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Executives

Brooke Deterline – IR

Jo Major – Chairman, President and CEO

Marla Sanchez – SVP and CFO

Analysts

Tim Savageaux – Merriman

Todd Koffman – Raymond James

John Harmon – Needham & Co.

Patrick Callery – Piper Jaffray

Sam Dubinsky – Oppenheimer

Stuart Moore [ph] – Thomas Weisel

Avanex Corporation (AVNX) Q3 2008 Earnings Call Transcript May 1, 2008 4:30 PM ET

Operator

Welcome to the Avanex Corporation third quarter fiscal year 2008 conference call. Just a reminder today's conference is being recorded. Now at this time, I will turn things over to Ms. Brooke Deterline, Senior Director, Investor Relations. Brooke, please go ahead.

Brooke Deterline

Thank you. Good afternoon and thank you for joining us today. I would like to remind you that this call contains forward-looking statements about our expectations, future events, and the performance of the company. Forward-looking statements are subject to risks and uncertainties and actual results could differ materially from those projected or contemplated by the forward-looking statements. We encourage you to look at the company's most recent SEC filings, particularly today's earnings release, Form 8-K, and the ‘Risk Factors' section of our most recent Form 10-K and Form 10-Q.

Avanex assumes no obligation and does not intend to update any forward-looking statements, including guidance as a result of new developments or otherwise. In addition, because non-GAAP information is presented on today's call, and in order to comply with SEC regulation, please note that Avanex has provided a reconciliation table and other information attached to today's earnings release which can be found on the company's Web site at www.avanex.com. I would like to take this opportunity to inform you that the company will present at the Oppenheimer Annual Communications & Technology Conference on June 3 in Boston. As events are scheduled during the quarter, we will make additional announcements.

With that I would like to turn the call over to Jo Major, Chairman, President and CEO. Jo?

Jo Major

Thanks, Brooke. Good afternoon, everyone, and welcome to our third quarter earnings call. We made significant progress on our growth strategy on multiple fronts. Our product initiatives have continued to gain traction at new and existing customers driving our revenue to the high end of our guidance. Execution was crisp in the quarter as we achieved or beat the high end of our internal targets. We recorded one of our highest design win quarters in the company's history with several design wins for important platforms in new market segments. I'll speak more about our design wins in a moment.

Fiscal third quarter revenue is $50 million. Gross margins were 32%. We expanded profitability and continued generating cash. Revenue growth was driven primarily by strength in our amplification products. Geographically, we saw revenue growth in the Pac Rim area driven by the approach of the Olympic Games in China. As we work towards our target of doubling our revenue by 2011, we expect half of our growth to come from markets we are entering in 2007 and 2008. We continue to invest in technology as evidenced by several important patents awarded during the quarter.

In addition, we are excited by a number of R&D initiatives that will serve to further strengthen our position as a competitive leader in the marketplace. As a definition, Avanex measures design wins by the revenue anticipated in the first 18 months of production. The design win is actually only recorded when all qualification work is done and the product is being purchased for deployment.

Now, I would like to review our performance by category. Please note that we have added a new chart on our Web site illustrating the growth in our served markets as we move forward. All market sizes are annual and reflect our serviceable market. The first is transmission. Included in this category are transceivers, transponders, modulators, and tunable dispersion compensators for 40-gig applications. We see transmission as a $600 million market opportunity growing to $1.1 billion by 2011. Transmission revenue was $15 million in the quarter. Design win performance in transmission was strong and represented over 50% of our total design wins during the quarter.

Of particular importance is that we secured a significant allocation of what we believe to be the largest tunable transponders slot in the world. Within transmission, approximately 90% of our design wins are colorless or tunable products addressing next-generation networks. In addition, we are now seeing design wins secured for 40-gig transmission applications.

