Ciena Corp (CIEN) 2010 Q2 法說會逐字稿

Good day, everyone. Welcome to the Ciena Corporation second quarter 2010 results conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Ciena's IR consultant, Robin Weinberg. Please go ahead.

Thanks, Michelle. Good morning and welcome everyone. I'm pleased to have with me Gary Smith, Ciena's CEO and President and James Moylan, CFO, and in addition Tom Mock, SVP Marketing and Communications, 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 financial performance in the second quarter, discuss our review of the market environment and give an update on our integration of Nortel's MEN business. Jim will detail our Q2 financial results and provide guidance for Q3 and we'll open the call to questions from the sell-side analysts. This morning's press release is on the national Business Wire and on Ciena's website, Ciena.com.

Before I turn the call over to Gary, I'll remind you that during this call we will be making forward-looking statements. Such statements are based on current expectations, forecasts and assumptions of the Company that include risks and uncertainties that could include 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 March 5, 2010. We will file our second quarter 2010 by June 10.

Ciena assumes no obligation to discuss information in the conference call whether as new information, future events or otherwise. Today's discussion includes certain adjusted and non-GAAP measures of Ciena's results and operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's results release available on our website at Ciena.com. Lastly, as a reminder this call is being recorded and will be available for replay for the investors portion of our website. Gary?

Thanks, Robin and good morning, everyone. Before I begin, I'd like to emphasize that our Q2 results should be viewed obviously in the context of our having closed a transformative acquisition during the quarter. Please bear in mind as we provide you information today and understand that many elements of today's report are not indicative of Ciena's ongoing business. This quarter's performance reflects only partial results from the MEN business' as well as a number of accounting considerations relating to the closing of the transaction during the quarter. As such, comparisons to previous reporting periods and future extrapolations may not be representative and should be made with due caution.

As we committed from the beginning, we'll be transparent and provide as much information as practicable to bridge the performance of Ciena standalone to the combined Company. With that said, today, today we reported fiscal second quarter revenues of $253.5 million. This includes approximately six weeks of revenue, or $53.5 million from the acquired MEN business. Revenue from Ciena's pre acquisition portfolio was $200 million representing a 14% sequential improvement. At 49%, our Q2 adjusted gross margin was higher than our near term forecast range, and largely reflects a number of favorable items in the quarter, which we'll discuss later. And our non-GAAP operating expense was $131 million, reflecting additional expenses associated with the MEN business.

Now I'll speak to our current view of macroeconomic and industry environments and provide an update on our progress in integrating the MEN assets. As I discussed last quarter, we think about the progress of our business in three fundamental ways. Firstly we examined demand in the global market and where we see it improving. We assess how the fundamental demand drivers of our business are performing and based on that, we determined where to make investments in our portfolio.

As for demand trends in the market, we're encouraged by recent signs of recovery, however some customers continue to remain cautious. We think this is consistent with our stated belief that we're likely to experience some turbulence as we come out of this global recession. In North America, we see signs that the market environment is definitely improving. The central and Latin America markets, as well as Asia Pacific which now comprise a larger portion of our business, are beginning to show some pick up in customer spending. In contrast, Europe continues to lag the global recovery and remains challenging due to volatile macroeconomic conditions.

With respect to the underlying demand drivers in our business, fundamentally they remain strong, driven by what we continue to believe to be the early stages of an industry wide optimization cycle. Service providers are reacting to competition from application providers by focusing on new services, and most networks are designed for terrestrial voice, not for video and advanced wireless applications, so existing infrastructure needs updating. As a result, we anticipate strategic spending as network operators transition from Sonet to next generation architectures to address new service demands and traffic growth to ensure their network upgrades are cost effective and efficient.

In terms of investment in our portfolio, we're focused on addressing the most critical areas of those next generation network architectures, which we view as high capacity transport, mesh-based switching and ethernet services. With the acquisition of the MEN business, we've effectively doubled our resources and are now large enough in our critical mass to execute on our plans, yet I would stress that we maintain very much our specialist focus. Our consistent strategy of sustained investments in our portfolio, even during market downturns, coupled with the additional scale from the MEN business allows us to more quickly bring new solutions to market.

Additionally, it enables us to better leverage key innovative technologies across the portfolio, including coherent 1400 gig transport, automated OTN switching, and carrier ethernet technologies. This is evidenced by our recent announcement of the integration of our market leading 40 gig coherent technology on our CN4200 platform as an example. Based on these dynamics, we continue to believe we are strategically well positioned to be among the beneficiaries of the industry's next investment cycle. Particularly so, given our strong customer relationships and a portfolio of leading technologies that are tightly aligned with this transition to high capacity, scalable, next generation networks, and we remain fundamentally the only Company of global scale, focused exclusively on converged optical ethernet.

Turning to the MEN acquisition, our last update we gave you was during our Analyst day on April 20th. Since then, I'm pleased to report that we continue to make very good progress in combining the two companies, and we remain encouraged by positive market reaction to the acquisition and growing levels of customer activity across the globe. We've already achieved a number of integration milestones, including the introduction of our target operating model, and we continue to move quickly and execute on plan. In fact, in some areas like operating synergies, we're slightly ahead of plan. For example, in addition to a targeted headcount reduction of approximately 70 employees in April, we've begun a reorganization of our EMEA business that could affect approximately 120 to 140 positions by the end of August.

