Ciena Corp (CIEN) 2001 Q3 法說會逐字稿

Good day everyone, and welcome to the CIENA Corporation third quarter 2001 earnings results conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Ms. Suzanne Dulong. Please go ahead ma'am.

Thanks Brian, and welcome everyone to CIENA's quarterly earnings conference call. Our thanks to all those joining us this morning to review our Q3 results. I am pleased to have with me Gary Smith, CIENA's CEO and President, and Joe Chinnici, our CFO. In addition, Steve Chaddick, our Chief Strategy Officer will be joining us for the Q&A portion of the call today. Joe will begin this morning's call with the review of the quarter's financial results. Gary will discuss the business in the quarter and CIENA's business outlook. Joe will wrap up our prepared remarks with guidance for Q4 in fiscal 2002. We will then open the call for questions from the sell-side analysts. This morning's press release is available on National Business Wire and First Call and also on CIENA's website at ciena.com. If you are unable to obtain the press release, or if you would like to be added to our e-mail distribution list, please call CIENA's IR department at 888-243-6223. Before I turn the call over to Joe, I will remind you that during this call it is likely that we will be making some forward-looking statements. Such statements are based on current expectations, forecasts, and assumptions of the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in context to the risk factors featured in our 10-Q filed with the SEC today. In addition, the company assumes no obligation to update the information discussed in this conference call whether as a result of new information, future events, or otherwise. Joe?

Thanks Suzanne, and good morning everyone. This morning CIENA reported third quarter fiscal year 2001 revenues of $458.1 million. We are very pleased with these results, which represent sequential growth of more than 7% over the second quarter's revenue of 425.4 million and more than a 96% increase over last year's Q3 revenues of $233.3 million. The third quarter included revenue contribution from a total of 45 optical networking equipment customers, a new all time high for us, exceeding last quarter's previous high of 33. Our optical networking customer base now totals 55. We recognized revenue from 6 new customers in the third quarter. We had 2 10% customers in the quarter, one North American, and one, which was a mix of North American and international deployments. Combined, the 2 10% customers accounted for approximately 57% of total revenue. This is an improvement over last year when 3 customers represented 78% of total revenues. International sales represented 30.8% of revenues for the quarter, up significantly as expected from last quarter's 13.4% of sales. Growth this quarter was driven by strong long-distance transport sales, and for the third sequential quarter, material revenue contribution from CoreDirector, our optical core switch. Sales of CoreDirector were very strong in the quarter surpassing 10% of total revenues for the third straight quarter. CoreDirector sales were up both in real dollars and as a percentage of total sales, versus Q2. Within long-distance optical transport and MultiWave CoreStream, our fourth

generation long-distance optical transport system and channel adds for CoreStream were the largest contributors to the quarter's revenue. CoreStream related revenues increased by 48% over the second quarter, and revenues from CoreStream Systems with OC-192 channel cards outpaced revenues from CoreStream Systems with OC-48 channel cards, with OC-192 related revenues more than doubling over Q2. The line between systems we previously described as ultra long-haul version of CoreStream and the initial version of CoreStream is blurring, as more and more customers are electing to take CoreStream's 10-gigabit cards, which incorporate forward error correction. This feature allows carriers to reduce the cost of longer-haul applications. Turning to net income, I would like to remind everyone that we will be referencing adjusted net income, which excludes stock compensation charges, payroll taxes on stock option exercises, a benefit from the receipt of previously written-off receivables, and amortization of intangibles and goodwill for the third quarter. GAAP net income or non-adjusted net income, as well as the adjusted net income, I will be referencing, are both shown in the income statements that accompanied our press release this morning. Adjusted net income for the third quarter, exclusive of items previously mentioned, was $58 million or ¢17 per diluted share. GAAP net income comes in at $5.7 million or ¢2 per diluted share. I think it is worth spending a few moments on a couple of the line items that appear in the GAAP statement. The deferred stock compensation charge of $22.2 million you see on the GAAP and P&L reflects charges incurred as a result of our acquisition of Cyras. The increase in this current quarter over last quarter is a result of the organizational changes made at our Metro Switching Division as noted in the press

release. In addition, you will note a line item adjustment in our provision for doubtful accounts. During the quarter, we recovered approximately $15.4 million of the gross outstanding accounts receivable balance previously due from iaxis ltd. primarily through our sales agreement with Dynegy. If you recall, several quarters ago, we believed we would recover only $8.8 million of the total iaxis related receivable, that was outstanding, and provision for that amount back in Q4 of 2000. Accordingly during the quarter, we realized a reduction in our provision for doubtful accounts for approximately $6.6 million. Turning to gross margin, gross margin for the quarter came in at 43.3%, down from Q2's 45.6%. Gross margin in the quarter was impacted primarily by a provision for excess and obsolete inventory of $31.2 million. In general, every quarter's cost of goods sold incorporates a provision for excess and obsolete inventory. The higher than expected charge to cost of goods sold this quarter resulted in a faster than anticipated transition from our older generation long-distance optical transport products to allow our latest generation of products. Exclusive of the incremental portion of the provisions this quarter, gross margins would have been flat with last quarter. It is worth explicitly stating that pricing was not a major impact on gross margins in the quarter, although in general the pricing environment remains competitive. With regard to operating expenses, operating expenses for the third quarter, exclusive of stock compensation charges, payroll taxes, stock option exercises, a benefit from the receipt of previously written off receivable balances, and amortization of intangibles and goodwill, totaled $119.7 million, up slightly both in real dollars and as a percentage of sales from Q2. This was as expected given that Q3 was the first quarter to

reflect the full quarter of the Cyras expenses. Turning to the balance sheet, working capital at the end of the third quarter increased by approximately $53 million from Q2. Cash, short-term and long-term investments totaled approximately $1.8 million. With regard to receivables, as a result of an improved balance between North American and international sales, day sales outstanding were 73 at the end of the quarter. This is up from the unusually low 57 days of the last quarter and better reflects our target range of 70 to 90 days. Based on what visibility we have into orders for Q4, we expect that DSOs will increase in Q4 and could stretch beyond our target range. On the inventory front, net inventory levels ended the third quarter at $306.6 million, up compared to the second quarter levels of $276 million. The inventory breakdown for the quarter is as follows. Raw materials $182.8 million, work-in-process $74.7 million, finished goods $100.6 million, and a reserve for excess obsolete inventory totaling $51.5 million. The majority of the inventory increase in Q3 versus Q2 came through the area of raw materials, as we adjust for changes in customer orders attributable to general market changes. Inventory turns in Q3 were flat with Q2 at 3.4. Given the rapidly changing market conditions, we are continuously monitoring our inventory position, and expected inventory turns will improve slightly next quarter. On the area of headcount, as we continue to grow our business, we have continued to add personnel, although at a slower rate given the economic environment. Our

worldwide headcount, at the end of the third quarter, totaled 3,895, an increase of 35 from the second quarter total count of 3,860. In contrast to others in the industry, we continue to hire, albeit on a selective basis, and see the current market environment as an opportunity to build our channel base, particularly in the area of sales and engineering talent. And now I will turn the call over to Gary.

