Ciena Corp (CIEN) 2009 Q1 法說會逐字稿

Good day, everyone, and welcome to the Ciena Corporation first-quarter 2009 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 Chief Communications Officer, Ms.

Suzanne DuLong.

Please go ahead.

Thanks, Lori.

Good morning and welcome everyone.

I am pleased to have with me Gary Smith, Ciena's CEO and President, and Jim Moylan, our CFO.

In addition, Steve Alexander, our Chief Technology Officer.

will be with us for the Q&A portion of today's call.

We are using a slightly different format for our call this morning.

Our prepared remarks will be presented in two segments.

Gary will discuss our outlook and strategy, Jim will review the financial results for the first quarter,r and provide guidance for Q2 where possible.

We will then open the call for questions from the sell side analysts.

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

Before I turn the call over to Gary, I will remind that you during 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 factor detailed in our 10-K filed with the SEC on December 23, 2008.

We have until March 12 to file our 10Q for this quarter and we expect to do so 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 event or otherwise.

Today's discussion includes certain adjusted or non-GAAP measures of Ciena's results.

A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's earnings release available on our web site.

Lastly as a reminder this call is being recorded and will be available for replay from the investors portion of Ciena.com.

Gary.

Thanks, Suzanne, and good morning, everyone.

I will talk first to our Q1 results and the actions we've announced today.

I'll then talk about the environment, what we're seeing and hearing from customers before discussing how we are running the business.

Our first-quarter results reflect not only the near-term challenges of today's environment but also the benefits of the actions we have taken to align with current market realities.

While revenue came in below the low end of our guidance range at $167.4 million, we managed operating expense down sequentially 12% from the fiscal fourth quarter.

Our tight OpEx control made it possible for us to deliver adjusted or non-GAAP operating margin and a EPS that was slightly better than Q4, despite the lower revenue in gross margin.

And we continued to take actions to reduce our operating costs.

Yesterday, we took steps to effect a headcount reduction of some 200 employees, or 9% of our global workforce.

With reductions occurring across every organization and geography.

As part of this action we will close our Acton, Massachusetts research & development facility during the course of the next four months.

Including Acton, we currently operate development facilities in seven separate locations.

Closing a site is never an easy decision, given the impact to people's lives and the surrounding community.

But because our R&D organization is comprised of highly integrated cross-functional development sites, we are able to consolidate any ongoing work in Acton with related efforts already in progress at other Ciena locations.

In light of the environment and our customers' resulting uncertainty, we have also been looking closely at our engineering plan of record during the last several months.

And we are prioritizing and aligning our planned deliverables with market and customer opportunities.

As a result, we do not envision any impact on near-term customer deliverables due to to this site closure.

We expect that during the next few quarters, these headcounts and facilities-related cost reductions, combined with the cost reduction initiatives we implemented during our fiscal first quarter, will reduce our adjusted non-GAAP quarterly operating expense to approximately $80 million.

Let me spend a few minutes now discussing the environment and what we are seeing and hearing from our customers.

While it now seems that this downturn will last longer than we originally anticipated, we still believe we are talking about recovery in terms of quarters and not years.

At this point, it is clear that the slowing is pervasive, touching all product lines, geographies and customer types.

And yet, while we continue to see order pushouts and delays, we are still not seeing order cancellations.

Perhaps more importantly, we maintain solid relationships with our customers, who are telling us that we are closely aligned with their strategic focus and their business priorities.

And we continue to work closely with key customers as we prioritize our product-related investment to ensure we are aligned with their network plans.

That said, the environment is obviously volatile.

And our customers continue to delay and more carefully scrutinize capital expenditures.

As a result, our short-term visibility is extremely limited, and we do not feel we are in a position to provide specific revenue guidance for the second quarter.

Now I know this is a departure from past practice.

We have always worked to be as transparent as possible with the financial community and we intend to continue to do so.

But in this environment, the potential range of revenue outcomes is widened to the point where we believe it is not constructive to talk to it.

What we can talk to with confidence is exactly how we are running the business and what our assumptions are.

As I mentioned previously, we expect that the headcount and facilities related cost reductions announced today we will reduce our adjusted non-GAAP quarterly operating expense to approximately $80 million.

With our revised operating expense level, we have sized the business to roughly break even as adjusted net income and cash flow if we achieve revenue and gross margin at approximately fiscal first-quarter levels.

There is no question that we are working to find the balance between preserving and enhancing our strategic capabilities longer term while preserving our balance sheet now.