We're also driving plans to rationalize our supply chain. This includes reducing the number of vendors and the consolidation of distribution facilities and most importantly, we continue to see positive customer sentiment for the new Ciena, with tangible examples of early momentum. For instance, we completed a cross selling deal with SFR recently in France. This existing Ciena customer will now be deploying for the first time the OM A6500 for high capacity transport.

Further evidence of the customer traction of these early days of the combined Company also include two new 40 G wins in the submarine space and a 40 G trial on an 8,000 kilometer under sea cable route that's underway. We also have successfully completed two separate 100 G trials and committment from multiple additional trials in the coming weeks. We've also closed several new carrier managed service deals during the last few weeks.

Outside the US, the impact of, and the negative associations with bankruptcy are probably more pronounced; however, we're seeing these MEN customers in these regions positively reengage with the new Ciena. We recognize that we still have work to do in delivering the full value of the combined Company and we are taking into consideration the uncertainties associated with predicting performance for the MEN business, particularly in the short-term; however, we're executing on plan and continue to be on track to deliver on the target operating model milestones that we previously communicated, including our goal to be at or close to breakeven, exiting fiscal 2010. With those comments, I'd like to hand it over to Jim who will take you through the details of our Q2 results. Jim?

Thanks, Gary. Good morning, everyone. Before I provide detail on the quarter, I'll reiterate Gary's earlier comment that this quarter's performance reflects only a partial quarter's results from the MEN business, so comparisons of financial metrics to previous reporting periods may not be representative. I'd also like to echo Gary's comments about good progress with our integration efforts. Along with the good work toward realizing operating synergies and the increasing levels of customer activity, we've had good results from the integration of back office systems, processes and controls, including our financial and accounting systems. The entire Ciena team deserves credit for their dedication and hard work which has enabled a smooth transition of the business to Ciena.

With that said, today we reported second quarter revenue of $253.5 million. Revenue from Ciena's pre-acquisition portfolio is $200 million, representing a 14% sequential improvement compared to fiscal first quarter revenue of $175.9 million. Compared to the same period a year ago, this represents a 39% improvement over revenue of $144.2 million. Q2 results also include $53.5 million of revenue from the acquired assets of the MEN business reflecting approximately six weeks of those operations.

This amount is exclusive of certain deferred product revenue from the MEN business that would otherwise have been recognized by Nortel, had the acquisition not occurred. Let me explain. At our Analyst day in April, I spoke about how certain deferred revenue from the MEN business would not be recognized by Ciena or reflected in our financials post-close. The MEN business, like all companies in our industry, recorded deferred revenue on its balance sheet made up of both product and services sales. Let me speak first to deferred services revenue. We did bring over roughly $19 million of deferred revenue for services from the MEN business. We expect to perform the remaining deployment or maintenance support for these jobs in due course and recognize this revenue.

Now let me speak to deferred product revenue. MEN's deferred product revenue can be as a result of a number of circumstances, such as partial shipments. We did not bring over any deferred revenue for MEN product, because in accordance with accounting rules, Ciena can only recognize revenue on products that it ships. This deferred product revenue would have been recognized by Nortel had the acquisition not occurred. We expect the total deferred product revenue amount that we will not bring over to be approximately $90 million, which is higher than what we indicated during our Analyst day when we told you $60 million $70 million. Of the $90 million, roughly $38 million would have been recognized by Nortel in this period. We anticipate the remaining amount will impact Ciena's Q3 and Q4.

Moving to other detail on revenue contribution, we had two 10% plus customers in the quarter, which represented 42% of total sales in the aggregate. One of these customers was also a 10% customer in Q1 and was also a customer of the MEN business. The second is a first time 10% customer. Sales from international customers represented 29% of total revenue in the quarter, roughly flat with Q1.

In reviewing specific results, I'd like to discuss how we will be reporting results going forward. Whereas before, we spoke to three product groups, optical service delivery, carrier ethernet service delivery and Ciena specialist services. We will now disclose our revenue in four segments, which is how we are operating our business going forward. These segments include packet optical transport, packet optical switching, carrier ethernet service delivery and finally, software and services.

Our packet optical transport segment includes all of our optical transport platforms and any associated operating system software and embedded software features. This segment accounted for $97.7 million in revenue in Q2, representing 38% of total sales. Our second segment, packet optical switching, includes CoreDirector, CoreDirector FS, and the 5430 reconfigurable switching system as well as associated operating system software and embedded software features. This segment accounted for $32.4 million in revenue for the quarter or 12% of total sales. This represents a sequential increase of 38% from Q1's revenue of $23.4 million.

Our third segment, Carrier Ethernet Service Delivery or CESD, includes our service delivery and aggregation switches, broadband access products, and the related operating system software and embedded software features. Sales of CESD were very strong in Q2 increasing more than 85% sequentially from Q1 contributing $74.8 million or 30% of total revenue. This increase was partially driven by a growing customer base for these platforms, which is a clear validation of our technology and strategy in this space. In fact, we have more than 100 customers for our CESD platforms and Heavy Reading recently estimated we held the number one market position in ethernet over fiber access platforms.

