Ciena Corp (CIEN) 2005 Q4 法說會逐字稿

Good day and welcome to the Ciena Corporation conference call.

Today's call is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the call over to Chief Communications Officer Ms. Suzanne DuLong.

Please go ahead.

Thanks, Trisha.

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 Alexander, our Chief Technology Officer will be joining us for the Q&A portion of today's call.

Gary will provide some brief introductory comments.

Joe will review the quarter's financial results.

Gary will then discuss the business in the quarter and our outlook for 2006 and our fiscal first quarter, and Joe will wrap up our prepared remarks with guidance for Q1.

We'll then open the call to questions to sellvide [ph] analysts.

To ensure that we answer questions from as many analysts as possible, we ask the sellviders to limit themselves to one question.

This morning's press release is available at National Business Wire and First Call and also on Ciena's website at Ciena.com.

Before turning this call over to Gary, I will remind you that on this call we will be making some forward-looking statements.

Such statements are based on current expectations, forecasts and assumptions of the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today.

These statements should be viewed in the context of the risk factors detailed in our 10-Q filed on the SEC on September 1st.

The results we are discussing today are unaudited results.

This is unusual for us, as we would generally have completed our year-end audit and filed our 10-K simultaneous with reporting our results to you.

However, given that this is the first time we've worked with year-end assessment internal controls under Sarbanes-Oxley, the process of year end audit and completing the 10-K is expected to take longer than it has in past years.

Given our desire to forthcoming and foreclosure we made the decision today to present our unaudited results to you.

We have until mid-January to file our 10-K.

We expect to do that by then or before.

Ciena 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.

In general, with our Q4 results, we again demonstrated evidence of our execution and focus on driving operating performance improvements.

In addition to our seventh sequential quarter of revenue growth we once again delivered significant gross margin improvements.

And we believe that our strategy, our investments, and the change in our business have positioned us to take advantage of market opportunity that for the first time in many years is growing as a result of fundamental demand drivers.

I'll discuss our business in the quarter, and our progress towards profitability and earnings growth in more detail after Joe reviews the quarter's results.

Thanks, Gary and good morning, everyone.

Joe?

As Suzanne mentioned I'd ask you to remember that the results I'm about to discuss are unaudited results.

Having said, that this morning we reported fourth quarter revenue totaling $118.2 million.

This represents an increase of 7% sequentially and 44% year over year.

Our fiscal 2005 annual revenue increased 43% over our fiscal 2004 total.

There was one 10% plus customer in the fourth quarter that represented 10.7% of total revenues.

This is customer is a North America customer currently purchasing long haul optical transport products as well as access gear.

While this customer has been a 10% customer in prior years, it was not a 10 percenter in other quarters in 2005.

For the year we had three 10% customers: Bell South, Verizon, and SAIC, the general contractor for the GIG-BE project for the Department of Defense.

Combined, these three customers represented 31% of the year's total revenue.

Domestic sales represented 78% of total revenue in the fourth quarter in line with 81% in the third quarter.

For the year, domestic sales represented 80% of total sales.

Moving now to talk about quarterly revenue contribution from our business units.

Revenue from our transport switching and group increased sequentially from $64.6 million in the third quarter to $74.1 million in the fourth quarter, representing 63% of the quarter's total revenue.

This group consist of core transport, core switching, multiservice access, metro transport and switching, and storage extension products.

As expected, long haul optical transport and metropolitan optical transport were the largest contributors to TSG's revenue in the quarter, representing roughly 43% and 28% of the group's total revenue respectively.

For the second quarter since its launch in Q3 we took revenue from our CN 4200 advanced services platform and while not yet a meaningful contributor to overall revenue we're please the with the traction and the ramp of this product.

Revenue from our Data Networking Group, or DNG, was roughly flat at $6 million in the fourth quarter versus 6.8 million the third quarter.

Revenue from our Broadband Access Group, or BBG, decreased slightly as expected from 26.1 million in the third quarter to 22.3 million in the fourth quarter.

Revenue from our Global Networking Businesses unit increased quarter-to-quarter from 13 million in the third quarter to 15.3 million in the fourth quarter.

In addition, we had $500,000 of licensing revenue in our fiscal fourth quarter.

Turning to our quarter operating results.

The press release presents 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 or are not related to ongoing business 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 I'll now get started.

The fourth quarter gross margin of 39.9% improved more than 500 basis points from the third quarter's 31.4% as a result of our ongoing product manufacturing related cost-reduction efforts as well as product mix in the quarter.

Product gross margin increased from 35.6% informant third quarter to 42.2% in the fourth quarter.

The fourth quarter services gross margin also increased from 22.5% in Q3 to 24.5% in Q4 as a result of the mix of services revenue in the quarter.

On a GAAP basis, our operating expenses in the fourth quarter totaled $301.8 million.

As noted in the press release this included a $176.6 million goodwill charge related to the write-down of good will associated with our broadband business union.

As Gary discussed in our Analyst Day in early October during the fourth quarter it became apparent that developments in the market for broadband products, particularly outside the United States, would require us to make a substantial commitment of R&D resources in order to compete successfully in this market with our existing CN 1000 next generation broadband access platform.

Given the uncertainty associated with this international market and the magnitude of the investment required, we determined it would not be cost-effective to make such an investment and have suspended Research & Development for this product.

As a result of this decision we incurred a goodwill impairment of $17.6 million related to our Broadband Access Group.

We also incurred long-lived asset impairments of $45.7 million in our fiscal fourth quarter primarily related to certain intangibles associated with our broadband business unit.

Notwithstanding these impairments we continue to invest strongly in our broadband and DSL system through IP-related feature and functionality enhancements.

In addition we will, of course, continue to support our existing CN 1000 customers.

