Optium Corporation F3Q08 (Qtr End 05/03/08) Earnings Call Transcript

Optium Corporation (OPTM)

F3Q08 Earnings Call

June 5, 2008 4:30 pm ET

Executives

Eitan Gertel – Chairman, Chief Executive Officer

David Renner – Chief Financial Officer

Veronica Rosa - Director Investor Relations

Analysts

Paul Silverstein – Credit Suisse

Paul Bonenfant - Morgan Keegan

John Harmon- Needham & Co.

John Lau – Jefferies & Co.

Analyst for Ajit Patel – Thomas Weisel Partners

Todd Koffman - Raymond James

Presentation

Operator

Welcome to Optium Corporation’s third quarter fiscal 2008 conference call. Today’s call is being hosted by Eitan Gertel, Optium’s Chairman and CEO and David Renner, Optium’s Chief Financial Officer. (Operator Instructions) Now at this time I’d like to turn the call over to Veronica Rosa, Optium’s Director of Investor Relations.

Veronica Rosa

Thank for joining us today to discuss Optium's third quarter fiscal 2008 financial results. Before we begin, we would we would like to caution you that some of the information discussed during this call including expectations concerning revenue growth and profit targets, business strategy, customer demand, market observations and future plans are based on information as of today, June 5, 2008.

In addition some of the statements we make on today's call constitute forward-looking statements within the meaning of the Section 21E of the Securities Exchange Act of 1934 and 27A of the Securities Act of 1933. We wish to caution you that such statements are just predictions based on current expectations and assumptions regarding future events and business performance, and involve risks and uncertainties that could cause actual events to differ materially.

We refer you to the reports the company files from time to time with the US Securities and Exchange Commission which are also available on the Investor Relations section of our website, and contain and identify important factors that could cause actual results to differ materially from those contained in our projections or other forward-looking statements.

Optium undertakes no duty to update any forward-looking statements to conform to actual results or changes in the company's expectations.

In connection with the proposed combination of Finisar and Optium, Finisar Corporation intends to file with the SEC a Registration Statement on form F4 containing a joint proxy statement prospectus and Optium plans to file the joint proxy statement prospectus with the SEC. Each company will also file with the SEC from time to time other documents related to the proposed combination. Investors and security holders are urged to read carefully the joint proxy statement prospectus when it is filed with the SEC and other documents by either Finisar or Optium with the SEC relating to the proposed combination when they are filed because they will contain important information.

During the conference call we will be referencing both GAAP and non-GAAP financial measures. A complete reconciliation between our GAAP and non-GAAP measures is available in the Investor Relations section of our website. All financial measures discussed during this call, unless otherwise noted, are GAAP.

Today's call will feature an overview from Eitan. Then Dave will review our financial results for the third quarter. Eitan will follow-up with an update on our goals and strategies and strategic priorities for fiscal 2008. Dave will then wrap with our guidance for the fourth quarter.

I will now turn the call over to Optium’s CEO, Eitan Gertel.

Eitan Gertel

This afternoon we are pleased to announce our results for the third fiscal quarter of 2008. The highlights for the quarter include record revenues of $45 million exceeding our original forecast range of $42-44 million fueled by products and customer diversification strategies that continue to strengthen our overall revenue mix.

As we have stated on prior calls we are focused on three main drivers of growth in fiscal 2008. 10G and cable TV product line expansion, 40G and ROADM product line ramp up and customer diversification.

Execution in each of these areas over the last 9 months has strengthened our competitive profile with strong technologies that are geared toward the highest growth area of the optical communications markets. During the third quarter we continued to add to the progress we have made in each of these areas throughout the fiscal year.

In the 10G area we strengthened our position as a leading supplier of tunable products with our highest quarter ever of tunable shipments. In the cable TV area we have experienced strong sequential growth due to solid demand for our expanded customer base.

Turning to our 40G and ROADM product line development, both are going extremely well. Revenues from our 40G product line represents 5% of the revenue mix in the third quarter, one quarter ahead of our original goal for the fiscal year. Our 300 PIN line side bps K solution began shipping in the second quarter and took off quite well during the third quarter.