That said, the revenue growth for this segment may be variable given the nature of Service Provider rollouts for the two primary applications that our CESD portfolio supports, wireless backhaul and business services. Nonetheless, underlying demand for our solutions in this nascent market is strong and this segment will continue to be a meaningful revenue driver for our business over time. Finally, in our software and services segment, which includes our integrated network and service management software as well as all of our services related offerings accounted for $48.5 million in revenue in Q2.

In the remainder of my comments today I'll speak both to the GAAP results and to what the results would have been if we excluded those items detailed in the Press Release. On gross margin, Q2's GAAP gross margin was 41%. Our GAAP product gross margin for the quarter was 43%, and our GAAP services gross margin was 36%. On a non-GAAP basis, gross margin was 49%. This reflects our normal adjustments for things like share based compensation costs as well as a number of items affected by the MEN acquisition. These include increased amortization of intangible assets, charges related to product rationalization, and the fair value adjustment of acquired inventory.

The gross margin we reported this quarter, although we're very pleased with it, is not indicative of the range we expect going forward, at least for the near term. There are a number of reasons to expect lower gross margin next quarter, and I'll try to bridge you to them. First, our second quarter results reflect only six weeks of revenue for the MEN business, and are not representative of the gross margin of product mix that we expect for a full quarterly period. Because MEN revenue is predominantly transport, we expect those products to carry a somewhat lower margin overall than the Ciena pre-acquisition portfolio. The MEN business will comprise a larger proportion of our revenue in future quarters than it did in Q2, which will lower our combined margin.

Second, there were several favorable items during Q2 totaling several points of margin. We do not expect these items to recur in the ongoing business. With respect to the Ciena pre-acquisition portfolio, these items mainly pertain to certain services contracts and better than expected gains on a number of completed customer projects. With respect to the MEN portfolio, revenue consisted of a greater proportion of higher margin channel adds than we expect for a full quarter.

Moving on to OpEx. On a GAAP basis, Q2's operating expenses totaled $196.2 million. This includes acquisition and integration related costs of $39.2 million, stock based compensation of $7.2 million, $17.1 million in amortization of intangibles and $1.8 million in restructuring costs. Excluding those items, Q2's adjusted operating expenses totaled $130.7 million, which is higher than Q1, but reflects the added expenses from the MEN business. Our Q2 GAAP net loss was $90 million, which is a loss of $0.97 per share. Adjusted for the unusual and/or non-operating items detailed in our press release, our second quarter net loss would have been $11.7 million or a loss of $0.13 per share.

On cash flow and the balance sheet, we used $78 million in cash from operations during the quarter. This includes the effect of $38 million of cash spent on acquisition and integration-related costs and a $36 million increase in working capital. You will recall that upon the closing of the MEN transaction, the amount of net working capital transferred was less than was negotiated as part of the transaction. Accordingly, the purchase price was adjusted downward at closing, and maybe subject to further downward adjustment. That being the case, we expected to build working capital to fund the MEN business, and we've done so according to our plan.

At April 30, we had approximately $614 million in cash, cash equivalents and short-term investments. At the end of Q2, our accounts receivable balance was $179 million, up from $105 million in Q1. Day sales outstanding were 64, up from 54 days in Q1 due to a higher proportion of sales later in the quarter. Inventories totaled $233 million in Q2, up from $95.4 million in Q1. This amount includes the fact that we wrote up our inventory as a result of purchase accounting. This purchase accounting intangible is removed from our as-adjusted income statement so that our as-adjusted margin reflects the true cost of the inventory.

Product inventory turns were two times in the quarter down from 3.4 times in Q1. This is not indicative of what we expect going forward for product inventory turns. As we get to a normalized run rate of sales and inventory, we expect the turns rate to be similar to that of Ciena's prior to the acquisition. The inventory break down for the quarter is as follows. Raw materials $21 million, work in progress $4 million, finished goods $236 million, and finally we have an accrued reserve for excess and obsolescence of $28 million. As to headcount, on April 30th, our worldwide headcount was 4,157 which includes approximately 2000 people from the MEN business.

I'll close our prepared remarks today by talking to guidance for Q3 of 2010. We currently anticipate fiscal third quarter revenue to be in the range of $375 million to $400 million. We also believe that adjusted gross margin will be consistent with our near term expectation of low 40s, and as I mentioned earlier, we are ahead of our plan in achieving some operating synergies. We believe that could put us in the range of our $190 million OpEx target in Q3, a quarter earlier than previously anticipated.

We expect other income expense net in the third quarter will be an expense of roughly $1 million. This quarter's GAAP results on this line reflect a gain related to our recent convertible debt. It is excluded from our as-adjusted results and should not be considered in our other income expense going forward. As for taxes, we expect our tax obligation for Q3 will be related to foreign taxes.

Depending on your assumptions, you may need either our diluted share count or our basic share count. We estimate Q3's diluted share count at approximately 135 million total shares. We estimate Q3's basic share count at approximately 94 million total shares. Michelle? We'll now take questions from the sell-side analysts.

(Operator Instructions). We'll pause for just a moment. We'll take our first question from Paul Silverstein with Credit Suisse.

Good morning, Paul.

Your line is open. You may have yourself muted.

Hi, I apologize. Paul isn't on the call at the moment. I'll keep him in the queue though, I'll put him back in the queue. Sorry about that.