Thanks Joe and good morning everyone. I think given the tough environment we were delighted to have beat both the top and the bottom line consensus this quarter, which I think is a remarkable achievement in this environment. This despite, as Joe described, some significant inventory obsolescence charges in our cost of goods sold line. We're beginning to see even more evidence that carriers while reducing overall capex are spending more on next generation equipment. Industry analysts such as CIR, IDC, Infonetics, Aberdeen, Frost & Sullivan, and KMI have all issued reports recently outlining details of the shift in spending from legacy to next generation equipment. Specifically, Aberdeen's research is particularly credible, because they surveyed over 74 carriers and service providers. The reports indicated that CIENA with its exclusive focus on next generation intelligent optical networking systems is the best-positioned optical equipment vendor in the marketplace. Carriers also told Aberdeen that money historically spent on circuit switching and SONET/SDH transport gear will be increasingly used in next generation intelligent optical systems. Based on its research, Aberdeen believes that CIENA is the overall intelligent optical networking leader and is also the leader in the long-haul transport and the core switching markets, with 30% and 52% market share respectively. Aberdeen states in its report that though network build outs will continue to occur, the shift is from an aggressive network expansion strategy to a revenue-based strategy. In other words, carriers are more closely examining how and where they spend their capex and how these expenditures translate into revenue generating services. CIENA'S equipment enables carriers to lower capital expenditures and operating expenditures, so they are spending fundamentally

less. It also brings more intelligence to the network which will enable them to deliver new revenue generating services and is very consistent with Aberdeen's and others' findings. With that as a preface, I'll review the quarter's business through a discussion of our products. Firstly long-haul products, MultiWave CoreStream our flagship long-distance transport product was again the largest revenue contributor in the quarter, and as has been the case historically, system sales continue to outpace channel card sales, which bodes well for the future. Continued growth in this product line, despite what seems to be slowing long-haul market growth, appears to be driven by CIENA's unique feature set availability including 10G transmission and built-in ultra long-haul capabilities. This quarter, shipments of CoreStream systems with 10-gigabit feature sets were more than double those with 21/2-gig feature sets. And keep in mind essentially all of the 10G we shipped was ultra long-haul or ultra long-haul capable equipment. We believe that we are seeing increasing evidence that open architecture next generation optical transport systems like CoreStream are taking market share from closed systems, and we believe this trend will continue as service providers look to maximize the value of their capital expenditures. As also indicated by Aberdeen's research, we believe we've taken the market share lead in long-haul for the first time. This is obviously good news because it means we've achieved a long-term significant goal. It does, however, obviously mean that future market share gains will prove somewhat more challenging, but it's a great problem to have. As noted in the press release, and as Joe mentioned previously, we have made some organizational changes in our Metro Switching group. This group will now be headed by Jesús León, who many of you know who was also in charge of our Metro Transport group and was also in charge of our CoreStream

Transport group before that. We believe there is a significant potential for synergies between the Metro Transport Division and the Metro Switching Division, and we believe that Jesús will be able to leverage these synergies to benefit the existing products, Metro and K2, as well as the next generation products that are already under development in both of these areas. In Metro Switching, specifically, we are continuing to make progress with MetroDirector K2. In fact, by the end of Q4, K2 could be in the hands of as many as 10 customers. We continue to expect that initial revenues on K2 shipments are possible in Q4. Turning to Metro Transport, our Metro Transport revenues more than doubled in Q3 over Q2, and during the quarter, we recognized revenue from 15 Metro customers up from 9 last quarter. We now have more than 30 customers with our Metro product worldwide, and we firmly believe that CIENA'S ability to offer both Metropolitan Transport and Metropolitan Switching will be a critical market differentiator in the Metro space, and going forward, we believe we'll be able to offer the benefits of an integrated transport and switching platform. Talking of switching, that obviously moves us onto CoreDirector, and we continue to be absolutely delighted with CoreDirector's market acceptance, and as Joe noted, CoreDirector revenues contributed to more than 10% of total revenues for the third sequential quarter. We have now shipped this platform, which includes CoreDirector on the smaller footprint version, the CoreDirector CI, to 19 customers worldwide. We expect that CoreDirector shipments will continue to ramp and that our customer base will continue to expand even in the environment of turmoil that we are in from telecom expenditures. We remain confident that CoreDirector will represent more than 10% of total revenues for the complete fiscal year, and in fact, CoreDirector

revenues in Q4 could double from that of Q3. Before I turn the call back over to Joe for some specific guidance on Q4 and Q2, I'd like to make some comments about the market dynamics in general, and specifically their implications on our business going forward. We believe that we will see more market analysis like that that we have seen from Aberdeen which attempts to separate the dynamics impacting the legacy telecom equipment market from the dynamics of the next generation market. We're confident that we will see increased proof of a dramatic shift in carrier spending and that the evidence will point to next generation suppliers like CIENA as the prime beneficiaries of this shift. We continue to believe that CIENA is one of the best-positioned suppliers to capitalize on this shift, and we've said all along that we couldn't be immune, however, from large market economic dynamics. So let's spend a few minutes discussing those market dynamics and how they are likely to impact our general product areas. Long-haul, Core Switching and Metro and both Switching and Transport. Firstly long-haul transport. Clearly, the purchasing of several of our large customers has insulated us somewhat, so far, from the slowdown our competitors have seen in long-haul deployments in 2001, and particularly, given our competitive advantage of our product sets. However, most analyses indicates that growth in this area, even with next generation products factored in, has somewhat slowed, and that the long-haul market opportunity will be flat to slightly down in 2002 versus 2001. We do expect to be able to maintain our leading market share, but believe that sales of our long-haul gear will be down in Q4 versus Q3 specifically. We also expect that our long-haul sales in fiscal year 2002 could be flat to slightly down from 2001, which was an extraordinary year of market share growth for