The second category is amplification products. Amplification, which includes sophisticated control amplifiers, low-cost gain blocks and integrated optical performance monitoring is currently a $300 million market opportunity with a CAGR going forward of approximately 18%. Total revenue in this category for the quarter was $24 million. Amplifiers – amplification comprised approximately 30% over design win dollars during the quarter. We anticipate that our Oasis platform and our low-cost gain blocks will drive significant design wins over the coming quarters.

The third category is Wavelength Management, which includes both static and reconfigurable wavelength routing and switching. We see wavelength management as a $250 million market opportunity with CAGR driven by ROADM expansion of approximately 15%. Total revenue in this category for the quarter was $5 million.

Avanex's strategy is to provide a full portfolio of ROADM solutions selling at a variety of levels of integration that offer expanding revenue opportunities over the long term. Our goal is to be the cost leader for switching architectures. Revenue from our ROADM applications has begun, we expect that wavelength management design wins and revenue will provide vigorous growth in the coming fiscal year and beyond.

In line dispersion management revenue in the quarter was $6 million, the size of this market is $100 million growing at 14% CAGR. Fixed dispersion compensation is a relatively mature market and not a large focus for our investment dollars. Using tunable dispersion compensation for in-line applications is a potential growth area for the company. As you can see from these categories and our results, investments are translating into design wins that are fueling future growth for the company.

Now I would like to turn the call over to Marla to discuss our financials.

Marla Sanchez

Thanks, Jo. Net revenue for the third quarter was $49.6 million, down 5% from $52 million last quarter and down 10% from $55.1 million in the same period last year. On a comparative basis, removing 3S Photonics distribution revenue from the December quarter, our core business grew 2% sequentially. This is significant given that we experienced the greatest ASP pressure during our March quarter. As we previously stated, the ASP decline for the quarter was 9%.

On a geographic basis, revenue from North America was $21.1 million, Europe was $18.6 million, and the Pacific Rim was $9.9 million. Growth was primarily driven by strength in our amplifier and gain block products. Customers with greater than 10% revenue in the quarter were Alcatel Lucent at 25% and Tellabs at 23%. Other strong customers were would Huawei and Sienna, both approaching the 10% mark.

Gross margin for the quarter was 32% compared to 31% in the prior quarter and 19% in the same period last year. Gross margin improvements were driven by the contribution for new product platforms, continued cost reduction, improvements in manufacturing variances, and higher revenue. Without a product credit, relating to 3S Photonics, gross margin would have been approximately 31%. We expect gross margins to remain relatively stable next quarter.

Total operating expenses for the third quarter were $14.1 million or 29% of revenue. This compares to $16.9 million or 32% of revenue last quarter, and $17.1 million or 31% of revenue in the same period last year. The sequential decrease in operating expenses was driven by a slight decline in R&D due to prototype shipments and favorable G&A trends such as spending reductions on legal and outside service fees. We achieved a one-time benefit of $2 million on the return of escrow funds from 3S Photonics. We anticipate R&D to drift down slightly as a percent of sales as we leverage our existing R&D dollars. We will continue to invest in new optical technologies in the growing market opportunities.

Starting next quarter and longer term, we expect operating expenses to continue declining as a percent of sales as we reap the benefits from our long-term structural changes including moving transaction based functions to lower cost areas and changing service providers.

Operating income in the third quarter was $2 million, up from a loss of $0.8 million last quarter and up from a loss of $6.8 million in the same period last year. After net interest and other income, of $1.3 million, net income was $3.3 million or $0.01 per diluted share for the third quarter. This compares to net income of $86,000 or breakeven per diluted share last quarter and a net loss of $6.7 million or a loss of $0.03 per diluted share for the same period last year.

On a non-GAAP basis, net income for the third quarter amounted to $2.9 million or gain of $0.01 per diluted share compared to $2.4 million or $0.01 per diluted share last quarter. This compares to a net loss of $3 million or $0.01 loss per diluted share for the same period last year. This is a major milestone for us as it marks our one year anniversary of being profitable on a non-GAAP basis. This puts us in a unique position for our industry.