Revenues from our WSS ROADM and ROADM circuit pack products reached 19% of revenue in the third quarter. Our target that we had mentioned on prior calls is for ROADM products to reach 20% of revenues for our fourth fiscal quarter. We are very optimistic we will exceed this target.

During the third quarter we also passed through our capacity of run rate milestone of 1,000 units per quarter in our Sydney facility and we are already in process of further extending that capacity.

Lastly, our customer diversification efforts continue to support growth for Optium in 10G as well as 40G and ROADM products. In the third quarter over 10% of our revenues came from new fiscal year 2008 customers.

As most of you know, on May 16^th Optium and Finisar had announced we have signed a definitive merger agreement which calls for the two companies to combine via stock-to-stock tax free exchange. Finisar with its core strength in enterprise networking and storage is a great complement to Optium’s core strength in telecom as well as the cable TV markets. With little product overlap we will have the broadest product portfolio in the industry as well as the highest growth area in optical communication markets.

In terms of manufacturing the merger combines Finisar’s best-in-class, low cost manufacturing with Optium’s mass customization expertise. We think there is a great potential here as our two companies come together and we are looking forward to a successful closing.

Due to the anticipated timing of the merger, closing during the third calendar quarter, we expect Q4 will be business as usual for Optium as we are looking forward to continued execution and a strong close to our fiscal year.

In all, we are pleased with our progress and we are managing to a high rate of growth fueled by new products and new customer qualification.

I will circle back to the outlook for our business later in the call but first I will turn the call over to Dave Renner who can give you a look at our financial results for the quarter.

Dave Renner

Revenues for the third quarter were $45 million, an increase of 30.3% as compared to $34.5 million for the same period a year ago. As communicated on our last quarterly conference call our expectation was for revenue to be in the range of $42-44 million. All product lines experienced growth year-over-year.

10 and 40G revenues grew approximately 11% year-over-year while 40G alone grew to 5% of revenues from zero in Q3 FY07. ROADM grew to 19% of revenues from 3% in Q3 FY07 while revenue for our analog and cable TV product area grew by about 4% year-over-year.

Looking at the direct growth trend sequentially, third quarter revenues grew 11.7% fueled by growth across all product lines. 10 and 40G revenues grew approximately 3% from Q2. 10G alone grew a little over 1% from the second quarter with strong demand for tunables and XFP devices offset by declines in shorter reach 310. Q3 reflects a full quarter of 2008 annual pricing adjustments for 10G.

40G revenues were $2.3 million increasing 29.5% sequentially. Revenues from our WSS ROADM and ROADM circuit packs grew to roughly $8.4 million in the third quarter, an increase of 44% sequentially. Analog and cable TV product revenues grew 18% sequentially.

As we have stated before, analog and cable TV have a limited number of customers, Cisco Scientific Atlanta being our primary cable TV customer which can contribute to large fluctuations in revenue quarter-to-quarter. From a customer perspective, we had three 10% or greater end customers that purchased product either directly or through contract manufacturers in the quarter. These three customers represented approximately 55% of total revenue and were the same as our top three customers in Q2.

Revenues associated with our top five end customers declined to 71% in Q3 compared to 73% in Q2 primarily due to our product line diversification efforts. In the remainder of my comments I will speak to both GAAP and non-GAAP results.

Our non-GAAP results for the current and all prior periods are posted on our Investor Relations website. Q3 GAAP and non-GAAP gross margins were 26.5% and 26.6% respectively, declining from 27.0% and 27.2% in the prior quarter. Non-GAAP gross margins declined by 60 basis points from Q2 largely due to a full quarter of 2008 pricing as well as the higher mix of the lower margin XFP and certain line card solutions in the quarter. We also saw some additional 10G price pressure from customers not subject to our annual price negotiations.

