Ciena Corp (CIEN) 2010 Q3 法說會逐字稿

Good day, everyone, and welcome to the Ciena Corporation fiscal third quarter 2010 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, Ms. Robin Weinberg. Ms. Weinberg, please go ahead.

Thanks, Allison. Good morning, and welcome everyone and I'm pleased to have with me Gary Smith, Ciena's CEO and President; and Jim Moylan, CFO. In addition, Tom Mock, Senior Vice President, Corporate 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. Larry will review our financial performance in the third quarter, give an update of our integration of Nortel's MEN business, and then discuss our review of the market environment. Jim will then detail our Q3 financial results 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 certain forward-looking statements. Such statements are based on current expectations, forecasts and assumptions regarding 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 10, 2010. We will file our third quarter 10-Q by September 9.

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 of operation. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's press 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, Robin, and good morning, everyone. We executed well this quarter and we're pleased with our overall results, and we believe our financial performance is evidence of both the strategic value and the market acceptance of the combination of Ciena and Nortel's MEN business, which closed in March. Today's results also reflect the more balanced business and increased scope and scale we now have with the addition of MEN's product portfolio, customer base and geographic reach.

Our Q3 results reported today represent the first full quarter operating as a combined Company. As a result, comparisons to previous reporting periods and future extrapolations may not be representative and should be made with due caution. With that in mind, today we reported fiscal third quarter revenue of $389.7 million. This includes $221.8 million from the acquired MEN business. Revenue from Ciena's pre-acquisition portfolio was $167.9 million. Our Q3 adjusted gross margin was 45.2 and reflects a number of favorable items in the quarter, and our non-GAAP operating expense was $178 million.

Both gross margin and OpEx were better than planned and we're ahead of schedule on several fronts as we continue to rationalize the combined Company. We achieved a number of synergies by way of significant progress and supply chain rationalization and the initial consolidation of distribution facilities, and we also benefited this quarter from the reorganization of our EMEA business and previously announced headcount reductions. I want to emphasize that while we are pleased with our progress, there is clearly more work to be done, and we remain focused on the continued execution of our integration plan. And building on that point, the integration of Nortel's MEN business is proceeding well, and remains firmly on track.

Thanks in part to the continued hard work of our team, the transition has been very smooth for our customers, partners and suppliers. Customers continue to provide positive feedback on the combined Company, illustrated in part by the strong performance of the MEN business this quarter. We've made great progress to date, and at this stage of the integration, in addition to ongoing product portfolio integration related primarily to network management systems our efforts are primarily focused on the areas of operations and IT. Our next goal is to achieve operational independence from our transition services provider, Nortel Business Services. That being said, I'd like to emphasize that overall, NBS has been extremely effective, and our working relationship remains very positive. We are committed to maintaining our strong momentum as we work toward the milestone of operating under one single infrastructure.

Moving on to the current market environment, with our greater market share, technology leadership and expanded global presence from the acquisition of the MEN business, we are seeing strong customer activity and have been afforded increased consideration to compete for new opportunities. With this elevated market position, we are confident in our ability to leverage our success and grow our business; however the competitive landscape and broader macroeconomic environment caused us to remain cautious, and we believe that our sector's recovery will be slow and gradual. That said, we continue to believe the demand drivers of our business are fundamentally strong. Simply put, underlying traffic demand continues to grow, and that remains the fundamental CapEx driver for our customers.

The proliferation of our high bandwidth services like video, mobile broadband and cloud computing applications continue to place unprecedented pressure on networks worldwide. Given the combination of traffic growth and new service demands, we believe service providers are raced with no real choice but to increase capacity, add service flexibility and improve the overall performance of their networks, and that network upgrade cycle is still in the very early stages. We are seeing signs of that activity though, particularly around the combined portfolio, which is driving multiple opportunities to cross sell and is opening doors into new accounts and additional projects with existing customers.

The customer base of the MEN business is increasingly embracing the combined Company, and reengaging with greater confidence in Ciena as the owner of the assets. In fact, our fiscal third quarter represented the strongest quarter in demand for the MEN optical platform in five quarters. The market leadership of the combined Company in high capacity transport continues to grow. Since the beginning of the calendar year, 40-G solutions have been shipped to more than a dozen customers in North America, primarily Tier 1 and tier 2 Service Providers and MSOs and we've recently added a Canadian Service Provider to that list. Internationally we've shipped 40 gig to more than a dozen customers in EMEA and several in both Asia and Latin America. This includes two recent new submarine wins as well.

On 100 gig, we're shipping commercial solutions to customers in both the US and Europe, including a new deployment with a Tier 1 Operator in North America. In addition, we have several trials under way around the world. Clearly, growing capacity demands are driving adoption of 100 gig solutions today and we believe that we remain the only Company capable of shipping commercially available systems that address these needs.