Beyond the goodwill and long lived asset impairments, the quarter's GAAP results also reflect nonoperating related or non-cash charges for stock compensation, amortization of intangibles, restructuring costs, the recovery of doubtful accounts and a loss on equity investments.

Let me add some color on the restructuring costs.

Of the $2.8 million of restructuring costs in the quarter, roughly 2 million was related to our revised assumptions about our subleasing activities.

In addition to the expense items I noted previously, we also had a $500,000 net loss on equity investments in the quarter.

Adjusted for these and other non-GAAP or nonrecurring charges detailed in the press release, our R&D sales and marketing and G&A expenses in the quarter exclusive of stock compensation costs would have been $667.5 million.

This is down as expected from Q3 but slightly higher than where we initially anticipated due in part to the timing of certain expenses including sales compensation costs.

Our GAAP net loss for the quarter was $252.9 million, or a loss of $0.44 per share.

This compares to a GAAP net loss of $495.1 million or a loss of $0.87 per share in the same year-ago period.

Adjusted for the unusual or nonoperating items I discussed earlier, our loss in the fourth quarter would have been 17.8 million or 11.6 million if tax affected or a loss of $0.02 per share.

This is better than the per share guidance range we offered and compares to an adjusted loss of $0.06 per share in the same period a year ago.

Now turning to the balance sheet.

We continue to make good progress toward positive cash flow from operations.

Cash, short term and long term investments at the end of the fourth quarter totaled $1.11 billion.

Our cash earned from operations in the fourth quarter was $8.9 million.

This is down significantly from Q3 when we used $39.3 million including our scheduled $12.9 million semi-annual interest payment.

I will provide more specific guidance on our cash expectations for Q1 later in our prepared remarks, but we're comfortable with our current cash levels.

Our accounts receivable balance at end of the quarter increased to $72.8 million from $70.6 million at the end of the third quarter.

Day sales outstanding in Q4 were 55 down from the level of 58 in the third quarter.

Inventory levels ended the fourth quarter at $49.3 million, down slightly from third quarter's $51.4 million.

The inventory breakdown for the quarter was as follows: Raw materials were $21.2 million, work in process was $3.1 million, finished goods were $47.6 million and the reserve for excess obsolescence was $22.6 million.

Product inventory turns were 4.8 in the fourth quarter consistent with the 4.9 in the third quarter.

We expect Q1's inventory levels to increase from the fourth quarter as a result of purchases we will be making to support demand.

Finally, headcount.

Our worldwide head counts at the end of the fourth quarter totalled 1,497 which is flat with the third quarter.

And now I'll turn it back to Gary.

Thanks, Joe, and as I said earlier in Q4 we have gained some evidence of our execution on a number of fronts.

We're simultaneously driving revenue and improvement and operating reductions and we're rapidly closing in on profitability.

But let's be clear, while profitability is a milestone for us, our goal is profitable revenue growing that drives earning growth and shareholder value moving forward.

At this point, getting to profitability and earnings growth beyond profitability does not require us to swing for the fences.

We've already taken the big steps we needed to and we've already put in place the plans that need to get us where we need to be.

Now it's a matter of our continued focus and consistent execution.

We're gaining increasing confidence that our network specialist strategy has positioned us to capitalize on the positive dynamics we see affecting the market.

It's admittedly early days but we continue to see signs of improving overall market strength.

We've grown faster than the market because the areas we focused on, our specialties, are growing faster than the overall market and because we're taking share from competitors.

At the highest level, our sales plan for 2006 is to keep doing exactly that: Focus on our specialties and continue to take share.

Let's spend a few minutes talking about the environment.

Upon close examination it appears that the growing market strength we're seeing has some fundamental drivers behind it.

First, we've had general under investment by carriers for several years while they've concentrated on lowering overall CapEx.

During this time, the CapEx dollars they were spending were predominantly focused on access networks.

And in part it's that access-related investment that's behind the second market dynamic.

We're starting to see real indications that access, and particularly video applications, wireless and enterprise traffic, is driving real capacity demands in core and metro network infrastructures, which because of the access focus spending saw a disproportionate under investment in the last several years.

Finally, we are seeing real movement towards next generation network builds driven both by the availability of equipment and technology that make it possible, and by the operational and economic necessity of convergence.

British Telecom may be the most visible example of this dynamic, but it's not the only service provider taking this kind of leap.

There is one additional industry dynamic that I think is worth mentioning in our discussion of trends of business in the market and that's clearly carrier consolidation.

There's no question that consolidation of the size and scope we've soon lately leads to uncertainty.

However, at least in the early stages, activity around the service provider consolidations that have happened and are expected to happen soon, seems to be moving this plan.

And we continue to be optimistic the consolidations could actually result in new opportunities for us.

But how is Ciena positioned to benefit these larger market conditions and what does it mean for Ciena's business?

Ciena is increasingly recognized by our customer for our focus and one of the clean invest to innovate, particularly in converge next generation optical applications.

Flex Select and the CN 4200 are excellent examples of this.

The features and functionality we're bringing to the market with our Flex Select architecture and at CN 4200 are providing the measuring stick which is being used to cleanly separate all static single service systems from flexible next generation systems.

And there is no question that ethernet will play an increasingly important role in network infrastructure and Ciena is quickly establishing itself as the vendor to turn to.

As I said before, we expect our network specialist positioning, investment in our position, and the resulting continued innovation, combined with these market dynamics will enable us to grow our revenue faster than the overall market.

Specifically, in the teleco space, we expect our access-related business will continue to benefit from the RBOCs access builds and their desire to capture broadband and triple-play customers and as Joe noted we will look to leverage our incumbency in customers like Verizon and AT&T with new IP-related feature and functionality enhancements to our existing access products as well as to our DN series which is currently used as a DSL aggregator among other applications.

We expect core and metro infrastructure activity to continue during the large carrier consolidations and we look forward to playing a significant role as large access, metro and core networks come together.