We are working aggressively on lowering costs particularly for pluggables and certain line cards but it will take a few quarters to fully realize the benefits. These margin pressures in the quarter were partially offset by a stronger contribution from higher margin product lines such as 40G and ROADM which continues to perform above corporate average.

GAAP operating expenses for the third quarter were $13.2 million or 29.3% of revenues compared to $12.2 million or 30.3% of revenues in the prior quarter. Excluding stock based compensation, patent litigation costs, Finisar merger transaction expenses and other non-GAAP adjustments non-GAAP operating expenses were $10.6 million or 23.5% of revenues in the third quarter compared to $9.8 million or 24.3% of revenue in Q2, an increase of $800,000.

As we stated last quarter we had anticipated that non-GAAP operating expenses would increase approximately $1 million Q2 to Q3 primarily to fund new opportunities in R&D as well as seasonal expenses such as the OSD Trade Show.

Both GAAP and non-GAAP operating margins improved slightly sequentially. GAAP operating margins improved from negative 3.3% to negative 2.8%. On a non-GAAP basis, operating margins improved to 3.1% from 2.9% in the prior quarter.

Interest income of $402,000 declined sequentially primarily driven by lower interest rates. GAAP income taxes totaled a benefit of $217,000 for the quarter. Our non-GAAP cash effective tax rate came in at roughly 5% for the third quarter and should be about the same for Q4.

On a GAAP basis we incurred a net loss for the third quarter of $662,000 or $0.03 per share. This includes $614,000 in Finisar merger transaction expenses incurred in the third quarter as well as other items we typically exclude on a non-GAAP basis such as patent litigation costs and stock based compensation. On a non-GAAP basis net income was $1.7 million or $0.07 per diluted share.

Moving to the balance sheet and cash flow, cash and short-term investments totaled roughly $46 million, a decline of about $6 million from last quarter. We used $3.3 million in cash from operations for the three-month period or $5.5 million year-to-date. Cash was used to support investments and receivables and inventory associated with the high level of revenue growth this year including two new product lines.

Capital expenditures for the quarter were $2.7 million or $9.5 million year-to-date. CapEx year-to-date is running a little less than 8% of sales, higher than historical levels primarily as the result of investments and building out production capacity for our new 40G and ROADM product lines. Day sales outstanding in Q3 were 66 days compared to 68 days in Q2. Inventory turns for the third quarter were 4.2 compared to 4.4 in Q2.

Back to Eitan.

Eitan Gertel

In the beginning of the year we set our detailed strategy to achieve above-market growth for fiscal 2008. In executing against this strategy we have leveraged our core strength in higher-end products to reach a growing list of customers worldwide. It is a strategy that matches product lines to high-growth areas of the optical communications market.

That market, as we often mention, is being fundamentally driven by an accelerated investment in bandwidth capacity extension to support fast growing video transport requirements including on-demand, NNS video, IPTV and extended high definition TV offerings on cable TV networks.

Taking a brief look at our identified growth platforms for fiscal 2008 in terms of future trends, 10G represented a little less than 60% of our revenue mix in Q3. Increased bandwidth and more agile systems within the network continue to drive the demand for tune ability. Optium is a leading provider of tunable transceivers and we continue to build on that each quarter.

In the third quarter more than 70% of our 10G revenues came from tunable products. New products such as our small foam factor tunable as well as new customer opportunities are contributing to our success. In the cable TV area we believe this market is growing by about 5-10% per year with overall market demand driven by fundamental needs for cable TV operators to remain competitive with telecom companies as fiber to the X program continue to gain momentum.

From a product perspective we continue to ramp our new DWDM 1310 and also the 1550nm where we turn past no transmitters. The two next generation technologies will allow cable TV MSOs to significant expand capacity without adding new fiber to the network.

In our 40G area the market for 40G is expected to grow significantly over the next several years with some industry analysts predicting compound annual growth rates of over 60% through 2011. For Optium, overall customer demand continues to grow for our 40G portfolio. Our portfolio is based on the 310 MSA and included fast modulation formats addressing both client and line side applications.