Furthermore, our industry leading switching portfolio continues to gain traction on the global stage, a testament to the value of our advanced control plain technologies and OTN capabilities. Of particular note, we had two new significant international wins for CoreDirector in the quarter, and we're gaining broad interest for our 5400 family. We are in various stages of testing multiple Tier 1 service providers. We've completed certification at a major European operator, and we're engaged with several more carriers globally.

Our switched OTN architecture vision is clearly resonating with customers; however, I'll remind you that adoption of these strategic platforms within major carriers for large infrastructure builds involves a long selling and certification cycle. We are leading the way in helping these customers transition their networks to this next gen architecture and we expect to see orders from multiple customers in the fourth quarter for the 5400 family and initial revenue in the first half of fiscal 2011.

Lastly, within our Carrier Ethernet Service Delivery or CESD family we continue to grow our customer base with more than 100 customers globally. For two consecutive quarters, heavy reading is estimated we've held the number one market position in ethernet over fiber access platforms. In our fiscal third quarter, as expected, revenue was lower for this segment.

As we've said before, service provider rollouts for these solutions can be uneven and may cause revenue to vary quarter to quarter. We are diversifying beyond the wireless backhaul, where we maintain the leadership position, and as the broader carrier ethernet market develops, we continue to capture new customers from multiple applications. In fact, we're integral to key business ethernet services offerings in several major carriers globally.

Underlying demand for our solutions in this nascent market is strong, with ethernet expected to exceed TDM as the primary driver of 3G and 4G mobile backhaul deployments over the next five years. With these dynamics and notwithstanding short-term revenue fluctuations, we believe this segment will continue to be a meaningful revenue driver for our business over time, particularly given our early positioning in the emerging LTE market.

Overall, our market position is strong, and we are encouraged by a number of strategic wins and momentum in the third quarter including new customers in Russia, the Middle East and France including a cross-portfolio solution customer for 6500 switching and CESD, cross selling and expansion of our portfolio in existing Tier 1 accounts in North America, continued success with our entry into the submarine space, including wins at two Tier 1 global Operators, three new deals with major financial institutions for our low latency solutions, and increased our customer engagement for our advanced service offerings.

This is a clear validation of our strategy, and as such, we're more enthused about the opportunity for the combined Company than ever before. With those comments, I'd like to hand it over to Jim who will take you through the details of our Q3 results. Jim?

Thanks, Gary. Good morning, everyone. As Gary stated, our results reflect the increased scope and diversity of our business with the addition of MEN's product portfolio, customer base and geographic reach. We have made much progress with our integration efforts. We are now very focused on continuing the work to integrate back office systems, processes, and controls, including our financial and accounting systems. Also, I'd like to reiterate Gary's sentiment that the hard work of Ciena's employees has been the driver for insuring that our integration goes smoothly.

Now on to our financial performance this quarter. Today, we reported third quarter revenue of $389.7 million. Revenue from Ciena's pre-acquisition portfolio totaled $167.9 million. $221.8 million of revenue came from the acquired assets of the MEN business, which reflects the first full quarter of these operations within Ciena. Last quarter, we told you about certain deferred product revenue from the MEN business that would have been recognized by Nortel had the acquisition not occurred, but that we as Ciena are unable to recognize. At this stage, we expect the effects of this deferred revenue to be essentially complete.

Moving to other detail on revenue contribution, we had two 10% plus customers in the quarter that represented 34% of total revenue in the aggregate. One of these customers was also a 10% customer in Ciena's first and second fiscal quarters, and was also a customer of the MEN business prior to the acquisition. Sales outside of the US represented 41% of total revenue in the quarter, a significant increase from Q2, which is due primarily to the larger international contribution from the MEN business.

Also last quarter, we introduced the four segments for which we'll now be disclosing revenue. To remind you, these segments include packet optical transport, packet optical switching, Carrier Ethernet Service Delivery, and software and services. Our packet optical transport segment includes all of our optical transport platforms and associated operating system software and embedded software features. This segment accounted for $242 million in revenue in Q3, representing 62% of total sales.

Of note, our CN4200 family accounted for $43 million in revenue, showing continued strength particularly with low latency applications. The MEN transport products generated $171 million, indicating strong reengagement from the customer base for these solutions. Our packet optical switching segment 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 $34.8 million in Q3, 9% of total sales. This represents a sequential increase from Q2's revenue of $32.4 million, driven by new wins for the platform. As Gary mentioned, we've been very encouraged by the level of customer interest in the 5400 family. We believe that we'll begin to see orders during Q4 and initial revenue in the first half of fiscal 2011.

Our third segment, Carrier Ethernet Service Delivery or CESD includes our service delivery and aggregation switches, Broadband Access products, and related operating system software and embedded software features. As expected, sales of CESD were down Q3 contributing $33.8 million or 9% of total revenue. Revenue this quarter was affected by two customers in the middle of large wireless backhaul infrastructure builds. Remember that these sorts of infrastructure projects have ebbs and flows in activity and we're only partially through both of these builds.

Finally, our software and services segment which includes our integrated network and service management software, as well as all our services related offerings accounted for $79 million in revenue in Q3. This represents a 39% increase over Q2, primarily reflecting addition of MEN service business for the full quarter.

