Ciena Corp (CIEN) 2004 Q2 法說會逐字稿

Good day, everyone and welcome to the CIENA Corporation second quarter fiscal year 2004 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, Miss Suzanne DuLong.

Please go ahead, ma'am.

Thanks, Dan.

Good morning, and welcome everyone.

I'm 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.

Gary will provide some brief introductory comments.

Joe will review the quarters' financial results.

Gary will then discuss the business in the quarter and our outlook and Joe will wrap up our prepared remarks with guidance for Q3.

We will then open the call to questions from the sales side analysts.

This morning's press release is available on national Business Wire and First Call and also on our Web site at CIENA.com.

Before I turn the all over to Gary I'll remind you that during this call it's 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 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-Q, which in keeping with CIENA's long standing practice of filing the same day we report, we expect to file with the SEC today.

In addition, the company assumes no obligations 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.

Our second quarter results came in at the mid point of our revenue and EPS guidance ranges reflecting neither worse nor the best possible scenarios for the quarter.

Some points worth highlighting.

Our customer base continues to grow and diversify.

We announced customer wins that spanned our solutions portfolio including an ultra long-haul win at MCI.

Multiservice switching wins at Verizon and at Red Electrica.

A B-RAS win with Laurel and Spain's Arsys Internet.

In addition, SBC recognized CIENA as one of a select group of suppliers honored for their work in helping SBC deliver outstanding service to its customers during the past year.

About 5,000 major suppliers provide SBC affiliates with materials and services and CIENA was the only company recognized for product performance specifically for its DN 7000 family of multiservice switching solutions.

We also recognized our first meaningful revenue from our GIG-BE win and from a financial performance perspective we delivered better than expected ongoing op ex as a result of our continued cost reduction efforts.

And though it technically happened two days after the quarter closed we did successfully close the acquisitions of Catena and Internet Photonics.

I will discuss the quarter in more detail and also our business outlook after Joe reviews the quarter's results.

Joe?

Thanks, Gary.

Good morning, everyone.

This morning, we reported second quarter revenue totaling $74.7 million.

This is a 12.5% sequential increase and roughly 2% increase from the second quarter of FY '03.

We had one 10% plus customer in the quarter representing 32.2% of total sales.

The 10% plus customer is a U.S. customer.

This compares to Q1 when one 10% plus customer accounted for 17.9% of the quarter's total revenue.

Domestic sales represented 78% of the quarter's revenue compared to Q1 when they represented 56% of the total.

On the product front, revenue from our core networking group which includes core director and long-haul transport, increased sequentially and contributed just under 50% of the quarter's total revenue.

Revenue from our metro and enterprise solutions group, which includes Metro transport, Metro switch, ONLINE Edge and the CN 2000 storage area networking extension platform also increased sequentially both in real dollars and as a percent of total, representing roughly 27% of total revenue.

Revenue from our data networking group represented less than 10% of total revenue.

Service and support-related revenue was roughly flat with Q1, representing approximately 17% of the quarter's total revenue.

The remaining revenue in the quarter came from our solutions group, which includes sales of on center network management software.

Turning to our quarterly operating results.

The press release presents a GAAP only presentation of our results as well as detailed information about the adjustments 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 those items detailed in the press release.

With that background, let's start with the operating results.

We cautioned coming into the quarter that our gross margin could vary significantly quarter-to-quarter and we'd be down Q2 versus Q1.

Gross margin in the quarter was lower than expected as a result of product mix.

We had slightly higher than expected sales of low margin, long-haul transport, and lower than expected sales of higher margin core switching.

Product gross margin exclusive of provisions for excess and obsolete inventory costs declined from 38.7% in Q1 to 9.9% in Q2.

In addition to the effects of a significantly long-haul weighted product mix, the quarter product gross margin also shows the effect of common equipment intensive initial ultra long-haul deployments at two customers.

Common equipment such as chassis and amplifiers were typically the lowest margin components of a system for deployment.

In addition, the revenue we recognized in the quarter included revenue from some of the first-ever shipments of our CoreStream agility platform.

And as would be the case with any new product introduction, since those initial shipments, which occurred in 2003, we have already significantly cost reduced the platform which will translate into better gross margins going forward.

Based on our current product mix expectations, which include the addition of Catena and Internet Photonics, higher margin platforms, we expect gross margins to rebound to near 30% in Q3.

Service gross margin continued to improve moving from 4% last quarter to 17% this quarter.

This quarter's service margin reflect a higher mix of tech support services and it's probably near the top end of what we expect will be a 10 to 20% range for services margin over time.

Our overall gross margin of the third quarter was 11%.

We expect our overall gross margin will rebound in Q3 and will approach 30%.

Turning to operating expenses.

On a GAAP basis, our operating expenses in the second quarter totaled $83.3 million.

As noted in the GAAP P&L, this included noncash charges for deferred stock compensation, amortization of intangible assets, accelerated amortization of San Jose leasehold improvements, restructuring costs, and benefits for doubtful accounts recovery and the use tax refund.

I'll discuss each of these.

As part of our acquisitions we recorded unamortized deferred stock compensation costs relating to the unvested stock options and restricted stock assumed in the acquisitions.

During the quarter, the amortization expense related to deferred stock compensation amounted to $1.9 million.

Amortization of intangible assets in a noncash expense, unrelated to normal operations, arising from the amortization of intangible assets acquired in our various acquisitions.