We'll move on to John Marchetti with Cowen & Co.

Thanks, guys. Just curious if you could talk a little bit maybe about the guidance in terms of maybe how we should think about the Ciena or the pre-acquisition Ciena if you will, relative to the contribution you're expecting from a full quarter of Nortel, and then secondarily, Gary you made a comment on the call about some of the non-US customers just starting to take a look again. I was hoping maybe you could expand on that a little bit and maybe give us a sense of a time frame, not necessarily for next quarter but more longer term as to what you see as the opportunities outside the US.

Sure, John. Let me take your first question going forward. We're clearly a single Company now. I've got to strike I guess a balance between trying to provide bridges for everybody as to around the historical performance of the Ciena and the MEN elements to it, which I think we've tried to do on the call today but going forward in terms of our guidance, I think we would limit that to a single Company, otherwise I think the complexity now of the converging product lines, the operating expenses and those kinds of elements, it's just too complex, and we are a single Company right now, but I think we've given you enough background in terms of being able to bridge to the Ciena and the MEN businesses.

In terms of the international customers, John, I think it's fair to say that the concept of bankruptcy protection, Chapter 11 outside of North America is not one that's fully understood, so the customers there I think have a more, it's more of an impact on them in terms of their ability to do business with a Company that's in Chapter 11. We knew that going in, we saw that in our due diligence and I think particularly internationally. What's been encouraging in the last six weeks or so has been the engagement of those customers again. Many of which put purchases on hold, we're now back I think in the engagement cycle with them and the purchasing cycle with them and they are both Tier 1 carriers internationally, and also some large tier 2s as well.

And I guess just as a follow-up to that, Gary has that been, has it gone sort of according to what you had thought maybe going into this process a little better, a little worse? Just curious as you're getting a feel for reengaging with those customers.

I would say about what we've thought. We clearly had conversations with them, and they signaled their sort of receptivity to the merger but you never know until you've actually, you're sitting in front of then as the combined Company, so I guess we take some satisfaction now that we're really starting to see some order flow, but it will take a while to get back to some of the levels that they were, but I would say pretty much on plan, John.

Thanks very much.

Our next question comes from Mark Sue with RBC Capital.

Hi, this is Joe Longobardi on for Mark. If you could comment on any negative product synergies you may be seeing if any and whether or not bookings are stronger on the Nortel or on the Ciena side.

Joe, there's probably a level of detail going forward that we don't think is probably appropriate, in breaking the two up for the reasons that I just talked about, but I think going into this, we were fortunate in that we didn't see a lot of product overlap and that's certainly been the case. I think on the transport side, 6500 predominantly on to long haul and with the 4200 into a lot of the carrier managed services and metro space, that's been borne through and in fact I think we're forecasting next quarter for 4200 to be up, so that said we take a lot of comfort from that.

And just to follow-up. Are we at the point where most of the product rationalization is behind us so that we can grow the combined product revenues following the July quarter?

Yes, I think that's a fair comment. What we tried to do going into this was to make decisions quickly, get it done, things like the platforms which were the MEN ethernet platforms, we moved very quickly on those and the other rationalization, so I think it's fair to say, we've kind of now got a streamline portfolio going forward. We do have some work yet to do on software tie-ins to the various platforms so that will be accomplished in due course.

I think one of the other things that may have helped along this process is the fact that we've engaged with customers well before the acquisition on what the combined portfolio might look like so there weren't really any surprises as we came down to it.

Great, thank you.

We'll now take our next question from Tal Liani with Banc of America Merrill Lynch.

Thanks, good morning. It's Vivek on Tal's behalf. A couple things. Gary, first of all, I know you're not breaking out the Ciena portion in the guidance, but is it fair to assume that Ciena is on track to grow at roughly the historical seasonal trends in Q3?

I would say that we saw a very strong Q2. Some of that was a rollover from Q1, a couple of things that we didn't recognize but even withstanding for that it was still strong. I think it's too early to tell in terms of the portfolio. We're seeing overall, I think the MEN business is stable, which is what we had anticipated going in so we're pleased with that and now we're looking to see this customer engagement and the leverage across the businesses.

That's no an answer to my question.

So your question is are we going to, is the Ciena business in the second half of the year the classic Ciena business if you want to call it that?

Right.

Yes, I would say from where we are sitting right now, yes.

Cool. Secondly, can you give us a sense for the exposure you have to Europe? I believe you mentioned 29% of total sales are outside the US, but how much is specifically the exposure to Europe?

The number moves around depending upon what happens in a given quarter, but typically it's going to be between 20% and 30%, something like that.

Got it, and lastly, Gary, can you address the competitive environment in CESD? It sounds like Alcatel and Cisco are trying to become more aggressive in that space, especially among the main US carriers that you're setting to like an AT&T or a clear wire for instance, so any comments on the competitive environment would be great. Thank you.

I mean, I think the CESD, we're focused on a particular, I guess you'd describe it niche which is the fiber access piece and the aggregation of that, and I think our approach in terms of the high software content in terms of the ability to deploy quickly, et cetera, is significant competitive advantage and I think we're expanding even in North America our customer base. As Jim said, we got over 100 customers, a lot of potential internationally as well. Clearly we've got some very tough competitors there but they were incumbent before we started on this so I think we've been able to grow that business pretty substantially as you saw in Q2 and I think we can continue to be successful in that going forward.

