Ciena Corp (CIEN) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen and welcome to Ciena's fiscal third-quarter 2011 results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, today's conference call is being recorded. I would now like to turn the conference over to your host, Mr. Gregg Lampf, Vice President of Investor Relations. Please go ahead.

Thank you, Allie. Good morning, everyone and welcome to Ciena's third-quarter 2011 review. With me today is Gary Smith, CEO and President and Jim Moylan, CFO. In addition, Tom Mock, Senior Vice President, Corporate Marketing and Communications, is here.

Today's call will follow a new format for us. In this morning's press release, which is available on National Business Wire and ciena.com, we have included much of the financial data that we normally would cover in our prepared remarks, largely in tubular format for easier sequential and year-over-year comparison of our results. We believe this change allows us to better focus our remarks during the call so we can spend more time answering your questions.

In our abbreviated prepared remarks, Gary will discuss management's view on the macro environment, as well as our business progress. Jim will offer some color on our Q3 results and provide guidance for Q4. We will then open the call to questions from the sell side analysts.

Before I turn the call over to Gary, I will 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 includes 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 most recent 10-Q filing. Our next 10-Q is required to be filed with the SEC by September 8 and we expect to file that by that date.

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 operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's press release available on ciena.com.

As a reminder, this call is being recorded and will be available for replay from the Investors section of our website. Gary?

Thanks, Gregg and good morning, everyone. Despite coming in at the low end of our guidance on revenue, we have made progress in many areas of our business that have enabled us to report strong results for the quarter. As expected product mix improved significantly with both switching and CESD up more than 30% on a quarter-on-quarter basis, contributing to gross margin improvement. Operating expenses also were significantly improved in the quarter. And as a result, we achieved an as-adjusted operating profit of 4%, which we believe is a solid result particularly given the challenging economic environment.

And I would like to take a moment to comment on that environment and what we are seeing in our business. Given customers' caution around the macro economy, our customers are scrutinizing their spending more carefully today and we are seeing some slowness in markets around the world, I think most notably in Europe. And given the level of our overall international business that we now have, we are seeing slightly longer cycles for sales, deployment and revenue recognition.

However, despite their caution, customers will need to move forward with network modernization. The growth of data, video, cloud storage and other bandwidth intensive applications is not slowing and at this time, our customers are continuing to advance their network modernization plans, albeit some at a slightly slower pace.

We are confident that Ciena is extremely well-positioned, even in a tougher environment. The demand drivers' underlying growth in our industry remain very compelling. We have industry-leading solutions and customer traction is strong. We are winning deals in the marketplace and we continue to see a healthy flow of orders. And while we remain optimistic, our industry is not immune to macroeconomic forces and we can't know for sure how the economy will play out. So we are focused on controlling the things we can control and optimizing the business with an eye on continuing to improve the bottom line.

Turning to the third quarter specifically, we have said all along that building the new Ciena would be a multistage process and as we discussed last quarter, the business is essentially moving from a phase that has been focused primarily on integration to a new phase focused largely on optimization and achieving operating leverage.

Because our early focus in the Ciena MEN combination was on a quick and smooth integration, we still have many levers available to optimize the business. In fact, our early optimization efforts have helped us pass another milestone this quarter as adjusted profitability. It is an important step, but we recognize that it is just that -- one step in the process. Nevertheless, our Q3 results illustrate that these improvements are beginning to happen.

For example, we reduced our overhead rate through a series of cost-reduction initiatives in the supply chain. We increased operating efficiencies in G&A and our product design cost-reduction efforts are progressing well. In addition, we are taking advantage of our significant investment in R&D that we have made over the last 18 months. This has yielded a considerable technology lead across virtually every Ciena area of focus.

In software, we announced in the quarter both control plane and management unification across the portfolio. Clearly, an essential step for increasing cross-product solution sales. The control plane software, which automates our CoreDirector and 5400 optical switches, has now been integrated into our coherent optical transport platforms.

In addition, our new OneControl cross-portfolio management system is now generally available and already has three customers.

In switching, we announced the integration of our leading coherent optics onto the 5430 and orders for that platform are continuing to ramp. We sold our first 100 gig 5430 solution in the quarter and our customers for the 5430 now total nine. Evidence that our OTN value proposition is being well-received.

It was also an important quarter for our transport business as we announced the integration of OTN switching across our transport platforms. This increases the overall value of a Ciena solution beyond transport. We are now approaching 100 customers for our coherent optical transport solutions and feedback from those customers, coupled with our field experience, is clearly telling us that Ciena's coherent performance continues to outpace competitors and we fully expect our ongoing development efforts to further advance our leadership position in this area.