CIENA. We expect to continue to take long-haul market share, however, from legacy suppliers, and as I mentioned earlier, given that we now have a leading market position, we expect these gains will be more challenging going forward. We believe that CoreStream continues to lead the market in terms of feature set and expect the commercial availability of upcoming feature enhancements to the product such as 25 and 121/2-gigahertz space channels and VSR optics will only strengthen CoreStream's economic case versus competing solutions. Secondly, Core Switching. We believe that more and more carriers are realizing the scope of the economics that CoreDirector has to offer, both from a cost savings perspective and from a potential revenue generating perspective as well. Recent research by CIR and Aberdeen, based on interviews with carriers, indicates that CoreDirector continues to dominate the optical switching market currently owning more than 50% of this segment. We believe that with the enhancements we plan for CoreDirector, we can maintain our market lead. We expect that the market for core switching products will almost double in the calendar year 2002 versus 2001, as next generation products like CoreDirector continue to erode spending on legacy SONET and TDM solutions. We believe specifically that CoreDirector revenues could be 25% to 35% or more of our sales going into 2002. Finally Metro Transport and Metro Switching. We're now putting considerable focus on the Metro space and are already rolling out next generation Metro feature sets such as 10G pack. We're seeing good customer traction here and believe that our ability to offer both Metropolitan Transport and Switching solutions as well as interoperability with core switching will

continue to differentiate us from niche Metro players. We expect the combination of Metro Transport and Metro Switching could be as much as 15% of our revenue in 2002. So what does all of this mean for our business? Well I think a few things. We believe the current marketing conditions reflect a change in spending, not a fundamental change in the underlying demand for bandwidth. In fact, we agree with a recent statement from market analyst CIR, which states that barring a deep and prolonged recession, the total amount of long-haul traffic will continue to decline dramatically, partially as a result of the continued growth of the Internet and wireless services, which simply means that more optical hardware is needed, and should come as good news to companies providing the right solutions. So if that's the case, then what's happened to this market? I think it's all been oversimplified frankly as a capacity glut. Our view is that the reality boils down to a few key but subtle dynamics. First, the carriers attempted to scale their networks and handle rapid traffic growth by deploying inefficient legacy equipment designed for voice. They really didn't have any other options. The result was clearly not a sustainable economic model for the carriers. In addition, an overabundance of capital resulted in the funding of some less than robust service provider business plans. It also encouraged very excessive vendor financing frankly as legacy vendors attempted to secure revenue growth and prolonged the lifecycles of their legacy products in the twilight of their years. The combination of excess capital and excess vendor financing created what amounts to an artificial demand bubble for telecom equipment, which was only further exacerbated by the carriers' dependency on inefficient legacy gear and the ensuing

economic issues that created for the carriers. In our opinion, the resolution of this situation is going to depend on a cleansing of the financial inefficiencies and widespread adoption of new technologies, particularly by large established carriers, and we believe we are seeing the beginnings of this now, and that's supported I think by the other analysts findings I had talked about earlier. The introduction and shift to more efficient, less costly next generation equipment is beginning to give carriers the tools they need to scale their networks appropriately and to support a more rational economic model. We are at the early stages of this. Given the economic turmoil and the traditionally longer acceptance cycles by these established carriers, the short-term impact has increased caution across the board in telecom spending which is what we are all seeing. These market conditions are challenging and they will separate undoubtedly the weak and opportunistic and legacy players from the strong and sustainable next generation players. We firmly believe that because we are able to offer service providers complete next generation solutions, we will continue to grow as we continue to gain market share from legacy providers. We have been most consistent with this message to the marketplace. Traditionally Q4 is the quarter into which we have the least visibility, and that's especially true in this turbulent market. However, we believe 2001 revenue growth will be in the range of 85%-90% over 2000, which if you recall, even at the low end of the range is still higher than where we thought we'd be when we entered 2001. Given the market turmoil, as you would expect, we do not have good visibility into 2002. However, our current view is that we believe we can continue to show revenue growth that reaches into the early teens in terms of percentage growth in 2002. And though this may

be down from our previous expectations, it is still a healthy annual growth rate in the light of the enormous market uncertainty and one which could prove conservative if the capex environment improves. We continue to believe passionately in this next generation market opportunity as I think you can tell. And while we will be prudent about expenses, we intend to run this business with the goal of creating long-term value. This means we will continue to invest in the business and continue to invest for our future. And now I would like to pass it over to Joe for more specific guidance for Q4 and 2002.

Thanks Gary. Before I begin to offer our guidance for CIENA's financial performance, I will remind everyone once again that the statements that Gary just made and those that I am about to make are forward-looking statements. And it is important to review the risk factors detailed in our 10-Q in order to understand the factors that might cause actual results to differ materially from the guidance. As Gary noted, we do not have good visibility for the remainder of 2001 or 2002, but with that as a base, we will do our best to help you understand where we think our business is going. We believe that revenues in Q4 will be down sequentially from Q3 by between 12% to 20%, as a result of slower growth in the long-haul transport space and anticipating customer and product mix in the quarter. As a result of lower revenues, we believe that gross margins will decrease from Q3 to Q4 on the order of 300-400 basis points, primarily due to lower long-haul transport volumes and the associated manufacturing overheads. As Gary said, we intend to continue to invest in the business. As a result, we expect our operating expenses will increase slightly, Q3 to Q4. We expect other income to be in the $4-5 million range, we expect our tax provision rate to remain at 33.5% on adjusted income before tax for 2001. Based on the wide range of revenue guidance we offered, we expect a wide range of EPS as well. Ranging from ¢7 at the high end to ¢2 on the low side. That translates into an adjusted EPS range of ¢59-¢64 for FY '01 which would mean an annual EPS growth in the range of 9%-19%. Now, turning to the outlook for 2002. As Gary noted, we expect we

will be able to deliver percentage revenue growth in 2002 that approaches the early teens. And though we expect to remain focused on the profitability of our business and to continue to prudently manage expenses, we will also make decisions with a strategic and long-term emphasis. As a result, we believe, based on the revenue growth described previously, that it will be possible for us to deliver 2002 EPS approximately flat with 2001 EPS. I will reiterate that we intend to adhere to our longstanding policy of not commenting on guidance during the quarter unless done in a public disclosure. Gary would you like to say a few closing words?

