protocols that I mentioned earlier. So, our strategy for growth right now is to provide a larger product line that covers more storage protocols and more customers frankly because all the SAN customers don't use all those protocols.

Sam Dubinsky - Oppenheimer

Okay, thank you.

Jerry Rawls

Thank you.

Operator

The next question is from John Harmon with Needham. Please go ahead with the question.

John Harmon - Needham

Hi, good afternoon.

Jerry Rawls

Hi, John.

John Harmon - Needham

This is just more a strategy question. This call for the first time you talked about long-haul products and you moved into ROADM, is your move into having the footprint in more of a traditional optics provider is this just the next stage in the organic evolution of the company or is this a way to stay popular with your big customers that are narrowing their number of suppliers?

Jerry Rawls

I think it's probably both. If we go back to the collapse of the Internet Bubble in 2001, and at that point we had virtually no telecom customers and all the telecom customers we added since then, as they started to use pluggable optics on the client side of their transport systems. So, for us to continue to grow that business with the telecom companies; we had to continue to broaden our product line and the obvious place is to move from the client side to the line side.

But as you point out, making our customers happy is always important to us and one of the things that as our customers view us favorably and give us status as an approved supplier and then a preferred supplier one of the things that comes with that are the words we'd like you to have a broader product line.

Because virtually all of the large OEMs want to have fewer and fewer suppliers, because that makes their supply chain more efficient and we'd like to be in a position to be one of those suppliers.

John Harmon - Needham

Okay, okay. Thank you. You were talking about your passive component business being about $2 million a quarter. I'm wondering in where in your breakdown do you include that revenue and you also sell some other 10 gig components to other vendors. Where do you include that revenue and maybe you could roughly ballpark it's size?

Steve Workman

It all appears under optics. The components that we might sell at 10 gig are not included in the 10 gig revenues that we talked about, that's buried in the LAN/SAN business actually. The passive components so that to me and I believe that's in the telecom sector.

John Harmon - Needham

Okay, great. Thank you. I just want to confirm one thing, the GPON transceivers that you're developing, you still fully developing for the central office side and not for the line side, and do you see any need or desire to do so?

Steve Workman

Well, we've a GPON OLT and a GPON ONU.

John Harmon - Needham

Okay.

Steve Workman

And we're currently in qualification with the OLT and we're either just about to go into qualification with the ONU at a major customer or we will just win I mean, we just submitted samples, I mean, that's very close. So, we're going to be a supplier on both ends. Though clearly, the first and the highest priority is for the OLT because that end serves all of the distribution. So, it's either, today its 32 clients get served from the single OLT. So, it's a high-performance product, where the service provider demands a lot of reliability for that product.

John Harmon - Needham

Got it, thank you. And just finally, you are talking about R&D expenses ticking up about $1 million in the quarter for chip development expenses. I believe you develop your own chips [at your] 40 gig transponder. Just given probably the highest expense arising from the high technical requirements is that something you're intend to continue to do?

Jerry Rawls

Yes. IC development for our transceivers is we think it's important to us. It's important for our performance, but it's also important for cost. We don't design all the chips that are used in our optical transceivers, we design most of the ones that are used in our high volume transceivers and some low volume flavors of these devices we'll sometime -- we'll buy a merchant semiconductors.

But for us to be able to tune the performance of a transmitter or a receiver by the inclusion of one of our ICs and we're you are able to go to foundry to have them manufactured and to achieve the efficiencies from doing that we think is really important for our future.

And in some cases, one of the things that happens as you're developing these products, you run into periods when if you've a number of them that are being taped out, you end with mass costs et cetera that are -- that can get reasonably expensive. But we do the make buy analysis on each one of them to understand its worth -- is it worth our effort to go spend the development dollars and the tooling dollars, the mass cost to be able to produce an IC and will it pay for itself, so.

John Harmon - Needham

Great, thank you very much.

Jerry Rawls

Thanks, John.

Operator

(Operator Instructions) Our next question is from Andrew Schmidt with Night Quest Capital. Please go ahead with the question.

Andrew Schmidt - Night Quest Capital

A quick question on the GPON product, is that something where you guys are developing a more of a diplexer based ONU or a triplexer based ONU?

Jerry Rawls

Triplexer.

Operator

There are no further questions in queue. I would like to turn the call back over to management for closing comments.

Jerry Rawls

Well, I thank all of you for tuning in today. It was a good quarter. I hope that and we expect the next one is going to be a good quarter as well. And we hope that all of you are back here one quarter from now same time same station. So, have a good day. Thank you.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Finisar Corp. F3Q08 (Qtr End 01/27/07) Earnings Call Transcript
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