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, Q3's GAAP gross margin was 37%. Our GAAP product gross margin for the quarter was 36%, which was affected by the increased charges related to acquired inventory from the MEN business. Due to the higher volume of advanced services as a combined Company, our GAAP services gross margin was 43%.

On a non-GAAP basis, gross margin was 45%. As expected, this was lower than Q2. This reflects our normal adjustments for things like share based compensation costs as well as a number of items brought about by the MEN acquisition. These include increased amortization of intangible assets and the fair value adjustment of acquired inventory.

Moving on to OpEx. On a GAAP basis, Q3's operating expenses totaled $244 million. This includes acquisition and integration related expenses of $17 million, stock based compensation of $8 million, $39 million in amortization of intangibles and 2 million in restructuring costs. Excluding those items, Q3's operating expenses on an as-adjusted basis totaled $178 million. As Gary said, this was better than planned, as we were able to achieve some operating synergies sooner than expected. Also, certain costs we expected to incur in Q3, we now expect will hit expense in Q4.

Our Q3 GAAP net loss was $109.9 million, or a loss of $1.18 per common share. Adjusted for the unusual and/or non-operating items detailed in our press release, our third quarter net loss would have been $8 million, which is a loss of $0.09 per share. On cash flow and the balance sheet, we used $130 million in cash for operations during the quarter which is generally in line with our expectations. This includes $109 million for increased working capital and $21 million in net losses as adjust the for non-cash items. The $21 million referenced above also includes expense of $17 million for acquisition and integration costs.

Absent the expected working capital build, which was the result of the MEN acquisition, and absent the integration costs, the operations of the business actually used cash of only $4 million. This is a metric we are tracking closely and we expect to improve over time. At July 31, 2010, we had approximately $470 million in cash, cash equivalents and short-term investments. At the end of Q3, our accounts receivable balance was $260 million, up from $179 million in Q2.

Day sales outstanding were 60, down from 64 days in Q2. Inventories totaled $222 million in Q3, down from $233 million in Q2. Product inventory turns were 3.6 times in the quarter, up from two times in Q2. The inventory break down for the quarter included raw materials at $27 million, work in progress, $6 million, finished goods, $220 million and we have an accrued reserve for excess and obsolescence of $31 million. Regarding headcount, at July 31, 2010, our worldwide headcount was 4,214.

I'll close our prepared remarks today by talking to guidance for the fiscal fourth quarter of 2010. We currently expect a sequential increase in our Q4 revenue of up to 5%. On gross margin, because Q3 gross margin benefited from both a favorable product mix and a favorable customer mix, we believe overall gross margin for the combined Company will be lower going forward. We believe that our as-adjusted gross margin in Q4 will be in the low 40%. This includes an expected gross margin on services in the mid to high 30s, as a result of a better mix of advanced services in the combined business going forward.

We expect adjusted operating expenses in Q4 to be in the low to mid 180s, which is well below the target we had talked about for OpEx of $190 million exiting fiscal 2010. The small increase from Q3 is partially due to certain expenses that we expected in the third quarter which we now expect will fall into the fourth quarter. We expect other income and expense net in the fourth quarter will be an expense of roughly $6 million.

This quarter's GAAP results reflect a loss related to the call provision in our recent convertible debt offering. It is excluded from our as adjusted results and should not be considered in our other income going forward. As for taxes, we expect our tax obligation for Q4 will be related to foreign taxes and will be between $1 million and $2 million. Before we move to questions I'll give you share count assumptions. 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 135 million total shares. We estimate Q4's basic share count at approximately 94 million shares. Allison, we'll now take questions from sell-side analysts.

(Operator Instructions). Our first question comes from Subu Subrahmanyan with Sanders Morris. Please go ahead.

Thank you. I have two questions. First, on the deferred revenue, if you can talk about deferred revenue adjustment that you had this quarter, I know you were expecting to have up to another $50 million almost of impact and you'd mentioned that you were past that. Was there any impact this quarter at all, because my understanding was your guidance had included a fairly substantial impact for this quarter, and then on the CESD side, if you could talk a little bit more about quantifying the impact between your two lead customers and the trajectory you expect for that going forward.

Yes, Subu, during Q3, roughly $50 million of revenue would have been recognized by Nortel, had they continued without the acquisition. At this stage, we think that the effects of this deferred revenue are essentially complete; however, if you're trying to get a run rate for MEN revenue, it's not as simple as just adding that deferred revenue to the quarter's revenue, the revenue that they reported for this quarter. The operations of the MEN business have been positively affected by the acquisition, which partially offsets the impact of not recognizing this deferred revenue. That would not have occurred had the acquisition not occurred; however, the larger issue for forward revenue has to do with the need to build the backlog and deferred revenue base for MEN, which we'll do over time.