During Q2, this expense totaled $3.4 million.

We also recorded a $1.7 million charge related to accelerated amortization of leasehold improvements related to the planned exit of our San Jose facility.

This charge is included on the P&L as part of R&D expenses.

We also recorded a $5.2 million charge in Q3 for restructuring costs, which breaks down as follows: $2.5 million related to a work force reduction and $2.7 million related to an adjustment of previously restructured facilities.

In addition, we recognized a $2.8 million net benefit for the recovery of doubtful accounts, and a $1.9 million payment related to a California use tax refund.

Ongoing op ex was lower than Q1 by about 5% reflecting our ongoing efforts to reduce expenses.

R&D exclusive of the accelerated amortization costs decreased by 5% from 47.2 million in Q1 to 44.8 million in Q2.

Sales and marketing decreased 2%, from 25.5 million in Q1 to 25.1 million in Q2.

G&A decreased 15% from 7.1 million in Q1 to 6 million in Q2.

Our GAAP net loss for the second quarter was $76.2 million, or a loss of 16 cents per share.

Exclusive of the unusual or nonoperating items I discussed earlier, our loss for the second quarter would have been $68.5 million, or $44.5 million if tax effected or a loss of 9 cents per share, which despite the quarter's lower than expected gross margin was the midpoint of our guidance range.

Turning to the balance sheet.

We continue to work to our quarterly cash burn, and preserve the strength of our balance sheet.

Cash, short-term and long-term investments at the end of the second quarter totaled $1.5 billion, a decrease of $60 million from the first quarter, which was in line with our guidance.

Our accounts receivable balance at the end of the quarter was down as expected, to $38.6 million, from $45.9 million at the end of Q1 putting day sales outstanding at 47, down from 62 in Q1.

Inventory levels ended the second quarter at $34.5 million, down 30% from the first quarter's level at $49.2 million.

The decrease shows the effect of converting some finished goods inventory into revenue as well as the benefits of tighter inventory controls.

In addition, we are beginning to shift toward a drop shift model across our portfolio.

And though it is too soon to predict what effect this shift will have on our inventory, it's worth noting.

The inventory break down for the quarter was as follows: Raw materials, 14.6 million, work in process, 3.4 million, finished goods, 36.5 million and a reserve for excess and obsolescence of 20.1 million.

Product inventory turns were 6.5 in the second quarter, compared to 2.8 in the first quarter.

Finally, head count.

Our worldwide head count at the end of the second quarter totaled $1,702 a decrease of 76 from Q1.

We expect Catena and IPI combined will add approximately 380 employees to CIENA.

And now I'll turn it over to Gary.

Thanks, Jeff.

And as I have for the last several quarters, I'll orientate my review of the quarter around our three strategic focus points of revenue, profitability and costs and I'll start with costs.

For some time, we've been articulating our intentions to meaningfully reduce our ongoing operating expenses.

At the end of April, we announced our intention to close our San Jose facility.

This was a difficult but necessary decision.

The timing of which was dependent upon achieving certain products and feature set milestones.

As a result of the closing and some related actions, we expect to reduce our head count by approximately 425.

With the actions we've already announced by the end of the fiscal year, we will have reduced ongoing op ex to CIENA, exclusive of Catena and Internet Photonics, in excess of the top end of our previous target range of between 10 to 20%.

Cost reductions are happening, and they are critical.

But we are still striving for a careful balance between cutting costs and prioritizing investment that leads to revenue.

For instance, cost reduction does not mean we're willing to sacrifice our market lead in our core competency of core networking.

Relative to our competition, we've invested more heavily in core networking for the last several years, both in core transport and in core switching.

This was a conscious and deliberate decision.

And as a result, we believe we are now in a position to leverage that investment without jeopardizing our competitive position.

We're also committed to maintaining our reputation as a leading innovator.

Which means bringing new products and feature sets to market in response to customer demands and evolving market opportunities.

You'll see some of the results of our development efforts at SUPERCOMM this year.

But you will also see the results of our ongoing cost reductions in our next several quarters' financial results.

So shifting to talk about profitability, we caution that short-term our gross margin would be volatile depending on product mix.

This quarter, we saw the negative effects of both product and customer mix.

And as Joe noted, in addition to having a significantly long call waited product mix, we also saw the onset of two ultra long call initial deployments which means there was an even higher percentage of lower margin common equipment in the quarter.

This combined with some core director revenue recognition that moved out of the quarter, the result was the worse possible scenario for gross margins.

In addition to the fact that we will be moving through the initial deployment stage of these ultra long-haul builds, we expect the addition of Catena and Internet Photonics will help us mitigate the potential for this level of gross margin downside moving forward.

And as Joe noted, we expect product gross margins for Q3 will be nearer to 30%.

We continue to work towards what we believe is an attainable overall gross margin mix for the company of better than 40%.

In addition to the actions we're taking at the ongoing operating expense level, we continue to work aggressively to consolidate our contract manufacturers.

Thus far, we've taken steps to reduce our CMs from six to four and with the recent acquisitions we've acquired two additional suppliers and will continue to work to get that number down overall.

Cutting our costs and improving profitability are two pieces of the puzzle.

We also have to accelerate our revenue growth.

The acquisitions of Catena and Internet Photonics are an element of that strategy.

In addition to incremental revenue, they also bring new markets, new customers and new pull-through opportunities.

But they don't address the entire challenge.