With MSOs our portfolio is well positioned as cable providers migrate their network infrastructures and also look to capture broadband and Triple-play customers.

In addition to the traction we've seen in the teleco space our new CN 4200 has been well received by the cable providers, and is currently undergoing multiple trials.

In the government space, over the last year, we've worked to enhance our support for government customers with a government dedicated subsidiary and advisory board.

As a result of our actions and high profile government activity like GIG-BE we've begun to build significant brands awareness in this important market segment.

And as a result of our federal engagements we're now involved in state and local activity where research and education initiatives among the major demand drivers.

Finally, in the enterprise market, capacity demands for bandwidth intensive applications and business continuity concerns are the driving forces behind enterprise activity.

This is particularly true in the financial, healthcare and retail verticles where we're getting involved in enterprise builds through our service provider partners as well as three channel partners like EMC.

Overall we're pleased with the direction we see the market heading, and we're confident that with continued execution we're well-positioned to benefit.

So, in the context of the market and the overall environment, how will we continue to drive operating profits improvement?

Let's focus first on gross margins, and, as Joe noted, we delivered gross margin improvement for the third quarter.

We've consistently stated our goal to return Ciena's business to one that operates with a gross margin of 40% or better.

As we discussed at our analysts day we've taken a number of steps to improve our gross margins including our efforts to diversify our overall portfolio the last few years through acquisition and internal development in investment.

In addition to product mix we expect our ongoing efforts to reduce product and manufacturing related costs will drive additional improvement over the course of 2006.

Now on a quarter-to-quarter basis, we continue to see the potential for certain amount of gross margin volatility based on product mix and volume.

And though it may not happen in neat quarter-to-quarter progression, however, we expect to improve our gross margin over the course of 2006.

Beginning with Q1 where we expect sequential gross-margin improvement in the quarter that we're now in.

Joe will speak specifically to our Q1 expectations in more detail during the guidance portion of our prepared remarks.

In addition to gross-margin improvement we're also focused on driving continued operating expense reductions.

And as Joe also mentioned, our operating expenses in Q4 were down from Q3 or were roughly flat if you adjust our Q3 expenses for the $3.8 million in accelerated depreciation expense in the third quarter.

This was higher than we initially expected due to the timing of certain expenses including sales compensation costs.

We are continuing to execute on a plan that drives towards a normalized operating model and we will reduce our OpEx going forward.

For instance, as part of our plan in early November, we implemented a reduction in force affecting some 64 employees.

This action was a continuation of the investment focus and product prioritization decisions I discussed at our Analyst's Day and on our last conference call.

So to recap, we are prioritizing our forward investments, focusing our dollars on the most significant opportunities where we have the highest probability of executing successfully.

Our revenue growth and gross-margin improvement will take us a long way towards profitability and earnings growth but more cost reductions are also required.

We've made good progress over the past few quarters but we believe we can get more leverage from our overall business model.

We can and will get more efficiency gains in part by improving our processes and our systems to enable us to scale our business without necessarily scaling our headcount at the same rate.

We'll also look toward mentor partnership programs to enable us to expand our portfolio and sales reach without adding incremental costs.

In summary, there is still more work to do.

But as a result of extraordinary focus on execution of our strategy across the Company, we're making good progress.

Because of the changes we've made over the last several years, we're working with a broader product base and a significantly expanded customer base and we believe we've created the foundation for a much more balanced business going forward.

It's a result of these changes that we're confident in growing our business during 2006.

On a number of fronts our industry also appears to be moving from a period of prolonged contraction into a period of growth.

I expect this transition will be reflected in our business in a number of ways during 2006.

For instance, during Q4 we saw a trend towards larger order sizes from many of our service provider customers.

We believe this is an effect of changing market demands and is a positive indicator for future CapEx.

In addition to driving fluctuations in cash flow, larger order sizes can introduce quarter-to-quarter fluctuation on top of what is a steadily growing business.

We're not saying this will happen, but we are just reminding you that it could.

So to recap our expectations for 2006: We expect our specialist positioning will enable us to continue to grow faster than the market.

We expect the combination of our evolving product mix and our product and manufacturing-related cost reductions will enable us to demonstrate gross-margin improvement over the course of 2006.

And we will take additional steps to reduce our operating expenses.

As a result, though we're not willing to produce provide an estimate on the quarterly timing today, if we execute on plan, we expect to achieve profitability on an as-adjusted basis during the quarter prior to the end of fiscal 2006.

Joe, with that, could you please walk us through our gains for Q1?

Definitely and thanks very much.

Before I begin to offer our guidance I will remind everyone that the statements Gary just made and the ones I'm about to make are forward-looking.

It is important to review the risk factors detailed in our most recent 10-Q in order to understand the factors that may cause actual results to differ materially from our guidance.

As stated in the press release we expect revenue in our fiscal first quarter will be flat to slightly up from our fourth quarter revenue.

Gross margin is difficult for us to predict with accuracy as it ultimately depends on a combination of volume, mix and effects of our ongoing product cost reductions.

That said, we expect gross margins will improve slightly over the fourth quarter's 39.9% level.

We also expect operating expenses in the first quarter exclusive nonoperating I know items will be down from the fourth quarter reflecting head-count reductions which have already been taken.

We expect to continue to drive down OpEx and throughout FY '06.

We expect other income expense in the first quarter will be income of approximately $3.5 million.

We estimate first quarter share count at approximately 580 million total shares.

As a result, we expect that exclusive of unusual or nonoperating items our adjusted net loss for the first quarter will be in the range of $0.02 to $0.04 per share.

This guidance does not reflect share-based payment expense rented to FAS 123-R an accounting standard which we will be adhering to in the first quarter.

Finally on cash.

We were very pleased with our significantly lower cash burn in the fourth quarter.

