Ciena Corp (CIEN) 2002 Q4 法說會逐字稿

Good day everyone and welcome to the CIENA Corporation's fourth quarter and fiscal year-end 2002 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 Pam and welcome everyone to our fourth quarter earnings conference call. I'm pleased to have with me Gary Smith, CIENA's CEO and President, and Joe Chinnici, Chief Financial Officer. In addition, Steve Chaddick, our Chief Strategy Officer will be joining us for the Q& A portion of the call. Gary will provide some brief summary comments, Joe will review the quarter's financial results, Gary will then discuss the business in the quarter and CIENA's business outlook and Joe will wrap up our prepared remarks with guidance for Q1 '03. We'll then open the call for questions from the sales side analysts.

This morning's press release is available on National Business Wire and First Call, and also on our website at www.ciena.com. If you're unable to obtain a 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 Gary, I'll remind you that during this call, it's likely that we'll be making some forward-looking statements. Such statements are based on current expectations, forecasts and assumptions of the company, and include risk and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in the context of the risk factors detailed in our 10-K 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. Gary?

Thanks, Suzanne, and good morning everyone. Overall, we're encouraged by the quarter's results. I think it demonstrates several meaningful steps in the right direction. We're pleased to see sequential revenue growth in the quarter, and to see solid progress with our other operating and financial performance metrics.

Gross margin turned positive and was about 10 percentage points higher than we anticipated going into the quarter, largely as a result of a favorable product mix and the cost reductions we've made in our manufacturing operations. Ongoing operating expenses reflecting the first full quarter of ONI expenses were lower also than we anticipated, reflecting company-wide cost control and resource prioritization efforts. Our cash position, exclusive of debt buy back which Joe will discuss in greater detail, was also stronger than anticipated. We're also pleased with the level of customer activity we're currently seeing in our fiscal first quarter. I'll talk more about the business in Q4 and our outlook for Q1 as our strategy for long term success after Joe reviews the quarters' financials. Joe?

Thanks, Gary, good morning everyone. As noted in the press release, we reported fourth quarter revenue totaling $61.9 million. Representing a sequential increase of roughly 25%. For the year, our revenue totaled $361.2 million. We continue to grow our customer base adding new customers in the quarter.

The quarter included revenue contribution from a total of 58 customers compared to 57 in Q3. Of the 58 customers contributing revenue in the quarter, nine were new to CIENA and four of those nine were customers from when ONI had previously recognized revenue. During the course of the year, we recognized revenue from 77 customers, an increase of more than 45% over last year's 53 customers. We had two 10%-plus customers in the quarter, one North American customer and one international. Combined, the two 10%-plus customers accounted for approximately 53% of total revenue in the quarter. This compares to Q3 when two 10 percenters accounted for approximately 32% of revenue. For the year, we also had two 10%-plus customers, Sprint and AT&T. Combined, these two customers represented approximately 36.8% of total revenue, signaling meaningful revenue diversification compared to 2001 when two customers, Qwest and Sprint, accounted for 50.5% of revenue. We expect that we'll see continued diversification in our customer base and revenue contribution during 2003.

In the quarter, the domestic international split of sales swung toward international as expected. International sales represented 55.2% of revenue, versus last quarter when it totaled 41.2%. For the year, international sales represented approximately 36% of total revenue. An improvement compared to 2001 when international sales were approximately 24% of total revenue.

From a product contribution perspective, CoreDirector was the largest contributor, representing just more than 50% of the quarter's total revenues. Revenue from our metro networking products contributed nearly 20% of total revenue in the quarter. Service and support-related revenue represented approximately 20% of the quarter's total revenues.

For the year, core networking represented roughly 66% of total revenues, compared to approximately 90% last year. Metro networking contributed almost [17%] of total revenues, compared to less than 5% in the previous year. Service revenue was about 16% of this year's total, compared to less than 5% last year.

Turning to our quarterly operating results, as was the case last quarter, the press release presents a GAAP only presentation of our results. As well as detailed information about the adjustments in the fourth quarter in the fiscal year that as management we make to CIENA's GAAP earnings in our analysis of CIENA's ongoing business. In general, we exclude items that are unusual and/or not related to ongoing operations. In my comments today, I'll speak to both the GAAP results and to what the results would have been if we excluded the items detailed in the press release.

Now that I've reviewed our approach, let's move on with the numbers. As Gary noted, gross margin turned positive in the quarter and was stronger than anticipated as a result of favorable mix and cost reductions we've made in our manufacturing operations. On a GAAP basis, our operating expenses in the fourth quarter totaled approximately $753 million. As noted in the GAAP P&L, this includes several charges and I'll discuss each of them.

First, let's spend a few moments on goodwill. In accordance with FAS 142 which requires annual testing to determine and measure goodwill impairment, and with assistance from an independent valuation experts, we performed an assessment of the fair value of CIENA's intangible assets as of September 27, 2002. The date was chosen so as to allow us sufficient time to complete the analysis in advance of the earnings report. In the analysis, we compared CIENA's fair value to its carrying value, including goodwill, and determined that CIENA's carrying value including goodwill exceeded fair value. As a result, we then assessed the fair value of CIENA's assets, including identified intangible assets and liabilities, and derived an implied fair value for CIENA's goodwill. The carrying amount of goodwill was greater than its implied fair value and impairment loss of $557.3 million was recognized.

The next item has to deal with restructuring. During the fourth quarter, we incurred approximately $78.7 million in the restructuring charges associated with our ongoing efforts to align our operations with the current telecom industry environment. The restructuring charge related to our previously announced work force reduction of September 20 which affected 450 people as well as lease terminations, noncancelable lease costs.

Next on the list is deferred stock compensation charges. As was the case when we acquired Cirus, as part of our acquisition of ONI, we recorded unamortized deferred stock compensation costs, relating to the unvested stock options and restricted stock assumed in the acquisition. During the quarter, the amortization expense related to deferred stock compensation amounted to approximately $5.7 million. Deferred stock compensation is presented as a reduction of stockholders' equity and is amortized over the remaining vesting period of the applicable options. As of October 31, 2002, the balance of unamortized deferred stock compensation was $44.7 million.