On the line side, demand for our BPSK solution which we began shipping in volume in Q2 is building considerably. As a result we expect to ramp BPSK capacity very aggressively over the next two quarters.

Following that we are looking forward to demonstrating our newest next generation line side product, our DQPSK solution. Some time in July of 2008 timeframe with production slotted for Q2 fiscal 2009.

Our ROADM revenues continued to ramp nicely during the third quarter with revenues reaching 19% of our mix. As we have stated before we would like to see ROADM products comprise of about 20% of our revenue mix for the fourth quarter so we would expect to exceed this goal in Q4. As you recall, we have been on an aggressive program to ramp capacity to a run rate target of over 1,000 units per quarter by the end of our Q3, a goal we met late in the quarter. We continue to expand this capacity with the transfer to our larger facility in Sydney and expect to be shipping products from this new facility later in the current quarter Q4.

Near-term capacity efforts will be directed towards our 50ghz platform with a goal of reaching equal capacity for both 100 and 50ghz platforms within the next couple of quarters. According to industry data the market for ROADM is expected to grow by a [inaudible] of over 30% over the next several years.

In addition, the market is still evolving and I believe it is still expanding. In the last 18 months market demands for ROADM has evolved from core to metro applications and is currently expanded to the edge of the optical network. To stay at the forefront of this opportunity we have continued to expand our ROADM product line taking advantage of the flexibility of our LCoS technology to address demand for higher port counts and higher resolution such as our 50ghz platform.

During the quarter for example we continued to ramp production capacity for a high port count 50ghz devices. This market leading offering continues to attract new customers. Over the next year we expect to ramp in volume with additional tier one customers that we are working with today. So we remain very optimistic that our ROADM product line will continue to be a very important growth driver for us.

On the third area of focus, which is the customer diversification, this area is going very well. Added sales focus on certain key customers and geographic regions in fiscal 2008 has strengthened our customer profile and has added to the successful ramp of our new product line. A clear example of our success in this area has been our ability to deliver record revenues performance every quarter of this fiscal year while observing considerable demand from our top fiscal year 2007 10G telecom customers.

To track our execution in this area we had set a goal of generating 15-20% of our revenue from new customers. In the third quarter we reached 10% and expect this ratio to strengthen in the fourth quarter as we begin to more aggressively ramp revenues with key customers in Asia.

Our expectations for growth for fiscal year 2008 was originally targeted as 30% year-over-year. Inclusive of our expectations for the fourth quarter we would expect to deliver growth of approximately 34-36% for fiscal year 2008. This growth rate is significantly exceeding the growth rate of the optical module subsystem markets. Naturally, this type of growth has required a great deal of up-front investment and management focus.

Our better than expected growth this year is the direct result of product and technology investment such as the accelerated introduction of line side 40G and our 50ghz ROADM platform. In response to customer demand we have raised the level of R&D spending this year so that we would introduce higher end technologies like these into the marketplace sooner than we had planned.

Going forward we intend to be equally aggressive in improving profitability. One of our near-term priorities will be addressing our cost structure for 10G especially for the lower margin, shorter reach, pluggable products and certain light card solutions. For example we have a number of low-cost component suppliers currently ramping capacity to accommodate demand for our new lower cost designs. Our higher margin 40G and ROADM product lines are performing to expectations and will add to the gross margin benefit which we expect to realize.

In summary, we feel good about our business. In the fourth quarter we will continue to focus on growth platforms we have put in place during fiscal year 2008 while we continue to form plans for a successful integration with Finisar.

Now I’d like to turn the call back to Dave who will wrap up with our guidance.

Dave Renner

For the fourth quarter we expect revenue to be in the range of $47-49 million. Our guidance incorporates bookings to date, customer forecasts, discussions and overall market trends. As a general reminder high customer concentration and the timing of shipping and deployment cycles that are indicative of our industry may cause fluctuation in revenues quarter to quarter.