In the first quarter we expect our cash burn from operations will increase primarily due to increases in inventory.

As Gary mentioned, in the last quarter we've seen larger order sizes from several of our service provider customers.

These larger size are in turn driving increased inventory and the corresponding use of cash.

We expect to use an additional $15 million to $25 million in cash in the first quarter associated with these inventory builds and inventory demands.

Beyond the increase in cash use associated with inventory we also will have our semi-annual interest payment on our outstanding convert note balance in the first quarter.

Because of the debt repurchases which we've made to date that interest payment has decreased from $12.9 million to $11.6 million.

You also see an operating-related cash outflow in the first quarter resulting from a lease buy out.

We've executed a $12 million lease buy out of our former Fremont, California facility to reduce future payments associated with our restructuring liabilities.

We expect to save approximately $6 million as a result of this buy out.

Finally, our first quarter will also show some additional financing activities affecting cash.

In November we repurchased 42.7 million in principal amount of our outstanding 3.3/4% convertible notes due in 2008 for approximately 39.2 million in cash.

This purchase will result in $3 million gain on the extinguishment of debt which consists of the 3.5 million gain from the repurchase of the notes less a write-off of $400,000 of associated debt issuance costs.

As a result of the repurchase of our outstanding convertible notes, balance has been reduced to roughly, approximately $600 million.

While our cash use will increase sequentially in the first quarter we're confident that our business is moving toward a cash flow positive position in 2006.

And now, operator, we will take questions.

[OPERATOR INSTRUCTIONS] And we'll take our first question from Michael Genovese with Citigroup.

Great.

Thanks a lot.

Hi, Mike.

Hi, Joe.

[voices at once] Hi, Mike.

My first question is around OpEx.

You know, I understand you guys are making a commitment to reduce OpEx over the next several quarters, but, you know, we still don't have any good quantification we can put about that.

Roughly can you give us an idea?

Can it come down to 60?

Can it come down to the mid-50s, as we look over eight quarters what should we be modeling here?

Mike, this is Joe.

I'll take a shot at that and Gary can finish it up.

That's a tough one to answer because we're only giving you guidance out one quarter.

The prepared remarks we gave, we said we'd continue to take it down.

Is it possible to get it 60?

The answer is is yes.

Is it possible to get it below 60?

The answer is at this point we're not offering you a lot of definitive timing and large orders come out.

Gary, I don't know if you'd--

Independent of the issue that's probably about as far as we're prepared to go today to be honest.

One other quick question.

In your guidance as well as in the press release, you spoke about achieving profitability at some point before we exit the fiscal year.

Should we think about that EPS break even or we talking about earning a penny?

What's your definition?

How are you using the word profitability there?

It'll be north of 0.0, Mike, but yes, you can talk about a penny or two pennies and it's definitely on an as-adjusted basis because as we cruise into 2006 we have to deal with 123-R.

And as soon as we get through that process and the calculation of what all that means to us we'll have to talk to you about what kind of guidance we give you and how we talk to you about numbers.

So we can't tell you whether it's one penny.

I can't tell you whether it's three pennies, because of the 123-R complexity that's being incorporated into this.

Okay.

Great, thanks, guys.

And we'll take our next question from John Anthony, SG Cowen.

Good morning, guys.

I've got a couple questions.

You stated that you're going to grow in excess of the market , but if we look at the statements you've made in the past coupled with the statement that you made today, that you are going to be profitable before the end of the fiscal year '06, you're implying an extremely fast growth rate unless your gross margins are kind of sliding up from that 40ish percent range.

So can you just give us more detail there?

Is this just going to be a bigger revenue year that's implied with the growth?

Or is this going to be more of an issue of gross margins being better-than-expected, or a combination in between?

Okay, John, let me of answer your question, there.

I think the answer to your questions is all three levers, it's revenue growth, it's gross-margin improvement and improved expenses and it's a combination of all of all of those.

And I think just from a pure revenue point of view, we grew at over 40% last year so I think we've got some good evidence to suppose that we can continue to, you know, out perform the market.

We've invested significantly during the down turn over of the last few years and we've got a very refreshed product portfolio and I think taking all that into account, it's not surprising that we're taking market share and continuing to grow faster than the market.

But, you know, I think it's all three levers of gross margin, operating expenses and revenues.

Okay.

And then if you could give two quick comments, one on the product redesign efforts, what kind of -- I guess how much room is is there on the component side especially within the optical components, and then secondly if you can just highlight some of the areas that you think are going to be -- are going to provide you guys with a greater opportunity i.e. long haul versus metro versus access, et cetera, where do you think you're going to get, so to speak, your biggest bang for the buck?

Hi Jonathan.

This is Stephen Alexander.

I'll take a product redesign pieces of it.

You had asked about the room and the optical component space.

A lot of what you're seeing is the migration to some more of the small form factor pluggable optics, the use of more merchant commodity parts.

In terms of the interfaces, lot of what used to be relatively expensive optical physical layer parts are available at a much broader sense in a more merchant market and that gives us a tremendous flexibility.

What we've been doing is moving a lot of the products on to that kind of an optical component platform, if you will.

Okay.

John, in terms of the you know, -- you've also got a number of -- before I move on to your other question there.

You've got a lot of manufacturing cost reductions as well from sourcing and economies of scale and the other efficiencies that we're driving through that as well from a sort of global supply chain.

In terms of the growth opportunities, you know, I think you'd say the access space continues to grow.

I think the demands there from, you know, the amount of video and things that are beginning to drive real demand there, that helps both our, you know, DSL upgrade business.

It also helps our aggregation business particularly with the DN platform and then clearly moving into the, what you can call the converged metro ethernet space where I think we're well-positioned with the 4200.

And I think you're beginning to see growth as well into the long haul space which we have seen for a couple quarters as well.