When we acquired the business, the amount of backlog was substantially less than sort of the current run rate that might have been expected due to both to the disappearing revenue phenomenon we've talked about and to the fact that the MEN business had been in bankruptcy and customers were somewhat reluctant to commit to new systems for MEN. We're going to build that backlog over time and we'll build the deferred revenue balance as well. So again, not as simple as just adding that deferred revenue to their base for this quarter.

Subu, why don't I take the CESD question. The short answer to your question is that the trajectory overall is up, it might not be completely linear quarter to quarter, but we're making very good progress in broadening our customer base. I think that we had an extremely good quarter in Q2 at about $75 million. We expected it to come down and it's characteristic of these large infrastructure builds, at a couple of them particularly into the wireless backhaul space.

We just think it's the normal ebbs and flows of that and I would also say as Jim mentioned, we're probably about a year into a multi-year rollout on both of those projects, so we expect those to return. We're also winning a number of new deals where we've got over 100 customers for these kinds of platforms. The ethernet business services is also just beginning to roll out. We've won an awful lot of Tier 1 carriers in North America, and we're also beginning to roll that out internationally as well, so we expect that trajectory to be upward over time.

Understood, if I could just follow-up on that MEN business, I just want to make sure I understood right, that if you could have recognized the deferred revenues and the ongoing business, that revenue would have been as high as $270 million plus this quarter. Did I understand that right?

Well again, the $222 million is reflective of our ownership of the business, not the business as it was as part of the Nortel entity. In other words, the run rate for that business would likely have been lower than $222 million plus the $50 million, had we not acquired the business and had we not been able to reengage with customers, so you just can't take that deferred revenue balance, add it to what we reported in our ownership of the business and say, that was the run rate of the existing business. It's not that simple.

Sure. And in your guidance, can you just talk about between the Ciena Classic business and MEN, where you're expecting to see the growth in your up 5%?

Yes, we've not given guidance on the individual pieces and we will not.

Thank you very much.

Our next question comes from Jeff Kvaal of Barclays. Please go ahead, sir.

Yes, thank you very much. I was wondering if you could help us understand a little bit about what is happening on the classic Ciena side. I think from most of our points of view the Nortel piece of business was well ahead of expectations for the quarter, but the converse is that things in the Classic Ciena weren't quite what we anticipated them to be. Could you help us understand if there's a product transition issue there or if people are slowing down the CoreDirector sales or any other variables we should be on top of?

Yes, Jeff. I'd point to two things. One would be CESD, was just the sort of cyclical nature, just the nature of sort of these kind of large infrastructure builds, so I think CESD going down from $70 million odd to 30 something, so clearly, that's what one of the contributing factors for that but we do expect CESD to continue to grow as a business overall. There's no question about that.

The other thing that I'll point to that didn't particularly impact in the quarter but this transition from CoreDirector to 5400, it takes a while for these kinds of transitions to take place. We expect our first orders, our first initial commercial orders in Q4 and I'll recognize revenue in 2011, but we're also going through that transition in the portfolio as well. That didn't really impact revenues but you talk about transition and those are the two large sort of elements that I think about in the Classic Ciena portfolio, but if I step back from that and you look at the transport segment, packet transport segment, I'd expect that to continue to grow both in terms of the 4200 and 6500, I'd expect once we get through this transition, the 5400 to grow, and I'd expect CESD to grow, so we're trying to hone in on these platforms that will drive the future growth.

Thank you.

Our next question comes from George Notter of Jefferies. Please go ahead, sir.

Hi, thanks very much guys. I guess I was trying to get a sense for when you parse down the Nortel product line on the heritage MEN side, can you give us a sense of how much of the business is really being driven by the OME6500 platform versus other portions of the portfolio?

Yes, we haven't broken it down into that level, George but I would say the predominant growth driver is the 6500 platform.

Got it. And could you give us a sense for how much of that portfolio then is a 6500 versus the other pieces? Is it a majority of the revenue there now?

Well you've got integrated line systems as well in there but I would say it's at least 50% if not more.

Great. Thank you very much.

Thanks, George.

Our next question comes from Rod Hall of JPMorgan. Please go ahead.

Yes, thanks for taking my question guys. I just had one more follow-up on the Nortel business which SKU guys give us any kind of an indication of what fiscal Q2 looks like on a like-for-like pro forma basis just so we can get an idea? It does feel like it grew quite a bit in the quarter but it would be nice to know how much and then I had a couple of questions on the interest and other income line. I was just wondering whether you guys could give us any more color within that particular line on the income statement. I guess one question would be whether it's correct to assume that derivative gain on the convert is ongoing or is that a one off. I guess we tend to assume it's a one off but it would be nice to know what we should be thinking on that and then also, are there any FX hedging impacts in this quarter that might go away. Just anything that are one off in nature that we should expect to be rolling off next quarter and quarters to follow?

Yes, with respect to the MEN business in Q2, we don't have perfect visibility into that number because some of it has to do with the way Nortel would have recognized revenue prior to the acquisition and everything; however, we did last quarter and at Analyst day, we talked about their sort of run rate as being in the range of about $200 million and we got there by trying to add up the actual revenue we reported, the deferred revenue effects and some other things, so this is not an official number but an estimate was around $200 million in our Q2.