Gross margin in the fourth quarter is expected to be roughly flat sequentially. There is the possibility for gross margin improvement but that will be dependent on mix and timing of cost reduction. While our ROADM and 40G continue to carry higher than average gross margins we are still very sensitive to mix especially within our 10G product line.

Cost improvements, as Eitan discussed, are underway but will take a couple of quarters to fully realize. Non-GAAP operating expenses are expected to increase by about $700,000 from Q3. At the high end of our expected revenue range this would represent a non-GAAP operating expense ratio of about 23% compared to about 23.5% in Q3 and 24.3% in Q2.

In terms of tax rates, as I stated earlier we are now modeling a non-GAAP cash effective tax rate of approximately 5% for the year.

That concludes our formal remarks. We will now open up the call for questions. However, please note we are not going to be taking merger related questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Paul Silverstein – Credit Suisse.

Paul Silverstein – Credit Suisse

First if I might before asking a real question, Dave I think you have now given us enough with guidance for the pieces but I just want to make sure. You said ROADM was $8.4 million, 40G was $2.3 million and excuse me I think you said transmitters were $7.7. Is that right?

Dave Renner

ROADM’s were $8.4 million, 40G was $2.3 and which transmitters are you talking about? Are you talking about cable TV?

Paul Silverstein – Credit Suisse

Yes.

Dave Renner

It is roughly just over $7.5 million for cable.

Paul Silverstein – Credit Suisse

So in order to figure out your 10G revenue, maybe you can just give me the number but I trust I can just take the total revenue, subtract that $7.5, subtract the 40G and subtract the ROADM and that leaves me with the 10G revenue, correct?

Dave Renner

Yes.

Paul Silverstein – Credit Suisse

Can you just give me that number?

Dave Renner

It is just about $26 million.

Paul Silverstein – Credit Suisse

So that begs the next question which is what was 10G last quarter? It was $25 right? Because you said it was up $1 million.

Dave Renner

It was up about 1% I believe.

Paul Silverstein – Credit Suisse

So it would have been roughly $20-24 million?

Dave Renner

No, $25-27 something like that.

Paul Silverstein – Credit Suisse

Last quarter what were transmitters?

Dave Renner

Give me a second here Paul.

Eitan Gertel

18% quarter-over-quarter.

Paul Silverstein – Credit Suisse

What was that number Eitan?

Eitan Gertel

The cable TV section grew 18% quarter-over-quarter.

Paul Silverstein – Credit Suisse

You said it was $7.5 million this quarter?

Dave Renner

Q2 analog and cable TV was $7.1 million and current quarter, Q3, was $8.4 million analog and cable TV.

Paul Silverstein – Credit Suisse

From a margin perspective I know you guys are investing in the business. I know the revenue is ramping well. The new products are all going nicely, ROADM, 40G, etc. The only place I guess I don’t fully understand, maybe it is what it is, but on the gross margin front we have now had several quarters where they have been going in the wrong direction. I understand the reasons for that. I guess I’m trying to understand, is there a structural industry issue above and beyond what many of us think we already know about the components industry that is proving to be an extraordinary challenge in you getting your gross margins moving to and above 30%?

Eitan Gertel

Paul what we have said is basically our gross margins are very sensitive to mix because we have our two top products producing higher gross margins, much higher than our average gross margin which is the ROADM and 40G. There we see achieving the high gross margin as marching forward very good. Where we saw the pressure is first of all definitely on 10G but first of all it is on the mix of how much pluggable product we get versus the overall ratio of products because the short reach XFP is the lowest gross margin product we have in the company and the second thing is this is the first quarter we implemented all the yearly for full quarter yearly price reduction with customers.

In addition to that there was market price pressures even on the customers who negotiated more often in which we had to accommodate so I would say right now we have implemented the cost savings in it and as Dave was saying in the next couple of quarters this is a process that is going to work in and bring up to where the margin was supposed to be for the 10G even though the pressures on the prices were higher than we expected.