As the traffic increases to that edge of the network it's logical that that flows through to the metro and to the core so, you know I think if we look at the portfolio, you know, overall, we're seeing pretty good growth in most of the spaces that we're in.

You know, and that shouldn't be a surprise because we've spent a lot of time making sure we're positioned in the right positions there.

Terrific, thanks, guys.

And we'll go next to Paul Silverstein with Credit Suisse.

Thanks a lot.

A couple of questions, if I may.

In terms your gross margin forecast for next year, how good can it get for you?

That is a good question, Paul?

I think you definitely can get into-- you know, depending upon the mix and the region where we're at, you're looking at some numbers that can go definitely into the low 40s.

Whether you can go up from there, we've got to see what else we've got to do, what markets we're selling into,which products they are, and what the mix is.

You know could it go into the mid-40s?

Yes, but I'm not getting that carried away just yet, but we'll see.

Long answer, trying to dance around the question, I'll admit that.

Okay, and Gary mentioned about increased order size.

It was interesting in that your customer concentration over the last several quarters has gone down significantly.

If I heard you guys correctly, you had one customer contributed 10.7% so it looks like concentration is actually going in the right direction notwithstanding the order size going up.

Is there any conflict in the two statements, Gary?

No.

I think it's a fair statement to characterize our business as much broader base generally.

You're still going to get from time to time some skews to that.

But I view it fairly positively.

We see it in a number of customers that are increasing the size of their orders.

It's not just one or two.

Gary, with the exception of BT, are you comfortable in terms of customer concentration?

We don't go back to one or two customers having an outsized impact on the order of 30% or 40%?

Yes, yes.

If you look at our customer base now, we've got 23 of the top 30 carriers worldwide.

We've got seven the top cable companies.

So it is much broader based.

Now, you can still have some lumps in volatility within all of that, but generally speaking it's a much, much different business than it was.

Okay.

One last question, if I might.

If you addressed this in your prepared remarks my apologies, but Cisco announced optics -- I believe it was on the Cirrus platform -- integrating optics into the platform.

Any comments on the impact on the DWD business?

So they're generating colors you still have to carry the colors on something, right?

And those are the line systems and all of the products that we've had in the market now in the past year have been built to take what we call third party wave lengths and that was by design.

We've been a proponent of integration of optics into the switches, the routers and everything pretty much from the get-go so we're well-positioned for that.

Thanks a lot.

And we'll go next to Tim Daubenspeck with Pacific Crest Securities.

Thanks very much.

My question is about larger deal sizes.

In terms of the larger deal sizes that we're seeing, how do we think about this in regards to calendar '06 and seasonality?

Are these larger deal sizes kind of the initial deals for calendar '06 or is a lot of this coming in calendar '05?

And in terms you talked about some of the drivers for this.

This preparatory work for video or are we trying to keep ahead of demand for broadband usage?

Tim, I'd characterize it outside of the general improvement in demand, I think, you know, I wouldn't talk to one specific overall trend about them, ordering in advance because of the video and the rest of it.

I think because we've got some good diversification now across different market segments and customers, I don't think we can point to one particular piece, but we're starting to see larger order components coming in across the board from the broader range of customers.

Is this the initial calendar '06 orders, or is some of this coming in calendar '05?

I think we started to see some of of it clearly in the Q4 that we've just come out of it and I think we're beginning to see some of it moving into '06 as well.

How should we think about seasonality on a calendar basis for your customers?

I mean --

I wouldn't, Tim.

Even though we made a comment about the order in the August time frame related to holiday season, I don't think we are seeing seasonality to that.

Either positive or negative?

Yes.

Exactly I just think we're seeing an upward trend to it right now that I don't think is associated with -- behind your question, is it an end of year fiscal revenue flush?

I don't think so, we have one or two examples but fairly small.

Is it people coming into a new budget in January, yes, that's going to help but I don't think we're seeing a whole bunch of seasonality to longer term plans that people are executing on now.

Great.

Thank you very much

And we'll go next to Brant Thomson with Goldman Sachs.

Hey, guys.

Hi, Brant.

So inventories are heading higher and larger order sizes.

Can you just talk about the near term order patterns that you've been seeing recently and how that looks like?

Second question, you mentioned the gross margins continuing to improve, there could be some volatility.

Maybe you can give us an idea -- obviously there's been a significant step up fundamentally on the business.

The volatility on the downside how much might that be?

Clearly there is more that might be the upside.

Thanks.

In terms of the order patterns outside of the issue that we highlighted going back to the August time frame, it's been pretty steady since then notwithstanding some of the larger order pieces so I think, you know, it's fairly smooth.

And we have no reason to believe the order outlook will not be the same going forward.

We've seen a lot of activity across the board.

On the GM volatility, I think we see more upside to the volatility.

If you're asking do you think the gross margin stands a chance of crashing down?

Always possible.

I don't think so.

I really don't.

I think we start with a full handle going forward notwithstanding any ups or downs that it may be be.

If you're trying to put a band around it, I would say it could be down.

It's going to be a function of what acceptance we get from each customer and it's going to be mix generated rather than anything else at a given time frame.

You know, you could be down maybe 20 basis points, 30 basis points to as much as 100 basis points, something like that.

Great, thank you.

And we'll go next to Marcus Cooper Schmidt with Lehman Brothers.

Good morning, guys.

Hi, Marcus.

Hi, Marcus.

Joe, in terms of the commentary about the gross margin, you talked about how you're thinking low 40s, mid-40s for the year I think but yet I would think we're talking about continued price reductions from here continuing to sell more and more of those cost-reduced products which I don't think are a big piece of your revenues right now.

I mean, why wouldn't gross margin have a meaningful upside potential from here?

Marcus, this is Gary.