It is not an easy balance, and it is a very different balance than the one we struck during the last downturn.

Because we remain confident in the fundamental demand drivers of our target markets, we are looking forward with the goal of emerging from this challenging period positioned to drive future revenue and EPS growth.

So let's talk about why we have chosen to size the business as we have and take this approach.

Firstly, the underlying traffic demand continues to grow.

While traffic growth may have slowed, it has not stopped, and traffic demand remains the fundamental Cap Ex driver in our business.

The transition to converge more cost-efficient Ethernet-based networks is clearly a driver as well, but there's arguably more flexibility in the timing of transitioning existing networks than there is in dealing with today's capacity demands.

A note on Cap Ex.

After averaging roughly 14% since 2004, the CapEx to revenue ratio for our top ten service providers fell to 12.5% in 2008 and could be less than 12% in 2009.

If that happens, it would represent an historically low CapEx to revenue ratio which we do not believe is sustainable given the dynamics around expected traffic growth.

The second factor we considered in sizing the business was specific customer input.

We appreciate that our customers are uncertain about the effects of the macro environment on their business, and their plans are subject to change.

While we don't know exactly when or how much they will spend, after much discussion with them, we believe we have a sense of their priorities for the coming year.

Beyond their 2009 goals, we also feel strongly that we understand where their networks are headed, and we believe that our product cycles will align well with that direction.

Thirdly, we have taken a hard look at where we believe our development spend needs to be in order to meet customer deliverables, and we are prioritizing that spend to ensure we remain on track and aligned with changing market opportunities.

In the short term, we are focused on significant ongoing development efforts, including bringing to market our data optimized switching solutions, which can also be described as the evolution of our CoreDirector family.

We are focused on filling out our converged optical service delivery portfolio, including 100G technologies and capabilities, and also expanding our Ethernet service delivery portfolio, and finally extending the value of software and unified network and service management across our portfolio.

Our final consideration was working under the assumption that we are able to sustain overall gross margin at least in the mid-40s.

Despite the current uncertainty, we are seeing the opportunity to expand footprint, both in new geographies and as a result of specific competitive situations.

And we factored that into our gross margin assumption.

All of these things contributed to our decision to size the business as we have.

Again, we are working to find the balance between preserving and enhancing our strategic capabilities longer term while preserving our balance sheet now.

If we get indications that our current assumptions are incorrect, then we are prepared to pursue additional alternatives to reduce costs.

Despite the short-term challenges we are facing, I believe Ciena is, in many ways, in an enviable position.

We have proven our ability to successfully execute our network specialty strategy globally and we have proven it is a strategy that resonates with customers.

In addition to establishing a recognized position as a market leader, we have got a broad customer base and portfolio with incumbency at many of the world's largest service providers.

We are capitalizing and in a position to capitalize on opportunities to expand our footprint and take share.

We are also bringing several significant new products to market in the next six to 12 months.

And we have an agile operating model with substantial operational flexibility.

And finally, we have a very strong balance sheet.

The combination of these elements gives us the confidence that we can strike the balance required to navigate today's difficult environment and to emerge stronger when things improve.

Jim, with that, will you please talk to the details of Q1.

Thank you, Gary.

Good morning, everyone.

We reported first-quarter revenue of $167.4 million.

This represents a decrease of 7% sequentially and 26% year-over-year.

We had three 10%-plus customers in the quarter that combined to represent 41% of total sales.

Two of the 10% customers are North American-based and one is international.

All three were 10% customers in Q4, as well.

Sales from international customers represented 41% of total revenue in the quarter, down from 47% in Q4.

We break out our revenue by three major product groups.

The first, Optical Service Delivery, which includes our transport and switching products, as well as legacy data networking products and related software, accounted for $130 million in revenue, representing 77% of total revenue for the quarter.

This is down slightly in real dollars from Q4, when it was $137 million in revenue but roughly flat as a percentage.

Within Optical Service Delivery, core switching was the largest contributor in the quarter, increasing 19% sequentially to $45 million.

At $50 million, revenue from our CN-4200 Advanced Services Platform was down from its Q4 high of $59 million but still well above prior quarter's revenue levels.

Long haul transport added $26 million, down slightly from $28 million in Q4.

Our second product group, Carrier Ethernet Service Delivery, includes service delivery and aggregation switches acquired from World Wide Packets, as well as Ethernet access products, broadband access products and the related software.

For Q1, Carrier Ethernet Service Delivery contributed $10 million or 6% of total revenue.