We ended the quarter with total cash of $54 million, an increase of $1 million from the second quarter. Inventory decreased by 8% to $15.6 million because of decreased finished goods levels. We may need to increase our inventory level slightly to provide customers a shorter lead time. At the end of the quarter, our headcount was 555, down slightly from 564 last quarter. This includes 44 temporary employees and/or consultants.

Following the quarter, the Board of Directors approved an Officer and Director Share Purchase Plan with an initial 2 million shares made available for purchase. This plan allows Executive Officers and Directors to purchase shares of the company's common stock at fair market value in lieu of salary or in the case of Directors', retainer fees.

Purchases under this plan will commence in May 2008. This plan is in conjunction with the program we announced last quarter, where we adopted stock ownership guidelines for our Executive Officers and Directors. Within this program, Officers and Directors are required to hold significant equity stakes in the company. These plans illustrate management's belief in and commitment to shareholder value.

With that I will turn it back to Jo, who'll discuss our outlook for the next quarter.

Jo Major

Thanks, Marla. Let me turn to the outlook for our fourth quarter. We expect revenue to be in the range of $50 million to $53 million. We anticipate that gross margins will stay consistent at approximately 29% to 32%.

In summary, we made solid progress in the execution of our growth strategy this quarter and are excited by the design wins from key customers in key new markets. We are quite pleased with our internal performance and our new product portfolio. In the larger market ordering trends are normalizing but visibility remains limited. We believe that most of our customers anticipate growing modestly this year. During the last several quarters, we engineered the company to turn revenues into long-term profits. As our focus now turns to doubling our SAM by 2011 we are well-positioned to enter new markets and grow overall share. With that, I would like to turn it over to the operator for questions. Thank you.

Question-and-Answer Session

Operator

Thank you, Mr. Major. (Operator instructions) We'll pause for just a moment to allow everyone a chance to respond. And also just a reminder, everyone, please limit yourself to two questions initially, and time permitting we'll take follow-up questions. We'll take our first question from Tim Savageaux of Merriman.

Tim Savageaux – Merriman

Hi, good afternoon, and nice a quarter and a nice outlook.

Jo Major

Hi, Tim. Thanks.

Tim Savageaux – Merriman

Question on the design win front. You seemed close to creeping up towards quantifying some of those, and given the criteria for what you define as design wins and also, thanks for the granularity in terms of product line breakout and reporting, that's very helpful. But as you look at your design win pipeline is there any more color you can give us around financial metrics in the aggregate of what you saw or just raw number of design wins beyond what you discussed already? Thanks.

Jo Major

Sure. First, design wins are a metric that gives forward guidance. I think we are real comfortable with the design wins that we see this quarter or the last quarter, Tim, and the quarter that we are in are both going to be very nice, very strong quarters and very capable of driving growth for the company. A couple of things and we want to make sure that we provide you as much color as we can. Sometimes design wins, the programs go away. Sometimes our customers don't quite get the sockets they want so the design win numbers don't always directly turn into revenue dollars and they're not as predictive as we would like, but we've got a number of new slots. We got a lot of new slots in places where they're very much next-generation networks.

A lot of those are tunable or colorless or switching fabric stuff. A lot of those design wins were in markets we have been investing in to enter into new segments of the market. So, that aspect of those design wins feels really good to us. I guess the last thing I would like to reinforce is when we look at design wins, there's a strict criteria in the company that we apply; and that is we really have to be shipping the things for revenue before we declare the victory and record it as a design win. So, these things are actually – when we talk about design wins that meant in the quarter we were shipping product into tens of new slots, and those product weren't going into qualification or anything, they were actually going in to carry live traffic. So, it really is the leading edge of a lot of new revenue in a company.

Tim Savageaux – Merriman

Okay, and if I could follow-up on the gross margin line, obviously I think you outperformed your guidance and expectations by a wide margin. I wonder if you could talk about the drivers there. Obviously you did you see overall revenue down both sequentially and year over year and yet some pretty strong performance there, so what were your key drivers there, and then one final question and I'll sign off. I don't know that we've heard a whole lot about Sienna previously on your calls, perhaps we have, but if you could talk maybe about what's driving your business there?