Regarding the Pirelli case. On August 19, 2002, Pirelli and certain of its affiliates filed a complaint against us in the United States District Court for the District of Delaware, alleging that we were in breach of our obligation to pay royalties under a license agreement that was part of the resolution of an earlier series of disputes between CIENA and Pirelli. We've reached an agreement with Pirelli to resolve the lawsuit. Under the terms of the settlement, we will pay Pirelli $11 million. And Pirelli will forego claims to all other royalties, past or future.

We accounted for the $11 million liability by recording an expense of $1.8 million in fiscal 2002 related to the settlement of the litigation. $.8 million had been reserved for prior to fiscal 2002, and related to past unpaid royalties. And the remaining $8.4 million was recorded as an intangible asset and will be amortized over eight years based upon the expected life of the royalty-free technology acquired in the settlement. Those unusual items aside, we are pleased with the results of our ongoing efforts to manage operating expenses.

R&D, sales and marketing and G&A were up sequentially reflecting the addition of a full quarter of ONI-related expenses though all came in below our initial expectations. R&D increased 12% from $54 million in Q3 to $61.4 million in Q4. Sales and marketing increased slightly from $30.8 million in Q3 to $32 million in Q4. G&A increased from $10.8 million in Q3 to $13.1 million in Q4. As I said, these increases were expected, given Q4 was the first quarter to reflect all in ONI expenses.

Other items on the quarterly income statement that warrant comment include a loss on equity investments and a loss on extinguishment of debt. So let's tackle the loss on equity investments first. As we do each quarter, we monitor the value of our equity investments. This quarter, we concluded that the value of these investments had declined. And that a write-off was necessary resulting in a loss on equity investments of $9.9 million in Q4.

The loss on the extinguishment of debt. During the fourth quarter of fiscal 2002, we took steps to improve our already strong balance sheet. We saved $21.9 million in principle by purchasing $97.1 million of the $300 million outstanding 5% convertible subordinated notes due 2005 on the open market. The loss on the income statement results from the early extinguishment of that debt.

To recap though. On June 21, 2002, CIENA assumed the outstanding ONI 5% convertible subordinated notes with an aggregate principal amount of $300 million due October 15, 2005. These notes were initially recorded at a value of $218 million as required by accounting rules, based upon the present value of the outstanding notes at the time of the acquisition. We are accreting on a straight line basis the difference between the present value of the notes at the time of the acquisition, and the principal value over the remaining period to October 15, 2005. Such that the carrying value of the outstanding notes equals the principal value at the time the notes become due. In Q4, we paid $75.2 million for notes with a cumulative accreted book value of $72.5 million at the time of the purchase. The difference in the purchase price and the accreted book value of the notes resulted in a loss on early extinguishment of debt of $2.7 million for fiscal 2002. As a result of the effect of the items I've just reviewed, our GAAP net loss for the fourth quarter was approximately $754.8 million or a loss of $1.75 per share.

If we were to exclude the unusual or nonoperating items listed in the press release, our loss for the fourth quarter would have been $63.2 million, or a loss of 15 cents per share. For the year, our GAAP net loss was approximately $1,597,000,000 for a loss of $4.37 per share. Exclusive of unusual or nonoperating items, our loss for the year would have been $415 million, or a loss of $1.13 per share. However, this does include inventory charges that we took during the year of $286.5 million.

Now turning to the balance sheet. We believe our balance sheet remains among the strongest in the industry. Cash, short-term and long-term investments at the end of the quarter totaled $2.1 billion. A decrease of $175 million from Q3. This does include the $75 million used to repurchase the 5% convertible notes. Last quarter, we cautioned that our cash burden would likely peak in Q4 and could be as high as 145 to $155 million in the quarter. Exclusive of the debt repurchase, our cash usage of $100 million during the quarter was meaningfully below our expectations, a s a result of lower than anticipated working capital needs,

Our accounts receivable balance at the end of the quarter was $28.7 million. Days sales outstanding were 42 at the end of the quarter. This is down from the 78 days of last quarter. Our DSOs are likely to continue to fluctuate and over the next several quarters may come in above or below our target range of 70 to 90 days due to the ongoing certainty in the market and our customers' desire to conserve cash. Despite the industry wide financial difficulties experienced by service providers, we continue to believe that CIENA's remaining receivable balance carries relative low risk due to the size and relative stability of most of our customers.

Inventory levels ended the fourth quarter at approximately $47 million down from the previous quarter when they totaled $65.5 million. The inventory breakdown for the quarter is as follows: Raw materials totaled $34 million, work in process totaled $12.7 million, and finished goods totaled $48.5 million. And a reserve for excess obsolescence of $48.1 million. Raw materials have declined in a large part due to our efforts to increase the amount of outsourcing we do to third-party manufacturers. Inventory turns were 4.5 in Q4 compared to Q3's 5.6. Year to date, we have physically scrapped approximately $256 million in inventory and made payments to settle excess purchase commitments of approximately $34 million.

Finally, head count. Our worldwide head count at the end of the fourth quarter totaled 2,118, a decrease of 520 from the July quarter total of 2,638. Reflecting the cumulative effects of synergies from the combination with ONI, our work force reductions implemented in September, as well as normal attrition and some selective hiring. Now I'll turn the call over to Gary.

Thanks, Joe. I'm going to take a few minutes to review the business in the quarter and to offer our thoughts about the future. First of all, CoreDirector continues to gain market presence and with the largest single product contributor for the year, representing slightly less than 40% of the year's revenues. Osmine certification for CoreDirector is progressing on schedule, and we expect that the first phase of the process will be completed by the end of the current calendar year. Because of its unique feature set, and its proven performance in large networks worldwide, CoreDirector continues to be a door opener for us and will continue to attempt to leverage it for product pull-through opportunities.

We have several customers and potential customers evaluating plans for long hall capacity adds and we continue to believe that our efforts to integrate long-haul transport functionality with CoreDirector will provide CIENA with a significant cost advantage as our customer's plans progress. We've successfully tested CoreDirector with integrated transport functionality, and we're in the early stages of system testing and validation. We expect that we'll have customers trialing an integrated system in the first half of the calender 2003.