And finally, our Ciena Specialist Services Group, which includes all of our services related offerings, was $28 million in revenue or 17% of total revenue in the quarter.

In the remainder of my comments today, I will speak both to the GAAP results and to what the results would have been if we excluded those items which we detail in our press release.

Turning to gross margin.

Q1's GAAP gross margin was 43%.

Adjusted for share based compensation and amortization of intangibles, Q1's gross margin was 44%.

This is close to the bottom of our mid to high 40s guidance.

Let me speak to that a little bit more particularly.

Q1's gross margin includes a higher-than-average charge related to excess and obsolete inventory, the largest part of which is related to a write-off of inventory related to our DSL access products in our CNX family.

Had the charge for obsolete inventory been at a more level, our gross margin would have been two percentage points higher.

As usual, the biggest variable in gross margin this quarter was product and customer mix.

Our GAAP product gross margin for the quarter was 45%.

Our services gross margin was 31%, significantly better than our target mid-20s range as a result of the mix of services revenue in the quarter.

On a GAAP basis, Q1's operating expenses were down 12% sequentially from Q4 at $99 million.

As a result of aggressive expense management, our as-adjusted operating expenses totaled $84 million which is also down 12% sequentially from Q4.

Our as-adjusted operating margin in Q1 improved slightly to minus 6% versus minus 7% in Q4.

Our Q1 GAAP net loss was $25 million or a loss of $0.27 per share.

Adjusted for the unusual and/or nonoperating items discussed previously, our first-quarter net loss is $8 million or $0.09 per share.

Turning now to cash flow and the balance sheet.

I am very pleased with our cash management in the quarter.

Despite the loss, we used less than $1 million in cash from operations.

So our balance sheet remains strong with $1.1 billion in cash short-term and long-term investments at the end of the first quarter.

For Q1, our accounts receivable balance was $130 million, down slightly from Q4's $138 million.

Day sales outstanding were 70, about flat with Q4.

Given revenue uncertainties, we continue to closely manage our inventory position.

Inventories totaled $91 million at the end of Q1, down slightly from $93 million in Q4.

Product inventory turns were 3.3 times in the quarter, up from 3.2 times in Q4.

The inventory breakdown for the quarter was as follows: raw materials, $23 million; work in progress, $1 million; finished goods, $92 million; and a reserve for excess and obsolescence of $25 million.

Before I close, a quick update on taxes and our $1.2 billion deferred tax asset.

As we have discussed in previous quarters, we have accumulated substantial tax deductions from our operations and acquisitions which can be used to offset future tax payments.

We continue to regularly evaluate this asset, but due to our GAAP loss for the quarter we did not release any portion of the valuation allowance in Q1 so in effect this $1.2 billion asset remains off of our balance sheet.

And finally as of January 31, 2009, our worldwide headcount was 2,238.

This is up slightly from Q4's 2,203.

As Gary noted, we expect that total will come down in Q2 as a result of the headcount reductions we detailed today.

We expect that the majority of of the cost savings resulting from the headcount reductions and facilities closure will be in place by the end of the second fiscal quarter of this year, which means we should see the full effects of the benefits by our third fiscal quarter.

We expect to record total restructuring charges of $5 million to $8 million associated with these actions during the next couple of quarters.

Let me conclude our prepared remarks today by reiterating what Gary has said about how we are going to run the business.

As we said, we are not in a position to provide revenue guidance for Q2 it.

We have taken actions that we expect will enable us to reduce our adjusted operating expenses roughly to $80 million per quarter run rate over the next couple of quarters.

This represents the combined effect of the cost reductions that we made at the end of Q4, as well as the headcounts and facility related actions we announced today.

With our revised operating expense level, we have sized the business to roughly break even as adjusted net income and cash flow if we achieve revenue and gross margin at approximately fiscal first-quarter levels.

We expect other income expense net in the second quarter will be roughly $2 million.

With respect to taxes, because we are unprofitable on a GAAP basis in Q1, we did not reverse any portion of our deferred tax asset and as has been the case recently, we expect our tax obligation for Q2 will be related basically to foreign taxes.

Our basic share county will be approximately 91 million total shares, and if we're in a loss position in Q2, diluted share count will equal basic share count.

If we're in a profit position in Q2, we estimate a diluted share count of approximately 112 million total shares.

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

( Operator Instructions ) .

We'll go first to Ehud Gelblum with

Hi, thank you.

Couple of quick questions, if I could.

First of all, you were down to $84 million, Jim, in OpEx reduction now.