As I said, the margin on the 40G and ROADM is performing to our plan and executing very well and as we go forward toward our long-term goal we expect that the mix of products or the overall mix of revenue from those products will be higher and the contribution to the overall margin will be higher so we can achieve our long-term goals.

Paul Silverstein – Credit Suisse

Eitan, I’m just trying to understand here. To the extent that ROADM and 40G is ahead of expectations and therefore the gross margin benefits should be that much better than what you were expecting obviously the balance of the business in terms of the mix on the pluggables side and short reach as well as the pricing pressure was greater than expected. The question I have is going forward while you are reducing costs what gives you confidence or what is your confidence that pricing pressure is going to moderate? This is an industry where you have always had pricing pressure no matter what product line whether systems or components. But here it looks like there was a step up in the pricing pressure. What view do you have that this is a one-time, extraordinary event or this is just life as you know it and as it will continue to be?

Eitan Gertel

In general I would say the majority of our revenue is coming from long-term contracts which as you know we take this quarter, the whole quarter, and then we know what they are going to be for the remainder of the year until next January 2009.

The rest of the products as you said, yes we have had more price pressures but in general we feel that the market is getting to a point where it is going to be slowing down on the level of price pressures in the long run. I can’t tell you they are going to go down to zero, but I think they are still going to be always price pressure there but they seem to be starting to…people start to talk right now as the next levels of price reduction are going to slow down.

Paul Silverstein – Credit Suisse

Eitan if I had asked you that question a year ago would it have been the same response in terms of slowing down on the rate of change on the pricing pressure?

Eitan Gertel

I think a year ago the product mix would have been different and where we talk about price pressures in a big way is on the plot of our products which a year ago we didn’t have much of those products in our mix so definitely not on the short reach as much. So, we feel more of it this year and would they be different? I’m not sure but this is the feedback we are getting right now from our customers.

Paul Silverstein – Credit Suisse

In terms of the split between revenue from long-term contracts and revenue from non long-term contracts where you could have pricing pressure from time to time throughout the course of the year can you give us some more granularity in terms of the split?

Eitan Gertel

I would say in general it is about 60% of our revenue, I believe 60% of our revenue comes from long-term contracts and customers as related to the 10G products.

Paul Silverstein – Credit Suisse

Finally, historically you had the issue with Alcatel Lucent and Eriksson in terms of customer concentration with two customers where there were various things happening with each one that caused a disruption in the business. The current three 10% customers that accounted for 52% of your revenue, are you comfortable those customers don’t pose a similar…I recognize the future is hard to predict but at this point in time is there any reason to be concerned there would be an issue like we have seen in the past with any one of those 10% customers?

Eitan Gertel

Paul from what we know we are feeling pretty comfortable with where we are at with those customers. If you look at the top three customers in Q2 they were the same as Q3 and we don’t see a major change in that consideration going forward as we stand today. I don’t know what surprises will be but we feel comfortable with what we are seeing and we feel comfortable where we are.

Also, in addition to that you have to consider that our diversification program is actually helping us to tame all those issues and it has been working well for us during this year and we expect it to keep working well for us as we go into the future.

Paul Silverstein – Credit Suisse

You said those three 10% customers are taking a wide range of product?

Eitan Gertel

Yes they do. They take across all our products.

Paul Silverstein – Credit Suisse

Finally, the Asian suppliers including [inaudible] I apologize if you mentioned it on the call but can you give us some sense of where they are at as a percentage of revenue?

Dave Renner

All of our customer diversification program, which is primarily Asia Paul, contributed about 10% of our revenue last quarter.

Operator

Your next question comes from Paul Bonenfant - Morgan Keegan.

Paul Bonenfant - Morgan Keegan

First question, your strength in the analog and cable TV you showed strong sequential growth there. Does part of that reflect shipping to a new customer or is that primarily strength into existing customers?

Eitan Gertel

Absolutely, Paul, but the only thing is we don’t call it new customer anymore. We have been talking now for a few quarters about new customers. Now we have new customers in cable TV and it does reflect shipping to them, absolutely.