Marla Sanchez

Okay. Thank you, Tim. I'll start off with the gross margin for the quarter, where we ended up seeing some improvements that were a little bit better than what we had originally expected when we gave guidance in the past were primarily in areas relative to our purchase price variance. We did better than we had expected there and also relative to our excess and obsolete programs. A lot of our new platforms are starting to kick in. They came in fairly strong. We had been anticipating that they would end up helping us in the gross margin line as we had been discussing in the past but we did end up seeing very strong benefit from them this quarter.

Jo Major

Yes, and Tim, I think the follow-on to that question might be, well actually a fourth question for your quota or two.

Tim Savageaux – Merriman

I must have missed that.

Jo Major

That's okay, I'm just teasing. I think one other things that's important, that when we talk about gross margins is it's mix-driven, and we have given long-term goals. A couple things are happening in the company that we are watching really closely. One is, at times people are seeking to purchase modules from us. At times they're kicking us up to providing full sub-systems for them and the margin performance is a little different there because you are selling at such a higher revenue point for the Subsystem than you are for the module. Typically the module has higher margin performance but from a total margin dollar perspective, you are much more strategically inclined to go get the full Subsystem. So, that we are seeing match, mix and play. We are also seeing the transmission products ramp very, very quickly and they have modestly lower margin producing capability right now in the company than some of the other products. So, when we are giving the outlook on guidance, or when we are giving the guidance on margin, rather that range that you see a big part of that comes from the fact that we are seeing mix of the company change. We are seeing a mix that pulls us to more Subsystems. We're also seeing a mix where we're getting a lot of revenue traction in transmission. As far as Sienna, Sienna sometimes it has been up in the 10%. The last few quarters, they haven't; but a lot of this is Sienna gets a few new programs that use the products we've got. We are there to provide it for them, and we run like mad with them, and they had a really good quarter. Huawei has been growing a little bit more consistently, we've been talking about Huawei now for a couple of quarters in a row and there is a big focus on expanding our footprint there.

Tim Savageaux – Merriman

Yes. Thanks a lot.

Jo Major

Sure, thank you.

Operator

And we'll take our next question now from Todd Koffman of Raymond James.

Todd Koffman – Raymond James

Thank you, and good quarter. Congratulations on a good quarter, and it's really refreshing to see that the product segment breakdown. I want to ask you about end market demand. When you look at your addressable market growth rates that you pointed out, and then you reconcile them with near-term customer project deployment plans, the next say, two or three quarters, do those seem to reasonably reconcile? Or is there some sort of technology inflection point a few quarters away which you think accelerates the market?

Jo Major

So, Todd, the way that we view – and we'll be happy to break it down for people in detail as we give presentations, we'll talk to it publicly here. I did try and stress the point that this company is really trying to grow in two ways. One is, we're trying to participate and grow market share in existing places where we have strength. The second place is we are trying to invest in parallel markets where we know the customers, we know the technologies, we know how the game works, but they are new markets for us to enter. So, when we give the market sizes to you, that's really what we view as our serviceable, available market and part of that is just normal market growth of these industries. Part of it is we are with intent saying we are going to enter that market and become a player in that market. And as we enter that market, potentially our SAM grows at a rate faster than the underlying growth rate of the market. So, the CAGRs that you see, and we can talk about these markets being additive to the overall market – serviceable market of Avanex, we can talk about that in a fair amount of detail, but basically we're expanding our market footprint into a bigger piece of the whole telecom world. Did that help?

Todd Koffman – Raymond James

Yes, just a follow-up related question. JDS Uniphase and Bookham both cited that they had experience in some segments, some supply and capacity constraints. Did you encounter any of those types of issues during the quarter?