Like the overall market, spending in metro networking remains volatile but we are very pleased with the customer and revenue diversity the online family has brought to CIENA. In addition, we've got an important release of MetroDirector that's on track for later this month and this particular release will add layer 2 switching capabilities for both 10, 100 and [GG]. We are also on track with plans to integrate the online network management with CIENA's own center and things are progressing very well. One of the opportunities we are exploring is how to address the new edge in enterprise possibilities that the Online 2500 opens up for us and the potential pull-through it could bring to us for the carriers. We've dedicated a part of the sales organization to pursue distribution relationships to better reach some of the enterprise customers these kind of products appeal to.

From an organizational level, the integration of our switching and transport teams both in Core and Metro is going well and in part, is responsible for our ability to deliver lower than expected operating expenses in the quarter. ONI's fully integrated and we're in the final phases of consolidating our California-based locations. To facilitate further cost savings, we're in the process of moving the first groups from our Cupertino California-based core switching facility into the south San Jose campus. We expect to have all our California based activities operating from San Jose by the end of our fiscal first quarter.

Turning to our strategy. Our focus for 2003 remains three-fold: Focus on and win incumbent carriers, expand our revenue opportunities and addressable market, and thirdly to manage our costs carefully, balancing strategic investment with careful expense management. And I'm pleased to report that we continue to make measurable progress in all of these three areas. Firstly on winning incumbents. During the quarter, we recognized revenue from our initial deployment with Telemex and I believe we continue to make good progress with several other PTTs. In addition, we've seen encouraging signs from several RBOCs, though the timing of specific decisions remains difficult to predict. These incumbent wins won't be quick or easy wins for us. But we believe we have a compelling value proposition and we're looking to take advantage of the current market uncertainty of our competitors' vulnerable positions, particularly while they're focussed internally.

As part of that effort and as part of our ongoing efforts to strengthen our executive-level relationships with our customers, I've personally taken on a more direct role in the sales process with the regional sales VPs now working directly for myself. This new sales structure affords me the opportunity to directly lead our efforts to penetrate these important target customers. Our strategy to expand our revenue opportunities hinges on not only winning new customers, but also on expanding the solutions we have to offer both existing and new customers.

Our product marketing strategies to expand up, out and across. Up into layer 2, providing services beyond layer 1 transport and switching, out is further across towards the edge of the network, and providing solutions across our complete product portfolio with LightWorks. The up into layer 2 has been accomplished both internally and externally. As I mentioned earlier, our latest software release adds layer 2 switching capability to MetroDirector K2. In addition, we're using our partnerships with Wave Smith and Equip to offer carriers next generation core and edge [ATM] solutions. We're also exploring other potential partnerships.

The addition of ONI's products to our portfolio takes us further towards the edge of the network and addresses the "out" part of our strategy. The across is really all about solution sales. We believe the more integrated compatible products we're able to offer our customers, the more strategic we become to them, and, therefore, the larger our opportunities will be. In addition to expanding our portfolio of products, we're also looking for new ways to sell what we already have. Our partnership program covers not only potential new distribution channels, but also other potential strategic partners. We believe that as a result of product extensions and developing sales channels, CIENA's available and addressable market will grow despite an overall decline in carrier spending in 2003. In addition, we expect to use strategic partnerships in distribution relationships to expand our addressable market further still.

The final leg of our strategy calls for continued pursuit of balance between investing in our business and carefully managing our costs. We'll continue to pursue a measured approach to managing our expenses, attempting to carefully balance strategic investment with expense prioritization. We continue to work to prioritize specifically our R&D efforts to align our investments and our costs with future opportunities. And our efforts are paying off. With operating expenses in the quarter below our initial expectations. I see this is a clear measure of the expense and cost management that is happening throughout CIENA. I also continue to believe that CIENA's progress forward in this turbulent environment will be measured best by our progress with incumbent carriers and by our improving financial performance.

The timing of any improvement in carrier spending remains uncertain. But, and this is what makes us different from our competitors, we believe the steps we've taken to increase our addressable market will enable us to grow our business regardless. We believe that we're in a position to take advantage of the current financial and directional uncertainty surrounding many of our competitors. And we believe we can expand our revenue opportunities taking the largest share of what will ultimately be, in our opinion, a smaller market. Clearly, we're in this to win, not merely to survive.

Now, there are those who doubt our ability to do so. But we think we've got a real opportunity and the only way to capitalize on it is to pursue it aggressively. Carriers are still facing the challenge of growing demand on networks that were principally designed for voice and not data. They still have business and operating models that need to be fixed. And CIENA is still one of the only equipment vendors able to offer them solutions that enable them to address those challenges. With those comments, Joe, will you walk us through the guidance?

Sure thing. Before I begin to offer our guidance for Q1, I will remind everyone that the statements Gary just made and those that I am about to make are forward-looking. It is important to review the risk factors detailed in our 10-K, in order to understand the factors that might cause actual results to differ materially from this guidance.

At this point, we believe that depending on revenue recognition timing, revenues in Q1 will be up as much as 10% from the Q4 levels. As Gary mentioned, we feel good about our progress with incumbents, and as a result, we are guardedly optimistic about our short to medium-term revenue prospects. This quarter's better than expected gross margin resulted from a favorable product mix and the cost reductions we've made in our manufacturing operations. Based on the continued effects of our cost-cutting and our current product mix assumptions, we believe that gross margins will improve slightly in Q1. We also expect operating expenses exclusive of any unusual or nonoperating items will decrease slightly from Q4.

In addition to the 5% convertible notes we purchased on the open market during the fourth quarter, the press release notes that we filed with the U.S. Securities and Exchange Commission a tender offer statement relating to an offer to purchase the remaining outstanding 202.9 million, 5% convertible subordinated notes at an offer price of $86 or 860 per thousand dollar principal amount. We expect other income in the remainder of the income statement in Q1 will be largely dependent on the response to our tender offer. For instance, if we succeed in purchasing all of the outstanding 5% notes at $86, we will save approximately $28.4 million in future principal payment and will record a book loss of approximately $18.7 million related to the extinguishment of the debt due to the fact that the accreted book value of the note will be less than the purchase price.

