Ciena Corp (CIEN) 2009 Q3 法說會逐字稿

Good day and welcome to the Sienna Corporation third quarter 2009 results conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would now like to turn the call over to the Chief Communications Officer, Mrs. Suzanne DuLong. Please go ahead, ma'am.

Thanks, Ben. Good morning and welcome, everyone. I'm pleased to have with me, Gary Smith, Ciena's CEO and President; and Jim Moylan, our CFO. In addition, Steve Alexander, our Chief Technology Office, will be with us for the Q&A portion of today's call. This morning's prepared remarks will be presented in two segments. Gary will review our third quarter performance and discuss our outlook. Jim will review the financial results for the third quarter and provide our guidance for Q4. We'll then open the call to questions from the sell-side analysts.

This morning's press release is available on National Business Wire and on Ciena's Website at Ciena.com. Before I turn the call over to Gary, I'll remind you that 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 factors detailed in our 10-Q, filed with the SEC on June 4, 2009. We have until September 10 to file our 10-Q 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 events 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 Website at Ciena.com Lastly, as a reminder, this call is being recorded and will be available for replay from the investors portion of our Website. Gary?

Thanks, Suzanne. And good morning, everyone. On balance, industry and macroeconomic sentiment is somewhat improved over the last quarter. We're seeing some signs of stability, specifically in North America, while in other parts of the world the recovery maybe somewhat slower. In general, we continued to see cautious spending across our customer base. In the last 12 months, we've managed the business with the objective of balancing operating performance with a disciplined approach to strategic investment and we believe we've done this successfully.

For example, in the last nine months, we've reduced our quarterly non-GAAP operating expenses by 17%. This discipline has enabled us to invest more in R&D and we expect our annual R&D investment will actually be higher in absolute dollars this year than last. In addition, we've delivered cash from operations over the first nine months of this year and we're on track to have positive cash flow from operations for the complete year. I'll talk to our third quarter performance, as well as the overall environment, before turning the call over to Jim to discuss the details of our Q3 results.

First, we're pleased to deliver strong revenue growth in the third quarter. Our sequential revenue increase was driven by improvements from long haul transport, our CN 4200 platform and notably, revenue from our carrier ethernet service delivery or CSD portfolio. CSD revenue increased more than 70% sequentially, contributing $23 million or 14% of the quarter's total revenue. You'll recall, this category includes both our broadband access products, as well as our service delivery and aggregation switches and the ethernet access products.

We're starting to see solid traction with the ethernet service delivery, aggregation and access products, with nearly 90% or $20 million of this quarter's CSD revenue coming from those platforms. in addition to business ethernet service applications, which we've talked about in the past, we're also seeing demand for these platforms in support of wireless backhaul. In fact, the largest portion of Q3 CESD revenue came from a 4G WiMAX related deployment. While it may not happen in a neat or even linear fashion, we do expect that, along with our CN 4200 and CoreDirector platforms, our CESD portfolio will become a meaningful revenue driver of our business going forward.

At 46%, our non-GAAP gross margin was generally consistent with Q2's gross margin, absent the effect of the lost contracts we called out last quarter. Despite the broader environmental challenges, we've been able to sustain gross margin generally in our target mid to high 40's range. In part, through the combination of disciplined and continuous product cost reduction efforts, as well as our fundamentally strong value propositions. While pricing remains competitive in certain segments and geographies, we believe our portfolio and feature sets are differentiated and will enable us to sustain gross margins in the mid to high 40's range in the near term. And as we've said in the past, a key motivator for many of our portfolio investments we've made and are making, is a desire to achieve a sustainable higher gross margin over time.

In terms of operating expenses, at $80 million and non-GAAP operating expenses were down 8% sequentially. Last quarter, we talked about higher than anticipated prototype related expenses. Those expenses came in as expected in the third quarter but were offset by lower employee related expenses due in part to some headcount reductions. Overall, we continue to work towards our goal of balance, carefully managing our balance sheet while prioritizing the investments we believe are critical to our future. Like many of our customers, we have constrained our investment over the last year as a result of the environment. We have several new platforms coming to market over the next several quarters, which is likely to drive R&D higher. We'll continue to monitor in the environment and our customers needs in assessing our operating expense levels. But as the environment begins to show signs of strengthening, our OpEx will have to increase to support these initiatives, albeit not at the same rate as revenues.

Before I ask Jim to review the details of the quarter, let me spend a few minutes discussing the environment and what we're seeing and hearing from our customers. Firstly, it's reassuring to hear some of our large North American service providers publicly recommit to their stated CapEx targets for 2009. It's also reassuring to hear customers say they intend to increase the pace of their spending in the second half of the calendar year. However, we expect it may take awhile for that sentiment to translate into real spending and recognized revenues.

That said, in general, our customers traffic levels have grown, their revenues have not significantly declined and CapEx to revenue ratios remain at historical lows. As a result, we continue to believe that current levels of spending are unsustainable over time, particularly given the combination of traffic growth and new service demands on networks. And perhaps even more so than even a year ago, many of our customers are facing multiple critical network and business priorities, from capacity crunches in the core and wireless backhaul to the need to deliver more cost effective high bandwidth enterprise type solutions.