Jo Major

No, I think we executed really cleanly. In fact, our on-time delivery metrics to our commitments to our customers and in fact, our on-time delivery to our customers request, and they can sometimes be quite demanding were both records in the quarter. So, I think we executed really cleanly. I'm very proud of our operations group, and I think they do a pretty good job of responding to the short lead time environment that we are in.

Todd Koffman – Raymond James

Thank you very much. Good luck.

Jo Major

Thank you, Todd.

Operator

We'll go next now to John Harmon of Needham & Company.

John Harmon – Needham & Co.

Hi, good afternoon.

Marla Sanchez

Hi, John.

Jo Major

Hi, John.

John Harmon – Needham & Co.

Okay, two questions. I'll try to stick to the rules. Or two actually means four I guess. So, my first question is, I just want to clarify though that, did you mean you want to double your sales by 2011 or double your addressed markets by 2011?

Jo Major

Actually both.

John Harmon – Needham & Co.

Okay, just because the growth rates you gave, if you want to double sales by 2011, you would be growing roughly 30% a year, your markets aren't growing that fast. It implies that you would gain a lot of market share, if I say so?

Jo Major

Remember, a lot of these markets we are entering new, right?

John Harmon – Needham & Co.

Okay.

Jo Major

So in effect we are – if we can pull off plans, we are in fact, looking to expand market share in a lot of markets that we don't quite participate in right now that are next door neighbors to places where we currently play, if you will.

John Harmon – Needham & Co.

Okay, understood. And secondly, again about gross margins, how should we really view your true gross margins, that's because you overshot your target by quite a bit, but then the June quarter guidance is flat to down? It sounds like the real region of gross margin might be 27% to 30% and you just had a really good quarter.

Marla Sanchez

Our gross margin was up, so we've 3 SP product credit that we will get for a couple more quarters. The timing is a little hard to predict on that completely because of the litigation that we are in with them, but we are confident that we will be getting that. The timing is just a little different. That's why we break it out for you. That's at 31% for this quarter. Going forward we do expect to remain relatively stable. We gave guidance at the 29% to 32%. We do expect to stay relatively stable in that range there.

Jo Major

And again, a couple of points of clarification. When we did 31% last quarter, we did over achieve, but I think the reasons that we over achieved were we ran revenue up, we had a good operational execution quarter. The new products like Oasis did kick in and we got the margin benefit from them. So, I think it was a real solid quarter on the margin side, John. I don't think you should think of our normalized – and these are all GAAP, so we're not pulling variances out, we're not pulling out stock-based comp numbers.

John Harmon – Needham & Co.

Right. I'm looking for pro forma margins which are a bit higher, which probably magnify the question I asked.

Marla Sanchez

Probably true.

Jo Major

Pro forma, if we remove those, our gross margins obviously would be higher.

John Harmon – Needham & Co.

So, I'd like to sneak another one in. Roughly how much revenue did you get from new product, just ballpark, if you could?

Jo Major

We actually don't track as a metric. What we track as a metric and we track very religiously is design wins because those dollars don't immediately translate into a revenue outlook. We would like to help you understand where they are occurring and what percentage and give you a good feeling for how heavy the design win activity was. We had a really strong design win quarter. I'm very, very pleased with that, but we aren't giving exact guidance to how many design wins –how many design win dollars, if you will, result from that, largely because although it's an overall signal of strength, the translation between that and forward going revenue isn't always really clear because sometimes a customer's program doesn't take off or something like that happens.

John Harmon – Needham & Co.

Understood, thank you.

Jo Major

Sure.

Operator

We'll go next now to Patrick Callery with Piper Jaffray.

Patrick Callery – Piper Jaffray

Hi, guys, thanks for taking my questions and congratulations on a great quarter.

Marla Sanchez

Thank you.

Patrick Callery – Piper Jaffray

If I could maybe go with a couple product based questions, you talked a little bit about moving into adjacent or complimentary market areas. Are you speaking more along the lines of getting into more datacom oriented stuff, or is it out of communications entirely?