We estimate the first quarter's share count at approximately 432 million total shares. As a result, we expect that exclusive of unusual or nonoperating items, our net loss for Q1 will be in a range of 13 to 15 cents per share for the first quarter. We expect that our cash burn peaked in Q4 and in Q1, exclusive of the cash used in the note repurchase, we will be in the range of 90 to $100 million. We continue to expect to be able to reduce our operating cash burden significantly over the course of fiscal '03 to the point where the returns to the 50 to $70 million range will be we've targeted as a start. Operator, we'll now take questions from the sell-side analysts.

The question-and-answer session will be conducted electronically. If you would like to ask a question, please do so by pressing the star key followed by the digit one on your touch-tone telephone. If you are on a speakerphone, please be sure your mute function is turned off to allow your signal to reach our equipment. Once again, if you would like to ask a question, please press star one on your telephone keypad. We'll take our first question from Nikos Theodosopoulos with UBS Warburg.

Thank you very much. My question is related to the RFP activity that you talked about and I guess it's kind of tied into that, can you talk a little bit about the deferred revenue that's on the balance sheet right now? Specifically, on the RFPs, are you seeing that more overseas for CoreDirector, or is it more broad based? You talked a little bit about some of your existing core customers looking for expansion. Can you give more detail on that and talk a little bit about the deferred revenue? Thank you.

Nikos, why don't I take the first part of it and hand it over to Joe for the deferred revenue piece. We are seeing an uptick in RFP activity, I think it's fair to say it's across the board, it is with the larger carriers, target accounts. I would characterize it as being both for Metro products and for CoreDirector. As I also talked about in some of my comments, we're also seeing some requirements in the long hall for the integrated CoreDirector and long hall capacity which is encouraging. I think it's very early days there. You know, I think from a geography point of view, it's pretty spread, but really into the large PTTs in Europe, Asia, a couple in Latin America and obviously into the RBOC's domestically. I would caution from drawing any great industry conclusions from this. I think it's related to our particular micro and having the value proposition that we have. So I any to summarize, Nikos, I think it's fairly broadly based into the target accounts and I would predominantly characterize it as being into the Core switching piece and into Metro. Joe, do you want to comment?

Sure. Nikos, I'm going to start off by making the statement that you have really two separate questions, because we don't view that they're related, per se. That being the case, when you see that the K, which should be within the next hour or so, there will be $30.8 million of deferred revenue disclosed in the K, that's both long and short-term. The majority of that has to do with services that people have paid for, but we just haven't supplied them as of yet.

Thank you, Joe.

Yes, sir.

And we'll proceed to the next question from Ahud Gelbloom with JP Morgan.

Hi, good morning. A couple of questions. You mentioned that the gross margin improvement had to do with the product mix and I was wondering if obviously you saw a lot more quarter activity this quarter than previously. The gross margin on CoreDirector seems to be better than the other products, can you give us more color on how you think that mix will go going forward, especially in light of the 10% potential upside next quarter, and whether we'll see a continued -- how that mix will influence gross margin from there? If you actually compare this quarter to last, it looks like there's a lot of operating leverage in the business and that you raised revenues by $12 million and the cogs barely moved. I know there's some manufacturing issues there as well. So if you can give any more color on that. And then on a totally unrelated issue, I just have to ask. If you have any comments on the lawsuit from -- with Nortel.

Why don't I take those. In terms of the gross margin, it is product mix. The other point that I think you made as well is in terms of the operating leverage. We have significantly reduced our overheads from a manufacturing perspective and so I think, you know, you're also seeing, you know, a lot of the benefits of that kicking in as well. So it's not just the product mix and increases in the software content. Clearly, they're a major contributor, but it's also the operating leverage that we've worked on, you know, in the last 12 months or so. So that's starting to kick in. As Joe indicated, you know, our current view is that that gross margin based on the mix and this leverage kicking in, should, you know, see a slight uptick next quarter as well, or -- you know, all being well, depending on exactly how the quarter flows out. I think we're optimistic that we can get that going north. Due mainly to the mix.

You know, I think if I look ahead at the kind of product mix, and I think really the first question I answered from Nikos, we see both strength in the Metro side and the CoreDirector platform as being, you know, probably the predominant areas going forward as the long haul, you know, improves slightly. And of course, with the integration that you've got on CoreDirector, that really is kind of a single platform as we move further out. In response to the Nortel piece, you know, as many of you know, upon acquiring ONI Systems, we became a defendant in a lawsuit originally brought against ONI by Nortel, and we believe the recent filing stems from our pending litigation here, and obviously we are not at liberty to comment further on the pending litigation.

Okay. So back to just a quick follow-up on the first part of that, if we were to assume an incremental gross margin of somewhere in the vicinity of 50, 60% on incremental revenue, is that roughly right as we move forward?

This is Joe. Let me tackle that one. Again, it's very hard to call. It's really a function of which product line is the revenue going to come from or be associated with, and even within that, whether it's a network build-out or whether they're just channel cards going into the network. So it's -- I wouldn't say it's quite that significant.

Thank you.

We'll take our next question from James Parmalee with Credit Suisse First Boston.

Thank you. I wanted to draw in a little more in terms of visibility. I guess a question for Gary. Gary, you talked about progress with PTTs, I heard from answer to Nikos. But could you give us more in terms of, have you been named on certain short lists, have purchase orders actually been awarded within new customer sets that really boost your confidence? If you can provide more granularity. And then a clarification on Joe's Metro networking comment. I think you said it was 20% of revenue, would that include both the MetroDirector as well as Metro Transport? Thanks.

James, let me answer your second part of your question first. Yes, it does. We include all of those together now.

Great.

In terms of the PTT activity or the international activity, I think we're vying for a number of opportunities in the large PTTs worldwide. They're at various stages of maturity. You know, I wouldn't want to comment further than that. We've not announced anything. And you know, I think we're doing very well from -- obviously from a technical point of view and we believe that we've got some good opportunities there that we're tracking, you know, but these things take time. And you know, we've been working on these for a while. They take a while to come to maturity, and we're patiently tracking those. I really wouldn't want to make any further comments right now.