One of the areas where we've seen a willingness to invest and where we are getting meaningful traction is managed service deployments, likely as a result of their immediate and direct link to revenue. We continue to prioritize our own development spend, such that we will remain on track and aligned with evolving market opportunities and customer concerns. At the highest level, over the course of this year and early next, we're focused on bringing to market a series of products in transport, switching and software, that together create a powerful toolkit to migrate today's networks to more efficient, more capable OTN ethernet.

Our four significant ongoing development efforts include; One, bringing out our market data optimized switching solutions and the evolution of our CoreDirector family. Two, filling out our converged optical service delivery portfolio including 100 G technologies and capabilities. And thirdly, expanding our ethernet service delivery portfolio and extending the value of software and unified network and service management across our portfolio. I'll touch briefly on each of these.

Firstly, on our switching solutions, as you know, one focus of our R&D efforts has been on bringing to market our data optimized switching solutions, which is often equated to the evolution of our CoreDirector family. I can't emphasize enough that this is not a CoreDirector replacement program. the simplest description of what we're doing is that we're building a family of switches to support next generation networks. We continue to make good progress on this and within the next few weeks, we'll be more forthcoming with some details.

In the meantime, I'd like to talk a bit more about the nature of these development efforts. Specifically we're doing two things. Firstly, we're enhancing the current platform by migrating CN 4200 technologies, primarily ethernet and OTN, in a release of CoreDirector that includes new hardware and software features. And we'll be introducing a new platform that will enable customers to increase capacity handled per network node, increase the number of switching nodes in a network and add package switching capability to the whole family. You can think of this like it is today. CoreDirector is the industry leader at managing circuits. We're going to take what CoreDirector does so well and apply it to managing ethernet.

On our optical service delivery portfolio, we continue to see strong interest on our 100G capabilities. We believe the broader commercial opportunity for 100G is likely to materialize in late 2011 or early 2012. In the meantime, we're active within the standard bodies and seeing opportunities for the capability in specialized applications, like our 100G win at the NYSE Euronext.

On our carrier ethernet service delivery portfolio or CESD, we remain very excited about the opportunity for our CESD portfolio as evidenced by the strong traction this quarter. As I mentioned earlier we were pleased to see strong revenue in the quarter, primarily from wireless backhaul-type applications. In addition, although we've not recognized any revenue to date, we are beginning to receive initial purchase orders for CESD products from AT&T in support of both their business services and wireless backhaul applications.

Finally, software and unified network and service management. This is critical to optimizing and making the networks work. Network automation has historically been our strength and we're investing strongly in our software architecture to leverage and optimize that strength. We feel strongly that we're in the midst of several important product cycles and we're excited about the opportunities we believe they enable us to address.

In summary, our goal remains as it has for the last 12 months, balancing operating performance near term with a disciplined approach to strategic investment longer term. I believe we are seeing the early signs of market recovery but I cannot predict the shape or timeline of that recovery. In the meantime, we remain confident that our current portfolio and future product cycles target the current and emerging critical network priorities of our customers. Jim, with that, will you talk to the details of our Q3 results?

Thanks, Gary. Good morning, everyone. We reported third quarter revenue of $164.8 million, representing a 14% sequential improvement. We had three 10% plus customers in the quarter that represented 37% of total sales. Two of the 10% customers are North American based and one was also a 10% customer in Q2. Sales from international customers represented 37% of total revenue in the quarter, consistent with the 36% in Q2. As you know, we break out our revenue into three major product groups. The first group, optical service delivery, includes transport and switching products, as well as legacy data networking products and related software. It accounted for $117 million in revenue, representing 71% of total revenue for the quarter.

Within optical service delivery, our CN 4200 advanced services platform was the largest contributor in the quarter at $43 million, up more than 30% from $32 million in Q2. Core switching contributed $38 million in the quarter, down slightly from $43 million in Q2. Long haul transport added $27 million, up sequentially from $23 million in Q2. Our second product group, carrier ethernet service delivery, or CESD, includes service delivery and aggregation switches, as well as ethernet access products, broadband access products and the related software. As Gary noted, CESD had a strong quarter, increasing more than 70% sequentially in Q3 and contributing $23 million or 14% of total revenue. Finally, our Ciena specialist services group, which includes all of our services related offerings, was $25 million in revenue, flat with Q2.

In the remainder of my comments today, I'll speak both to the GAAP results and what the results would have been if we excluded those items detailed in our press release. First, I'll speak to gross margin. Q3's GAAP gross margin was 45%. Adjusted for share-based compensation and amortization of intangibles, Q3's gross margin was 46%, which is generally consistent with the last several quarters' normalized gross margin. Our GAAP product gross margin for the quarter was 48%, up from 45% in Q2. You'll recall that Q2's product gross margin reflected the adverse effects of orders associated with loss contracts in that quarter. Our services gross margin was 31%, once again better than our target mid 20% range, as a result of the mix of services revenue in the quarter.