Sorry, just lastly. Even if AT&T were to select somebody other than Ciena for some of the IP MPLS portion, do you think you can still maintain the growth of your CESD sales at AT&T?

I wouldn't get into specifics about a customer like that, but I would say that we've got a broad customer base now and we're very confident about continuing to grow that business and specifically in AT&T, we're providing both the wireless backhaul and the ethernet businesses services to them as well.

Okay, thanks and good luck.

Thank you.

We'll take our next question from Kevin Dennean with Citi.

Great. Thanks very much. A couple questions. I think Jim Moylan mentioned that MEN in the quarter benefited from some higher channel adds. Any thoughts on what the kind of open installed capacity is out there in the MEN installed base? I guess what I'm trying to drive at is there potential for this type of business to follow on through the next couple of quarters?

It's a difficult question to answer, Kevin, because a lot of the install base out there has been out there for a good while, but I think it's safe to say that on the Sonet SDH as well as some of the optical transport products that there's a big install base out there and that represents an opportunity. I think the uptick you saw in channel cards this particular quarter probably had more to do with the short duration of the measurement than it had to do with any particular trend.

And then can we get an update on where CoreDirector FS and the 5400 stands? I think the last time everybody spoke in public, it was that these products were in carrier labs or undergoing testing and verification or in the integration process.

Yes, the CoreDirector FS has been deployed and deployed into new customers. The 5400 as we said before is in labs and those lab trials take a good while, but we expect to exit those trials in the second half of this year.

And Tom, will there be a long integration process tying those boxes into carrier systems or do you think that winds up by the end of the year also?

A lot of that is happening in conjunction with the lab testing. That's one of the reasons the lab testing takes as long as it does and it's not to say there won't be some kind of details that need to be tied up after that but I think a good bit of that will be done and I think most of what you see happen on 5400 would happen in 2011.

Great. Thanks very much.

We'll take our next question from Paul Silverstein with Credit Suisse.

Jim, Gary, can you hear me?

Yes, we can hear you Paul.

I apologize if this was already asked, I suspect it was but in light of some recent commentary at AT&T regarding the wireless backhaul, I know you guys don't want to go into detail on any one customer but can you give us any insight on your backhaul position? Has there been any change to your knowledge?

The question was asked before but I'll go back through it. Without going into too much detail on customer specific stuff, we feel very good about our position. I'd just express it like that both in terms of our engagement to date and the opportunity that we see going forward as a multi-domain player of AT&T. We think we're incredibly well positioned.

Okay, and again, I apologize if this already came up, but with respect to packet optical and your integration of 100 gig into CoreDirector along with layered capability, can you give us any insight in terms of customer activity, what type of RFP activity if any you're seeing out there?

We're continuing to see strong activity 40 and 100 gig around various packet optical architectural discussions that we're in, IP bypass, and that's really booked into the 5400 family and as quick as we can get the 40 and 100 gig into that as well so we're seeing a lot of activity out there, Paul, certainly amongst the Tier 1 and those kinds of architectures. That's continuing.

Gary can you give us any quantification, any metrics about that activity?

I would say that given the portfolio we've got particularly with the 40 and 100 gig I'd say we are more engaged now across a broader range of Tier 1 carriers than we were prior to the acquisition. I think we're much better placed now.

Gary, would that be a dozen trials, a dozen RFPs? Can you give us some--

Well it's tough to put a metric on it. That's a very broad based but if you look at 40 gig trials, 100 gig trials we've got a number of those lined up and that's increasing on a daily basis. We're into the double digits in terms of trials.

Right and one last question if I may and again I apologize if this came up but any evidence of any meaningful change in the pricing environment?

Not really. It continues to be challenging if you choose your geography and choose your application and we're very careful to try and choose markets that value our value proposition and our technology. It continues to be challenging.

I appreciate it. Thanks.

Thanks, Paul.

We'll take our next question from Simon Leopold with Morgan Keegan.

Thank you. First I just want to get a quick housekeeping question out of the way. With the first full quarter of Nortel in your operating expenses, looks like kind of some moving parts, some allocation questions, so you guided to about 190 million of OpEx. Just wondering how that would be split among R & D, sales and marketing and G & A?

The proportions of the costs are percentages are not going to be too dissimilar from what they were with Ciena as a standalone for the last couple of quarters.

Okay, and I know you don't want to go into providing details of specific products as you've integrated the companies but I'd like to try to get a baseline of the Ciena long haul and metro businesses, the 4200 of where we were in this particular quarter. It's pretty easy to kind of get a rough guess but if you could give us that level of detail?

Because this is a transition quarter, we'll give you that this quarter. We're not going to give product details going forward unless there's some exceptionally unusual thing that we feel we should point out. 4200 was around $42 million in revenue. That's slightly down from Q1; however, we've had a good order flow on 4200 and we do expect that to be up next quarter. Core stream is about 13 million.

Okay, and it sounds like your services business in light of the merger was particularly strong. Was there anything in particular that drove it this quarter?

Well, the MEN business has had a very strong service portion of their business because they have such a large installed base, so that's the single biggest item. We also are beginning to get active in professional services and that was, we had a nice quarter in professional services, not huge but nicely growing and we'll continue to grow.