Paul Bonenfant - Morgan Keegan

In terms of you are talking about ramping capacity in ROADM and continuing to do that. You talked about demand growing considerably for the 40G products and ramping capacity for those products over the next two quarters. Would it be fair to say that you are capacity constrained today? If you could build more you would ship more?

Eitan Gertel

I would say that right now everything we build on ROADM we ship and right now in the 40G it is slightly different. We build them and we ship the product but there is a lot of transform since the production of the product is done in PA rather than where it is done in Israel there is a lot of NPI process to ship into the production line and get it to the customer as fast as we can.

Paul Bonenfant - Morgan Keegan

I’m going to come back to the question that Paul had there. I don’t know if I quite caught the answer on customer diversification. Is there a chance we may see a new 10% customer on the list in Q4 perhaps coming out of the Asia Pacific region?

Eitan Gertel

The thing with that I can’t predict that because we aren’t at the end of Q4 at this point. We have very large companies who are our customers in there and whether they happen in Q4 or Q1 is yet to be seen but I expect it to be in the next few quarters yes.

Paul Bonenfant - Morgan Keegan

Last question, you may have addressed this already but I’ll circle back anyway. The gross margin benefits that you are talking about realizing it doesn’t sound like we are going to see an up tick there for at least a quarter, maybe two. Do you have a sense for what timeframe we might see some of these benefits and maybe a reversal of direction of gross margin?

Eitan Gertel

What we said is the gross margin improvement is going to happen from two areas. One is the mix change as we grow 40G and ROADM and they are a larger part of the mix the gross margin overall for the company should improve. But as we talk specifically about the 10G products it is not a set function. It is going to be a continuous process from now into the next couple of quarters. So we expect some of it to start happening but as we go along we expect a full benefit to happen in a couple of quarters.

Operator

Your last question comes from John Harmon- Needham & Co.

John Harmon- Needham & Co.

Working off the last question what kinds of things are you doing to reduce costs of your 10G products? I assume it is given the predominance of revenue it is more transponders and pluggable transceivers. Is it offshore sourcing? Maybe you can just list a couple of the things you are working on that will reduce costs over time?

Eitan Gertel

Those efforts do not include where the products are made, it is all swapping of components from the optical side and how do we get the best cost without changing the performance for our customers. Those are not new designs. We have designs already developed and implemented. It is a function of all the suppliers ramping up to where they need to be.

John Harmon- Needham & Co.

You were talking about your two ROADM channel spacings. Are those both products you can make in your old and new facility or is the new facility to 50ghz whereas the original facility does 100?

Eitan Gertel

Obviously 100 in the original facility we have been making for awhile. The 50ghz ROADM for the new facility is being shipped to customers during the last quarter in more serious quantities. As we move from the old facility to the new facility all the products are going to be transferred to the new facility and keep ramping up capacity. The way the transformation is designed so that we don’t get a hiccup in deliveries both facilities will be out for a little while as we are confident we can make the shipment and the ramp then we shut down one and move the rest into the other.

John Harmon- Needham & Co.

Finally, I apologize. After having a fantastic quarter this is kind of a glass half empty type question. Your Q3 guidance was up $2-4 million and you are up about $5 million which makes your Q4 guidance of up $2-4 million just look weaker in comparison. Is that conservatism or are there some capacity constraints coming into play? Maybe you can elaborate on that please.

Eitan Gertel

We were trying to predict quarter-over-quarter growth. We are still well above our projections for the year and we tried to be conservative in our numbers and make sure that things happen and we’ll see what happens during the rest of the quarter.

Operator

Your next question comes from John Lau – Jefferies & Co.

John Lau – Jefferies & Co.

In terms of your ROADM there has been a significant ramp and we have been for a couple of quarters now for that ramp and it looks open-ended. Can you tell us how much visibility and how closely you work with your customers to kind of see where that ultimate terminal value is and how that ramp continues?