On a GAAP basis, Q3's operating expenses total $97.6 million. That included stock based compensation, as well as $6 million in amortization of intangibles and $4 million in restructuring related costs. Excluding those items, our adjusted operating expenses totaled $80 million. Which as Gary noted, represented an 8% sequential decline from Q2 and represents the results of our efforts to control our costs as we were in the downturn. Our Q3 GAAP net loss was $26.5 million or a loss of $0.29 per share. Adjusted for unusual and non-operating items discussed previously, our third quarter net loss would have been $4.8 million or a loss of $0.05 per share.

Turning now to cash flow and the balance sheet. We continue to be pleased with our working capital management. Despite the GAAP loss in the quarter, we generated $3.5 million in cash from operations. Our balance sheet remains strong, with $1.1 billion in cash and short and long term investments at the end of the third quarter. For Q3, our accounts receivables balance was $120 million, up slightly from $117 million in Q2. Our day sales outstanding were 66, down from Q2's 73 days.

Given ongoing revenue uncertainties, we continued to closely manage our inventory position. Inventories totaled $89 million in Q3, down a little from $91 million in Q2. Product inventory turns were 3.2 times in the quarter, up from 2.9 times in Q2. the inventory break down for the quarter was as follows. Raw materials, $20 million. Work in progress, $0.8 million. Finished goods, $90 million. And a reserve for excess and obsolescence of $22 million. With respect to headcount, as of July 31, 2009, our worldwide headcount was 2110.

I'll conclude our prepared remarks today by talking to guidance for Q4. Before doing so, however, I would like to caution that although we are providing some limited guidance for the upcoming quarter, our visibility remains limited. We expect to deliver Q4 revenue roughly flat with Q3 revenue. We also believe, based on current expectation about product mix, that gross margin will be in our mid to high 40's target range. We continue to work to our goal of balance, carefully managing our balance sheet while prioritizing the investments we believe are critical to our future. We believe Q4 non-GAAP operating expenses will be in the low to mid $80 million range. We do expect that prototype expense will be higher in Q4. We expect other income expense, net in the fourth quarter, will be an expense of roughly $1 million.

As for taxes, we expect our tax expense for Q4 will be related to foreign taxes. Depending upon your assumptions, you may need either our diluted share count or our basic share count. We estimate Q4's diluted share count at approximately 113 million shares. We estimate Q4's basic share count at approximately 92 million shares. Ben, we'll now take questions from the sell-side analysts.

Thank you. (Operator Instructions)

Our first question comes from George Notter with Jefferies. Hi. Thanks very much guys. I wanted to better understand sort of the trajectory of operating expenses going forward. I understand there's a bit of a bulge here, from an R&D perspective, with new products coming out. But as we get beyond that bulge, any sense for how much reduction we can get in operating expense in absolute terms, it would be great? Thanks.

Thanks, George. Yes, with all these platforms coming out, it's a little bit lumpy in terms of both prototypes and also, we've got some strategic hiring as well. We see the sentiment overall getting better. We want to make sure we're optimized around our resources and the platforms to market and the timeliness of that. I would say that we've continued to balance it very carefully as we come out of the downturn. We've got, clearly, operating leverage in the business. We've reduced operating expense significantly and we'll continue to be very disciplined around it. I think, Jim, we talked about being up in Q4 with some prototypes and some additional strategic hiring in R&D as well particularly. But we're going to manage that very carefully going forward, George.

Got it. In terms of just the OpEx spend, over the last few quarters and obviously you've brought it down the same time you've invested more aggressively, I'm still trying to parse the amount of OpEx reduction you've had here against the amount of incremental R&D investment from all of the prototypes and activity. I'm still trying to figure out exactly how much you could maybe come out as you get beyond this bulge. Any numerical sense for that at all?

Well, I still think, George, we've got an environment that's not got great visibility and we're managing it very carefully on a short-term basis. We've reduced the underlying operating expenses, perhaps this is a better way of looking at it. We've reduced some 17% in total over the last nine months and yet, we've still been able to spend more on R&D than we did in 2008. And I think that really talks to prioritizing and optimizing our spend, things like G&A and some of the other expenses we've managed very carefully. Clearly, compensation is always a big aspect of it. And given the fact that the Company is not profitable, we're not paying bonuses, etc. And all of those things accumulate up and that's enabled us to take the operating expenses down. The other thing I would say is that we've now got a Company that's got a much more agile operating expense model. Meaning, we're outsourced in terms of manufacturing, we've got some strategic outsourcing in terms of our service partnerships. So, we are able to flex those kinds of things when you get into a downturn. The last time we went through this in 2001/2002, we didn't have those kinds of flexibilities in our operating model.

Great. Thanks.

Our next question comes from Nikos Theodosopoulos with UBS.

Hi, this is Jack Monti in for Nikos. Just a question on the guidance, trying to understand some of the puts and takes to the flat quarter-over-quarter revenue guidance. In that, maybe you can help me understand if I'm thinking about this the right way. So I'm thinking international is going to be weaker. Domestic should out perform. And then, I'm trying to reconcile some of your key customers, guidance commentary on CapEx with the flat outlook. So, AT&T is supposed to be up 30% plus in the second half and then we only have flat revenue guidance. So kind of what is the thought process there? What should I be thinking about?