I would. I would like to remind people, I think, that in a very difficult telephone equipment environment CIENA continues to differentiate itself by demonstrating strong year-over-year revenue and net income growth and by taking market share. The past year has been a particularly challenging one for the industry, but size mix shifts in technology have historically caused market turmoil. This market turmoil in turn sets the stage for a changing of the guard, and for new leaders to emerge, and we believe CIENA is positioned to be one of these leaders. As we look into 2002, we do not believe there has been a fundamental change in the demand for bandwidth. There is significant market turmoil, and as a result, we have more limited visibility. When the market conditions improve, we expect CIENA will be among the first to benefit fundamentally, and we are very different from our legacy competitors. With that, Brian, we would now like to take calls from the sell-side analysts.

Thank you Gary. Today's question and answer session will be conducted electronically. If you would like to ask a question, you may do so by pressing the 'star' or 'asterisk' key followed by the digit '1' on your touchtone telephone. Once again, ladies and gentlemen, to pose a question, please press '*1'. We will take our first question from Paul Silverstein with Robertson Stephens.

Hi. Can you talk a little bit about your K2 shipments, as well as what you are seeing in the optical switches base relative to competitors? Obviously, you are doing very good there, but are you seeing Sycamore are you seeing others? And also K2, you mentioned you're expecting 10 customers in Q4. Any shipments this quarter, for the product?

Thanks Paul. Regarding the K2 specifically, we expect to have it in trials and in customers of about 10 customers probably by the end of Q4, and we do have potential for taking actual revenue for the product, in Q4, so in our fiscal year. Talking to the optical switching competition, I think we see Calient from time to time, but quite candidly, we don't see a whole lot of competition in this space, and I think that is borne out by the fact that we have moved from 15 customers to 19 customers in Q3, and we are confident of increase in that customer count moving forward. So, we think we have a significant competitive advantage that is both sustainable in probably 6-9-12 months ahead, depending on what day of the week it is you ask us, over the competition.

Okay. Gary, given the statements, going back to the guidance. You gave some fairly specific guidance with respect to long-haul for the K2 in the Metro space including the MultiWave Metro product, as well CoreDirector, in terms of the outlook especially for next year, as well as for this coming quarter, can you give a little bit more color in terms of what you're seeing in the marketplace, the opportunity for these products?

I think what we're seeing is an attractiveness from a customer point of view of an integrated product set, although it's open architecture, but being able to really get a complete solution, both in the K2 and the Metro space, the combination of that, and also the ability to link into CoreDirector and the intelligence of CoreDirector. I think we're starting to rollout some of our new feature sets in the Metro Transport space, and we're starting to see good traction from customers with that. So we're very focused on this space now, specifically with K2 and the transport space and linking that in to CoreDirector. I think we said that in 2002 our best view is that the K2 in the Metro Transport could be as high as 15% of our total revenues and that CoreDirector could be as high, anywhere in the range between 25% to 35% of 2002 revenues, or even possibly more.

Thank you.

Thanks Paul.

We'll take our next question from Nikos Theodosopoulos with UBS Warburg.

Yes, thank you. I guess I had two questions. The first one is on the gross margin. Can you give us a sense of, in terms of your guidance for next year, what the assumption there is in gross margin because you got CoreDirector, that's a good margin product, but obviously you're taking down long-haul guidance. I'm just curious to see what your expectation is built into the guidance. That's question number one. And question number two, I just want to make sure I understand the revenue guidance for '02. Did you say overall revenues would grow in the mid-to-high teens? Did I hear that right? And as part of that, long-haul sales would be flat to slightly down? I wanted to make sure I understood that correctly.

Okay Nikos. Let's do the second one first. In terms of revenue guidance, I think the way we read the script was we were in the low teens.

Okay.

Okay. In terms of gross margin guidance, effectively it's where we see the guidance is going to be a function of what happens and how visibility materializes. Right now we're taking it cautiously. We're determining what is going to happen with the overhead and when we can start leveraging that again, and really it's going to depend upon what the products mix is which we've offered some pretty wide ranges. So really there are going to be some wide ranges on the mix. Sorry I don't have much more for you on that. That's about what it boils down to.

Okay. Alright. So getting back to the first part, growth of the low teens and long haul being flat to slightly down. It sounded like CoreDirector, you anticipate that the market is going to double next year, so given that you're not planning to lose share, we would expect your sales there to double at least, and Metro sales to make up the difference to get us to low teens. Is that a fair assessment?

Nikos, this is Gary. I think it's a reasonable assessment at broad brush.

Okay, alright, great. Thank you.

We'll take our next question from David Toung with McDonald Investments. Mr. Toung your line is open. We'll take our next question from Alex Henderson with Salomon Smith Barney.

Thank you very much. I was wondering if you could give us some better clarity on a couple of things. Looking at these numbers, having a little difficulty getting them to fit, given the guidance on Transport and Metro and CoreDirector. Could you talk a little bit about the services piece? Is the services percentage declining in the mix? And then secondly, going back to the current quarter, you highlighted the $31 million charge for components in the cost of goods sold line. What would that normally be if you were to take it as a percentage of normal charge? How much of that's abnormal and how much of that should be backed out of the number? And then secondly, you sort of implied that there was a gain in some of the other line items. At least that's what it sounded like. Could you clarify whether there was in fact a gain in the operating expense lines?

Alex why don't I take the first part of the question, then Joe can take the rest. In terms of services and software, we expect them to be higher as a percentage term next year, though we're not giving detailed guidance about that.

Okay. Alex this is Joe. I'll deal with the next two. In terms of the normal inventory charge, again it's a function of the mix of products that we sold in any one given quarter. The range could be anywhere from the low side of 4-5 to the high side of 7-10, but again, it's a function of how much CoreDirector you sell, which one of the long-haul product lines you sell, and that's what it boils down to.