With respect to the interest and other income, we did in the as adjusted interest and other income, we reported $4.7 million expense. That consists of interest expense of around $6 million and an FX gain of about $1.3 million. In our GAAP results, we also had a $4 million expense related to the call provision embedded in our recent convertible debt offering. We backed that out for purposes of as adjusted results, so the as adjusted results were $4.7 million expense. I mean, we don't have knowledge of what FX is going to do in Q4 so we're just ignoring that and that's what our guidance for Q4 is an interest expense number of $6 million.

Okay, Jim, so the $6 million we should be, it sounds like that's kind of a run rate for expense going forward. Is that correct?

Yes, it is.

Okay, great. Thank you.

Our next question comes from Nikos Theodosopoulos of UBS. Please go ahead, sir.

Yes, thank you. I guess I wanted to touch on two things. I guess first of all on the international strength, you mentioned it was predominantly due to the Nortel business. Can you give a sense of geographically where that strength was, that would be my first question.

Well the basic fact is that the Nortel, the MEN business was more geographically diverse than we. They had a bigger Canadian business than we had. They also, as we had, had a big business in EMEA, so the change from the quarter is essentially because we've combined these two companies, one of which was heavier outside of the US than we were.

Is the other 10% customer this quarter overseas? You didn't mention any color on that.

No, it's not.

Okay, and then the second question I had was related to I guess it's maybe a two part question. When you gave guidance last quarter for gross margin, you said one of the reasons that it would be down into the low 40s was Nortel, the Nortel MEN business would be a bigger percentage of the revenue and it ended up that Nortel MEN was an even bigger percentage than most had expected, and yet you showed a better gross margin overall, so I guess first part of this question is, the mix was even more pronounced yet the gross margin was better than expected. Why are you guiding down again next quarter, and as part of that, why was there an inventory charge if the Nortel business did better? It would seem to me there would be less obsolescence if the business is doing better than you had expected. Why did we see an additional charge there? Thank you.

Let me clarify that inventory charge comment. This has to do with the purchase accounting requirement that we have to write up the value of acquired inventory for GAAP purposes so that our GAAP results reflect just a sales margin on the product sales. I think the number that we booked at the time of the acquisition was around $40 million or so.

Most of that actually hit in this quarter. It was attached to inventory that we sold this quarter, so we had something like a $35 million adjustment from GAAP results to as adjusted results, because we don't think that from a operating point of view and an as adjusted point of view, this accounting write up is reflective of the operations of the business, so that's the write up. There was the excess and obsolescence charge on the MEN business was inconsequential this quarter. Gary do you want to talk to the margin?

On the overall margin, the margin came down last quarter we were up 49 to 45 and we came down to 45 as expected, it came down. Clearly some of that was just the full quarter effect of having a combination of the business, but also we had a very good product mix within the MEN business. We also were able to realize some cost savings and move into some low cost manufacturing, some cost reductions ahead of schedule, and also the services content was extremely strong with a lot of advanced services where we typically get higher margins. We don't expect that to continue in quite the same wave and we do take our longer term perspective around services into the mid to high 30s going forward, so taking all of that into account, we think that in the short-term, the best perspective on the combined gross margins is in the lower 40s. Also, the other thing I would say particularly is we've had some new wins in the quarter that are new builds and typically are lower margin in their initial phases as well.

Okay.

So we've also taken that into consideration.

Got it. Thank you.

Thanks, Nikos.

Our next question comes from Michael Genovese from Soleil Securities. Please go ahead.

Thank you very much. Just a few quick ones. First of all, your inventories went down quarter-over-quarter. We see a lot of companies in the industry building inventories because of supply constraints. Are you seeing any supply constraints at this point impacting your revenues?

The reason, the main reason our inventory went down for the quarter, Mike, is that the $35 million upward adjustment that we made to our inventory at the time of the close has gone away, so $35 million went away as a result of that, and had nothing to do with what's going on in our inventory. We actually did build a little bit of inventory in the quarter. That's just consistent with what we're trying to do in order to manage our supply chain.

We have seen some lengthening of lead times and some of our products are in very high demand right now so we're managing through that. As of today, we haven't seen a big effect on revenue of these sort of tightening in the supply chain. We're watching it and we're managing it.

Great. Earlier you gave us some sense of what the 6500 was as a piece of the MEN business. Can you give us a sense of how much of that is 40-G at this point?

We haven't broken that out. I mean, we continue to see 40 gig build particularly into North America and Europe and we're also seeing submarine builds around 40 gig as well, so we've had our highest shipments of 40 gig in the quarter looking through the MEN business, so it's continuing to ramp.

Okay, and then in your comments, you talked about the 5400 quite a bit and the timing for that. I'm not sure if I missed it or if you just didn't comment so much on the CoreDirector FS and what the timing of that rollout is looking like?