Jack, I'd say a couple of things. One, as we come out of this downturn, I think that it's going to be a little lumpy anyway. The second thing I would say is, in absolute terms, we've just come off a quarter where we've delivered 14% revenue growth. So effectively, we've delivered above, I think, what was our Q4 consensus. So, we've delivered that in Q3. And we're saying that we can do a similar kind of performance in Q4. So I think the trajectory, overall, is positive and I think it's consistent with some of the utterances you've seen from some of the North American carriers. But I think it just takes time for the increase in spending to filter through in terms of shipments, revenue recognition, those kinds of things. So I think, overall, it's consistent with what I think most people are saying around an uptick. It's just the trajectory of that is just difficult to predict.

Okay. And then, am I thinking about it the right way that the international piece should kind of under perform? It's kind of -- if I take a step back, if I think about the international piece this past quarter it was up 16%. It out performed versus the domestic piece. So, maybe that won't continue and it will under perform with the recovery lagging internationally or how should we think about that?

Well, I would say, there's a couple of projects internationally that we've won with a couple of tier one's that will help sort of offset the overall feeling. And I think, Jack, it's more Europe I think is sort of lagging than some of the other territories. And that tends to be I think a general commentary we're seeing from other people too. So how that manifests itself in quarterly, quarter to quarter revenues, again, I think will be a little bit lumpy. But overall, I think Europe generally is lagging a little bit in terms of recovery. And internationally, we've got some offsets against that in a couple of decent sized projects that we've won.

Thank you very much.

Thank you.

And our next question will come from Samuel Wilson with JMP Securities.

Good morning. Just a couple very small questions this morning. First, you talked a little bit about CapEx, the disconnect between CapEx and actual revenue recognition at Ciena. And I just wanted you to fill in some of the details. Is most of that behind customer acceptance and the issues around customer acceptance and the accounting behind it? Or do you just think carriers at the front end are spending on some other things first and you're a little bit later in the spending cycle?

I would characterize it as not specifically to Ciena but I can talk about what is specific to us. By the time you get orders and particularly, in the second half of the year, carriers tend to place orders in the first half of the year for deployments in sort of Q3 and early Q4. Don't tend to deploy a lot around the holiday season from Thanksgiving to Christmas generally. Our revenue recognition is clearly driven by accounting policy and it varies by customer and if it's a large turnkey project. The other thing that I would point out as well Sam is that when we talk about -- Q4, for us, ends at the end of October. So we have an earlier fiscal year close as well. And I'd just be mindful of that. Where most of our competitors and a lot of the commentary clearly talks to the full calendar year and that can be a little misleading as well.

Got it. And then my other question is on your talk about the new CoreDirector platform, as you talk about a new platform and the expanded product portfolio and it's not a replacement to the existing CoreDirector. Do you see this as a product where it's going to take that sort of traditional six months to one year sell cycle where carriers -- your customers will feel like they have to go through lab trials, to field trials, to broader deployments? Or do you think that, given the large installed base of CoreDirector already, it will be more of just we know this product, we're ready. We'll just put it in a few field trials and we're deploying relatively rapidly.

Yes, Sam. This is Steve Alexander. I think you're going to find that there's going to be a broad spectrum of the way people approach it. The software between the various members of the family, and what I want to emphasize here is that family approach we've taken to this, will be -- the same software will run on different boxes. And so, you'll have people that say, "Okay, I'm very comfortable with the operation of it. I just want to check on the hardware side of it." Then there's going to be others, just on a policy basis, are going to put it through a longer acceptance cycle regardless of their view of the platform. So I think you're going to find both.

Got it. And then, my last question is actually for you Steve, so thank you. Can you just talk a little bit about ethernet? Ethernet really showed a surge this quarter or it appears, at least in the numbers, to show a surge. Has there really been -- I don't want to call it a sea change but we've reached that point in the hockey stick where we're seeing ethernet sales really fundamentally take off here and that's where carriers are putting their effort?

Well, Sam, I think we've said in the past one of the things that we're betting on is the emergence of ethernet, in particular, the way we implement it with ethernet and OTN combined, as playing not only the role as service or service delivery but actually playing a role in infrastructure. It really lets the carriers optimize their total investment. And we do see more interest than ever in ethernet service delivery and ethernet OTN as an infrastructure play. And we think that's going to continue.

Steve, what I'm asking though is, based on the results of the quarter just reported, did it surprise you to the upside in a sense of how much business you did there or you'd seen this coming for a while?

Well, I think we have expected a transition, if you will, away from the more conventional side of the SDH world, over to one that is much more ethernet and ethernet OTN centric. That's the way that we have built the features in for the portfolio. That's the ways that we have optimized the investments that we've made on the R&D side. I think you're starting to see some of the benefits of that.

Great. Thank you very much gentlemen.

One thing I would say Sam is that, as we said, we have not seen any significant rev rec from AT&T in our CESD portfolio yet.

Yet. Great. Thank you.

And we will take our next question from Mark Sue with RBC Capital Markets.

Thank you. So just as a clarification, the higher than expected revenues, that was not related to recognition of deals that slipped last quarter. It was more the broader growth in carrier ethernet. Is that the characters?