Just a quick follow-up, in terms of the size of the potential opportunities versus kind of your historical experience Gary, can you comment on how you think things will evolve?

You know, I think they vary in terms of size, what we're focussed on right now is more becoming a strategic vendor to many of these large carriers. I think, you know, if I understand the gist of your question, I think the days of folks turning around with $100 million orders that we need to deploy, you know, within 12 weeks, are probably not going to be around for a while. So I don't think you're going to see, you know, the multiple hundreds of millions of dollars deals being executed. I think these are more deals that migrate the networks to next-generation networks and as such, I don't think they'll be as large as, you know, the heyday of the big transport builds.

But they are, you know, multiple products and really what we're encouraged by is the traction that we're gaining with the whole LightWorks piece and particularly our ability to integrate long haul capacity on CoreDirector and then the whole LightWorks piece and with our Metro offerings as well. So it is across the broad product line and could be very substantial over a period of time. But it's really about, you know, expanding our relationships with these large incumbent carriers right now.

Thank you.

We'll go next to Kevin Slocum with Sound View.

Hi, guys.

Hey Kevin.

Sort of a mechanical question. Assuming you have success on some of the layer 2 efforts, where's that revenue going to fall out, Joe?

You mean which quarter?

No, in your -- the way you lay out the business in terms of where you've succeeded during the quarter, I mean, how are you going to be lumping it in? Are you going to be calling it out specifically or is it going to be part of the broader categories you talk about today?

No, I think with regard to these significant distribution relationships, we'll have to talk about it internally and then of course we can't do anything without consulting with legal counsel, but we're probably going to have to spell that out, Kevin going forward and separate it so you can see it.

And would you expect it to be a material contributor to revenue in the new fiscal year, material being defined as, you know, a 10% or greater figure?

Well, that puts me into a corner. It's a little bit early to tell, but I think that you know, we try -- CIENA's always tried to offer everybody a bit of balance and share with you what we see today. I think what we see today is that there's a possibility, but it's as equal as not being a possibility. I think we're right in the middle of the road and whether we get to the favorable side of that or not is a little bit too soon to call, Kevin but it's -- we're moving forward. I think, you know, Gary, I'll let you comment, we're happy with the progress where those relationships are going.

Yeah, I think we're happy with the progress. I think the answer is, it's too early to tell, the honest answer to it, we're encouraged by it but, you know, we're early in the game. There's a long way to go.

All right. Congratulations on the improvement.

Thank you.

Thank you, we'll take it.

We'll take our next question from Christin Armacost with SG Cowen.

Good morning. I have a couple of questions. First when you talk about your strategic relationships, how important do you think it would be to have more traditional optical relationships or companies that have had significant market share? You highlight Wave Smith and Equip, but clearly these are small companies, making small but important steps into some of the RBOCs and other areas. I wanted to see how critical it would be for you to have kind of legacy relationships out there with some of the other vendors. And also, last quarter, you talked about one major China opportunity that would come this year. I was wonder to go you could update us on the progress there?

Sure. In terms of the, you know, characterizing our strategic relationships, they fall broadly into two categories, one is from a technology perspective. We've announced two of those. And the second piece will be from a channel distribution. We haven't really announced too much around that. So I think, you know, we're looking to, you know, increasing our addressable market in two ways, as we said, up, out and across. I'd like for our technology partnerships to help with that.

And in terms of increasing our addressable market, clearly you know channels and distribution partners be them geographic or in particular market segments like storage, et cetera, you know, the direct question of whether we need -- I think what's behind your question is do we need some relationships with legacy vendors in terms of channels to market? You know, my initial reaction to that would be we don't think so. We have a very targeted account list that we've been working on for a while and we have good relationships we believe into most of those accounts and they're continuing to develop. So you know, on the face of it, I don't think a legacy equipment vendor really would have a lot to offer us in that particular regard.

That answers that question, thank you.

The other one was China. I think what most vendors are seeing is sort of a delay in a lot of the China activity. You know, we're also seeing that. There's still good opportunities there. We just opened our office in Beijing, and we have a dedicated team in China. We still see good opportunities there, but I think I'd characterize it as it's taking longer than we all thought. I think that's really an overall industry piece as well.

Fair, thank you.

We'll take our next question from Simon Leopold with Merrill Lynch.

Great, thanks a lot. Two questions really. One is, I'd like to get an understanding for your confidence in the 10% sequential improvement in the next quarter, maybe talk about your book-to-bill or a little bit about the mix changes. Also, when we step back and look out beyond the first quarter, thinking about gross margins, if we assume, just to sort of keep things simple, revenues stay sort of flat, are you doing a lot to improve the gross margins from the current point? Or should we sort of think about the kind of progress we're seeing from the October quarter to January quarter as being the right kind of incremental step? Thanks.

Simon, why don't I take the confidence piece and really parse it into two areas. One is the current quarter that we're in. I think we have a reasonable degree of confidence that we can get to some kind of sequential growth. Clearly we're halfway through the quarter. It's a very volatile market though. You don't need me to tell you that. So I'd describe the confidence as being cautiously optimistic. I would not want to share metrics in terms of book-to-bill or backlog but I think we tend to be pretty cautious and we are guiding to a slight revenue improvement in Q1. I'd just like to leave it there.

In terms of, you know, moving forward, you know, we still don't have great visibility in this environment. While we're encouraged by going north in terms of revenues last quarter, we think we can achieve it this quarter, we remain very cautious in terms of a broader outlook. We think we can get from what we're seeing right now in terms of our involvement in RFPs and general activity in the pipeline, we believe we can get revenue growth overall for the year, but time will tell on that. On the gross margin issue, let me hand over to Joe.