In the last several quarters, we've closed some significant customer wins, including ultra long-haul wins at GIG-BE, and MCI and a multiservice switching win at Verizon.

We've also built a solid roster of Tier One customers that includes the like of BT, AT&T, SBC, Telmex and SingTel.

And we're seeing the benefit of a growing diversity of smaller and enterprise customers from sales of our agent storage platforms.

However, we've yet to see these positives translate into meaningful and predictable revenue growth, in large part due to the environments of continued uncertainty.

I believe the environment has stabilized to some extent.

In the unlikely environment of two years ago, for example, the large service providers are making decisions.

However, they are doing so cautiously and with much deliberation.

They are also being just as deliberate with the spending and timing of the rollout that goes with such a decision.

Obvious deliberation translates into longer cycle times, which in turn requires patience.

In several cases, it is simply taking longer to get to revenue than we initially predicted.

We are also facing some shorter term customer specific uncertainty such as the threat of a strike at SBC.

So in addition to being patient and working to translate the deals we've already have won into revenue, what else are we doing?

Stepping back, our large service provider customers are focused on three priorities.

Getting more customers onto their networks, profitability, holding on to their existing voice revenue for as long as possible, and thirdly, improving the operating costs across their networks.

These priorities are the drivers behind our deliberate move towards service delivery platforms and new data-driven features for our core platforms.

Carrier spending follows their pain points and we now have a range of solutions that target those key pain points.

We'll be working to ensure we maintain Catena and Internet Photonics momentum and aggressively pursuing cross-selling and pull-through opportunities across our entire product portfolio.

In addition, we're also continuing to revamp our sales organization in part to reflect the change in the scope of our offerings, but also because I believe we need a more aggressive approach.

Jim Collier is now responsible for our worldwide sales efforts, replacing Nick Jeffrey who is leaving CIENA to pursue other interests after a brief transition period.

Jim joined CIENA in 2002 to run our RBOC sales efforts and most recently was responsible for our business development efforts including the Catena and Internet Photonics acquisitions.

Clearly, this is a critical role for CIENA and I'm confident that Jim has the experience and scope of vision necessary to drive revenue growth.

Leaders from both Catena and Internet Photonics have taken key rolls in our new sales organization, where their market expertise and customer relationships will be extremely valuable.

In addition to revamping our direct sales efforts, we are also placing increased emphasis on channel and partner opportunities.

For instance, we've made excellent progress with managed service offerings using the CN 2000 and the ONLINE Edge, signing agreements with at least two RBOCs and several other large carriers.

And as a result of preliminary work done by Internet Photonics, we are also working with a large international player to establish a potentially significant channel partnership globally.

I see four things as key to CIENA's revenue short-term.

Clearly, translating the deals we've already won into revenue, maintaining momentum for the acquired platforms, accelerating portfolio-wide sales through partnerships and channels, and supplementing our DN 7000 wins with Verizon and SBC with another major win for the platform.

Longer term, we need to establish significant traction for Catena's CN 1000 BLC platform, will also be key.

I will personally be focused on making those things happen as will Jim and his entire sales team.

Finally, a brief update on the acquisitions and the integration progress.

We were pleased to close both the Catena and Internet Photonics acquisitions towards the optimistic side of our possible time frame.

As a result, our third quarter will reflect a full quarter's contribution from both.

Combined Catena and Internet Photonics will add about 380 employees to CIENA.

Catena is now our broadband access group and Internet Photonics is now part of our metro and enterprise solutions group.

Most if not all of the mechanical portions of integration have been completed including IT infrastructure, payroll, finance and HR benefits.

We are now working on the longer term projects like meshing processes, product strategies and more carefully evaluating technology cross-over potential.

Generally, the initial integration has gone very well.

Largely as a result of the energy and extraordinary commitment level of the combined teams from CIENA, Catena and Internet Photonics that have made this their clear focus since the deals were announced.

And I'd like to take this opportunity to thank those teams.

In summary, we continued to take steps to drive revenue growth and to accelerate our move towards profitability in an environment of ongoing uncertainty.

The adoption of broadband services by enterprises and consumers around the world is reshaping our industry.

And new operating realities are driving new thinking for our customers.

The real opportunity for CIENA is about enabling profitable service offerings that drive new revenue streams for our customers and value for their customers.

In order to compete, carriers and cable operators need a better ability to offer bundled services.

For residential customers they need the triple play of voice, video and data and for enterprise customers they need the ability to bundle data, voice and storage.

From a vendor perspective, we need to be able to sell and support success-based deployments.

CIENA now has the portfolio to drive this next generation of service offerings.

We firmly believe the steps we've taken to evolve CIENA's vision and solution set to encompass new technologies and new areas of network focus position CIENA for stronger, more sustainable revenue and earnings growth longer term.

If there is one thing I believe the street underestimates about CIENA, it is the commitment of this management team to fix the business model.

Closing the San Jose facility was painful, but a necessary step.

And at this point, the entire company is focused on taking the necessary steps that get us to two major milestones.

Achieving a cash flow breakeven and achieving sustained profitability beyond that.

In terms of cash flow, we've got a few quarters of deal related and restructuring charges to get past, but after clearing those hurdles, getting to cash flow breakeven should be a fairly straightforward step for CIENA.

But that's a good first step.

Our goal is sustained profitability.

And by that, I mean profitability in earnings growth that comes with revenue growth, not just from cost reductions.

I am personally committed to taking the steps necessary to achieve these milestones, as is everyone on my executive team.