Well, it's not really a result of slippage. Certainly, there was some stuff that came into the quarter but at the end of every quarter, there's some things that move around. So no, I think it just reflects what we expected, which was an improvement in our basic revenue situation Mark.

Got it. Okay, and maybe Gary, your comments on CapEx linearity offset by the pace of spend. That implies that after a flat October quarter, we can potentially have a very strong sequential January quarter. Is that a reasonable assessment?

I would hesitate to say that. I think we're at the fairly sort of nascent stages of this sort of recovery and I think that it's going to be lumpy. That would be a nice thought though, Mark.

But can you say that quantified orders and quantified customer commitments are at the highest levels that you've seen in awhile?

Well, I think orders are one indication, they're not the only piece. It's around sort of pipeline and book and bill and all of those things. It's never a particular single dimension for us but generally, I would say that activity is certainly improving. Sentiment is definitely improving overall. Certainly, a lot better situation than we were six and nine months ago. I just think the size and shape of this recovery is going to be kind of difficult to predict. But as I said earlier, I think we've got a situation where I think the CapEx to revenue ratio is unsustainable even from a carrier point of view over the longer term, which I think is encouraging for us. And as Steve outlined, we've got a lot of very strong product cycles coming to market over the next 12 months.

And just lastly, on CapEx year-end spending flush, if you had to say one way or the other, do you think the carriers are intent on spending at least a part of their remaining balance late this year?

I would say that I think the carriers are feeling a little more optimistic around their spend but I think how that translates to revenues and orders and it takes awhile for that stuff to filter through. And if their intent is to spend more, it takes awhile for that to get out. And I think you more likely to see that -- you could see some of that in Q4, at the end of the fiscal year for vendors.

Got it. That's helpful. Thank you, gentlemen.

Thanks, Mark.

And we will take our next question from Michael Genovese with Soleil Securities.

Great. Thanks. Congratulations guys on a good set of numbers. You gave us a update on your 100G road map. I was wondering if you could maybe talk about 40G for a minute, where you are there? What that road map is looking like? And then secondly, tangentially related, there's been a lot of speculation about these Nortel assets in the market. And just any comments you could give us on what you think about the technology, what you think about in terms of industry consolidation, what the sale of the Nortel assets could mean for the industry? That would be great. Thanks.

Okay, Mike. I'll take the first part of it on the 40 and 100 gig. As we've said in the past, we think ultimately the high ground, if you will, in all of the transport is going to be 100 gigabit ethernet. We've seen the emergence of the 10 gigE world. 40 gig remains what we think is important but it's a stepping stone ultimately to the 100 gig. We've clearly placed the majority of our investment dollars in the 100 gig world. And I think you're starting to see some of the first benefits of that with the announcement of the New York Stock Exchange, Euronext deal that we've got. It clearly is intended to optimize the performance of networks that are latency sensitive. That's essentially why you go down that path. So again, we believe 40 is important but it is a stepping stone that see going to the 100 gig world.

Mike, in terms of the industry structure, etc. I think, generally speaking, sort of consolidation I think is generally helpful. So, whatever those assets end up, I think that will be helpful from an industry point of view.

Thanks.

We will take our next question from Alex Henderson with Miller Tabak.

Thanks. Can we just go back to the R&D line for a second? Obviously, with the new products getting ready to launch, the prototyping costs should fall back out. Can you give us a little bit more clarity on what the size of the slug of R&D that are associated with prototypes will be over the next quarter or two and when you might expect those to actually drop back out?

Well, typically, prototype expense is going to come up as we bring products to market. And then for those products at least, prototype expense will fall down. So, what we said in the third quarter was we didn't bring a lot to market immediately, so we had lower prototypes than sort of our run rate was in the second quarter. We also said that we expect coming into the fourth quarter because, as we've said, we're bringing some things to market, we're going to spend more on prototypes. So that's about as far out as I'll be able to speak to it but you could say we try to optimize our prototype expense to match the timing of products coming to market.

Are we talking about $3 million to $5 million slug in the R&D line as a result of that?

Well, I think you can get a sort of a guess at it by our language. We said we did just under $80 million in the third quarter and we said that we'd be in the low to mid 80's in the fourth quarter.

Okay, second question. It sounds like the design of the CoreDirector family that you're coming out with is targeting the fine grooming/almost direct attack on what Infinera might want to do down the line. Certainly, Infinera's grooming functionality is highly limited versus what you guys can do. Is this somewhat of a preemption of them coming into the marketplace, putting in digital nodes and improving flexibility of the network using the CoreDirector as a way to obviate that need? And if that's the case, can you talk a little bit about how the cost differential of the CoreDirector might look versus one of their digital nodes in a similar scale unit?

Sure, so Alex, I'm not sure we would say that we designed it as a preemption. I think we've approached the CoreDirector family from really three directions in terms of scalability. Right? You want to increase, effectively, the capacity on each one of the nodes. You want to increase the number of connections that each node can manage. And you want to basically increase the total number of nodes that are available in the network. Right? And this falls along the lines of what we're trying to do with managing, connectivity managing circuits, managing connections, all in kind of an ethernet flavor going forward.