Regarding carrier Ethernet, we are excited about bringing to market in the coming months expanded packet networking capabilities and additional packet integration across the portfolio. In the meantime, volume CESD shipments have resumed to one of our large Tier 1 customers who is now using carrier Ethernet solutions for both mobile backhaul and business Ethernet services. In addition to significant wins in both North America and Europe, we added two new customers in the Asia-Pacific region.

In summary, we continue to make progress in our business. From a technology perspective, we are moving forward, taking important steps to ensure that we maintain our significant development and technology lead across the portfolio into the years ahead.

From a market standpoint, we continue to leverage our solutions into actual design wins. And from an operational perspective, we are demonstrating a firm commitment to controlling the things we can control and further optimizing the business.

So while the macro environment has caused some customers to be more cautious, we continue to be confident that we are very well-positioned to grow faster than the market and deliver operating leverage. Now I would like to hand over to Jim for some color on our Q3 financials and our guidance for Q4. Thanks, Jim.

Thanks, Gary. Good morning, everyone. I will take a few minutes to provide some detail on the results that we published earlier today. As a reminder, I will be speaking only to non-GAAP results. Please refer to this morning's press release on our website for the reconciliations to our GAAP results.

Starting with revenue, there are several factors that contributed to revenue coming in at the low end of our guidance range. As Gary indicated, increased customer scrutiny on spending is lengthening sales, deployment and collection cycles, especially in Europe. This dynamic also likely contributed to a back-end-loaded quarter for orders, which limited our ability to respond in the quarter to customer demand.

In addition, we are seeing slightly longer revenue recognition cycles as a result of multiple large international builds currently underway. We are just now beginning to recognize revenue from several of our previously announced design wins. At 44.1%, gross margin was solid, mainly due to contribution from higher-margin productlines. We had a favorable mix of CESD and switching in the quarter. Combined, they contributed more than 18% of revenue. Both product sets are gaining traction in the marketplace and we believe that the trend for both of these segments is upward. Of course, as we have often said, we do expect product mix to vary from quarter-to-quarter.

Operating expense also came in better than expected at approximately $175 million. The lower OpEx reflects a $4 million benefit related to a strategic jobs investment grant that we received from the province of Ontario. We accrued an unusually high amount of the grant this quarter as a credit to R&D expense because we essentially are recognizing three quarters of benefit in this quarter. We do anticipate future benefits to be approximately $1 million per quarter, again, as a credit to R&D expense. In addition, we did a good job of controlling costs in the third quarter and our efforts are starting to be reflected in our results.

Turning now to the balance sheet, we ended the quarter with approximately $537 million in cash and liquid investments. DSOs were higher in the quarter. This was due in part to a higher proportion of international business, which typically has a longer payment cycle. Also, revenue for the quarter was back-end-loaded, which somewhat overstates DSO. However, as part of our optimization plan, we do believe that we can shorten our cash cycle, which we believe will bring down DSOs in the quarters ahead.

And finally, as a result of our focus on the supply chain, we reduced inventory in the quarter to $244 million. Turns improved to 3.3 times, pretty much according to our plan.

I will now discuss guidance for the fiscal fourth quarter of 2011. Absent significant change to exchange rates, our guidance is as follows. We expect revenue to be in the range of $440 million to $460 million. As a result of expected growth in our transport business in Q4, we expect adjusted gross margin to be somewhat lower than Q3, but within our target range in the low 40s. And adjusted operating expense is expected to be slightly higher than Q3 levels, in the upper $170 million range given the smaller effect of the grant in future quarters.

With respect to our post-integration target operating model for Q4, about which we have spoken a number of times, we expect our adjusted operating margin in fiscal Q4 to be roughly similar to that of Q3.

With regard to other income and expense in the fourth quarter, we project an expense of approximately $9.5 million related to the interest on our notes. We expect our tax obligation for Q4 will continue to be related purely to foreign taxes.

As for share count, we estimate Q4's basic share count at approximately 98 million total shares. Fully diluted share count will depend upon the level of profitability for the quarter given the way the convertibles act in the diluted calculation.

I will close by talking a bit about the milestones we have set out for the evolution of Ciena. We have talked about as-adjusted profitability as a key metric and we achieved that in Q3. Our next milestone is to get to a positive cash flow from operations, which we fully expect to achieve in Q4.

That concludes our prepared remarks and with that, we will move to the Q&A portion of the call. As a reminder, in order to maintain fairness, we will be taking one question per sell side analyst with follow-ups as time allows and we should have a fair amount of time this morning given our new format. Allie, we will now open up the line for questions.