And just one last question. There's been some news about India's new policies, understanding that's a pretty modest portion of your business, just wondering what impact you either had in the quarter or what you expect for the remainder of the year given India's security policies and the impact on sales.

There's been no result to date on sales. The regulations are still being finalized. They moved around a lot over the last couple of quarters. We've been closely monitoring the situation. We've put in measures that allow us to continue our business in India and we'll continue to watch the situation. India is an important market for us. We have as you know, a big R & D operation there. We have some very nice customers there, and we hope that it will be a place for us to grow in the future.

Thank you.

Our next question comes from Jeff Kvaal with Barclays.

Yes, thanks very much. Gary, Jim, I was wondering if you could help us a little bit with the Nortel's trajectory over the next several quarters, if one backs into the numbers you're talking about, you put in the deferred revenue scale up for a full quarter you're at about 180 million run rate for Nortel. Can we be thinking about that crossing back over to 200 getting back to where they were a year ago is 250 feasible, any commentary there would be helpful.

Yes, Jeff, I would say that clearly I think you've got enough pieces there that you can put the thing together but I would say let me kind of help you bridge it if I can. I would describe the MEN business right now, we've rationalized the portfolio, I think the businesses I would describe it as stable in terms of their business that we brought across. I think that given the rationalization of the portfolio and the engagement in taking away the uncertainty that it's been operating in, I think it's reasonable to expect that business to expand over time and certainly as we get to 2011, I think we said as an overall operating model, 10 to 12% growth for the combined business and clearly MEN is a large part of that so I would expect the business to grow as we get through 2011.

Got a lot of new platform additions coming out that they've invested in as well, so I think that and the benefit of a dedicated and broader salesforce and cross-selling, those are the synergies that we acquired the business for. Jeff, I absolutely think the first thing is to get it stable which I think it is and to get the business integrated and we're off to a good start with that and all the indications from the customer engagements that we've got are very positive. They've all got to translate into orders and revenue going forward but I think we can absolutely grow that business.

Okay, that's a good lead into my second question which is, we're about a year into the recovery economically speaking and I'm just a little surprised that you and many others frankly are talking about signs of recovery in carrier spending even in the US rather than there's a pretty healthy uptick under way here. What's taking so long, Gary, I guess?

That's a good question. I mean, I think you're seeing putting aside the six weeks of MEN revenue, you're seeing good growth on the Ciena business. We're up 37% so why aren't we being more bullish is a fair question. I think that everybody certainly from the next gen vendors feel very optimistic around the dynamics that we see in play. I mean these carriers have to upgrade to scale their networks and there's a lot of forcing functions there so we feel very positive about that. I think what's causing caution on everyone particularly if you look at sort of the European situation is I think we're going through some turbulence as we come out of this global recovery and I think particularly in Europe with the debt situation I think people have been cautious about that.

I think that's what's tempering down any sort of outrageous exuberance, and I think that's right. I don't think this, even though we see very strong shift in spending and we see good overall recovery particularly in North America, I don't think this is going to be a rocket ship taking off. I think it's going to be good steady growth and particularly for players like us that are well positioned for the Next Gen, so I think that's really from my personal perspective, Jeff, that's what I think is happening.

Thank you both very much.

Thanks, Jeff.

Our next question comes from Michael Genovese with Soleil Securities.

Great. Thanks a lot. Just first to just clarify something you said earlier, so CESD was $75 million and am I correct that that compares to $40 million last quarter?

That's right. It's in the range. Yes, Mike.

And in that division just to be sure is that all products from worldwide packets or does that include other products as well?

It includes certain legacy Ciena applications but by far the largest piece is the packets stuff.

Tying that in with your 10% customers when you talked about the second 10% customer being a first timer is that a first time 10% customer or is that a first time customer?

First time 10% customer.

And then how much of the quarters gros's margin outperformance -- first of all -- it looks to me, am I correct in assuming that the organic Ciena gross margin was over 50%?

Well, I think you have to be careful about trying to break it out that way. I'd say overall, we are pleased with that margin. We thought we had a terrific quarter in both companies with respect to margin but there are just a number of factors that we don't think are going to repeat so that's why we guided to the low 40s and that's where we think we're going to be.

In mentioning those factors you didn't talk about product mix at all so was it a factor at all, the growth of CESD related?

Absolutely. Well our CESD revenue was high as you saw which was a good margin contributor. CoreDirector was up over last quarter which as you know good margin contributor, and so yes, there was a product mix component of it for sure.

Great. Thanks a lot.

Our next question comes from George Notter with Jefferies & Company.

Hi, thanks very much guys. I guess I wanted to ask about the $190 million OpEx target, I guess now we're looking at hitting that for Q3. Is that improvement or a pull forward in timing for that run rate, is that driven by the headcount reduction? Is there a faster than expected headcount reduction going on here or are there other types of synergies involved in driving that, and then also, I guess I'm curious about how much cash restructuring costs we expect to have on a going forward basis as well.