I agree with your observations. We think it's a much better solution than some of the alternatives that are out there, both from a connections management, as well as an availability point of view. The CoreDirector family is really optimized around providing very resilient connections and networks. These initially started as TDM connections and over the next few years, they're all going to migrate to become ethernet connections. And we basically want to do for ethernet the same thing that we did for TDM. All right? We want to provision them faster than anybody else. We want to make them more reliable, more available than anybody else can. In terms of cost points I think you'll find it's competitive and inarguably, we think it will be market leading.

Can you give us some sense of the fine grooming of some sub-lanes of traffic here, what type of degree of fine grooming we should anticipate?

Well, so it's a family. Right? Again, I'll go back to emphasizing the family piece of this. And so, you do a family approach to optimize what is effectively the carrier's operation. So, the smaller boxes at the edge of the network would be able to groom or process finer grain flows. You wouldn't necessarily want to be doing megabit manipulations on 100 gigabit core switch.

Right, of course.

So obviously, you optimize the grooming throughout the network.

On a related subject, when you talk to your carriers, in the optical ethernet, people think about it on the sell-side and buy-side of it as an optical market. But in fact, it looks like a lot of the decision process that's being made isn't being driven by the optical market at all but rather, by the router market, the router overlay in particular. Can you talk to a little bit about how much capital substitution you see shifting money from --putting money into the router footprint as they shift traffic off the router, using router bypass, as well as deliver off the routers for ethernet service delivery, how much do you see this carrier shifting the CapEx off the router piece down into the service and transport piece in the optical layer? It seems like the router problem is driving decisions to put money into optical, as opposed to optical economics per se.

Well, so I think you've touched on a number of topics there. I think the carriers are always trying to optimize the way their networks operate. They've got a number of choices now and in many cases, our role in life is to give them as many choices, so they can optimize the best possible way. They can manage circuit flows on an optical level, which people would typically call wavelengths. They can optimize their networks using containers. Right? So, we speak of OTN as kind of being the containerized freight model for the carriers. It carries anything they want. It can carry IP services, it can carry ethernet, it can carry storage, it can carry high-def video. So, we think that there's a broad market for the approach that we've taken.

Some of it you would describe as maybe router offload. Honestly, some of it's just going to be described as point-to-point connectivity but maybe for high-def signals going forward. Right? So we see things changing in the way that carriers can build their infrastructure. And so, again, the use of OTN kind of -- and I'll go back to the containerized freight model, you look at what that did for the shipping business. Right? You can expect similar things to happen in the transport space. It's something that carries almost anything they can imagine and it changes modality very easily. You can move things across boxes using OTN in a much more efficient way than you can using a lot of other technologies. And again, it's all around how to optimize the spend.

So just to point to the question, do you see spending shifting off the router plane into the optical plane?

I think we see it continuing in all of the layers of the network. There's going to be spend in layer zero, which is wavelength. Spend in the kind of layer one space on OTN. Lots of spend in layer two in ethernet. And there's continuing spend above that with the routers. So, I think it's going to be in all of the areas of the network. We think there's lots of opportunities to do more in layers zero one and two than ever before.

Thank you.

Thanks, Alex.

We will take our next question from John Marchetti with Cowen and Company.

Thanks very much. Just getting back to the CESD line for a second here. Obviously, a big switch up this quarter, at least on a sequential basis. A lot of that, if I understood your comments, it seems to have come from the one big North American customer. As we look into Q4 and maybe beyond there, do you think now we're at this sort of higher run rate for the business? And like you said, AT&T still hasn't come in here. Can we expect we can see this sort of level of revenue, obviously, with some variation going forward? Or do we sort of -- or is this sort of a one-off, very lumpy deal and we'll have to kind of wait and see how this turns out over the next several quarters?

John, I would say overall that I would expect this to be one of the sort of -- if I think about families of platforms, I would think that CESD would be a driver of revenues going forward, along with 4200 and the CoreDirector family. So again, it's going to be a bit lumpy and it's still a nascent market. But I think overall, we've got, since the acquisition of World Wide Packets, we're now over 50 new customers. They vary in size but we've got a number of of tier ones that we've been able to secure that are beginning to roll out. One large one you just touched on, which we haven't really even taken any revenue for yet. So, I'm very optimistic about that space. I think that it's taken a little bit longer than we'd anticipated. We were a little, I think, overly optimistic around that and some of it was the overall environment, probably a combination of both. But I think we feel pretty good around the broad base of activity with CESD now.

And then, Jim, maybe for you, you talked about revenue in Q4 being relatively flat. Should we expect that that is sort of how the way your two major segments play out? On the product side, last quarter, we talked about everything being sort of up sequentially. Should we think -- are there any big variations in there or do you expect that, as a whole, the business will sort of move flat sequentially as we go into fiscal Q4?

I would say -- there's always a bit of a change in the mix but I would say broadly, a similar kind of mix I would expect in Q4.

Okay.

I would agree with that.

Hence, a similar kind of profile around the gross margins, etc.

That's helpful. And then lastly, just real quick, last quarter you booked the two new long haul contracts, you took some of the losses up front. Did either of those contribute to revenue in this quarter?

I don't believe they did, John. I don't think they did.

Not in any material way. One of them might have contributed a minor amount but not in any material way.