Eitan Gertel

I’m not sure about the term ultimate terminal value but I would say that we are working with many customers right now, around 10 customers, when 3-4 of them are the main revenue generators for all our ROADM products. The rest of the customers are new customers which a lot of them are Q1’s which are coming in with either 100G or 50G or flexible channel plan products. Every ROADM we make we ship and we keep raising our capacity. Right now capacity growth is centered also in addition to the 100G around the 50G so we believe by the end of this quarter we will have significant capacity on both of those product lines on the low port count and high port count and continue to grow that in the next couple of quarters. The demand coming from our customers makes us feel pretty comfortable about our ramp plans.

John Lau – Jefferies & Co.

I guess the main point was that you continue to work pretty closely with your customers on all their needs as they continue to ramp throughout the year, right?

Eitan Gertel

Absolutely and as they have new requirements we continue to work with them on those too as we have a flexible platform. We can help them bid different types of projects and help them win.

Operator

Your next question comes from Analyst for Ajit Patel – Thomas Weisel Partners.

Analyst for Ajit Patel – Thomas Weisel Partners

First I wanted to ask about the tunable product in your 10G mix. What was the percent of that product in the last quarter and in the year-ago quarter?

Eitan Gertel

I think last quarter we said was 60-70% of our 10G revenue came from tunable products. What it was last year I honestly don’t remember but we can say it was probably in a similar number, maybe even slightly higher for the tunable. That is something we can check.

Analyst for Ajit Patel – Thomas Weisel Partners

The other question I have is in terms of the full impact of the pricing reductions you guys talked about last quarter what was that impact on the gross margin in the current quarter? Can you quantify that?

Eitan Gertel

You said what was the specific…

Analyst for Ajit Patel – Thomas Weisel Partners

You had a full quarter impact of the negotiated pricing reduction in the current quarter which I guess you said had a partial impact in the last quarter.

Eitan Gertel

In the last quarter it was only one month which was January. This quarter is all three months we are carrying that and by the way that is not the only impact. The other impact is the higher mix of short reach pluggable products into the mix. So all together they impacted our margin. Are you asking what range of margin impact did they do?

Analyst for Ajit Patel – Thomas Weisel Partners

Yes.

Eitan Gertel

I would say between 0.5 to 1% in the overall mix of our products.

Analyst for Ajit Patel – Thomas Weisel Partners

The last question I have, in terms of the capacity additions should we expect for next quarter the same margin impact from the capacity additions as you guys had this quarter?

Dave Renner

For which products?

Analyst for Ajit Patel – Thomas Weisel Partners

In terms of 40G and ROADM.

Eitan Gertel

Basically we expect the margin in 40G and ROADM to actually track what they did this quarter and actually slightly improved. As we said on the call those are the two highest margin products we have and their contribution to the overall margin is actually pulling the margin of the company up. As we see the mix of those products growing we see more positive impact on the margins. So as we go along in the ramp percentage of quarter-over-quarter is slowing down we should see that impact less. It is becoming lesser and lesser. But still they are performing to our plan and they are our highest gross margin product that we have.

Operator

Your next question comes from Todd Koffman - Raymond James.

Todd Koffman - Raymond James

A question on the ROADM business. You have been very successful ramping this business very nicely and you are even still sounding like you expect it to continue to ramp very nicely. You made a comment that this business is now split between three or four main customers. I was under the impression this was one very large anchor customer rounded out by some much smaller companies. Is that accurate or is this business more evenly split between 3-4 customers?

Eitan Gertel

Todd as we started this business a couple of quarters ago the concentration was much higher into one customer. As we go and add more customers the rest of them are ramping up. Right now we said the majority of the business by far is on four customers. Each one of them is the largest one. But the magnitude of the overall share is lower. So the diversification of more and more customers taking the ROADM product is growing every quarter we pass by. We expect it to continue as we are dealing right now with ten different customers worldwide and lots of them are tier one customers who are ramping their requirements with us.

Operator

There are currently no further questions at this time.

Eitan Gertel

Thank you all for attending our conference call and have a great evening.

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