So the variance is roughly $21 million then?

Yeah. That's a good ballpark number. I don't quite understand what do you mean by gain in other line items, but opex was a little bit lower than what we had expected for the quarter. If you're referencing a gain in other line items as it relates to the GAAP P&L, yes there was a gain. The sales team has been very successful as they continue to move the iaxis equipment where we had to take that very large provision, if you remember, back into the latter part of '00.

That's not showing up in any of the 3 line items though on a cash basis here.

That is correct.

Okay, and then finally, could you talk about customer concentration please? Any 10% customers?

Yes. I think we talked about 2 10% customers early on when we reported.

What was the magnitude of the combined revenues of the two?

57% was down from 78% for 3 customers over the last year.

And are they are the same customers or no?

We don't call them out specifically.

Thank you.

We go next to David Jackson with Morgan Stanley.

Hi. Thanks very much. I wondered whether you could talk a little bit about how you see the European market next year. You said, I think, on your last conference call that you expected Europe to be the key driver of growth. And second, you've talked a little bit and you've given some guidance about Metro products. Could you give us a little bit of color as to how you expect your Metro sales to look on a geographical basis next year as well? Thank you.

Hi David. This is Gary. I don't know about Europe specifically. Obviously, we've got a fair amount of our revenues from Europe. I would say, I would characterize it as international is certainly a very good opportunity for us next year. If you look at us historically, we've had international sales, I think, that at some periods in 1997-98 as high as 30%-40% of our total revenues. So we have a very strong base internationally, specifically in Europe and Japan, and we intend to leverage that very strongly next year. We think there are very good opportunities in Europe and Asia and Latin America. One of the reasons for that is we're just launching CoreDirector internationally because we've been waiting for the SDH function which has now been shipping for a little while. It opens up a whole new market to us. So that's one of the reasons that we've focused on North America really with the CoreDirector launch initially. That's one of the reasons for growth. Also, K2, I think that Metro plays particularly well into some of the European and Asian markets. The Metro diversity is pretty well spread. We have about 30 customers now for Metro, and I would say that a fair proportion of those, this is off the top of my head David, I would say 30%-40% of those customers are international. I don't think we've ever kind of segmented it specifically, but if you're asking me for a ballpark number, it's pretty spread. My own view is that that could grow as a percentage because Metro is obviously well suited to densely populated, smaller geographies, which I think Europe would probably qualify for that.

Great. Thanks. Are you expecting the larger proportion of your Metro growth to come from outside the US?

I would think that Metro growth would be higher outside of the US than in the US, yes.

Great. Thanks a lot Gary.

We go next to Jeff Lipton with JP Morgan H&Q.

Thanks. A few questions on the CoreDirector. First, as far as the book business goes, can you give us a feel for international versus US or North America? And secondly, can you give us some sort of a feel for how much of the book business would you consider top tier IXCs? How much would be competitive carriers? And then I have one quick followup.

Jeff this is Joe. In terms of book business, it is kind of difficult to tell by customers, because we have customers that are doing deployments of the CoreDirector globally. In fact, we have quite a few of them in terms of the total customer base. So it is a tough one to call currently in terms of what we have got in the way of book business. Two of them are doing deployments both here in North America domestically, as well as Europe and as well as Asia, so that's where we go there. In terms of the IXCs versus competitive carriers, I will turn that one over to Gary.

Yeah Jeff. I would characterize that most of them are IXCs. I mean that some of the larger competitive carriers, but I think if you just look at the customer base that we have announced which is indicative of the larger well-funded IXCs or the tier one players as we characterize them, which are people with cash.

Okay, that is great. Thanks. One followup for Joe, when you said the gross margin should decrease from current levels in Q4, is that from the adjusted level after we back out the inventory charge?

No sir.

Okay. So that is from the stated level.

That's correct.

Thank you.

We take our next question from Subu Subrahmanyan with Goldman Sachs.

Thank you, couple of questions. First, could you talk about just book to bill, how that's changed? How the order trends have changed? And the second question was the second 10% customer you said which was US and Europe, is that a new 10% customer?

Let me answer the question in reverse order. Yes it is. It is a new customer for us. In terms of order trends, CIENA has typically fluctuated very dramatically from book to bill, and that's why we don't talk about things like backlog because it is not particularly indicative of how well we are doing. That's fluctuated dramatically even during the year we have just come off. I think it talks to directly the issue of visibility, and as I said, I think most of the carriers are now having whatever the current expression is, success-based bills. Where they used to bill 3 to 6 months in advance, they are now waiting for their orders, and then turning round and expecting very quick shipments from us, and I think that characterizes what everybody is seeing in the industry right now. So I think the catch phrase is, when one talks about visibility, it is not good as it was, but I think that is just how the industry is right now.

Alright. Thank you.

We take our next question from Steven Levy with Lehman Brothers.

I was actually wondering on the customers, were there are any other customer shifts that you are seeing here that are impacting the visibility? For example, from the 10% customers, at least a couple of them in the past that you are expecting to fall off, I don't know if there was anything else you have seen in the customer base specific to the customers.

Steven I think what we have tried to do is to get as many 10% customers as we can. I mean there is no rocket science to it. We want to spread our customer base out. I think that we're already seeing, the remarkable thing is we are continuing to expand our customer base at this time. We are up to 55 customers, 6 new customers. As much as you spread out your dependency, the better and more robust your business is. I think what we have seen is really across the board. The issue is relating to the sort of telecom spend, even though it is shifting into the next generation which is I think how clearly we are able to better perform than any of the other large telecom vendors. I think it is across the customer base. It is not specifically related to 1 or 2.

Okay, and then just another little numerical question for clarification. In the opening remarks, I am not sure Gary if it was you or Joe, said that CoreDirector, but in the press release it said it was up 20% sequentially, and I think in the comments it was that CoreStream was up 48% sequentially. Is that right?

No. I think it was CoreStream related revenues increased by 48% over the second quarter. I think that was related to CoreStream Steve.

Okay. So CoreStream was up 48%...

CoreStream was 48% and CoreDirector I think was up 20%.

Okay. So its sales were overall up 7%. Is that right?

Yes.