The $190 million range that we expect for this quarter is a combination of a lot of thing and clearly, we've acted quickly in terms of the headcount that we wanted to move. We've also done some shuffling with respect to third party services and we've been quite aggressive on that so yes it's a combination of a lot of different things. We have I think we've done a good job there and we'll continue to manage those costs closely. With respect to integration costs, we've incurred roughly $68 million or so. We have about $110 million to go. We think that over the next couple quarters we'll spend in the range of $45 million $50 million a quarter in that range.

Great. Thank you.

Thanks, George.

Our next question comes from Subu Subrahmanyan with Sanders Morris.

Thank you. I wanted to touch on two things. First on 40 and 100 gig the transport side, can you talk a little bit about how timing of those especially with some of the large carriers into making 100 gig commitments at timing of 100 gig revenues or start getting meaningful and then Jim, I was wondering for the three-month period if you back off any deferred revenue, partial quarter kind of things, can you just give us a Nortel MEN number just on a comparable basis for that three-month period, not going forward but for the past three-month period and then deferred revenue impact must be remaining about $50 million. How do you expect that to play out over the next couple quarters?

Let me handle the numbers first. We said that there's roughly $50 million to go and that will be heavily concentrated in Q3 but there will remain a small portion of that which would have come through in Q4. With respect to the MEN business, we'll have some pro forma numbers in our 10-Q which you can refer to. It's probably not going to answer your question precisely but it's about what we can do.

In terms of your question about the transition from 10 to 40 and ultimately 100 gig, I think we're well in the midst of the transition from 10 G to 40 G that's being deployed in a lot of networks worldwide. In terms of at what point we think that transition will go over to 100 G, there are a number of different economic models that one can use to do that, but I think our belief right now is the technology will reach a maturity level and it will have been operationalized in carriers so that you begin to see what I would call significant deployments of 100 G in the late 2011, early 2012 time frame. That's pretty consistent with what we've been saying for a year or so now. There's a time that's associated with Service Provider beginning to operationalize a technology like that. It's as in the early days of 40 G, a lot of the deployments were driven by devices that connected to networks that had made a 40 G interfaces that really aren't devices out there that have made the 100 G interfaces but those are likely to come here soon. Nevertheless, we've done a couple of live deployments with 100 G, prior to the acquisition of Ciena the one with New York Stock Exchange and Nortel did one with Horizon in Europe and we have a number of trials in that space ongoing today.

Understood and is 100 G being fairly close around the corner, late next year creating some holdup on the 40 G side from carriers who have not deployed it yet?

I wouldn't say necessarily that you have a number of people out there who are holding off on 40 G to get to 100 G, because we're at a point where 40 G economics are beginning to prove in, and there are also applications that demand 40 G and also near term cases in networks where you really need to go to 40 G to hit the capacity because of efficiency constraints, so and I think most of the Service Providers are at each stage now where they're looking to evaluate the technology.

The other thing I would answer is that the architecture that we've got to house that upgrade from 40 to 100 gig so we're uniquely placed around that I think in terms of both the technology and the fact we can take the same platform and just upgrade it to 100 gig. But we can do the same thing with our existing core stream plan. We can over lay that with 40 or 100 gig from the coherent technologies from 6500.

Got it. Thank you.

Our next question comes from Todd Koffman with Raymond James.

Thank you. Can I just get a clarification on the Europe exposure on a more normalized going forward basis. I think someone asked the question before. You threw out a 20 to 30% number. Is that total revenue?

That's total revenue, yes.

Thank you.

Our next question comes from Blair King with Avondale Partners.

Hi, thank you. One question. Jim, you'd mentioned I think some talk about the back office component of the integration I think being complete. Is that a fair assumption or did I miss something there?

No, I didn't mean to refer to it as complete. What I was saying was that I believe that our people have done a great job on the initial stages of that and all the planning and work that went into that enabled a smooth transition of all of the back office things. We were shipping kit in three or four days after the close. We took all employees on to our payroll and all things necessary to operate the business, that all happened seamlessly. What has yet to happen is that we still, because we are operating on MBS ERP systems, we still need to transitional of that set of transactions on to our Oracle implementation. That's going to happen over the next call it six to eight to 10 months and that will complete the integration of the back office. We're going to put the same amount of planning and effort into that set of processes as we did in the initial integration, so I'm confident we'll be able to do it seamlessly as well.

Okay, just one last follow-up to that then, Jim. As you kind of transition on to your own Oracle platform, is there a declining rate of support that you need from Nortel as that transition happens or is it a step function that once you convert all of a sudden you're away from Nortel?

Well it's going to be a series of dropping off the Nortel platforms and coming on to ours. There will be a pretty big step when we actually move the products off but it won't be one big bang that happens on one day.

Thank you, Jim.

Our next question comes from Alex Henderson with Miller Tabak.

Hi guys.

Alex.

Was wondering if you could give us a little bit of sense of what's going on in the components markets in terms of availability, lead times and if you could break that between your typical optical components and other types of components that you might be using that would be very helpful, thanks.

Alex, why don't I take that. In terms of there's been a lot of talk about supply constraints. I'll try and serve it up for you. We're certainly finding that vendors are somewhat reluctant to invest in capital to increase output so we're experiencing some lengthening of lead times. This is not to date really significantly affected our business and we've taken a lot of steps to deal with that by investing in strategic inventory reserves if you will and future allocation commitments with our contract manufactures so we're not being hit really by some of those common parts, shortages etc. and because we're somewhat vertically integrated in certain key components that's helping us as well in terms of our planning. So we haven't seen anything really significantly affect our business. There's always puts and takes all the time but nothing particularly unusual to be honest.