Well we've won a couple of new deals in the quarter on both international on the CoreDirector FX, they will rollout in Q4 and Q1 and we are now shipping FS, we will be shipping in Q4, but we are going through that sort of transition. We expect our first orders for 5400, Mike, in Q4 as well and we'll recognize revenue in 2011, so we are going through that transition. I think it's fair to say it's taken a little bit longer than we had expected, just because of the adoption and the certification required for the major customers, but the engagement is very positive.

Great and then last quick one hopefully. Thanks for answering these. Obviously the OpEx at 178 was positive and even the guidance next quarter below what we're thinking before, but I'm just curious, is that just you running ahead of plan because you've been working on that all along, or did you see organic revenues coming in soft at any point in the quarter and sort of accelerate your cost reduction efforts because of that?

I wish we could control it that easily. I would say we had a plan of the synergies of the two companies coming together and we were very focused on operating expenses and particularly in uncertain macro environments so we're managing that very tightly and we've been driving the synergies between the two companies very aggressively and we are slightly ahead of where we thought we would be on the operating expenses, but I think it's more, Mike, in just an overall strategy to contain or control what you can control, particularly in this environment.

Thanks, Gary.

Our next question comes from Mark Sue of RBC Capital. Please go ahead.

Thank you. Perhaps Gary, just on your big picture views of the reduction and the outlook versus what you're seeing from your customers, maybe there are indications, behaviors, intentions, and if you could add some thoughts on maybe the overall pipeline in how you see the deal closure rates.

It's early days for the two companies coming together but I think our pipeline activity continues to build. Activity levels are continuing to increase, so we're seeing all goodness there and we're forecasting revenues up next quarter, so I think things are going to plan in that regard. I think overall, folks are just cautious around the overall macroeconomic environment. I think everybody is engaged around multiple projects and looking to spend, but I think that's providing a degree of caution right now across everybody's outlook.

I see, so are you assuming maybe a more conservative closure rate for the upcoming quarter?

Well, I wouldn't necessarily put it into a metric around closure rate. Our deal flow is looking good and we're closing what we would normally do but we are actually getting a bigger pipeline overall of longer term, larger projects and some of that is just the nature of our scale and reach now, so we're probably not the best barometer of that, given we're a new enterprise essentially.

Got it, and then maybe in terms of how we should look at the prior expectations of breakeven on an operating basis by the fourth quarter with the moving parts and the timing of the expenses. Is that kind of off the table at this stage and when might we reach breakeven?

I think what we said was I think at Analyst day in April, we said that it's possible we could get to breakeven coming out of fiscal 2010 into 2011. I mean frankly, we came close to it this quarter, so we're probably right where we thought we would be so I'm very pleased from that point of view, but it's very sensitive to a few million dollars moving around as we get to this phase of it, so I'd hate to sort of predict any of that with any great clarity, but clearly, we're right in the zone here, very pleased with where we are.

Okay, that's helpful. Thank you, gentlemen, and good luck.

Thanks Mark.

Our next question comes from Paul Silverstein of Credit Suisse. Please go ahead, sir.

Two questions if I may. One, can I ask you to revisit the 5400 and FS commentary in terms of leading edge indicators, in particular the customer activity? You'd rattled off some metrics in terms of Tier 1 wins, I believe you mentioned North American international but can you revisit that commentary and then I've got a question for you in your backlog business.

Yes, we had a couple of Tier 1 wins for the CoreDirector FS. Both of them were international with Tier 1 players, so we'll take some revenue for that in Q4 and then 2011, so those were good wins. Overall on the 5400, the activity pipeline remains very positive, and we're engaged with a number of Tier 1 carriers globally both in certifications, multiple testing, both at our site and the customer sites, so all of that is going to plan and we also expect that to translate into the initial first orders from multiple of those engagements in Q4, so we expect the order flow to begin ramping up in Q4.

Gary, can you contrast that with the prior period in terms of the number of engagements in the progress?

I would say it's steadily increasing across-the-board, particularly since we have reach with the MEN folks into some new accounts so we're getting some introductions, some cross portfolio selling from some of the MEN accounts with 5400 but as you know, this kind of thing takes time to get adoption of these kinds of switching, and we also got certification to replace some of the commentary. We did get certified in our first Tier 1 player in EMEA so we expect orders from them in Q4.

Gary when you talk about engagement certification testing your expectation is that all of these engagements the bulk of them resort in revenue or you're talking about something different?

Ultimately, yes. We're confident that we can get the order flows going in Q1 or in Q4 from some of these engagements, but they do take time to get adoption and they will take time to ramp up.

At this particular juncture, is there any indication as the size of these deployments that are being discussed?

They vary in size. Some of them are a smaller getting initial deployments and others are more broader in nature. I think it's fair to characterize it Paul, that its taken a bit longer than we would have thought if you'd ask me this question about a year ago and that would be fair commentary. On the platform I think we're seeing a lot of interest in the architecture and the OTN elements and particularly now with 40 gig, from being able to put the coherent 40 gig in there but I would say its taken longer and some of it may be the global macro environment, it's tough to tell.