What was down so dramatically?

Yes. Steve this is Joe. You have the other old long-haul product lines like MultiWave 4000, the original MultiWave 1600 product line, as well as MultiWave Sentry. They are down, and that is part of the corresponding reason for the inventory adjustment.

Okay. And if you look at the gross margin, the impact of that shift, specifically if you look at CoreStream versus the other long-haul products, what is the relative margin on those?

Steven, I think...

Steve this is Joe. They were very, very consistent.

Okay. Thanks.

Thanks.

We go next to John Butler with SG Cowen.

Yeah, just a couple of questions. First, Gary you mentioned in terms of growing the Metro business, you hinted at new features on the system that are going to make it more competitive. I was wondering if you could comment on those. And then for Joe, in terms of the changing guidance in long haul, what is the assumption on pricing going forward in your estimate there? Thanks.

John this is Steve Chaddick. Let me take some of the Metro feature questions for you first, and I will be as brief as I can in a very big subject. First of all, the first 10 figures that we introduced recently that's had an impact is adding powerful forward error corrections to our 10G line parts, which increases system route substantially and has caused us the ability to win some bids where we needed that feature for longer range, bigger systems. Secondly, we are adding, as Gary mentioned, we have started developing an entire next generation feature set for Metro that includes a number of new optical features. So [_______________] optics, amplified systems, and so forth that we will be introducing incrementally over the next months, quarters, and next year, that we will eventually evolve the platform into completely new platform that includes incorporating many of the features of the Metro transport optical system into the K2 switching platforms so that those two interoperate seamlessly, and also coincident with that, allowing the K2 platform to operate interactively and seamlessly with CoreDirector, meaning terminating multiple access rings on CoreDirector to provide some more integrated and less, therefore, costly solutions for systems solutions. So all in all what we are really doing is, as you probably have figured out, is that we believe we have got a great technology base in the switching area which we have invested heavily in recently. We are beginning to move more investment into the Metro space and expect that to begin to pay off handsomely in the next year or so.

John let me take your other question as it related to, as I understand it, the pricing in the long-haul sector going forward. Pricing is competitive. However, it is not any different than it has been probably over the past 2 or 3 quarters, and we have played in a similar trend going forward, so there is nothing unusual in there from our perspective.

Hey Joe, one follow on to that if I may.

Sure John.

You added a 10% customer and obviously lost one, and I was wondering what your outlook is on the potential of getting those former 10% customers back into the 10% plus range again?

John this is Gary. I mean I think I wouldn't describe it as lost one. I think they are just cyclical. The trick is to when you have got one of your large customers building out, you have got another one ready to build out so that you can keep your sustainable revenue growth, and I think it is just a characteristic of the particular trends or particular carriers of building out at different times.

Fair enough. Thanks very much.

Thanks John.

We take our next question from Stephen Koffler with First Union.

Hi Gary. I just wanted to make sure I understood the 2 guidance items on CoreDirector and Metro. So I think you said 25% to 30% of revenue would CoreDirector going into 'O2. So this way that's about the percentage we should expect for the October quarter. Is that correct?

I think the guidance, Stephen, is really for 25% to 35% for 2002, of the total 2002, I am sorry.

Okay and can you just repeat what you said about Metro?

The Metro, I'm including the K2 piece, will be about 15% of revenues in 2002.

Thanks a lot.

We take our next question from Rick Schafer with CIBC.

Hi. Can you hear me?

Yes.

Couple of quick followups on some earlier statements. The first thing was on long haul. I think you talked about CoreStream and the fact that sounded like 10-gig outpaced 21/2-gig by about 2:1 margin. Does that ratio hold for switching, if we look at the CoreDirector?

Rick I don't think it does because some of the functionality of the CoreDirector is really about aggregation at different levels. So whilst we're seeing good demand from the 10G perspective, I don't think, my own personal view is that I don't think you're going to see the same kind of percentages. Certainly not in the next year or so, and particularly with 10G, it was only reasonably come on CoreDirector recently, and I think we're going to have to wait for more evidence as we go through 2002. But I would not think it would get to the same kind of proportions.

Okay, another quick followup. When you said that systems deployment still outpaced channel cards or channel adds in the quarter, have you guys noticed is a noticeable change in that ratio though? Is that percentage, has that shrunk? I mean are we getting closer to even there? I mean kind of where does that stand?

Surprisingly not. We're still seeing new bills where you've got a lot of, in simple terms, chassis going out that don't have a whole lot of population on them, and so obviously the logic there is that bodes well for the future where you can just add channel cards incrementally on the systems.

Can you expect that to continue going into next year?

I think the mix may change going into next year but that's just a speculation frankly. I mean we've got a lot of chasses out there, which is the good news part of it. I think we're going to have to wait and see as to whether we get any new customer build outs on new channels and new customers. It'll certainly be some of that. The percentage may change.

Okay and last question. Talking about MetroDirector, do you guys still plan on having OSMINE by the end of the year? And then, of the roughly 10 trails/customers you want to have by yearend, can you break them out, give us any idea what percentage of those are ILECs versus CLECs or others? And that's it. Thanks.

Rick I think K2 is still on track for full OSMINE by the end of the year. I wouldn't want to breakout the customers too much, which is to say that they're really most of them are ILECs. It's a pretty good mix.

Okay. Thanks.

We take our next question from [_______________] with Bear Stearns.

Hi. This is actually Mike Renegar for [_______________]. Could you just clarify once again about how much of the core transport is the older stuff, the Sentry versus CoreStream? And then I also have a followup? Thanks.

Yeah Mike this is Joe. We typically don't go into that level of granularity in terms of which product line was which on the transport front. So I believe we did that. But the thing is CoreStream is up. It's continuing to grow. We see good business from both the 21/2G or OC-48, as well as the OC-192, and it's moving more and more towards OC-192.

Okay. And also just within your customer base, we know what's happening kind of with the emerging carriers, but kind of what you're seeing. You have a couple of ILEC customers, as well as IXC customers. Can you tell us kind of where those guys are? I mean what they're telling you for next year, like in terms of the ILECs? Where do you really think the real capacity utilization is, and what are they telling you about what they have to spend and how long they can go without spending? And then also on the ARBOCs launch, what are they telling you about some of the stuff that they could do and the gear that they could buy from you next year? Thanks.