Short-term, there is admittedly continued uncertainty around things outside of our control, and that leads us, I believe, to be appropriately cautious.

But I am confident that the combination of the opportunities we expect to generate with our broader solutions portfolio, including the broadband and service delivery opportunities that have become a key strategic focus for our customers, and the cost reductions planned and already underway, position us for real earnings growth.

Joe, with that, I'd like you to walk through our guidance, if you would.

Thanks, Gary.

Before I begin to offer our guidance, 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-Q in order to understand the factors that might cause actual results to differ materially from this guidance.

We expect that revenue in the third quarter will increase by as much as 30% from Q2.

As we've mentioned previously, we continue to anticipate gross margin fluctuations quarter-to-quarter depending largely on product mix.

We believe overall gross margin in Q3 will rebound from its Q2 levels due predominantly to anticipated product and customer mix as well as the addition of higher margin revenue from Catena and Internet Photonics.

At this time, we expect Q3 gross margin to be close to 30%.

We expect overall operating expenses in Q3, exclusive of any unusual or nonoperating items, will increase to between, will increase to between 90 and $94 million, reflecting the addition of Catena and Internet Photonics-related expenses.

Looking beyond Q3, we had previously told you we anticipated to, we would reduce cost efforts during '04 to result in cost savings of 10 to 20% off of what was then $80 million in operating expenses.

At this point, giving the initiatives already under way, we expect to overachieve our previous goal and now expect the savings will likely to be on the order of 30%.

As a result, we expect to exit the fiscal year with a 65 to $70 million operating expense run rate.

We expect other income expense will be an expense of approximately $1 million.

We estimate Q3 share count at approximately 575 million total shares reflecting the addition of shares related to the acquisitions.

As a result, we expected that exclusive of unusual of unusual or nonoperating items, our net loss for Q3 will be in a range of 6 to 8 cents per share.

Finally on cash.

We expect our total cash use in Q3 will be approximately $90 million which includes approximately $25 million related to the payment of deal related and restructuring costs.

Operator, we'll now take questions from the sales side analysts.

Thank you.

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 are you using a speaker phone, please make sure your mute function is turned off to allow your signal to reach our equipment.

Once again, it's star one for questions.

We'll take our first question from Samuel Wilson, J and P Securities.

Good morning this is John Coyle for Sam.

Just a few questions.

First on the Catena and Internet Photonics, have you provided a revenue estimate for the coming quarter, what they will contribute?

This is Joe.

Good morning.

Individually, no.

What we've done is we've given you a total target for all of the product lines combined.

Okay.

And Gary, on the revamping of the sales model, in addition to just changing personnel, have you done anything in actually changing the strategy and the way you're presenting the portfolio?

And then on terms of the, moving into and building channels, is it fair to say you're focusing more on developing relationships with systems integrators or are you working with, trying to work with other equipment vendors?

John, I think, I mean first off, you know, we've restructured it to reflect the broader portfolio.

For example we've got a dedicated cable sales team, et cetera.

So, and we've also got a dedicated channel team, now that we've got this portfolio, and also we've reflected, you know, our growing business in the government area as well, so we've got, you know, segment-focused sales organization.

With regard to channels, some of it is systems integrators.

It's also the enterprise sales channels within some of the major service providers as well.

And we've now got a portfolio that we believe is very attractive for them, specifically built around the storage and enterprise side.

I also mentioned that we're looking at other channels that would help broaden our geography as well, particularly internationally.

Great, thanks very much.

We'll take our next question from Wojtek Uzdelewicz with Bear Stearns.

Thank you.

Good morning.

A couple of questions that we could clarify, one you mentioned core director business was somewhat weaker than expected.

You know, obviously it sounds like BT was a large customer for core director.

It did look like that stalled off.

Any sort of issues with the customer or is it sort of being pushed out and do you expect it to come back next quarter?

Also, the second question I had was in the previous quarter, you mentioned that Catena was running at 25, and I think Internet Photonics was running at 5 million.

So if I look at the guidance, this would imply that with 30% growth, that you are guiding for is almost either the core business is expected to be down sequentially, or those businesses would be down sequentially.

Can you kind of give us a sense what's happening there maybe?

Yeah, let me take the core director question first of all, if I may.

First of all, you know, the core director business is always lumpy and I think it's fair to say that the BT rollout is certainly affected by that.

It's slower than we had anticipated.

But absolutely BT is exceptionally pleased with core director's performance and we continue to play a key role in the rollout of their Century 21 network.

With regard to the guidance, I think we're at a point where you know, execution is key and there is a lot of moving parts.

We're taking two acquisitions into the fold, some of the moving parts are within our control, others are not, for example I mentioned the disruption at one of the RBOCs with this threat of a strike.

And I think as a result of all of that, you know, we are being appropriately cautious across the board, you know, I don't think we're breaking out any of the product lines for information, but I think, I understand your analysis, and it's perfectly reasonable.

I think it's really a combination of factors and I think we're being appropriately cautious given the environment and what we've been through in the last couple of quarters where, you know, you've got major wins, you've got things that seem to be very solid revenue streams, and the timing of them are just not always predictable.

Okay.

Just a suggestion or maybe kind of a question more.

If I look at like Juniper or CIENA, I'm sorry Cisco, when they made acquisitions, like Linksys and so, and for 12 months they were giving us a pretty good sense so we can see the core business how it is doing versus the new acquisitions.