And are any of the 5400 trials or any non-existing CoreDirector customers?

Yes.

Finally on the backhaul piece, if we look beyond the next 90 days, if we look further out, is there any reason to believe, based upon what you're seeing, that the numbers in terms of number of customers and revenues do not significantly ramp from here? I want to make sure that the decrease this quarter was those two specific customers taking I believe the word you used was a pause. Is there anything more going on in terms of this just being lumpy, or is there something else going on?

I think its just been lumpy, Paul, but I'd also say Q2 on the other side was probably abnormally high, given the ramp, but I would expect this business to grow and ramp up both in terms of the backhaul and the business services, the main two applications for it.

Have the two customers in question given you any visibility as to their plans going forward?

I would describe it like this. I would say we're a year into multi-year programs at both.

So they've made it clear that this is in fact a pause?

Absolutely.

I'll pass it on, thank you.

Our next question comes from Blair King of Avondale Partners. Please go ahead.

Yes, thank you for taking the question. I just have a couple, which one is a follow-up to Mark Sue's question earlier on the breakeven fourth quarter outlook which slipped out a little bit potentially, but should we still be thinking the other milestone we put forth was 7% to 10% operating margin exiting 2011 so should we still be thinking of your business ramping in that fashion through 2011?

We still believe that exiting fiscal 2011, we're going to be in that sort of 7% to 10% range on operating income.

That's helpful and one last question. Could you just give a brief update on the supply chain rationalization and where you are in that process and how you see that playing out in the gross margins over the next few quarters?

Well we've been very active in our Supply Chain and we've already taken steps we thought would take longer. We've consolidated one of our several distribution centers into one of our previously existing distribution centers. That will likely continue and with respect to contract manufacturers and other component suppliers, we've yet really to start the process of rationalizing that and we've got a lot of work to do in planning those things. We're very early in the process. One of the things that you have to think about when you do a very complex rationalization like this is that it's much easier to do it once you're in one ERP system.

Right now we are still on Nortel's SAP system. We think some time early next fiscal year we'll be in one system and once that's done it just becomes a lot easier to start rationalizing the supply chain. There will be gross margin improvements over time. We haven't really quantified them but when we talked about our margin growing from the low 40s to sort of the mid 40s, clearly a part of that increase was the result of the things that we expect to do and in some cases already have done in our supply chain.

And just moving from the low 40s to the mid 40s, you still see that as being realistic even after having a few quarters or a few months under your built with the Nortel products?

As far as we know, yes. Now we also said that we'll have to continue to grow our higher margin businesses and that we expect.

Okay, thank you very much.

Our next question comes from Tal Liani of Banc of America.

Hi, I have two sets of questions. The first one is about some of the things we just answered, the prior question. So you're kind of going between the optimism about contracts that are going to come in and orders that are coming in and between the fact that you sound a little bit cautious about the spending environment and there are delays or pause in spending of projects so I wanted to understand whether altogether you've seen any slowdown in your business and discussion with customers over the last few months. Can you describe the environment as slowing down overall at the macro level, or your feelings or your thoughts about the environment are exactly the same as they were the quarter before?

I would say that overall, Tal, the environment remains cautious. If you go back a couple of quarters, people were feeling a little more optimistic about the macro environment, albeit with Europe lagging a little bit. I think that's probably settled down a little bit, and people are probably a little more cautious than they were six months ago just based on the macro economy.

I can't particularly point to anything in our customers that they're thinking any differently but I think at this stage of the cycle, could have been more robust if that sentiment would have been more positive, but that being said, we're continuing to win business and we're continuing to grow the business and make progress with it, so I'd say we're sort of bouncing around a little bit right now. It's not appreciably worse, it's not appreciably better. It's certainly better than it was 12 months or so but I would say that and the overall demand drivers continue to be validated.

The second question is the CoreDirector or switching, if I have my numbers right it declined by about 50% this quarter?

No, it actually went up.

It went up, okay, so I'll skip this question.

From last quarter.

I'll skip this question. The last question is about just the expenses. You had $178 million and you're guiding to low 180. Is the increase totally related or exclusively related to the deferral of expenses that you mentioned and then if that's the case, why don't we see expenses continue to go down?

First of all, there's a lot of moving parts in our OpEx. We're managing a very complex environment right now, Tal, and we have the transition services agreements, we're integrating a lot of things, and so not all expenses necessarily come in exactly at the time at which you expect them to come in, so essentially, what happened this quarter is that certain expenses that we expected to incur in Q3, we didn't incur, and we will incur them in Q4, so that speaks to what our sort of current level of OpEx is. Now, once we get out of the TSAs there will be, there should be a downward move to expenses. We've got other things that are going to change, so we're not making any comment about long term expense levels. What we are saying is that due to things that didn't happen in Q3 that we thought were going to happen, we expect expenses to be up a little in Q4.