Is that more on the optical component side or more electrical component and sort of semi piece parts?

On the optical side, we're seeing some shortages but no more than the rough and tumble of things. On the sort of other electrical components we're able to secure supply of all of the key stuff that we need right now.

But the lead times have stretched a little bit you said?

Yes, they have. We saw that start as soon as the uptick started I guess somewhat probably about 12 months ago, nine months ago and so having lived through a number of these we got on to that quickly and we're able to secure through commitments and strategic inventory reserves some of that stuff so we feel it's certainly in the foreseeable future. We're in reasonable shape or that.

The part two of that question is how does that fold into your exercise of reducing the number of suppliers that you're talking about? I assume that you're the large optical component suppliers will probably be gaining position relative to your--

Yes, I think it's necessary, Alex that some vendors will get more business, particularly those that the combined Company selects going forward. We've got a number of contract manufactures between the two companies and that probably, well it will be rationalized going forward, but in terms of the component vendors, it's greater purchasing power and we need fewer vendors.

So the supply constraints isn't going to slow that process down though?

I really don't think so at this stage.

Great. I'll cede the floor, thank you.

Thanks, Alex.

Our final question comes from Hasan Imam with Thomas Weisel Partners.

Yes, hi, this is Shubho Ghosh for Hasan. Just going back to the 40 versus 100 gig cycle, wanted to get more color on where you think we are in the 40 gig cycle and you'd mentioned the 100 gig by late 2011. How much bigger do you anticipate the 100 gig cycle, if at all from what's going on right now in 40 gig?

I'd go back to one of Gary's closing comments, and that's that we think most networks will have a mix of those technologies as time goes on. There's still a good bit of 10 G technology being deployed. 10-G is still a cost effective technology in a lot of applications. We're probably past the point where 40 G was deployed as a particular technology to address specific applications. It's now moving into the broad infrastructure type of deployments and we expect that the bridge to 100 G will follow a similar path, that it will happen over time as the transition from 10 G to 40 G happens but the one thing I would stress is that the biggest issue on here is making it easy to make that bridge from 10 G to 40 G to 100 G and be able to evolve your network carefully and be able to support the applications that you need at the time you need them.

Got it, and kind of going to some of the model questions, acquisition and integration related costs, do you expect that to spill over into 2011 at this point?

I think it is likely that we'll spend some money in 2011. We're working as fast as we can to finish this integration but it's just it takes a while to do some of these things so some of these costs will likely fall over into 2011.

Got it and the fair value adjustment of acquired inventory as well as the product rationalization charges, do you expect a spill over of that into next quarter as well?

As far as the product rationalization, we don't expect anymore significant product rationalization charges today. Now what happens is that as products reach the end of their life cycle then we do sometimes have some charges related to that. We don't expect any of those either, but they could happen.

Got it, because if I take both of them out I'm coming to 42% non-GAAP this quarter so if you were to include any of that going forward that would mean an organic decline in non-GAAP gross margins?

Well, the non-GAAP margin does not include either of those. If you're trying to bridge from the 49% GAAP margin to 42%, yes, you have to exclude those items.

That's right but if I exclude any further going forward in Q3 for example, if there's any other exclusion of acquired inventory and rationalization charges to an already kind of loaded Q3 quarter if you know what I mean, if I take that out, it helps your non-GAAP gross margins going into Q3, so are you at all considering that going forward?

We're getting a little detailed here, but let me just make it clear. In constructing our non-GAAP or as-adjusted margin, we did not include in this quarter any charges related to product rationalization and we excluded this write up on the inventory related to purchase accounting so the net effect in going from our Q2 gross margin on an as-adjusted basis to the Q3 gross margin on an as-adjusted basis is not affected by anything related to product rationalization charges or purchase price accounting.

Fair enough, and is it possible for you to give us a quick recap of the target operating model?

Sure, what we said at Analyst day was that we based on what various industry analysts say as well as our own analysis of the market, we expect those segments of the market in which we compete to grow at sort of a 10 to 12% annual rate and we expect to be at roughly that same rate. We said given all of the things we know about gross margin we expect that to be in the low to mid 40s range. We said that early on, we would expect to be in the low 40s range, and that we believe we can move to the high end of that range over the next sort of 18 months.

We said that OpEx as a percentage of revenue would be in the low to mid 30s range in our target. We talked about, we expected to be at sort of a $195 million to $200 million operating rate of OpEx today or near term and that we would move to $190 million or so as we exited 2010. I'll point out that we now expect this to be in the approximately $190 million range in Q3 which is ahead of schedule, and finally, our target range, our target operating margin is sort of the 7 to 10% range. We think of that in terms of some milestones. We hope to be close to breakeven exiting Fiscal Year 2010 and we hope to be able to achieve operating margin in the 7 to 10% range exiting fiscal year 2011.

Great. Thank you very much.

At this time there are no further questions. I'd like to turn the call back over to our speakers.

Thanks, Michelle. I'd like to thank everybody for your time this morning for joining us on the bridge and for your continued support. Thank you.

That does conclude today's conference. We would like to thank everyone for their participation.