Is the plan to provide at least in the next three or four quarters to give us some sense how those businesses are doing versus the core business?

Just to clarify that.

We will be breaking out, you know, what we think is sort of material pieces, but I think, you know, what happens is, as we integrate a lot of these, it gets more difficult to do that.

For example, you know, IPI will be integrated within the metro group, and it is not always easy to do that.

I think, you know, what we'll try and do during the calls and with our filings is to break out anything that we think is material, and also bearing in mind these are both two private companies.

I understand.

Thank you.

We'll take our next question from Steven Kamen, CIBC World Markets.

Just a little concerned about the acquisitions we've seen so far don't seem to be necessarily really ramping up to kind of a full level of operating volume.

You know, WaveSmith, the data business still below 10%.

Trying to figure out whether or not if we go forward are we going to see the current acquisitions ramp up or are we going to end up with a lot of sub scale businesses?

I realize you've been asked this question 16 ways and 16 times but still trying to get some comfort here.

Just the track record right now is not showing too well.

Steve, that's a reasonable question.

I think if you look at the platforms that we've acquired both the WaveSmith platform and the Akara platforms, were both, you know, they're both earlier stage companies, the products are shipping but those markets are at the early stage of their growth as well, and you could also say the same thing to some extent for Catena and IPI except they are more mature and they have had some revenue consistency over a period of time.

So I think we've gone for platforms that we think have higher growth over mid to long-term, rather than just buy some short-term revenues.

And so I think, you know, as we look at the transformation of the company, as we, you know, augment our core transport business, which is coming back a little bit now, based on, you know, the couple of the large wins that we've had, I mean I think it's taking longer that than we would have thought or liked as well.

But I think they're both doing well, both Akara and WaveSmith and WaveSmith has penetrated two RBOCs already into Verizon and SBC and I think has a, you know, a good platform in front of it.

But you know, it's going to take a while to get those revenues up.

For example, we've not recognized any revenues yet for Verizon for the WaveSmith platform.

And we believe that we have a backlog of orders for Verizon now that's starting to ramp on the WaveSmith.

So you should start, Steve, to see some actual revenues from that now moving forward.

Okay.

Thanks.

That is heartening.

Our next question comes from Hasan Imam, Thomas Weisel.

Hi.

This is actually Bobby Sarkar for Hasan Imam.

I have a couple of questions.

My first question is if you look at your market over the next six month or so, what do you see in terms of long-haul and ultra long-haul deployments?

You know, market opportunity out there.

And the second question is, you know, you're raising your op ex reduction guidance from 10 to 20 to 30%.

What are kind of some of the steps you're taking for this higher number?

Thank you.

Hey Bobby, in terms of the transport market and the core, clearly we've got two large wins.

I think we're seeing signs of other opportunities, you know in that high end ultra long-haul market.

I don't think they'll translate to wins and revenues, you know, immediately.

I think that's going to be a 12 to 18 months a piece.

Some of the large carriers now look to upgrade the core of their network, both driven by operational expenses and also some capacity issues driven by the fact that if you put all of the, if we're right about all of this broadband deployment, you know, if that goes out, it does create demand and need capacity of the core of the network.

But I don't want to overstate that, but I think we are seeing some signs of that.

And I think with the CoreStream agility platform, we've got a leading platform there.

And we've invested in that heavily over the last couple of years.

In relation to the op ex, I think it's more around now that we're well into execution on a number of those op ex reductions, we're seeing that the initiatives we've already announced and are already underway including the closure of San Jose, is going to lead to about 30%.

So I think it's really just a better handle on some of the initiatives that we've already announced.

That's how I would describe it, Bobby.

Thank you.

We'll go next to Marcus Kupferschmidt, Lehman Brothers.

Hi, thanks.

Gary, just kind of wanted to go, try and talk about Catena and the IP acquisition again.

A quarter ago when you announced the acquisition you talked about revenues for about 25 million for Catena in the December quarter and about 5 million for IP.

Can you give us a sense of what that looked like in the March quarter?

And you know, should we assume it hasn't, maybe just start with that, please.

Thank you.

Marcus, the answer to that is no.

Unfortunately, you know, I think my previous answer to it, you know, I understand the math around, you know, where our business was, and we gave, you know, the numbers for Catena and for IPI, you know, but I think we're being, you know, appropriately cautious, given all the pieces that are coming together here.

We are very confident that both the Catena and IPI business is stronger, and will continue to grow.

But in terms of our quarterly guidance here, you know, it is what we've given.

Okay.

And along those lines in, is it fair to assume since you talked about those products being more mature, more stable than some of your other recent acquisitions we should assume there's been no material change or at least decline in those businesses since the numbers you talked about for the December quarter?

Correct.

I mean it's just the fact that, you know, you're going to get lumpy business from quarter-to-quarter.

You know, and you know, for both of those businesses, the same as us.

But I think, you know, absolutely no material change to it.

You know, the thing that we're kind of entering in a little bit is the SBC strike, and not particularly the strike, it's just the diversion that creates in terms of their budgeting and rollout.

And then just also in terms of the gross margin guidance.

In terms of understanding going back to around 30% potentially here for the July quarter, how big of a factor is it, the idea that we are going to see improving product mix versus a better mix of long-haul shipments?

And should we assume in the idea that mix improves that there could be some potential rebound in the core switching in the core director business?

I think, let me sort of break it down for you.