But I would say, Tal, overall we are lower than we thought we would be. We are ahead of our synergy, we said about 190, I think Jim coming out of Q4 and we're clearly well ahead of that.

And that's exactly my question. So my question is if we've seen such an improvement last quarter, only part of it was because of the deferral, so some of the sequential increase is just a small part of being deferred, let's ignore it. Why don't we see continued pressure on expenses. That was my question.

Continued pressure downward?

Downward, right. Why don't we see further cuts to expenses?

Well, you've got some other things to consider there. As Jim was saying, we're coming off the TSA services and we need to build up the IT infrastructure. One of the issues we need to build up the IT infrastructure if you like to catch that, so it's an upward pressure on operating expenses which we're also taken into consideration in the guidance as well.

Last question. Cash burn. You gave an explanation on the cash burn at the beginning. Would you mind to repeat that? It went up from about 78 to 130 but I didn't get the explanation. Thank you.

Yes. We ended the quarter with $470 million of cash and short-term investments. We actually used $130 million in cash from operations and that's about what we expected. That includes $109 million for increased working capital and so we pretty much have finished our working capital build for the MEN acquisition. As we grow, we will have to add some working capital just for sort of receivables balances, but we finished the MEN sort of build, so that leaves $21 million in net losses as adjusted for non-cash items. That $21 million includes an expense of $17 million for acquisition and integration cost, so if you take away all of the stuff which has to do with the acquisition which might be considered sort of non-recurring numbers or one-time in nature, the operations of the business actually used cash of only about $4 million, and as we're looking at the business, that's the metric that we're tracking and most focused on. We expect that over time that's going to improve.

Got it. Thank you.

Our next question comes from Todd Koffman of Raymond James. Please go ahead.

Yes, one last question on the CESD segment. You had said earlier in the call that you thought the trajectory of that business was up. Were you referencing that off the current level of business you had just reported or was that just a general comment?

It's just a general comment to be honest, Todd. I wasn't intending to reflect it will be absolutely sequentially up. I would say it's going to be non-linear as we go through this. It's going to have its ebbs and flows, but generally the trajectory is absolutely up. This is a growth market where we're extremely well positioned, and we made good progress to date.

And given that that business is so project related and sees these large step functions up and down like you saw in this quarter, it would seem as though at least for one quarter or so looking forward, you would have at least some sense of directionally what level that business would be and so I'm wondering, you gave a fair amount of specificity last quarter about this quarter's step function down and was wondering if you could give any additional insight for the current quarter where that business might be.

I understand, Todd. There are some puts and takes in the guidance. It's not an absolute number and it depends on some of the revenue recognition things that go on in the quarters that relates to that so that's my reticence in doing that, where we've got a clear view of that built into the guidance from time to time we will do that. For example, I could probably say that 4200 revenues would be up in the quarter because I have a very good view around the revenue rec and all of the rest of those diversified projects. CESD is not quite as clear, so that's why I'm a little more reticent about that quarter to quarter, but I absolutely think we'll see a bounce over time from where we are currently.

Thank you very much.

Our next question comes from Simon Leopold of Morgan Keegan. Please go ahead.

Great. Thank you. Wanted to get in a couple of clarifications first. One is on the services revenue, the press release talks about $77 million and I think in the prepared remarks Jim mentioned $79 million. Just wondering what the gap is there if I got that right?

Ask your second question, well I'll get the answer to that one and answer it in a moment. I don't know right now.

Okay, on the second question, you talked about having two 10% customers. You gave us some detail on one of the two I believe but not the other. I'd like to get a little bit of a better sense about that second 10% customer, specifically the applications and whether or not they've been on the 10% customer list and geographically where they're located.

Okay, I would say that they are both North American and they have both taken multiple products.

And is the second one a repeat 10% customer?

I'm not sure it's quarter to quarter repeat. They've definitely been a 10% customer, probably at both companies before.

Okay.

And Simon, sorry for the delay there. The $79 million is the segment revenue, software and services. The $77 million is the services piece of that $79 million.

Okay, that's kind of what I suspected but I wanted to double check that. Okay, great. Just doing a little bit of quick math, which may in fact be wrong, it seems to me that the sort of through process of elimination, the CoreStream product seems to have done pretty well this quarter up sequentially, perhaps double or on that order from the previous quarter so the first part of the question is am I doing my math correctly and the second part is you can give us some more color of what's going on with that product portfolio?

You are correct. It is up sequentially, and we have a pretty big install base of CoreStream and we'll continue to sell that product. We'll continue to add features to it. It's not a product that's going to have an infinity life to it over time that customers are going to switch over to 6500 or other platforms but again we have a big install base. We're going to continue to support our customers on that platform and you can expect to see movements up and down in that revenue going forward.

Great. Thank you. That's all I had.

Thanks, Simon.

I'm showing no further questions at this time.

Thank you all. I appreciate it. Thanks everyone for their time this morning, for their continued support and we'll look forward to talking to everybody soon. Thank you.

Ladies and gentlemen, that does conclude today's conference. You may now disconnect, and have a wonderful day.