Mike I really think we have talked to this in the call. I think it is pretty wide spread. I mean it is not a delineation between them specifically. I do not think overall there is a glut in bandwidth to talk to that point. I will talk about in general terms without talking about ARBOCs or ILECs or whatever. I do not think there is a glut. I think people are confused between fiber and capacity, and it's very different. It's like saying there's a lot of oil in the world while there is not until you refine it, and there is not a lot of capacity until you put electronics on the fiber. So I would characterize it overall, as we articulated earlier, we think that end user demand is still there. Those issues relating specifically to the economics of the industry that have to be worked through, but I think that carriers specifically are just very cautious right now in this kind of environment, and the key issue is when do they run out of any inventory that they have, inventory defined as capacity that they have in advance and may have to satisfy end user demand.

Okay thank you very much.

We will take our next question from Kevin Slocum with WitSoundview.

I think it's asked and answered.

We will take our next question from Andy Schopick with Nutmeg Securities.

Thank you. My questions have also been answered.

We are clearly doing a good job this morning.

We will take our next question from Chris Sessing with Crowell, Weedon & Co.

Yes, good morning. I missed the first part of the call, so I apologize if it has already been covered, but can you talk about the Metro Transport segment as it compares to the last quarter?

Chris it has doubled in revenue over the last quarter.

Metro Transport doubled?

Metro Transport.

Okay, and were there any sales from the new China agreement with Beijing IDN?

We have not talked about that specifically Chris.

Okay. On the operating expense line, it looks like sales and marketing only picked up slightly. And then G&A, it was down in second quarter. Were there some redeployments of old Cyras people or what was going on in that space?

In the case, let me take that one Chris, no there was not any redeployment. It was just a function of some one-offs that we had in 2Q related to some merger related expenses and things of that nature that would characterize that. Sales and marketing was up slightly, specifically sales. It is a function of how we expand in Asia and in Latin America. We are putting a lot of attention on that now, as well as Europe. We are concentrating on the PTTs and the incumbents as we move forward, and as a result, we are looking to invest in sales as efficiently as we possibly can. In Europe, we are managing the expenses, but then again too as released to the incumbents and the PTTs we need to invest there, and that is what that is all about.

Okay and then just one last question. It has been known now that the third party installation services were going away and you guys no longer break them out, but is there still some revenues in there, or are they completely gone?

In terms of the third party work, there is a very, very small bit of revenue.

Okay. So it's what 5 million, under 10 million...

Yes. It is definitely less than 10, definitely less than 10.

Okay. Thank you.

Alright.

We will take our next question from Hasan Imam with Thomas Weisel Partners. Hasan your line is open.

Oh hi. Thanks, two quick questions. On the deferred revenue line, could you talk about what was behind the increase? And second, just on the long-haul expectations for 2001, is that majority of that from upgrades, or are their any new bills built into that? Thanks.

How about if I take the first one. In terms of deferred revenue, there was a jump in the quarter. That is a good thing. I like that kind of stuff. It has to do with product that we have been paid for, that is in the field, that is installed, and it is going through the final stages of acceptance. When you get into a couple of builds that we are doing that are as broad, meaning geographically, as they are, that really is the function of that. And I will turn it over to Gary for part two.

Hasan system sales continue to outpace channel cards sales, to the point we make about, we are putting more systems out there than just putting channel cards. So that gives us an opportunity in the future, we have a large installed base that people can just put channels in as they grow their capacity. So even in last quarter, we still shipped more system sales than channel cards sales.

Right. So I was trying to understand that. I mean, so for 2001, would it be a fair assessment that you could see the channel cards increase, that means most of the revenue comes from upgrades?

You mean 2002? Okay. The 2002, that's a speculation. I don't think we know at this time. I still think there are a number of carriers looking to have new builds into new routes, etc. So I think there is still plenty of opportunity to put more systems out there, but one could speculate that with such a large installed base as we have now, we have the number one market share, the number one footprint, then it certainly gives us the opportunity to leverage that into channel sales.

Thank you.

We go next to Martin Pyykkonen with Unterberg Towbin.

Yeah thanks. If I could just ask a question on the concentration, I got the sense one of the two 10% customers this quarter was the North American service provider, but with maybe some significant international operations where revenue came from, could you just clarify that? And then as you look into next quarter given the lower guidance in terms of total, would you foresee top 2 customers that were 57% this quarter being up, down, or flat, as a percentage of revenue, going into the next quarter? Not really those same two, but talk to those particular types.

Sure. This is Joe. Martin let me take the first one. That's correct that one of the 10 percenters was a North American headquartered customer, that most of the revenue came, geographically speaking, probably Europe and Asia. Does that answer that part of the question?

Yeah, thanks.

And in terms of next quarter, I will turn that one over to Gary.

Martin we believe that we will have at least two 10% customers next quarter, wouldn't want to speculate on which two they are frankly.

Yeah, it wasn't so much of the which two. It could even be...

Whether they're the same, yeah. I do not think they will be the same.

Okay, thanks.

We will take our next question from Raj Srikanth with Deutsche Bank.

Thank you. Very short question. In terms of the Metro Transport carrier, can you discuss the comparative landscape out there between you and O&I? And also with regard to K2, other than Cerent, is there anybody else now who is getting traction out there? Thank you.

Raj I think Steve's probably better qualified to answer that.

Raj competitive landscape, we continue to do well. As I mentioned earlier, we've added new features to our current Metro platforms. We have improved this competitive position, particularly with respect to longer 10-gig systems and rings. We are continuing to expand the feature set and performance capabilities of that platform. So it is better positioned for regional networks, as we go forward. As Gary mentioned, our revenue more than doubled in the quarter in Metro Transport. Cerent clearly is the leader, but the Cisco 454 is clearly the leader in that space. However, we will have a great position going forward in that space. There really isn't anybody else that is coming on strong there. The Ribeck product is the only other platform getting traction at the moment, and they have the wrong issues to deal with. In terms of competitiveness, one of the things that we have as a very strong competitive advantage is the ability to integrate the switching platform K2 and the transport platform of Metro Transport into a seamless single sell offering that provides really a much broader solution than anybody else is going to be able to offer. As we go forward and make those integrations available, I think our competitive position will improve in that space.