I think the core transport business going forward, if you took a photograph of that stand alone would have better gross margins than we've enjoyed in the last quarter.

And that's, you know, driven by two things.

One, it's at the early stages of a new platform that we've launched.

And your costs, your component costs, et cetera, are at their highest because you've got no volume, et cetera.

So that's one driver of it.

So like for like, product for product, you know, we make a better gross margin now than we would have when some of those products were shipped.

You know, some of them are shipped in 2003.

We've also had some cost reduction activities that have already kicked in on the platform.

Joe?

Marcus, Joe here.

The other thing is if you take a look at the finished goods inventory, it's still a sizable number and what that leads you to is that we've got some stuff out there sitting, waiting for revenue recognition.

A couple of instances Gary already alluded to.

One was that in answering another gentleman's question, I think it was Steve's, we hadn't recognized any DN revenue yet from Verizon, but the shipments are out there, they've been out there for several quarters, and there's a good chance that that will turn into revenue recognition in this given quarter.

So that will significantly help the margin number.

The other thing Marcus, just to give you some more information there, the long-haul will likely be down in Q3.

Just, you know, from a rollout point of view.

Core switching, you know, based on, you know, what Joe just said as well will likely be increased in Q3.

You know, we have some shipments that we've already made to customers that we will recognize in Q3.

And also, you've got the added, you know, in addition to the Verizon comment that Joe made, you've got the higher gross margin coming from Catena and IPI.

So I think you know, you can see our gross margin last quarter I think for product was about 38%.

So we're, you know, we believe that the blended should be approaching 30% in Q3.

And then with all of the other activities we've got in terms of cost reductions, et cetera, we believe that we can get to the mid-40s.

Okay.

And just to clarify, Gary, when Joe talked about the core switching revenues, when you talk about core switching revenues being potentially up, in 3Q that's core director plus WaveSmith?

No, that's, core director on its own will be up and also the DN platform, which is you know, the WaveSmith platform, will also be up.

Perfect.

Great.

Thanks for the clarity.

Appreciate it.

We'll take our next question from Brant Thompson, Goldman Sachs.

Hi, guys.

Hi, Brant.

I was wondering if you could give us a little color on the kind of duration of the impact of gross margins that you expect to see from the ramp of some of the old long-haul business?

How long is that going to continue to impact us?

And then secondly, on the channel partners, you know, push, you mentioned the international opportunities, is that carrier focused or is that partly enterprise focused?

Or could you give us a little bit more color around that?

Thanks.

Okay, Brant.

In terms of the transport piece, I think, you know, the shipments that we make now will be better in terms of gross margin, and the shipments we would have made last quarter are indeed, you know, prior to that, are the result of two things.

You know, one is component cost out, the other one is, you know, design of cost reductions.

And also, we're ramping, you know, to some volume as well given the fact that we've got both of these builds are rolling out.

So I think we feel better about the transport gross margin as a stand alone contribution and then you've got these other pieces coming in from [IBI], et cetera.

In terms of channels, it's predominantly carrier.

In terms of the international pieces, is predominantly to address some of the carrier space and some of the other segments within it such as, you know, wireless applications, et cetera.

And then additionally, you know, we're looking at some of the enterprise channels through systems integrators, and through the enterprise elements of the large carriers worldwide as well.

And you know, as I said in the script there, we've got a number of carriers that we've signed up for managed services, as well, where they're putting the platform out and wrapping managed services around it as well.

And could those non U.S. kind of carrier channel partners, could those allow you to reduce some staff or your cost base in the non U.S. markets?

I would see it as more enhance our revenue opportunity, being realistic, Brant.

You know, we have a significant international presence, you know, in some key markets, but I think it's more sort of, but we have not covered all of the international markets, clearly.

But I think it would realistically would provide us with better revenue upside.

Okay.

Thanks very much.

Thank you.

Our next question comes from Evette Aroyo, Merrill Lynch.

Good morning.

A couple of questions.

First related to op ex, you know, Joe, if you could walk us through the op ex guidance again for Q3 and Q4.

What I heard was 90 to 94 million and then exit the year with 65 to 70 million and if you could just walk us through that one more time.

And the other more important question is as you go through these head count reductions, what effect does that have on your customers?

Because you know, you are playing with the big boys here, with the BD's the SBCs, the Verizon.

When they see you laying off so many people, what effect does that have on them?

Have you heard any feedback from them?

How are you sort of structuring your layoff so that they don't impact any R&D that might be required on products that you already in the pipeline for those particular customers?

And the third question is on the linearity of revenue from GIG-BE and if you can give us any color on what you see from MCI going forward?

Thanks.

Okay.

I think I got three questions there.

I wrote them down.

We'll try and knock them off for you.

Good morning.

I'll read you the prepared remarks that we had at the beginning on the op ex.

We expect overall operating expenses in Q3 exclusive of any unusual or nonoperating items will increase to between 90 to $94 million, reflecting the addition of Catena and Internet Photonics related expenses.

The second point we made says looking beyond Q3 we had previously told you we had anticipated our cost reduction efforts in fiscal '04 to result in cost savings of 10 to 20% off what was then an $80 million operating expense base.

And then the third statement we went on make was that at this point, given the initiatives already underway, we expect to overachieve our previous goal and now expect the savings will likely to be on the order of 30%.

So what that all adds up to be, we go on to say as a result we expect to exit the fiscal year with a 65 to $70 million operating expense run rate.

So you had the numbers right on the money there.