The Acton facility and the extra 200 people would bring you only incrementally down $4 million.

Why wouldn't it bring you down more than just the $4 million to $80 million on OpEx in the quarterly run rate?

And what actions did you do during the quarter to bring you down the 12% that you did to the $84 million you did this quarter?

To the first question.

There are always puts and takes in a quarter, and if you look at our underlying run rate in Q1, it is slightly higher than the $84 million.

So we are starting from a little bit higher run rate and that's why the 200 people gets us down to an $80 million run rate.

With respect to the actions that we have taken, recall that in Q4, at the conference call for Q4, we announced that we took out, I think, about 3%, 4% or 5% of our headcount in a trimming exercise to get us down to a little bit lower level.

That's the basic thing that has happened.

We also had a little bit lower expense with respect to outside services, with respect to discretionary spending and lower travel.

So we have managed all of our spending that is discretionary in a very tight way, and that's how we got to $84 million in the quarter.

Okay.

Could there be other trimming that can get you below $80 million or to get appreciably below $85 million, like to $75 million, that would require another plant closing if you had to?

We did say that there are other things that we can do.

And I don't want to get into specifics, but if we feel that we have to take the costs down farther, then there are things we can do.

I want to -- go back to our strategy, our philosophy here.

We are trying to strike the balance between being break-even and maintaining the strength of our balance sheet and yet holding our strategic investments and products, features and functionality at a level where we would like them to be.

So that's why we struck this $80 million number.

If we find that we need to take it lower, then we will do what we have to do.

Okay.

And now, the strategy at this point seems to have been to keep your cash burn positive or break even, and it sounds as though the OpEx reduction came because you hit the break even point a quarter or two ago and you are trying to keep that stable.

Your lack of guidance for the next quarter, Gary, you mentioned the possible range of values that next quarter could come out would make it, I think you said unconstructive to talk about it right now.

If it does come lower, I would presume then in that case you would be burning cash next quarter.

How many quarters of that would you go through before you took the next action on the OpEx side?

It is a good question.

I don't think -- what I would point out is, we are not going to react just to one particular quarter's data.

Clearly what we have seen since we went through Q3, Q4 is a deteriorating macro environment, and we are clearly responding to that.

So it is a confluence of indicators.

If it meant that we were losing money in a quarter then we wouldn't necessarily respond to that with more operating expense cuts.

We would look at it on the balance of inputs, including what's the order flow, what's going on with our customers, what's going on in the macro, et cetera.

But the objective as you point out, is really for us to manage the business, clearly even in this environment, with the intent of not losing money.

Okay.

And then finally you mentioned traffic growth slowed.

That is the first time I've heard of that, if you could expand on that.

And then, as you look at the projects that you are working on right now, are any of them late right now, or you are not being assessed fees for any late project as you play around with the R&D in the projects you are working, specifically CoreDirector 2 and things like that?

First of all, the traffic growth, we are not really seeing it, and the dialogue we are having with our customers, we are not really picking up much of that, and we are clearly questioning them intensely.

I think there is a view that some of the enterprise growth, what's going on in the macro, is clearly going to have some kind of an impact on traffic growth.

But I think it is fair to say that we're not seeing any of that really being related back to us from a customer view yet.

But I think most analysts, industry analysts, believe it has got to have some kind of impact given unemployment rates, et cetera.

On the alignment around development, we are always looking, making sure that we have got that timed with market realities and opportunities, particularly in this kind of an environment.

But our key developments remain on track and we think that even in this environment, it is very important that we push forward with a strategic rollout of things like the evolution of the CoreDirector family, et cetera.

Okay, thanks so much.

Our next question is from Mark Sue with RBC Capital Markets.

Thank you, Gary.

Following on your comments.

What is your best sense of where we are in terms of network utilization and capacity requirements?

And if you can parse your response between business critical traffic and regular traffic.

Yes, I really wish I had a crisp answer to that, Mark.

As you go around and talk to the large carriers, you'll have different ways of measuring utilization.

I would say that overall my impression is that they are running the networks hotter than they have done typically and some carriers probably hotter than others.

But given the last downturn, it is very different than that and they had a bunch of capacity out there.

Now they don't, and they are living more hand-to-mouth, and so I think we will get a better view of that as we get through the next couple of quarters.

With that being said, Gary, do you think that $440 million is a base number in terms of product revenues?

Do you think we'll bounce around that for the foreseeable future?

I caveat my answer to that with I don't know, as being the honest answer to it.