Simon, this is Joe. Your assumption let me get this right, is that if revenues stay flat, I think the rest of it is could we continue to grow gross margins? The answer is a little bit but not significantly. What that would translate into, is in the restructuring, the most recent restructuring we took in September, was in the middle of the quarter. So you would on a flat revenue assumption basis, you would see a full quarter impact. And then the other slight benefit you would get is, I think, the major you know flushing out of the inventory. And what we need and what we didn't need has taken place. So that's pretty much behind us from a really significant point of view as well. So to the degree that you don't have those going forward, you would see some improvement but to really get a big uplift in it, it's going to be volume-driven.

Could you give us maybe a little sense of the sensitivity to the volume? Just to play with numbers, let's say revenue doubles. What does that do to your gross margin?

Well, everyone's laughing, because we're saying it's going to up, but I think you want a more specific answer.

Yeah.

That's pretty good, Simon. It's going to be dependent upon the product mix, if it's transport-driven, it's not going to be as significant. If you double the revenue and you get to, I don't know the 140, 150 range, say 140 range, you potentially could get well into the 20s, cruise into the 30s maybe. It's going to be a function of pricing. I mean, I guess I'm struggling giving you an answer because that's a tough one to call, because there are so many moving parts.

We don't ask easy questions.

I know, especially you.

That's good, a 30ish neighborhood on a $140 million is as good an answer as I can expect. So thanks.

We'll go next to Mike Gargano with Bear Stearns.

Good morning, everyone. Just a couple of quick questions. You said on the call and kind of in the press release that for 2003 you could see a slight increase year-over-year in revenues. I was just curious as to, we've seen a lot of these PTTs, the RFPs particularly on the optical switching side have been out for a while assuming they don't execute on a lot of these and they kind of get pushed out, what do you think you could expect in terms of revenue growth throughout the quarter? If you're going to get revenue growth in 2003 you're probably going to have a steady ramp as we go out through the year. So assuming just in terms of capacity upgrades, with current customer base, any assumption we can get in there in terms of growth?

Mike, I think -- let me answer what I think, you know, you're -- behind your question there. What are our assumptions in terms of wins at the major sort of carriers around the world, you know. And I think our current best view of an improved revenue in 2003 as to 2002 is based on winning some of these large new customers. You know, we think it's realistic. I would say that I think particularly given that, that you know, the quarters could be very lumpy. You know, we've seen that historically. I don't think generally you're going to see a real smooth rollout of that. We've got a lot more customers than we had and that's clearly helpful, but you're -- you know, in terms of getting good baseline business, but you're still dependent on winning new reasonable-sized situations that contribute to the various quarters. So I guess what I'm saying there, I think it's going to be lumpy on the way.

Okay. And given that some of these RFPs have been out for a while, can you tell us anecdotally, why there's more conviction right now in terms of what they're doing to move process.

I think it's more to do with the compelling value proposition. You're always seeing, particularly in this environment, things like delays and downsizing of plans, et cetera but I think the fundamental value proposition of moving to next-generation networks and lowering their capital and their operating costs, you know, automating the network is very compelling. I think you've seen most of the major carriers worldwide at some degree of maturity in terms of evaluating this. So even if, and you know our assumption is that, in fact, even amongst the major carriers that CAPEX will be down in 2003. It's really where are they spending the dollars that they're spending. Our view is that we have a very compelling value proposition that will capture that. So we're looking to capture more of the spend that's out there that would have gone to legacy equipment.

Okay, great. Just a follow-up, was the entire Telemex order recognized in the current quarter?

Yes, Michael.

Yes, okay. And lastly, in terms, I know you've been taking write-downs of the inventory, in the future is that going to be a broken note if it has any effect in terms of the gross margin?

This is Joe. If it's something really big in nature, we'll talk to you about it. As a part of your normal [INAUDIBLE], there's a certain percentage that provides for inventory material usage and things of that nature but we're back to that steady state as far as we can see today. Unless it's something big, we won't spike it out.

Great, thank you very much.

We'll take the next question from George Notter with Deutsche Banc.

Thanks very much. When you look at the different PTTs opportunities that are out there, I assume in some instances maybe you haven't made short lists. Can you talk about in those cases, if there are those cases, what's the set of circumstances that maybe causes you not to kind of get on short lists? What issues are there for CIENA in winning these deals, if there are any?

That's a good question. The challenge for us is really one of, you know, incumbent relationships, George. And a lot of the legacy vendors clearly have long relationships with, you know, the RBOCs and the PTTs. And they provide a lot of existing equipment to them. And I think, you know, -- and I'll characterize from it an extreme perspective. On the one hand, some of those large carriers are concerned about the future viability of their existing legacy vendors. And when I mean concerned, I think there's two aspects to that. One is, you know, their ability to continue to sustain investment in the area that's of interest to the carriers. And the second thing is more sort of general financial concern. But I think, you know, what's clear to most of the carriers worldwide is that their traditional vendors will not be able to play in all the areas that they're playing in right now.

And so that translates as either a great opportunity for CIENA, because they're looking for a viable alternative with a next-generation architecture, or in some circumstances, it actually leads them to want to place business with the legacy vendors to make sure that they're okay. I don't know that I've described that properly. Those are the two kind of poles apart in terms of some of the decision-making that's going on in the incumbent carriers. And depending where each of the individual carriers are in that decision process, it's either very good for CIENA or very bad for CIENA. And so some instances where we've seen delayed decisions has really been due to some concerns about their existing vendors.

Got it. Just as a quick follow-up, the DSO calculation, Joe, is that more about improved collections ability in the quarter or improved linearity or both? Maybe you can parse it out.

I'd say predominantly it's from the collections, but it's also being driven by the types of payment [INAUDIBLE].

Got it, thanks.

We'll take the next question from John Wilson with RBC Capital Markets.

Thank you very much. Two quick ones. One, Gary, in your earlier comments and in the press release you talk about the opportunity for CIENA to achieve growth in 2003. To clarify, are we talking calendar or fiscal '03 on that one? That makes a big difference. And second, Joe, I guess if you can maybe give us some visibility as to the organic growth in the quarter excluding ONI, given that we've got the full quarter of ONI this quarter?

Let me answer the growth. I think, you know, given we don't have a huge visibility, it's really just based on our feelings right now, the comments were intended to be fiscal.