Jo Major

No, no. The company really believes in focusing on optical communications. So, it's not like we are trying to enter into a laser printing industry. I can give a good example of it, and you can understand it better if I put it in its context. We've sold a lot of fixed Optical add/drop multiplexers, so fixed OADM has been part of our portfolio for quite some time. Those often include things like variable optical attenuators. There's software to hook up into our customer's world, a market that we are now entering into is WSS ROADMs, and essentially that's a reconfigurable version of something we already have. So, we know the customers, we know how the software and firmware in the Subsystem level works. We know how to talk back and forth with their equipment and what we have done is we brought in a new low- cost – essentially a new-low cost OADM that happens to be reconfigurable; and said, look, do you like this product? And by doing that, we've have taken our market that we participated in and gone from fixed optical switching to fixed plus reconfigurable optical switching. In our market presence, the fact that we know the customers allows us to come in and make that move very elegantly. Does that help? That's what we're talking about, is we are talking about expanding our markets.

Patrick Callery – Piper Jaffray

Yes, that makes a lot of sense. I was just trying to figure out if maybe you guys had something up your sleeve in terms of a new strategy area.

Jo Major

Yes. There's nothing really up our sleeve. We're not – there are some markets that we've looked at but right now we want to move in a more, if you will, incremental fashion in bolting these new markets onto the company, as opposed to going into a place. If we made a jump to datacom, as an example, we really wouldn't know the customers. That is a very, very high volume industry with some technologies that we don't know, and we have got plenty of opportunity with the customer base that we have and with markets that are adjacent to places we already play.

Patrick Callery – Piper Jaffray

And then if I could ask one more, you also mentioned seeing a little bit more momentum on the Subsystems level, higher levels of integration. I know some of your competitors have also talked, actually talked a lot more than you have about where they're going with that. Is that a growth trend, do you see a lot of good traction in there in terms of customer interest in getting those higher levels of integration?

Jo Major

That really – to be honest that depends on a customer-by-customer basis. We have been selling at the Subsystem level now probably for – since well before I came, so I can't take credit for that. These guys have been selling Subsystems for five, six years. We were the first company to be (inaudible) certified. We are the first company that have really a software and firmware presence in China, so that we could design round the clock. In general, that market ebbs and flows, and we view that as – we've a core technology of optical design, integration, firmware expertise, and we've got a really nice core competence to take that – take it to a Subsystem level. So, if a customer wants to be buying from us with their nameplate on a Subsystem that we design and manufacture, we are very happy to do that and we can do that very quickly for them. If they are more interested and they have some IP that they want to protect, and they want to buy individual models from us, we can do that also. One thing that is tilting it to the Subsystem level is if you take a node, we now have a really great amplification group. We have in Oasis, a wonderful software platform that ties all these things together and controls them in a way that really takes a lot of cost out. We have a good WSS architecture. We've got a lot of things that we can do on the optical performance monitoring side; and we can put all of those together and integrate them very nicely into a package at the Subsystem level, so they can take advantage. Basically economies of scale that we can offer to customers, and there's a couple vendors that can do that with us, and I think those guys like Avanex and guys like us are very well-positioned as you start to see the nodes become more and more complex and intelligent.

Patrick Callery – Piper Jaffray

Great, thanks, Jo.

Jo Major

Thank you.

Operator

We'll take our next question now from Sam Dubinsky of Oppenheimer.

Sam Dubinsky – Oppenheimer

Hey guys. Very impressive quarter on the margin front. Not to harp on the gross margins, but I'm just curious, your gross margins came up a lot with a 9% price decline, so I'm just trying to figure out in terms of your product mix, where is this – where are the high gross margin coming from, is it from the amplification of the ROADM products? You mentioned that transmission is lower, and if so, how do I think about gross margin in both of those businesses going forward?