Thanks very much.

Thanks, John.

We will now take our next question from Tal Liani with Bank of America-Merrill Lynch.

Hi, guys. I have questions on the P&L, margins and expenses. On the gross margin side, you're now at about, if I look at it correctly, you're now at about 46%. And the question is how much more upside do you see in the long run? What I'm trying to understand is whether from absolute expenses, OpEx, you've maxed out the declines you can deliver? And then, on the gross margin side, same question, whether you've maxed out on the increases you can deliver? And just the understand whether the story going forward is more about revenue growth or it's also about additional declines in absolute dollars and expenses?

Why don't I take -- I'll take the gross margin one, Tal. I think in this kind of an environment, I think we've been able to maintain our margins in the mid 40's, mid to high 40's range and I think that talks to the strength of our value proposition. Our intent in terms of what we're investing in and a key motivator for the portfolio investments that we're making and that's -- you'd summarize it in simple terms in terms of software but it is embedded on the platforms and across the architecture. And generally speaking, that's higher gross margin. So, we still have ambitions driven by the investments that we're making to increase that margin over time. And I think -- we've talked previously around those margins in the -- over a period of time, getting closer to 50 and beyond. But in the short-term, from what we can see right now, we're in that sort of mid 40's type range.

And with respect to OpEx, Tal, we have signaled that our OpEx will be up a little in Q4. We're not prepared to speak beyond Q4 at this point in time. But what I would say is I'd point out that we were able to take OpEx down 17% from the end of last year to the Q3 of this year. And we did that by a very disciplined approach to our expenses but were able to increase our R&D expense. And so, it's that balance that we're able to strike and that we intend to keep striking going forward. We believe that there will be operating leverage in this business going forward. We're not prepared to talk about when that's going to occur but it will occur.

So if you look at your expenses, on a year-over-year basis, R&D is slightly lower but the majority of declines are sales and marketing and G&A. If you separate the two and you say R&D is related to the business, it's more variable, do you think that sales and marketing, which is also variable, do you think it will start going up in absolute terms or are there more cuts that you could deliver within the sales and marketing?

As of right now, we don't have any plans in that regard. The sales and marketing has a naturally variable component because there is a commission component of that cost tied to orders. And so, as orders increase, that expense will go up. If orders went down, that expense will go down. We don't expect the latter, of course.

And the last component of the OpEx is the G&A, it was down quite substantially on a year-over-year basis percentage-wise. Are there, again, any structural changes that you could make that will further the reduced G&A or G&A -- do you think that on the G&A side, it is $9 million roughly a quarter, it's the bottom and from here it really depends on the business?

Yes, Tal, this is Gary. I think the overall approach to the business was to invest more in R&D in the downturn because we think that will give us strategic advantage going up and to stay cash flow positive. Those were the two design criteria we went into this downturn with. And so, I think we've structured our operating expenses around where we thought that might be and broadly speaking, that's proven about right. We'll be cash flow positive for the year, we believe. And so, from that point of view, we're not really looking to take more costs out of the business, frankly. We think we've sized it about right in terms of -- and in fact, we've aligned and optimized some of the sales expenditure, so that we've gone into some new territories in this downturn. And so that, I think, will help us as it comes out. The overall point that I would make is that going forward, as we see a recovery here, OpEx won't grow at the same rate as the revenue but it will grow. But there will be -- as Jim said, there's operating leverage there. So I think we feel that we've got the structure around about right and that we can get good operating leverage going forward as the market recovers.

Thanks, Gary. Just last question, different topic. What about pricing pressure? Most players I'm speaking with are noting increased activity of Huawei. Long term, I'm not talking about one quarter impact, but longer term increased activity of Huawei and more presence outside of even Europe, so into the US and European markets, did you start noticing Huawei? Do you have any direct competition? An second, any impact on margins because of competition?

Well, I'd go back to the point that we talked about earlier, that we've been able to sustain our margins in the mid 40's type range, which I think is testament to our value proposition. Our value proposition is really -- we don't sell on price. It's really around the overall solution and the value that we bring to the customers. I think people like Huawei and other low cost vendors are more of a threat, I think, to price focused vendors. And so, I think the solution that we've got to market is less sensitive to that. We've seen them. We do compete with them particularly in the transport space. Particularly in Europe, we've seen them at places like BT. And we are able to compete with them and get decent margins. So, we understand how to compete with them. And they're just going to be a fact of life and I do think they will be in North America. And I think that it's really more of a threat, I think, to vendors who are just focused on price.

Thank you.

Thanks, Tal.

Our next question comes from Sanjiv Wadhwani with Stifel Nicolaus.

Thanks so much, a couple of questions. Gary, I'm guessing with AT&T you're probably recognize revenue in this October quarter?

Sanjiv, you're referring to the CESD portfolio specifically?

Exactly, yes.

Not sure but possibly, yes. Possibly we'd recognize some.

Got it. And then, any color on the timing and adoption of the new CoreDirector family of products by our largest customers, any color over there?

So, Sanjiv, we expect they will be in customers hands the end of this year. And that begins the lab trial portions of it and the rest, again, you'll see a broad spectrum of how people approach this thing. Some will want it as it comes out of the chute because they're very familiar with the box and they just want to get additional features. And others will put it through a much longer acceptance cycle.