Okay.

In terms of organic growth from the ONI, I don't think we'd split that out. We've integrated that now within our Metro division basically, and so I -- to be honest, I don't think we'd be prepared to split it out. But I will say that online was a meaningful contributor to the quarter.

If you go back and listen to the beginning of the script or call, in case you missed it, it all boiled down to CoreDirector was a big contributor to this quarter.

Right. But directionally, if you look at where Metro went and you talked about other 20% in the quarter, I think, directionally you know, with the MetroDirector business and the ONI business have moved sort of the same or did you see more ONI versus---

I think we saw both. And I think directionally, that whole Metro space, you know, is sort of alluded to earlier, I think the Metro space and the CoreDirector will be the primary players.

Okay. And so -- and Metro is a key contributor in terms of that outlook for growth?

Yes, it absolutely is.

Thank you very much.

We'll take our next question from Hassan Imam with Thomas Weisel Partners.

In terms of cost reduction over the next two quarters, what are you looking at primarily, head count reduction, process improvements, or primarily interest cost reduction? The second is a product-related question. Gary, you talked about integrated transport and switching product files next year first half. Is that or an ultra long haul application or a more conventional one? Thank you.

All right, I'll do the first one, and then Steve will do the second one. We've got to give Steve something to do here. He's sitting here the whole time. In terms of cost reduction, if you take out all of the unusual stuff, we had operating expenses all in of about, I think it was 106, $107 million. In terms of what the first quarter looks like, it will be down by several million dollars from there. You know, in and around the $100 million mark, depending upon what the timing of some prototype parts can be. It can be a little over, a little under. That's kind of where we see that. Does that answer your questions?

Well, I was looking for a more, you know, further initiatives you may be thinking about. Will that be primarily focused on interest cost reduction or for the head count reduction or just process improvements?

We're -- if you're asking us are there any further head count reductions, there's nothing to talk to you about today. The repurchase of the notes will have a -- may or may not, depending on how successful we are, on the interest line. But again, we won't know that until we see if we're going to be successful or not there.

Okay. Thanks, Joe.

All right, Steve, your turn.

With regard to the integration of long haul and CoreDirector as an integrated platform, it really is independent of application it can do both. The conventional several hundred to a thousand kilometer mid-distance or mid-range applications or [INAUDIBLE] independently. It's based on a mirroring of various CoreStream line systems with integrated optics in the quarter. Really it can do both.

Thanks, Steve.

Our next question comes from Ted Jackson with U.S. Bancorp Piper Jaffrey.

I have a couple of questions, they're actually pretty simple but I think the answers might take you a little bit of effort. So the first one kind of has to do with let's call it, like, new sales piece of the add on and upgrade within the existing business. I guess I'm curious as to what you've seen in terms of the trend of that business going forward, and how that plays out in your thought process -- I mean, in the past and how that plays out in the thought process going forward. The concept being that if you think about sort of like a comparable year-over-year and stability aspect of revenue, clearly if you've had a follow-up as I imagine you've had over the last number of quarters on new business, and you sort of add on or upgrade business why not install base is more or less stabilized, you would hit a point where you would have a stable business model on a go-forward basis. That would be the first question. The second question, which would kind of go back into probably Nikos's initial question, and it relates to the opportunities that you're seeing really kind of across the globe. And it could be answered maybe in two parts. And it's: What is the underlying driver behind some of those opportunities? One, looking at it from, say, a long haul and a metro perspective specifically. Like for instance in North America. Is it being driven, you know, by 271 relief or, you know, those types of drivers. And then you know, a second way to answer it, if you could, is maybe looking at it more from a geographic perspective, if there's any differences from, say, North America to Europe to Asia, et cetera. Thanks.

Okay, Ted, let me have a go at that.

I told you it would be a little challenging.

Let me try and -- I think what you're getting to in the first question, is there a baseline of which we have recurring existing customers placing channel adds and adds, et cetera, that gets us to a certain number. We're very leery to draw any conclusions in that. I think given the environment and really the lack of trend that we're seeing there, frankly. You know, if you'd have asked me nine months ago what our baseline would be, I would have, you know, come up with a certain number. But frankly would be higher than the revenue we did last quarter. Just based on existing customers, add ons and upgrades. We're very leery in this environment. We try very much internally to get to exactly that. You know, what's the base-line revenue for the company, and then what are the new wins in addition to that. I think it's too soon in the environment to be able to call that, to be candid.

So you're seeing no -- you haven't seen any indication, at least in the last quarter, or the last you know near term that there's been some kind of stability on that front?

No. No. I think you're still seeing carriers going to extraordinary measures to conserve cash. They're still moving equipment around. Now there's a logic that at some point they get to the end of that, and they have to place some orders. I think it's too early in there. I would not describe it as a stabilizing situation. And I'm talking about the industry generally.

Yes, that's actually what I'm going for. You have to ask yourself, how much more -- how much time, I've been doing this for like a year, how much longer can they sit there and move around things that have already been installed.

I think they've become very adept at it unfortunately. And it's a big focus for them and I think will continue to be. I don't think you're going to see a recovery in the industry in the way some people are perhaps talking about. I think in our own view of the world, even amongst the large carriers, we think CAPEX will be down next year slightly in 2003 than 2002. So we're clearly a micro in the macro and, you know, we're looking to expand our addressable market but I don't think -- we're not the best barometer for the overall industry, I guess is the conclusion I would draw from that.

The other part of your question, Ted, was really around what's driving these RFPs. I think it's a shift from the first lever that the carriers could pull was CAPEX, and clearly they've done that in the last 18 months. But the underlying issue is also operating expenses and automating the network. And that, I think, is what's, as an overall comment, driving RFP activity and will drive any new awards, either in the Metro space. You know the Metro space tends to be more success-driven. So if they get customers, they need to deploy capacity at the edge of the network, so I think it's an easier equation for them to make.

On the core side, it's more strategic decision about reducing their operating expenses and automating the network. So I'd simplistically answer you those are the two areas, they've got slightly different drivers. I think it's all around customer capture and reducing operating expenses in addition to capital.