Marla Sanchez

Well, we have said in the past and just to reiterate with the new Oasis platform we do expect our gross margins to improve. That was a lot of the driving force behind the development on their side, some of the performance issues that we actually – improvements that we get with that as the better heat dissipation that we've talked about in the past and some of the smaller footprint that we can get with it. We also got quite a benefit in terms of the reduction of the cost on it. We've talked about in terms of the three areas. We get better building materials cost. We get lower variances on it relative to excess and obsolete, and we also are able to deploy resources that were involved in the production planning of that into other areas. So, it does benefit us at many levels, and we are starting to see a lot of that (inaudible) that's part of what we saw.

Sam Dubinsky – Oppenheimer

Are ROADMs also higher than corporate average gross margin today?

Jo Major

So, again, if you recall what we talked about last quarter, we're at small – on the WSS side, not blockers or other thing, but on the WSS side, our ROADM revenue is pretty modest in the March quarter, it will start to take off at the end of this quarter. So, I don't want to confuse you and tell that you that ROADM sales were slinging margin up or down in the March quarter. In the March quarter, we did get a lot of benefit from Oasis. We also ran revenue up $4 million from the bottom end of our guidance; and we've got pretty good operating leverage so we try like mad to make sure that when our revenue goes up we don't put in any additional costs in to capture that and it flows quite nicely into our margin line. In general, ROADMs, we think we can be priced very, very competitively and have margin performance at the module level above corporate average right now. If they ask us to sell at a much higher revenue level, but the lower gross margin percent level associated with the Subsystem, they're a little bit below corporate average. Transmission as it ramps, that particular market is a little bit beneath corporate average. So, it depends on a few things. It isn't that ROADMs are above or below, it really ROADM Subsystems are a bit below corporate average, ROADM modules are above corporate average. Transmission tends to be a little bit below as we get Oasis on board. Oasis tends to drift a little bit above corporate averages because we basically strip so much of the guts of the amplifier out via the Oasis software.

Sam Dubinsky – Oppenheimer

Okay. Thanks. And maybe you can give me just on a quarter-to-quarter basis what each segment was up, transmission, amplification, ROADM and dispersion compensation?

Jo Major

It's a little bit apples-to-oranges because there was some 3SP distribution revenue last quarter. The big growth driver last quarter was amplification. This quarter transmission will be really driving revenue growth as we start to see those design wins kick in and really run.

Sam Dubinsky – Oppenheimer

Okay, and as you guys ramp new transmission products, and ROADM products, should we be expecting additional 10% customers or would you think your customer mix will stay the same?

Jo Major

We really have targeted a lot of new customers, and it's interesting because as we move into standardizing our platforms, we're in effect, Sam, able to go out to an awful lot of customers and offer very high performance that they can get without much modification. So, one thing that's a real interesting trend last quarter we saw is that we were very successful in penetrating a lot of our smaller customers who previously needed a lot of customization to get the performance they needed as we start to bring in, as an example, the Oasis 1600 amplifier. It has a very nice compatible interface, it has a great size, it has great performance, and we are finding that we can sell that to a much broader customer base. So, I don't know if we would have more 10%er, but if you looked at the number of customers we have and we are engaging with, that list is really broadening as these new platforms start to roll out.

Sam Dubinsky – Oppenheimer

Okay, and also, can you just tell me what your ROADM capacity is per quarter and how you see that ramping and whether you expect to hit capacity?

Jo Major

The way the thing is built and put together, I can't imagine that we would have severe capacity problems.

Marla Sanchez

As we talked about before, we've got this in contract manufacturers. We had changed over the pilot production, had started since last quarter, and we were very set to end up manufacturing this in volume. So, we would be very surprised if we had that capacity constraint.

Jo Major

Yes, I don't.

Sam Dubinsky – Oppenheimer

I'm just trying to figure out how many units you guys think you can ship on a quarterly basis because to my knowledge the ROADM market is very strong this year and most vendors will take ROADMs if they can get them. I'm just trying to figure out what type of capacity you guys are building in going forward. What capacity assumption?