Okay.

So the 65 to 70 is then including Catena and IPI?

Yes.

Okay.

So really what we're saying is, as you go out of October, you should be able to do the first quarter in the 65 to $70 million target range.

So Q4 is in the 65 to 70 or Q1 of next year is in the 65 to 70?

No the Q4 will not be there.

It's targeted to Q1.

The prepared remarks, the way [inaudible] --

So another way of putting it is the sort of monthly run rate, by the time we finish the fiscal year, and we go out of Q4, we'll be at that kind of number.

I see.

So expect, you know, expect that kind of number in Q1 is what we're saying.

I see.

So Q4 will be in the 90 to 94 million --

No, no, no.

It will be guiding, you know, it will be coming down from where we are now.

Okay.

So is that okay?

Yeah.

Okay.

So Q3 90 to 94, Q4 going down from there and trending towards 65 to 70, but you hope to achieve 65 to 70 in Q1 '05.

Correct.

Very good.

Let me take the second part of your question which is around customers and it is a good question.

We've been very careful and made every effort to ensure that we do not impact customers and I think it's worthwhile sort of stepping back and seeing the picture over the last two or three years.

We continue to invest heavily in the core optical infrastructure when other folks did not and we did that very deliberately.

We're working on some additions to the core director family, some features and functionalities and continuing to develop that platform.

A lot of those features and functionalities are now completed, not all of them, but a lot of them are of that phase of it.

We've also developed new transport platforms and CoreStream agility, which allowed us to win MCI and GIG-BE.

That platform is largely finished in terms of getting that platform out.

So you know, it's timely for us now to decrease our investment there, and move our investment, some of our investment into the service delivery platform.

So it's really balancing our portfolio.

We continue to have a significant investment in the core optical infrastructure both core director and the new transport platform.

So I think we're confident that we're able to manage the technology and the rollouts of new features and functionalities for our road maps.

In terms of your third question, the GIG-BE, we did recognize our first substantial revenues from GIG-BE in Q2.

And we believe that will continue to rollout over the next few quarters.

We also recognized our first revenue from the MCI build, and we believe that also will continue to rollout over the next 12 months or so.

Okay.

Great.

Thank you.

We'll go next to Susan Kalla, FBR.

I wonder if you could give us what is likely an ongoing run rate perhaps for 2005?

And if you could give us an idea of what kind of revenue production you need to breakeven?

Good morning, Susan.

This is Joe.

Good to hear from you.

On the 2000 run rate, at this point in time, with bringing the acquisitions together, and the integrations and so forth and so on, as Gary alluded to earlier, in his prepared remarks, things are stabilizing but I don't think they're quite there yet for us to go out that far so we're just going to stick with going out one quarter with regard whether it be revenue or operating expenses and I'll let Gary tackle number two.

Okay.

Susan, in terms of the, let me answer you, I think we've given some fairly clear guidance on the operating expenses.

Depending on your assumptions and product mix and gross margins, it could be as low as 140 to $150 million.

And that would be, cash flow breakeven.

What about earnings breakeven?

Earnings breakeven would probably be a little bit higher than that.

Susan, this is Joe again.

If you want to go to the earnings breakeven it would go up somewhere between the 155, 165 mark.

So probably about 10 million on top of that, Susan.

Okay.

But you can see that, you know, even with, we've got IPI and Catena in there now in terms of their revenue stream, and we're below our operating expenses we've got.

You can see that that's clearly, we're closer to it.

And how does the Tellabs, ASCI merger announced this morning affect your ongoing business?

Steve, do you want to take that?

I don't think it affects us at all.

I think that's a great deal for both of those companies.

Whether it's a good deal with ASC or not will depend on whether Tellabs gets significantly into an RBOC.

One of the reasons that Catena was so attractive to us is they are shipping in volume in the space really that ASC is in to three of the RBOCs already.

So we are actually an incumbent in three of those RBOCs.

So, and getting stronger, I think, quarterly, so I think for the industry in general, it's a very good thing.

I think the consolidation that has been in dribs and drabs the last two years needs to continue.

That's a good step.

And I hope the Tellabs folks can handle the cost of California.

I think it's a good step for both of them.

And I think, I don't think it does anything but good for the industry all in all frankly.

Thank you.

Our next question comes from Ehud Gelblum, J.P. Morgan.

Thank you very much.

Can you hear me?

Yes.

Great.

A couple of questions.

One, it's clear that the core business, meaning the optical business, the DN business, et cetera, has some lumpiness to it and it creates the ups and downs throughout the quarters.

The Catena business to me however seems much more on a secular type of upswing as opposed to anything that's particularly seasonal.

I was just wanted to get your opinion, is that true?

And should we see pretty much as DSL continues to be an important factor and we see DSL stubs in general when the RBOCs start moving up.

Is that something that we should pretty much expect should sequentially pretty much improve as time goes on, we had that mark in the sand of $25 million in the fourth quarter of last year, and I don't see a reason why it would necessarily slow down one way or the other.

Is that the right way of looking at that particular type of business?

I think there's some seasonality to it.

You know it can still be a little bit lumpy quarter-to-quarter.

We feel good about the business and we think it will absolutely continue to grow and really there, you know, they've got a lot of new products coming out, as well, and we expect, you know, very, very good growth.

I mean they're the only people out there with a new broadband access platform, a next gen platform, and that's, you know, not really included in the numbers right now.

It's a brand new platform.