Okay. So you don't see it as any kind of new revenue opportunity at all anywhere? It's really simply put, just about reducing operating costs?

No, I think the Metro part of it, I think there are opportunities for revenue capture, you know, of new customers and new services on the data side. I mean, we're consistently seeing from the large carriers that their data traffic is growing. The challenge that they have is how to deploy an architecture that can get revenue from that. At the edge of the network. I think that's the challenge that they have, is really how can they get revenue from new data services. So I think there is an opportunity there at the edge of the network.

Okay. Thank you very much.

We'll go next to Steve Levy with Lehman Brothers.

Thank you. Just two questions, hopefully they're easy answers. One, in the revenue projection for the first quarter, are you counting on any new customers to generate some of that revenue? And the second thing, can we specifically address the breakeven point? In the past you've talked about numbers in the 200s of millions per quarter. Can you give us an idea of what you think your breakeven point is with a certain gross margin assumption today versus where you think it might be let's say at the end of next year? Thank you.

Steve, I'll take the first part of that. The answer to your question is yes. We reliant on revenue for Q1 from new customers being realized for the first time. There is clearly risk in that. Joe, do you want to take the other one?

Steve, let's do the breakeven one, but let's make sure I answer your question because it was a long one. In the case of the breakeven, the former guidance we gave is still valid. You know, the revenues need to go up, the margin needs to go up into the 40% range. We still think that's a target we're achieving, based upon what we know today, we feel as though it's achievable. And that being the case, with the guidance we gave you previously when we've talked about restructurings and the like, that gets us into the 175, 225 range, depending upon, you know, what you guys think the right combination of those numbers are. And so you've got another part to your question. Why don't you reask it, I want to make sure I answer it.

I was confused about the previous guidance, but let me make sure I get this right. So what you're saying is your projected breakeven at some point in the future would be somewhere between 175 and $225 million per quarter, based on gross margins getting up to around 40%?

You've got to make that call yourself, you're the analyst, whether you think it's 40, whether you think it's 43, whether you think it's 39 but it's in that general ballpark.

But that's how you're managing your operating expenses? That's probably the best way to --

That's correct.

Correct, Steve.

What we're doing day in and day out.

Okay, thanks.

We'll go next to Chris Fischer with Raymond James.

I'm going to follow-up on Steve's question on the breakeven point. Looking back in my notes, I had commentary that gross margins in the 40s were possible on $175 million in revenue. The breakeven commentary had been somewhere, I think, between 280 million to $300 million in the last conference call. In September there was some commentary that you came out, that you were going to take around $25 million related to gross margins out of the business and another 25 to $30 related to operating expenses. If you put those numbers in, that gets you to, I guess, the $240 million range. Where's the other $50 million in savings to get you to breakeven coming from?

I think if you're referencing the last call in August, Chris -- this is Joe -- we did another restructuring in September that would help bridge that gap.

Right, that would get you from the 280 to 300 level referenced in the last conference call to around 235 if you put the September guidance in there. How would you get to the $175 million level?

Well, you'd have to have a different gross margin assumption. We're giving you ranges.

So it would have to be meaningfully above 40%?

Yeah, you'd have to go closer to 45.

Okay.

I don't have a calculator in front of me.

Okay. Fair enough. The other question I had was when you talked about cash burn in the quarter, $50 million better than expected, it sounded like a good portion of that was related to working capital. When you look forward sequentially, you're at 90 to $100 million Q1 and then I think the longer term target is 50 to $70 million. How much is that going to be based on any more leverage you're going to get on the working capital line? Is that largely behind us?

No, you're going to get a little bit more leverage. For example, the Q1 number would be lower than what we shared with you if we would have had a different outcome on the settlement of Pirelli claim, it would have been down by another $10 million, which would have gotten us even closer to our target range, so there's that artificial item in Q1. If you take that out, we would have been in the 80 to 90, rather than the 90 to $100 million ranges. Or something like that. We don't have to deal with any more of the inventory losses and things that were in the numbers. And there's a little bit in this quarter that we had to pay on some commitments and things.

So you're actually a lot closer to your target range than your first commentary suggested when you back in a couple of the extra working capital items?

Well --

If you don't want to say that, but we can make our own judgment on that?

Yeah, I mean again, too, let's do some scenario playing. Say that revenue goes up really large, then you're going to put a little bit in AR, so from a pure mechanical cash flow calculation, it might not be as good as you would have hoped, but the most important thing is here, the cost management, the prudent cost management is helping bring down the outflow of cash, I think that's the good thing to talk about.

All right. Okay. Thank you.

We'll go next to Alex Henderson with Salomon Smith Barney.

This is Darrell Armstrong for Alex today. A couple of questions. In terms of your fiscal 1Q guidance, how much of that is coming from an expectation of a seasonal year-end budget flush from your existing customer base? The second question I have is, it's pretty good that some activity in -- is starting to tick up. As you look at the competitive landscape, what are your competitors doing relative to pricing? Have they sort of learned their lesson from what's occurred over the last year and a half or two years, or are things still pretty tough on that front? Thanks.

Darrell, in terms of our assumptions on Q1, I don't think there's much assumption on a budget flush-out. It's certainly not been a factor historically. I think we look to what happened last year and I think we saw zero in our assumption is not the -- folks are going to find budget in the year-end to flush out. That's -- I think that wouldn't be smart of us in this environment. In terms of the pricing, I think we're particularly seeing very competitive pricing. That's the question, I think the answer's no, I don't think folks have learned. There's particularly one or two vendors in the Metro space where they don't have a technology advantage, some of the legacy vendors, who are, you know, just being very, very aggressive on the Metro pricing. And we as always are pricing strategically. We have technology advantages and we're focussed on our value proposition, but we are seeing pressure in the Metro space particularly on pricing.

Thank you very much.

Due to time constraints, this does conclude the question-and-answer session for today. Mr. Smith, I'd like to turn the conference back over to you for any additional or closing comments.

I'd like to thank everyone for their time this morning and for your continued support and have a safe and happy holiday and we will talk to you in the new year.

This does conclude today's conference. We appreciate your participation. You may now disconnect.