Jo Major

We're not prepared to give that information today. I think a reasonable way to think about is, we're a company that really believes on focusing on opportunities that are worthwhile and big. So, we focused really on three customers, one in Europe, one in North America, one in Asia. And each one of those are big, big opportunities. Each one of those can drive a substantial piece of revenue on an annual basis for the company. As we take the portfolio and move from one by four to one by eight – one by nine, we'll look at another series of key customers and broaden that portfolio with the growing team that we have in place. Again, it was really meant to be something that was very easy to manufacture and something where we could pull costs out of it very naturally as the volume grows so that we could be consistently getting at the forefront of cost effective solutions there.

Operator

(Operator instructions) We go next now to Ajit Pai at Thomas Weisel.

Stuart Moore – Thomas Weisel

Yes. Hi, this is Stuart Moore [ph]. I'm calling in for Ajit. I've a couple of quick questions. First one has to do with your commentary on pricing for the last quarter. What is the pricing outlook for this quarter?

Jo Major

We don't break it down by a quarter-by-quarter basis except in March when it just hammers us, because it's a tough quarter for us to maintain margin performance. I can't say enough good words about the group and what they did to get to the 32% gross margin when they've got a 9% ASP decline. We would be happy to talk about it on an annualized basis. On an annualized basis, you're probably looking at 15% to 20% in a normal environment for us. If demand starts to pick up – the truth of the matter about a short lead time environment is that the way that short lead time environments happen is that our customers pull their inventory levels down and down and down, and they really look to us to provide the materials just when they need it. And the truth of the matter is any demand spike will really stress the system here and push lead times out. It will change the pricing dynamics also and you will see if demand picks up, you will see the ASP declines moderate and soften but in a normal year maybe 15%, 20%. For us, something like half of that happens in a single quarter being the March quarter.

Stuart Moore – Thomas Weisel

Great, thanks. Second question is in terms of the ASICs products and the trend or profitability on those, how is that progressing?

Jo Major

In general we've been very happy with the ASICs group and where they've gotten their design wins. Their design wins aren't running hard revenue right now. The June quarter, they'll really start a nice ramp. They've got products that are making their way in Japan in some slots that we had not thought possible. They've got some of their products being sold directly into China and into Korea, and we are very, very pleased with that. They've got designs now where we're looking at small form factor tunables, where with our modulators inside, we think we have a nicely differentiated product and we'll be able to take that into a very broad range of customers. So, all in all, we think that they've done a good job. The revenue, partly because the general economic conditions gave a little bit of scariness to the market over the last couple of months. The initial uptick of their revenue was a little bit slower than we thought. The design wins they're getting and the footprint that we see them achieving, however, is actually more bullish than we thought when we bought them.

Stuart Moore – Thomas Weisel

Great, thank you.

Operator

And we'll take a follow-up question now from Tim at Merriman.

Tim Savageaux – Merriman

It's me, Savageaux?

Operator

Tim, please go ahead.

Tim Savageaux – Merriman

Okay. Great. Sorry, I cut out there. More of a housekeeping question on the other income which looks pretty substantial given the cash balance. I would assume there's something else in there that seems to be recurring a little bit. I wonder if you might give us a little expectation of where that should go going forward.

Marla Sanchez

Sure. We run about $500,000 to $600,000 on interest on the cash balance, and the differences are primarily the exchange rate gain on the dollar to the euro.

Tim Savageaux – Merriman

Cool. Thank you.

Marla Sanchez

Sure.

Operator

And ladies and gentlemen, that is all the time we do have for questions today. But I would like to thank you all for participation. Mr. Major, I'll turn things back to you for any closing comments.

Jo Major

Thanks, if there's no other questions, we'll wrap up. Thank you very much for attending our conference call and have a wonderful afternoon. Bye-bye.

Operator

And again, that will conclude today's Avanex Corporation conference. We would like to thank you all for joining us and wish you all a great afternoon. Good-bye.

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Source: Avanex Corporation Q3 2008 Earnings Call Transcript
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