Got it but it looks like at the end of this calendar year, it should be in customer hands basically?

Yes, that should be the beginnings.

Got it. And then last question, the two wins from the April quarter where you took some pricing action, looks like revenue contribution this quarter was fairly minimal. Does that spike up a little bit in the October quarter? Any sort of flavor over there?

The biggest piece of it actually will early next year, the biggest chunk of it.

From both the customers?

Yes.

Got it. All right. thanks so much guys.

Thank you.

We will now take our next question from Jeff Kvaal with Barclays.

Yes, thanks very much. I was wondering if we could delve a little bit more into the 40 gig story. Obviously, you folks have clarified where you've put your own investments. Has there been any shift in the way that carriers think about the migration from 10 to 40 to 100 over the past six or nine months?

So Jeff, I haven't detected a major shift. I would say maybe two or three years back, what you would get were RFx activities around a 10 gig network that was upgradeable to 40. And so, then there was an upgrade cycle that went in place. I think what you're now seeing are similar, the RFI RFx around 40 gig deployments that are upgradeable to 100. I think that's been the change over the last couple of years. I haven't seen anything or noticed anything specific in a change in the 40 gig marketplace per se.

How do folks you wrestle with migration plans as people want 40 and then go to 100?

So, we design the products from the beginning to be upgradeable. And so, even as back to the CoreStream system, which has been in market for quite awhile, which started as 2.5 gig waves, is upgradeable to 40 with the 4200. That's the platform that has 100 gig on it. Right? And that again, started as a 2.7 gig platform. So, our design philosophy, from the beginning, has always been to allow for basically a straightforward upgrade process.

Okay, makes sense. And then, my second question is on linearity through the October quarter. One could make a reasonable assertion that the order patterns in August might not be as strong as they would be later in the quarter. I'm wondering how you folks have baked that into your outlook statements?

I think what we've seen Jeff, we saw an improvement in sentiment in sort of the March/April time and it's been fairly steady since that. There's some holiday fluctuations in terms of flow orders and stuff but generally speaking, it's been pretty steady since then and we're seeing a fair amount of activity.

Okay. So would it be fair to say that you are expecting that level of activity to become flattish through the quarter then, not see any major spikes in linearity?

Not particularly. You're going to see some lumpiness in orders. And clearly, generally speaking, September and October are better order months than August, as you say. But that's only one part of the import. When we look at what we're going to do in the quarter, we look at backlog, revenue recognition and all of those things combined. So a broader answer to your question is we take into account all of those things.

Okay, perfect. Thank you, all.

Thanks, Jeff.

Our final question comes from Simon Leopold with Morgan Keegan.

Thanks. I was wondering if I was going to sneak in there. Just a couple of quick questions really. On the AT&T business with the ethernet products, I'm wondering how much of the obstacles are within your control and how much is really internal to the customer, as sort of the typical network management issues versus your requirements to deliver some features?

Simon, are you talking about the ethernet stuff? Without getting sort of too customer specific, these kind of markets, we think, are nascent. It takes awhile for large tier one carriers to get it integrated into their systems and software management, etc. So, it always takes a while and I don't think we're seen anything unusual about these slower start on the project. And the other question you got to ask is, how much of the environmental stuff plays through of that as well? It's difficult to tell.

Well, maybe what you can answer is in terms of what you control. Have you -- are there features that you're still developing and work you still need to do internally to meet requirements or is it more or less in your customers hands?

Well I think it's -- on these kinds of projects, there's deliberate -- let me answer it like this. We've met all of our time frames perfectly.

Okay.

There's some more ongoing things, of new platforms we're going through and all of the rest of it but that's on a scheduled road map. But we've met all of our deliverables.

Okay, that's helpful. That's basically what I was looking for. And then on the 10% customer list, I believe one of them was international. I wasn't sure whether you mentioned if that was new. If you could give us just a little bit more color or description of what type of carrier it is, what they're buying so we can try to guess what it might be?

I can tell you it's EMEA based

And it wasn't a new customer.

Yes, it has been 10% previously.

Okay, that's helpful and just one last one. I think you've made some references to refreshing your long haul product line by essentially evolving the 4200 as sort of the next generation from the CoreStream. Could you just update us on where that is? And I'll be done.

Sure. And so, you're basically correct. Right? The 4200 was a platform that was designed around multi-service delivery using OTN. Over the last year or so, we've added a number of features to it to increase channel count, increase distance. You can expect the same thing to happen going forward as we'll continue to evolve that platform.

And that's sort of -- is that like a 2010 transition?

So some of what will be coming to market, that Jim's alluded to in terms of additional prototype spend, is associated with additional features on 4200. It will be rolling out throughout the next several quarters.

Great. Thank you very much.

Sure.

That does conclude our question and answer session. I would now like to turn the conference back over to Mr. Gary Smith for any closing or additional comments.

Thank you, Ben. And thank everyone for their time this morning and for your continued support. We look forward to seeing many of you at SuperCom in Chicago in late October. Thank you very much.

That does conclude today's conference. We thank you for your participation.