Thank you.

We'll take our next question from Ken Leon with ABN Amro.

Thank you. First for Joe, can you give us a more detailed explanation on DSOs which may be beyond the target not only for 4Q or perhaps even for next year? And on gross margin impact from obsolete product, is this going to continue to be a material issue for next quarter and the next, and why not just write-off those products? And for Gary, can you give us the product revenue mix in the third quarter? You gave it in the forecast. And is CoreDirector for FY '02 back loaded to the second half?

Okay. We are going to give us a few seconds to make sure we've got all these questions written down so we can answer them. In terms of item number 1, a more detailed DSO target, the range on the average is 70-90 in terms of being slightly above that going into Q4. It is difficult, at this time, to put a fence around it. It is a function of customer mix. It is a function of geographically on a couple of customers since we are doing bills for them in multiple areas, meaning Europe, Asia, and the like. It will be a function of that. Will it go significantly above the 90-day range? No, we don't anticipate that at this point in time, but it could go slightly above it. In terms of gross margin impact of the inventory obsolescence thing, at this point in time, we don't anticipate playing a major role going forward. What we did in the quarter was very much so in line with what we do in our approach every single quarter in terms of just writing it all off and doing away with it. I don't think it is an issue of that severity at this point in time Ken. A lot of it has to do with some of the MultiWave Metro product, and as Bill [_______________] of the Horizon team take orders, lot of that stuff will be worked on. We do anticipate getting future orders from them. So we are not willing to throw in the towel on that one yet. I think there is still reasonable amount of possibility that that product will be sold. What was the third one?

Product of your mix in Q3?

Yeah, the only thing that we have disclosed relating to Q3 is the fact that the CoreDirector was over 10% of revenues.

Okay, but as a baseline, I mean, you have given us guidance on mix on FY '02, but you are not giving it either for the quarter or for FY '01.

Correct.

My other question was on CoreDirector. With an aggressive target on total sales for next year, is that back end loaded, particularly if you are focusing on the international market and PTTs, which have slower sales cycles?

That's a good point Ken. It is somewhat back loaded, but we would still see healthy CoreDirector sales even coming out of Q1 and Q2. It does ramp up. And I think specifically into some of the larger carriers, their adoption as we have seen takes a while. So there is some hockey stick to it, but we would certainly be able to see incremental growth, I would think, in the first half of 2002.

Okay. Thanks guys.

Thanks Ken.

We'll take our next question from Mike Ching with Merrill Lynch.

Thanks. Two questions. One, have you seen any specific cancellations or deferrals of orders in the last month or so from your customers? And do you get a sense that the calendar '02 capital budgets are any way stable enough at this point? And then lastly, are you shipping the CoreStream product to any ARBOCs currently?

Mike the specific question around cancellations and the rest of it in the last month. I don't think we have seen anything in the last month that's been materially different from what we've experienced in the last couple of quarters. There is a lot of volatility around the orders and changes and the rest of it. Your second question was, I just want to...

Whether or not the capex budget is stable?

Whether the what sorry?

The capital budgets. Do you get a sense that the capital spending budgets from your largest customer are stable going into '02, right now?

I don't think they're set for '02 yet. I think that is really the issue I think. The carriers are beginning to grapple with what they want to spend next year and what they want to spend it on, and I think they typically don't start doing that until September or October time.

So are you making any assumptions at all in terms of what the capital budgets will be going into '02 and the guidance you have given on revenues?

I think what we are saying is that the situation does not materially deteriorate. I think if you are looking for underlying assumption on that then it stays how it is right now, and it does not materially get worse or get better.

Okay. And on CoreStream, are any of the Baby Bells taking the old Baby Bells taking the product?

I believe not.

Thank you.

We go next to Michael Davies with Ladenburg.

Yeah, hi guys. Thank you. I just have a question for Steve. Looking at the CoreDirector, how important is the STS-1 grooming in comparison to the other players who are using grooming at the OC-48 level?

Well, I think, Mike, it's extremely important particularly when you consider our view that next generation products need to displace the legacy ADMs and what not to save money. The problem with doing grooming only the OC-48 is they don't displace any of the old stuff. If you're not displacing the old stuff, you are not saving any money, and so I think the view that OC-48 grooming alone can solve the problem reflects the view that all traffic is carried in OC-48 from Juniper N160s in everybody's basement. That hasn't happened yet. And in particular, as we have gone into slowdown in spending and particularly in certain types of traffic, it has become even more important to be able to manage traffic effectively in grooming STS-1. So in some ways, the market dynamic that is prevailing right now has strengthened the position of CoreDirector over I would expect the non-grooming products that are out there.

Alright. Well thanks guys.

Due to time constraints, our final question will come from David Toung with McDonald Investments.

Yes. Thank you. At the Opticon show, there was a lot of talk about on the switching capacity versus grooming, meaning that switching against the OC-190, OC-48 versus the STM grooming, that is that I think some of the other vendors are talking about you need 2 boxes to do the switching at one end and the grooming at the other. How is your product being positioned? I mean, do you see the need for both, or can you do very high port capacity and grooming down the STS-1 in one box?

David this is Steve. Whatever misconception is out there that has been propagated by some of our competitors is that you can't do both in one box, in fact CoreDirector does. We manage at the OC-192 C-level all the way down to grooming the STS-1 with the same fabric in the same box, so it is equally applicable to core switching in the large circuits and edge grooming the STS-1 and everything in between. So the fact is that we have a super set of all the features that are out there and every other competing product and that is, I think, reflected in our customer base.

Thank you.

Gary, at this time, I will turn the call back over to you for any additional or closing remarks.

Thank you Brian. It strikes me in this environment, specifically, it seems that an investment decision should be based less on short-term performance and more on the belief about who the survivors of this shakeout will be, and of those survivors, who will be the strongest. We know we are a survivor, and we certainly think we will be amongst the strongest. Our performance this year I think gives further cause to believe that. I would like to thank you all for joining us this morning and for your continued support. Because our next quarter is our fiscal year end, our next conference call will be slightly later than it would be during the regular quarter. We are scheduled to report our fourth quarter and fiscal 2001 results on Thursday December 13th. Please note that in your diaries. With that, I would like to say thank you.