I still feel, in dialogue with our customers and the overall market that I feel pretty positive around the overall dynamics in the industry and our position in it.

Lastly, Jim, just on gross margins, should we model 46% going forward at a minimum considering the write-offs or decline?

That puts us in a position of giving guidance there.

I guess what we are saying is we are assuming, Mark, we built our OpEx at a point with an assumed revenue and operating level of break even.

So, that is as much as I can tell you about it.

Okay, thank you.

We will go next to Paul Silverstein with Credit Suisse.

Gary, from a geographic perspective, any incremental insight in terms of the visibility or lack thereof between the US and non US markets?

The main markets that we play in is Europe and North America, and frankly we are not seeing much difference, Paul.

The European markets I think have been as badly affected as the North American markets.

I would add a sidebar to it, if you will, in that we are specifically seeing opportunities in some of the European carriers that we have been working on for a while seem to be opening up a little in this environment, and so we do see that as an opportunity to expand our geographic footprint.

Are there any concrete data points relative to Nortel and what is going on over there in terms of you seeing specific opportunities?

I think it would be unfair for me to comment directly on a competitor, but we are seeing opportunities present themselves, generally, around concerns of continuity of supply, et cetera.

There is nothing I could concretely point to as a piece of revenue or a piece of business.

I would more describe it as engagements with customers.

Gary, finally, I think we all understand the challenging environment that you and everybody else are operating in, but when you talk about your belief it is still going to be measured in quarters rather than years in terms of recovery, what is the basis for that.

Is that concrete data points or just more optimism?

Well -- yes, and you can also say that quarters equal years, as well.

But the other thing I would say, the real bedrock to that, Paul, is around the dialogue with our customers and just looking at the traffic growth and just the dynamics around that.

And back to the question Mark was asking around utilization of the networks, the utilization rate is pretty high, and traffic continues to grow on that.

You look at things like the CapEx to revenue ratio and I mention that in our comments coming down below 12%.

That is at a pretty low rate historically.

And so you join all of those dots together, and that really forms the basis for our thesis around that.

Thanks very much.

Thanks, Paul.

We will go next to Tal Liani with Bank of America Merrill Lynch.

Can you hear me?

Yes, Tal.

I have a few questions.

First, just clarification.

You said second-quarter guidance you would be break if sales and gross margin levels remain flat.

Do you mean the gross margin including or excluding the $6.5 million?

Well, first of all, Tal, we are expressly not giving guidance for Q2.

What we have given you is what we can control, which is our OpEx.

And we are going to manage our OpEx for now to an $80 million-per-quarter level.

What we said was that assuming that revenue in the second quarter and gross margin is approximately where they were in the first quarter, that results in about a break-even.

And when we think about that, we are really thinking more like the margin without the extra excess and obsolescence charge.

And let me clarify.

We haven't taken away -- when we have done that 2 percentage points, we don't take away the entire excess and obsolete charge.

We just took away that which represents an unusually high amount.

So it's an incremental piece which happened in the second quarter that we have taken away to get to two points.

And so, clearly, we are going to manage the business over the long term to better than break-even, but at least, as we are sitting here today, given our OpEx level and assuming Q2 being roughly like Q1, we will be at about break even.

Thank you.

My question -- I have two questions.

First, in your last answer, Gary, you highlighted utilization rates and bandwidths as drivers for growth.

If I look at your big customers' big projects last year, if you look at British Telecom, AT&T and Verizon, none of them was actually related to traffic growth.

It was more related to transformation of networks and deployment of new types of technologies.

Do you think that we are going to see decisions about these kind of transformational projects already in 2009?

That is the question.

And second, it is about good will writedowns.

Some of your competitors have taken goodwill writedowns and are taking the opportunity to do it in this kind of an environment.

My question is more about World Wide Packets, do you expect to deliver the same level of top-line growth as you did before?

What should we expect from this acquisition and the original AT&T win?

Thanks.

Okay.

There's a number of questions there, Tal.

I want to have a run at some of them and Jim will take some, too.

The point that you make is an interesting one around capacity versus transformation and what a carrier is thinking around that.

If you look at some of the examples you gave, certainly there is a large element of transformation around the spend from them, but there is also some element of fewer capacity requirements for people like AT&T, Verizon and BT as well, given the fact that we have already built out some of their newer networks.

But I think this balance, and I would say to that you that overall the dialogues that we are having at the executive level with a number of the carriers around their strategic direction and what they are planning to prioritize is very aligned around the transformation projects.