We're not saying that they don't, but we've come a long way and we're focused on driving the continued improvement and we do show gross-margin improvement over the course of '06.

I say let's see how we do with that before we raise that bar.

I think we're at a new threshold now, and I think we signaled that threshold is being at a 40% gross margin, and we're seeing what we can do to improve beyond that.

But I think it's just a little too soon to go raising the bar right now.

And then a couple of other clarifications.

You talked about seeing nice, big orders coming in, a change from before.

What would constitute a big order to give us a sense of that?

Are these coming from existing customers or new customers?

And can you give us any sense of what products these relate to?

I think they're existing and new customers, Marcus.

It's a blend from those.

We're seeing some orders from customers that we haven't had much activity with, I think it's fair to say, in the last couple years.

That's encouraging, as well as some new business as we go into new markets.

So we're seeing both.

I guess a strong market, what would constitute a larger order size would be something over 10 million just to give you a number.

And you're starting to see a number of orders come in at that kind of size or more.

Okay.

And what products are these relating to?

Really across-the-board.

You've seen it in the access space.

You're seeing it on the DN side.

You're seeing it on long haul.

We're seeing it on the converged ethernet metro.

It's the sort of whole infrastructure portfolio.

All right, great, thanks.

We'll now go to Jonathan Curtis with JMP Securities.

Hi, just a couple of questions.

On the competitive front what are you guys seeing from some of the rising Asian competitors?

Are you seeing their presence in the market and if so, sort of where are you seeing them and particularly what products are you seeing from them?

John, I think specifically we're seeing them more so in Europe than North America.

Definitely more international which is where they're focused.

We're can competing with them and have competed with them in a number of deals.

You know, some of which we've been very successful against them.

I think they're here to stay.

You know, we understand our value proposition very clearly.

We're not, you know, we don't compete on price, typically most of the Asian vendors, it's a price value proposition.

You know, one can argue about their motivation for that and for their ability to do that.

But, you know, I think they're here to stay.

And, you know, they're part of the community that we're going to have to battle with.

I mean, from our point of view, you know, we're really not a commodity vendor so we concentrate on the value add and that's really where we focus and we play well and we choose the right places to play against them.

Okay.

You guys have been talking for some time your out and across strategy.

In terms of continuing for climb up the OSI stack, if you will, obviously you added some of the DNG stuff here recently.

Is there anything else that you think you need to be tacking on to the top?

The entire portfolio now is much more ethernet-centric than it's been in the past so where you go in terms of adding additional features.

You continue to do the things that you need to to offer the services the customers are interested in.

In many cases this takes you to the [inaudible] space, into the IP space.

You basically do the things that you need to to bring the services and the solutions to market.

Okay.

And then finally, who back on the competitive front, who do you think you're actually taking share from right now?

Where do you see your greatest strength?

John, I'd describe it as -- I think what's happened in the last few years is, you know, a lot of larger all things to all people players, you know, have you know under invested in this space and it's understandable giving of given some of their other priorities and I'd describe it a lot of the large traditional equipment vendors really sort of atrophied in some of this space because they haven't invested in refreshing their portfolio on the transport and converged Ethernet side.

And I think we're able to pick off spaces that are significant to us and certainly in the aggregate, significant in the market.

But I think because they've been focused on things like pure wireless or being a service-based company, et cetera, it's enabled us to basically refresh our portfolio and be able to take market share.

So I think it's the more traditional players such as Lucent and Nortel.

And finally just quick housekeeping.

Did you guys recognize any revenue from British Telecom this quarter?

We're not commenting on that but the answer's no.

we'll go next toTal Liani with Merrill Lynch.

Hi.

Good morning.

This is Vivek Arya.

Gary, can you walk us from the segment by segment outlook for next year?

When you look at transport segments what do you expect to be the impact from British Telecom and Verizon consolidation on data?

You know the sales seem to have stalled at the $6 million level so what's the outlook on that?

And finally in access although I understand that sales were not in the mid-20s level, but in CNX 5 sales have been in this mid-20s level for the last two quarters and I will be interested in getting the outlook on that the next year.

Thank you.

We touched on this during the call but I think we see on the long haul side good demand across a broad array of customers and particularly with the merger so far we don't see any sort of interruption to the roll-outs that were planned.

And if you think about it, with the overall traffic levels coming through, people in the under investment in the core of the network that's continuing to grow and we've got people like France Telecom which are new wins for us.

British Telecom to roll out and the others so I think we feel pretty good around that space.

And you know as Steve alluded to, I think, probably, when you talk about data, a lot of our platforms are now data enabled, specifically around ethernet so you can't really look at it as just a single, a single platform.

A lot of the technologies off the DN, for example, the ethernet expertise we're deploying across the portfolio into things like the 4200 so I think the more traditional way of looking at these segments really are not going to be terribly helpful to understanding sort of market dynamics going forward.

But specifically on the access side, we'll continue to invest heavily into developing the video applications beyond the DSL and that really involves putting IP enablement on CNX 5 IP.

So I think we're well placed there,both from an incumbency point of view and the innovation that we're applying to that platform to see a pretty good runway going forward in terms of revenues.

So, across all of the segments I think we see good opportunities for growth.

So then Gary, in the press release you're saying that you might break even in a quarter next year.

What is your top line assumption for that quarter or at least what the plan might look like for that particular quarter that you expect to break even?

we haven't been specifically of specific about that because back to one of my earlier comments it's a matter of all three levers.

Our plan, which we think is absolutely appropriate for the business clearly is not just to get there one of these levers.

It's not just revenue, and it's not just gross margin and it's not just reducing the operating expenses.

It's all three of those things.

And I think if you look at the performance of the last few quarters, this is our seventh quarter of revenue growth and our third-quarter of operating gross-margin improvement and we've also reduced our operating expenses so you can follow the track for these things.

Great, thanks.