So you know, we feel very good about their growth.

What they're shipping right now is really the CNX 5 chassis, the replacement cards, and we think that's, you know, very good business that's going to continue for a while.

But then that will also be augmented by, you know, if we can break through on the CNX 1000 platform into some of the large carriers then that would have a significant growth to it.

But I think there's some seasonality to it but I think if you look at the balanced portfolio, once we get our arms around this, I think we should be able to get, you know, a more balanced growth scenario for the whole company that, you know, that is a little more predictable.

Okay.

And then if you look at what's happening right now in the industry, have you MCI who has cut back enormously from their own capital spending plans, even two months ago, let alone a little while before that.

You have had AT&T who when they report in their large core director user as well, not as well but core director and MCI more long-haul, they also have had trouble at least with some of their earnings, and so it's unclear exactly how aggressively they can actually afford to continue pushing out.

And then you see a lot of other kinds of pieces of news about how the industry is going.

You're sitting next to, I calculated using a 40% gross margin.

I calculated 167 million breakeven.

I understand how Joe you get to lower numbers with the 45% gross margin but you're still, the gap between your guidance for next quarter and that breakeven rate is still a good $70 million or so away in an environment where a large part of your revenues seems to be in a stagnant market, and the growth parts of your revenue, DSL, et cetera, there do seem to be more competitors, Alcatel continues to talk about a lot of pricing pressure in the DSL and D-Slam world which would impact Catena on the pricing side.

You have Tellabs and advanced fiber coming from the other angle, and it has to have some sort of impact if nothing else than through pricing through more competition.

How do you, what time frame do you think you can actually close that gap in?

It just seems that it's still even with all of the cost cutting it still seems to still be a formidable thing to have to jump over.

We think we are in a much better position now than we were, you know, a few months ago, given the acquisitions and the other things that we've been doing, and the wins that we've had.

I think your point about the core optical infrastructure is a valid one and that's really, you know, I think validates our strategy to move in addition into the service delivery space as well.

So we can provide a full next generation portfolio.

You know, my comment would be that while, you know, ASC and Alcatel are formidable competitors, I think there's less competition in that service delivery element overall, and bear in mind Catena is not just in the lower end D-Slam business, it's really, as I said the only player with a brand new broadband access platform.

I think that, you know, whilst we don't underestimate the challenges of that space, if you look at the portfolio that we've now built around you know, the aggregation and the edge and the service delivery pieces, I think, you know, we've got a very, very strong portfolio there.

Steve?

Yeah, just a couple of comments.

One to reinforce something that Gary said.

We are not in the low end D-Slam business competing directly with Alcatel and [ALWAY] and our DSL business is really in two parts, the CNX 5 which is a very high margin replacement or upgrade business for Lucent and DLC cabinets, there is no competition for that, there is no price pressure.

In fact we save so much money for our carrier partners there that we command a very, very good margin on that product.

The other product line would be he broadband [inaudible] carrier product is not aimed at low end DSL it is aimed at more high end triple play services including media gateway, video, data and voice.

And very, very competitive prices and margins and that product, although shipping now will not really ramp in volume to later, and it is extraordinarily competitive from a margin and pricing perspective.

The other thing that we haven't talked much about today I think is really, really important is the other half of this industry, and service delivery is in the MSO space.

And we have made a huge jump into that space with the acquisition of Internet Photonics which is really the standard for transporter video on demand and other video services in the cable infrastructure world, and we expect to expand our presence there.

So yeah, very, very tough market.

But when I look at compared to competing with eight or ten folks in the long-haul or core space, two or three in the edge, in the cable space and in broadband service delivery to consumers and small businesses, I find it a much more comfortable space to be in.

Can you give any kind of comfort level on timing for an operating income breakeven, do you have a sense as to is it closer than it was before and is it in the next year or two?

It's certainly closer than it was before.

We've not given guidance to it.

What we've tried to do in terms of guiding on the operating expense, you know, and also on some of the gross margin pieces, I think, you know, provided that we get, you know, modest revenue growth, based on the platform that we've got, I think we've given enough data points there to suggest that's absolutely coming forward.

Okay.

If I could sneak one last question in, I apologize for the number that I'm throwing out here.

Of the Catena and Internet Photonics just recently closed, of the head count that you acquired from them, can you give us a sense as to how many people have left since there were no lock-ups?

I think, I'm not, Ehud, this is Joe.

I'm not aware of any, but to be safe, I'd say maybe one.

Less than five.

Yeah.

I mean I'm not -- yeah.

Out of how many?

400.

Okay.

That's good to know.

Just I had no sense.

You're going to have a couple of, you know, departures, not the key people, though, in terms of getting some synergies on the G&A side.

So I don't want to you go away without, you know, giving you a full clear picture there, but --

But the leadership team both from a business and technology perspective is all staying.

In fact, have, you know, a few cases have assumed very large leadership roles particularly in the sales channel, as Gary mentioned earlier.

Okay.

You managed to keep them all.

Terrific.

Thanks.

Thank you.

And due to time constraints this will conclude our question-and-answer session for today.

At this time I'll turn the conference back over to our hosts for any additional or closing comments.

Thanks everyone for your time this morning and for your continued support.

We look forward to seeing many of you at SUPERCOMM in Chicago where we expect to have a number of our new products and feature announcements and new service-oriented demos.

Thank you very much.

This does conclude today's conference.

We do appreciate your participation.

You may now disconnect.