To be candid, I don't think that's being particularly represented in what's going on in the CapEx cuts to date.

Overall, I think they are just trying to preserve capital spending and watch it very carefully and it has been more, I would say, indiscriminate across the board right now of just holding on projects, be it capacity, or be it for transformation.

I would expect that as the challenging macro environment continues, a revisitation of that around really prioritizing some of these more strategic projects.

But that's just a personal view.

Regarding the World Wide Packets, clearly -- and this is an example of that -- I would say the adoption of some of the Ethernet business services has been slower than we would have anticipated, and some of that is clearly, it is difficult to say how much of that is macro, how much of that is just slower than we thought .

But, in fact, I think we still feel very confident around that sector and the take-up of that.

It is a very nascent market.

It is taking longer than we would have anticipated, notwithstanding the macro.

We are very comfortable around the value proposition that we are bringing to market.

We have got some additions to that to be rolled out during the course of the year, as well.

Specifically relating to AT&T, I think that project continues to be committed on their part for obvious reasons, but it is taking longer than we both anticipated to roll out.

Jim, do you want to

With respect to goodwill, Tal, we do have a fair amount of goodwill on our balance sheet as a result of a number of acquisitions we made.

We report as one segment, so, therefore, any goodwill write-off that we may take would be in total, not looking at any individual acquisition that we have made.

Now we took a hard look at the question of goodwill impairment at the end of the Q4.

We took another hard look at it at the end of Q1.

And we believe in both cases that goodwill writedown was not called for, given the rules.

Now the rules ask us to look at a number of things, including the sustained level of our stock price compared to our book value, rate of orders in the business, our outlook for the business.

There are a number of things that we look at, and I would say that as we move through this year, and if it gets worse or if it doesn't start to get better, I think it's possible we could be looking at a goodwill impairment, but we will make that judgment on a quarter-by-quarter basis as we move through this year.

Thank you.

Thanks, Tal.

We will go next to Nikos Theodosopoulos with UBS.

Yes, thank you.

Can you hear me?

Yes, Nikos.

A couple of quick questions.

What are the actual R&D activities that were done in Acton?

It's Steve Alexander.

So Acton came to us through the Waysmith acquisition and they were responsible for really some of the first data product integrations into the rest of the portfolio.

So the DNA that came into the company through that shows up in some of the services that CoreDirector offers, some of the cards on the 4200s, some of the activities around On-Center.

So it was spread across different portions of the portfolio.

Okay.

Can you give an update on the timing under the new plan here on CoreDirector 2, when that would be made available to the market?

So we haven't put any go to market plans public yet around what you are calling our CoreDirector 2.

CoreDirector has continued to evolve over the last several years.

It started out as a layer one switch.

It is now, in networks today, provisioning layer two Ethernet services and such.

We are adding additional functionality to it to integrate it in with things like the 4200 family and such.

Clearly there is an objective to scale the product, to be a much more capable family of service providing and service delivery switches.

And so over time, you can expect additional features, functionality, as well as additional scale out of the product.

Okay.

And on some of the numbers, the services gross margin over 30%.

Is that something that was an anomaly?

Do we have a new range going forward?

What do we think about that?

Without giving guidance about what we expect, I would just say that we have really put a lot of effort into improving our services top line and margin and we've seen very good progress on both sides.

So I believe we feel very, very good about what we are doing in services, and we are pleased with the 31% in the quarter, and we'll see what happens going forward.

It was due, by the way, to a nice mix, and we are hopeful that we can keep that mix going.

Okay.

On the inventory writedown, the extra two points, maybe you can explain to me some rationale behind that, because if I look at your balance sheet, you typically have about $25 million, give or take, every quarter on reserve provisions for inventory obsolescence and excess, so I am curious why would you have to take a higher number this quarter given that you've got almost 25% of your inventory reserves every quarter going into the quarter?

If you look back over the past really three years, the amount that we've taken in terms of a reserve for excess and obsolescence has averaged about 1.8% of revenue.

In this most recent quarter it was about 3.9%.

That's how we get the 2 gross margin points is what resulted this quarter.

As to why it occurred, we do a very thorough job every quarter of looking at our inventory balances by product and even within each product by component.

We have a forecast for demand.

We then have a process by which we estimate the amount that we reserve, or in some cases we write-off.

And I can just say that what has happened is that forecasts are changing.

And we are taking a careful look each quarter, and we are making decisions with respect to portfolio, and all that factors into forecasts versus inventory levels and that's how we took the charge.

Okay.

Okay.

All right.