And we'll go next to Cobb Sadler with Deutsche Bank.

Okay.

Thanks a lot.

Quick question on backlog.

Can quantify backlog maybe versus last quarter and kind of traditional, historical levels?

I know you can't talk about revenue on BT 21CN but can you talk about orders and if the answer is yes, do you think it helps you out at the overall optical wallet at BT?

And that's the first question.

Thanks.

That sounded like two, Cobb.

Two and counting.

On the backlog question, that's not something that we would normally talk to but I think it's fair to say, if you put the sales comp expense in there, and look at the overall comments that we've made, I think it's a generally-improving backlog position.

On BT Century 21, you you're right we can't talk about that only as much as because of the negotiations that are ongoing, and we're optimistic about the outcome of that so it's still pretty much contract, Cobb.

Do you think your familiarity with the network will allow you deploy ahead of some of the other competitors on the optical front at BT?

I would say I think we're confident of our overall value proposition to British Telecom.

Okay great.

And one quick question on partnerships.

Where do you think partnership revenue could be in 2006 and I'm including there EMC, IBM and any wireless long haul partnerships that you may be looking at?

I think if you look at the partnership piece overall, I think it could be meaningful.

What does that mean, you know, and these are sort of approximate numbers of channels in partnership sales of 20% to 30% ,if you look at the overall mix the next year so.

So, it's significant.

Great, thanks a lot.

And we'll go next to John Marchetti with Morgan Stanley.

Thanks Joe.

Real quick on the product gross margin improvement this quarter.

Can you give us a sense from a percentage basis how much of that might be manufacturing or cost related and how much of that is mix related?

As compared to Q3, John, yes, we can do that.

The majority of the improvement in Q4 versus Q3 was driven by cost reductions.

And is that more a sourcing issue, Joe, or does that come, you know, using, you know, fewer contract manufacturers, that kind of thing?

Or is it mix-related as well?

No, it's not the mix thing again.

It's more the work that Steve's guys have been doing to modify boards and designing multiple piece parts, that way we have some leverage on the competitive front.

It's design work on regional long haul as opposed to just selling long haul.

It's a lot of different efforts.

And then just real quickly on 123-R you said come back to us on that, but when you do report it next quarter do you expect that to be included in your as adjusted numbers or would that be part of the GAAP figure.

We can't go there yet because we haven't decided.

We haven't figured out what we are allowed to do, versus what we'd like to do.

Fair enough, thank you.

And the next question comes from Joe Chiasson with Susquehanna Financial.

Good morning.

Thanks.

Two questions.

Guys, it looks like there was a large sequential uptick potentially in the optical switching area.

I know Joe gave the numbers for long haul and metro transport and if you just sort of do the math there, at least by my model, it it looks like there was an uptick in the switching area.

Can you just comment on that and the market overall, Gary?

Yeah, Joe, I think we're seeing some good trending there.

It was roughly -- -- and this is off the top of my head, Joe -- It was actually flat during the quarter from a revenue perspective.

I think we're seeing some good opportunities for it but it was roughly flat in the quarter.

I think the people are beginning to look at this sort of mash architecture.

Everyone's moving towards an IP enabled network.

But it's got to run on something, and I think a lot of intelligence for that comes from the transport and switching piece.

And I think you're seeing it over the last couple of quarters some renewed interest in how they actually provide intelligence on the network.

Okay and just one follow up if I could.

Has there been any revenue or product shift from Broadwing as part of the settlement a couple of quarters ago?

The answer to that is yes, Joe.

Was that in this quarter, specifically?

I think probably in both. [voices at once] A little bit about every quarter.

Okay.

Thanks.

Next we'll go to Simon Leopold with Morgan Keegan.

Thank you.

I wanted to first ask you for a quick clarification on the head count.

I think you mentioned at the end of the quarter it was 1,497.

If you can give us an update of where we are today?

I understand you've done some cuts during the quarter.

I wanted to revisit the 10% comment you made.

You suggested that it was a North American carrier.

I'm wondering if you can comment?

Was it North American and also international.

And then finally just looking at kind of the longer-term trends, I wanted to see if you can touch on how you see your mix shift between international and domestic.

Your domestic has been rather high lately.

But it does look like it's should shift toward international, thank you.

Yes, Simon, I can't give you a exact number, but it is down from the 1497 number.

The customer is really North American.

I don't think they have many operations outside of that.

And your point about international versus domestic, I think is pretty accurate.

We would expect our domestic business to grow, but we will disproportionately our international business to grow more.

Just going back on the 10% customer, Mexico and Canada are also in North America.

I'm wondering if the customer could be in either one of those countries?

No.

Okay.

Does that help you, Simon?

Yes, it does.

All right, very good.

We'll now go to Todd Koffman with Raymond James.

Just a quick follow-up regarding those large orders you have seen.

With regard to those large orders that you've been talking about on this call, will the shipments already received largely commence in the current quarter, or is there a deployment timetable that probably doesn't get into the bulk of those order shipments for a quarter or two?

Thank you.

You may not like this answer, Todd, but it's both.

So you're going to have shipments this quarter and you're going to have shipments as well as next quarter as well.

The large order thing is -- they're just coming in.

It's a very nice feeling to be truthful to you.

But to go back to large order thing real quick.

We talk about 10 percenters.

What we're trying to give you is some indication here that we're dealing with folks, you know, if you had to you talk about a 7%, 8%, or 9% these are the types of size of the orders that we're seeing when we talk about large orders.

Thank you, very helpful.

We'll now go to Gina Sockolow with Buckingham Research.

Thank you.

Just to continue on this large orders march could you talk about first what percentage of the business from those orders looks to be follow on sales as opposed to initial shipments even as they are dormant customers?

And also, how will that impact the revenue recognition cycle?

Do you expect revenue to be lumpy?