And just one last question on the inventory then.

Are there any other what I would call small products in terms of quarterly revenue?

Like you mentioned this quarter it was on the broadband access side.

If I look at products like in storage, your traditional data networking products, are there any other categories where maybe you don't have much reserve that you think there could be potentially additional above-normal inventory reserves in the next couple of quarters?

None that we know of.

We try to put this reserve on a constant basis, keep it current every quarter.

But forecasts will change.

And so as we move through this period of uncertainty, I can't say that we will have unusually high inventory charges.

We will just have to wait and see what happens.

Okay.

All right.

Thank you.

We will go next to George Notter with Jefferies.

Thank you very much.

Guys, in the monologue, you talked about variable outcomes for revenue in Q2.

I understand you didn't give guidance, but can you talk a little bit about what the factors are that could potentially contribute to a wide range of outcomes on revenue for 2Q.

Thanks.

Yes, George, outside of obvious ones like order flow and things like that, it's revenue recognition being a factor.

It is all of those things.

The ability for supply chain to operate effectively.

Customers taking delivery and not delaying, those kinds of things.

So it is really a confluence of elements that create a range.

There is always in any quarter, frankly, a range in puts and takes, even when things are moving in an upward direction.

I think we just feel that given the environment, it is a wider range than normal that we are going into Q2 with.

Got it.

And how do you look at capital budgeting as it relates to outcomes for revenues in Q2?

Are you assuming that operators will pass budgets internally, will be more capital dollars around.

Are you assuming budgets get delayed in terms of passing internally?

Any thoughts there?

I think what we are seeing, George, is a very cautious approach on behalf of the carriers.

Typically on an annual basis they've approved their budgets, but I would also say that once they are approved they are looking at it on a monthly basis and they're scrutinizing all of that CapEx.

So just like every other business, I guess, right now, they are looking, they are scrutinizing all of their capital expenditures.

So we don't take too much comfort, frankly, from the fact that they have approved their annual budgets because they are managing it truly quarterly.

And we are seeing things like, say, a project would be an order for $10 million.

We are getting an order for $5 million, and it's smaller across the board.

So we are seeing things like that, and yet they have got the budget for the $10 million but they're not spending it all.

Okay.

Last question, in the October quarter you bought a couple million dollars in debt back, well below par.

Your debt, I haven't looked in a while but it's trading below $0.50 from a dollar, in some cases.

I guess I am trying to understand what your appetite is for any potential buybacks of that debt off the balance sheets.

Thanks.

As you noted, George, we did buy a very small amount.

We have been monitoring the market.

We are in a situation of high uncertainty.

We like our cash balance, and we are going to use great judgment and discretion as we move forward through time.

That's about all I can say on the topic.

All right, thanks.

We will go next to Samuel Wilson with JMP Securities.

Thank you.

This is Doug Ireland for Sam Wilson.

I was wondering if you have seen any changes in the competitive environment.

If you feel like there has been any change in share or change in aggressiveness and pricing, or if this is more of a fallen thing across the board.

I would say overall it's been a challenging environment and has been for a while, before the macro stuff across the board, haven't seen particularly any changes.

As we go into new geographies and we break into new accounts and displace competitors that tends to be a little more challenging from a pricing point of view, but that's nothing different than we have seen in the last few years.

I think it is generally true, as we said earlier though, that we are seeing a few more opportunities to gain footprint in this environment than we have seen.

And that does tend to affect margins.

And another thing I was wondering, I think of carrier investments as alternating between the core and the act, and I was wondering if you have seen any shift in that investment pattern or if carriers are just holding everything back together.

So this is Steve Alexander.

I think your model historically has been correct, right.

You would tend to think of people building out core capacity first and then maybe the metro or metro first and then core.

What we have seen, and they do try to strike a balance in how they do their investments.

What we have seen them move to is that as some of these new technologies become available, in particular, Ethernet, Ethernet is a technology that is applicable on the enterprise side, in the metro side, as well as can be used in the core side.

It also gives the ability to capacity very quickly.

So in the past where they may have been putting, let's say, a Sonnet or SDH infrastructure in place, they will now go for an Ethernet infrastructure with the understanding that that's going to start to give them scale up into the multiple gigabits, arguably now coming to 100 gigabits.

So I think they are looking at it a little bit more holistically in how they look at building out their entire infrastructure.

Thank you.

Our next question comes from Subu Subrahmanyan with Sanders Morris.

Thank you.

I have two questions.

First, can you talk a little bit about moving your product portfolio between core, transport, switching and on the Ethernet side, where you think carriers can defer spending, or you mentioned Ethernet as an area where it is a condition technology where they could push it our more versus where they have capacity requirements that they need to fill more on a near-term basis.

And my second question was on the product introductions you talked about, the priorities for this year.

Any more detail -- I know you answered on the CoreDirector side but on the transport and Ethernet side if you can give us more detail.

Sure.

So the first question around the switching and the core, transport and such of it.

I think what you see is obviously it is going to vary carrier to carrier and it also has some regional flavors to it.

The folks who have done large-scale builds, and some of these were talked about earlier, it wasn't driven entirely as a transformation or driven entirely around a capacity expansion.

What they basically did is put a network architecture in place that started them down the transition path toward a more pocket centric or Ethernet centric world but also gave them the ability to scale very quickly.

They really got two solutions that way.

I think they have to strike a balance in how they invest in terms of adding capacity versus making an architectural transition.

When you look at what we are doing with the portfolio, the basic strategic themes continue.

We are going to continue to do data optimized switching solutions.

We are adding additional features onto the CoreDirector family.

CoreDirector is converging together with the 4200 into an extended family.

We have done the demonstrations of the 100-gig transport portions of it.

You would expect that as we look at bigger switches having those switches built for 100-gig world with maybe a gigy as the Ethernet currency, I think would be a sensible thing for us to pursue.

Moving Ethernet service delivery out to the edge and particularly simplifying how it gets delivered is pretty key to us, and that gives us the opportunity to unify it all together with a common software infrastructure.

That is really where the portfolio is headed.

Got it.

And just to clarify on my first question.

Do you see on the metro Ethernet transformation the capability of carriers to push it out a little bit more because they have existing networks that are able to do maybe a less efficient job but still able to carry the, traffic and more requirements on the core side because there is just traffic that they need to support?

Specifically to the metro side of it, I think you are going to find, again, they are going to take a toolbox approach.

There will be some people that will pack on what is an existing legacy sonnet full of Ethernet and we will give them the tools to do that.

We're also going to have people who will do it as an overbuild and realize they eventually want to get to an Ethernet infrastructure as well as treating Ethernet as a service, and we can help them do that also.

The trick for us is to have those tools in the toolbox so that we can address the variety of problems that are out there.

Got it, thank you.

Our final question today comes from Simon Leopold with Morgan Keegan.

Thank you.

I wasn't sure if I was going to get in there.

First, I want to clarify the operating expense trend here, because you mentioned it would take perhaps months to fully close down the Acton facility.

I just want to make sure, should we be thinking of the April quarter as reaching your $80 million target or trending toward it?

You will see a trending toward it, and by our third quarter we should be roughly at the $80 million.

Great.

And then in terms of the poor visibility.

Point understood.

Just wondering how big a factor it is that historically your largest customer, AT&T, is in strike preparation mode with a union contract expiring in April?

Just trying to get a sense of what's been going on there in terms of preparation, the potential for a strike, factors into your forecast.

Simon it's difficult for me to comment on a particular customer like that, but I think the general consensus is it's very hard to predict what is going to happen there.

There is always the potential this time of year with a number of these large carriers with the union negotiations, and I think there is always potential for distraction.

I am not asking you to predict whether there is or isn't a strike.

What I am really trying to get at is the preparation activity serving as a distraction right now that has led to some slower business.

I would have to say, we are not particularly seeing that any more than the normal.

No, Simon, I don't think so.

I think they are balanced around it.

Okay.

And then also in terms of linearity, it sounded like the last quarter really wound down in January which was pretty awful.

If you can confirm that and talk about how things have been trending just over the last, let's say five weeks.

I would say that typically the first quarter is not a good one for us, given the timing from a CapEx.

You are at the end of the fiscal year for a bunch of carriers and they don't want to deploy stuff at this time, and you've only got January and they are just starting back up again and then you got all of the various holidays.

So there is some seasonality to that, and it is difficult to separate that out from the overall macro stuff that we are seeing, quite frankly.

We are seeing that environment continue.

How would the most recent five weeks coming up to today compare to the month of January?

I would say that, on balance, similar.

Okay.

Thank you very much.

That does conclude our question-and-answer section.

Mr.

Smith, I will turn it back to you for any additional or closing comments.

I would like to thank everybody for their time this morning.

And for your continued support.

And I look forward to talk to you soon.

Thank you.

That does conclude today's conference.

Thank you for your participation.

You may disconnect at this time.