And then I have another question about an international mix.

Gina, let me try to take them in order.

I think we're seeing a pretty good mix of follow-on orders and new.

We're seeing orders from customers that we haven't done a lot of business with over the last couple of years and some of that is refreshing their network, adding capacity to their network.

And we're also seeing some newer customers start to get some builds out as well.

And that really sort of flows into your second question.

You know, I think we've got enough in the pot, as it were, to Joe's answer to the previous question.

You've got various different points where you can recognize that.

Our backlog is improving so that kind of visibility even though it's spread out amongst different rev rack and different deployment activities with the various customers, actually gives you the ability to have a smoother and broader-based flow of revenues notwithstanding some of them are larger than others.

So I think, you know, all we're really flagging there, Gina, is potentially lumpy, but equally maybe able to see a fairly good margin of revenue growing, and we're really just flagging -- you've got these many moving parts.

You can have that in your business.

Okay.

When you look at metro products, do you see the same mix as your total corporate mix between domestic and international for the transport and the switches and also the same mix as between new business or restarts of dormant customers and follow-on sales?

I think, Gina, there is a different mix there,predominantly because a lot of DSL products that we have are really applicable to North America and not internationally so I think we tend to be skewed a little bit toward the access side in North America.

I think the other thing that's happening is the 4200 which is -- again as the converged east coast net platform on the metro side is gaining particular traction internationally as well.

Because I think, frankly, a lot of the Ethernet services are a little ahead of the North American deployments right now.

So we're seeing strong interests in North America but really strong interest in Europe and international on the metro side.

As the traffic level increases, I would assume your rate of business for follow-on sales will increase.

How will that effect your profitability?

I think, you know, we've got now a broad portfolio and you know with the cost reductions that we've got, I think pictured in our overall guidance continue to get an improving gross margin.

Okay.

Thank you.

Thank you, Gina.

And due to time constraints we'll take our last question from Andy Schopick from Nutmeg Securities.

I'd like to run through a few very quickly with you, Joe.

You mentioned a licensing revenue, I believe, of $500,000.

Was that for the quarter?

Yes, sir, Andy, it was.

And how much licensing-related revenue did you achieve in the fiscal year?

The same $500,000.

It's the first time we've seen it.

Yep --

Hold on.

We've got a new program where we're trying to leverage some of the intellectual property that the engineers have come up with.

And although we're putting some resources behind it, we're trying to see if we can get that into something a little bit more than just the 500,000.

So you can see more of that in the future.

That was my question.

The prospects for continued licensing revenue going forward.

Yes.

Okay.

Product gross margins.

Now, I'm a little bothered by a comment that I heard before in response to one question because FAS 123-R, of course, it's a complex situation and it really does get spread across the various categories of expenses.

So when we talk about gross margins, I mean, there has to be some adjustment factored into what you're trying to communicate here, but in reality it doesn't sound like you're prepared to make any kind of specific commentary related to123-R.

Can I ask you this?

Had it been adopted in 2005 can you give us any sense of what stock option expense would have been under FAS 123-R?

That's a very good question and I would concur with you, it is very complex.

When we issue the K you should be able to get a relevant range of something from that possibly.

At this point in time we're not done doing the analysis so I can't really give you an idea because the rules that have come out and the parameters that you have to look at in order to do the calculation are very complex.

Yes.

All right.

Now let me move to obsolescence.

Reserved for inventory obsolescence.

I thought I heard you say at the beginning of the call, 22.6 million?

Hold on a minute.

I have to look at the description.

That sounds about right.

I already said that.

Go on.

You can continue on with your question.

Okay.

If that was the number was that for the fourth quarter or for the full year?

It's a balance sheet value so it's an as-of date.

And that would have been a cumulative addition to reserve then over the course of the fiscal year.

Am I understanding it correctly?

No there are puts and takes each quarter.

It's an as of value.

Okay.

With respect to that, if there are ongoing product redesign efforts so on and so forth and prospects for increasing inventory going forward, can you give us some sense of what the exposures there might be or what you are anticipating there could be in the new fiscal year and how you will more or less allow for that?

Okay.

That's a complex question as well.

First of all, a part of what our goal is to do is to mitigate any type of a reserve that we need to take in any given quarter.

When the engineers come up with a new design, they have lead tables or lead forecasts so that they can run off the old and bring in the new so you're not left with a lot.

At any given quarter, the charge for obsolescence is not that material as it relates to the overall cost of goods sold.

So at this point in time I don't have a number going out in '06.

We don't give guidance that far out and if I were to give it to you, I think it would be very immaterial.

Yes, this is something that could also affect the gross margin calculations or prospects in any given period.

Andy, this is Gary.

We'll continue to manage our inventories carefully as we scale this business.

I would hope so.

Finally, on the 10% customers, I heard you say three customers represented 30% of your revenue in the fiscal year just ended.

I think that's what we said.

It was 31%

31%?

And so effectively, Bell South, Verizon and were also 10% customers for the year.

Yes, sir.

The GIG-BE project, going forward, can you give us some sense as ramping as a revenue opportunity for the Company or whether it has more or less peaked?

Andy, this is a program to build the core infrastructure--

I understand.

Okay.

We believe that they've put the main stage of that in which is the main backbone and what they're doing now is to bring traffic on to that.

That's approximately it.

It's a secret program so I haven't got a lot of detail to it.

But we believe that we're now into the phase where they're actually putting traffic on to the network.

Any implications for the revenue side of of it though from your perspective?

We would continue to see revenue from this, I believe.

Okay.

Thank you very much.

With that, I'd like to turn it back over to Mr. Smith for any additional remarks.

I'd like to thank everybody for joining us today and we wish you to have a happy holidays and thank you for your continued support.

Thank you.

Ladies and gentlemen, that does conclude today's conference.

You may disconnect at this time.