(Operator Instructions). Rod Hall, JPMorgan.

Yes, thanks for taking my question, guys. So I guess I should ask two, one for Gary, one for Jim. Gary, I just wanted to ask if you could give us any more color on what you are hearing back from European operators. It seems a little bit early in the cycle for them to be cutting CapEx. We know that there are concerns over the finance market out there and debt spreads are blowing out and so on, but just wondering if you think they are trying to conserve cash to prepare for some sort of a new credit crunch. Are there other things that are affecting spending? I'm just wondering if you could give us any more comment.

And then Jim, on the OpEx, if you could just give us some idea why the OpEx would be going up in Q4. It seems like with the headwinds on the economy and this little bit lower revenue than we expected -- I mean revenue is not that different from what it was in Q3, yet OpEx is bouncing up. If you could just help us understand why that is happening and whether you have any more flexibility to maybe bring that in a little bit, that would be great.

Okay, why don't I take the first one -- what we are seeing in Europe. I think overall if we were to sort of step back from it, I think we are seeing a little bit of slowness predominantly in Europe. I would caution that that also coincides with us doing some sizable projects in Europe. So it is really difficult to discern the timing on those projects, just were we overoptimistic in terms of assuming revenue recognition with them, which can be the case with these international projects or are they trying to elongate the process.

Our view is it is probably a little bit of both. We don't have a lot of -- a long period of data on it, but as we look back on the last couple of quarters, I think a couple of things. One, with hindsight -- with the benefit of hindsight as we look back at that, I think we can see a little bit of slowness in Europe in terms of just increased scrutiny. I would add to your specific question though, we are not seeing any cancellation of projects or significant delays in the awarding of those projects, but as we look back on it, we are seeing it has taken longer to get to revenue for some of those larger projects in Europe.

Is it (inaudible) Europe mostly or is it -- are you seeing it in core Europe as well? Is it the countries like Greece where we have got debt problems or is it actually making its way into Germany and some of the other core countries?

I would describe it as core countries. We don't have a lot of exposure to Greece, etc., those kinds of countries that have obvious sort of debt issues. We don't have a lot of exposure to them. It is mainly the core countries of France, the UK.

Rod, on the OpEx, we printed $175 million for OpEx in the quarter. I want to make sure everybody understands, we did receive a grant from the province of Ontario. It is a five-year grant. We will get it over the next five years. However -- and it will come in as a credit to R&D expense. We actually just signed that grant during the third quarter and so we recognized a disproportionate amount in Q4, roughly $4 million. Going forward, the amount is going to be $1 million. So that is the biggest reason why we expect OpEx will be up a little bit in Q4.

Okay, great. Thanks, guys.

Mark Sue, RBC Capital Markets.

Thank you. Good morning, gentlemen. Can you classify maybe the situation in North America? Are things stable now following the lengthening sales cycles or is it still somewhat fluid? Maybe if you could comment on the pipeline in North America, what kind of linearity, what we should expect in Q4 and if the increased back-end-loadedness is something that is going to stay.

Specific to North America, I would say Tier 1s, we are not seeing anything different than we have seen. We have seen no different behavior from the major Tier 1s in North America. Perhaps a little bit of elongated cycles into sort of Tier 2 and enterprise, which is why we would conclude that those folks typically can react a little bit quicker to concerns around the economy.

But with all that being said, we had strong order flows relative to Q3. Our pipeline continues to improve in North America and we are not seeing particularly any of the macro issues certainly in the Tier 1s reflecting in any delays in projects or cancellations or any conversations about it.

Got it. So if anything, your pipeline is actually improving?

Our pipeline is actually improving and certainly overall, it is improving and certainly in North America.

Got it.

With respect to the back-end-loaded point, Mark, I think most companies that are in businesses like ours do experience back-end loads to their quarters. It is just a function of the way the business works. And by the way, we have always been somewhat back-end loaded.

What we have seen the last couple of quarters, and we've pointed it out, is that we were just a little more heavily back-end loaded than we have experienced in the past. We are not sure what to make of it. Our order flows have been good and healthy overall, but they have been a bit back-end-loaded.

Okay. And then how should we extrapolate the trajectory of switching and CESD and likewise, wouldn't the gross margins continue to remain at least flattish near term if those products are doing well? And then subsequently after that, what does that mean for kind of operating margins, which are still very mix-dependent following Q4?

In terms of both CESD and switching, I think as Jim commented, we are very pleased with the traction that we are seeing and overall, I would expect their revenues to go up. That might not be on a quarter-to-quarter linear basis, but we expect them to continue to improve. We also expect transport to grow as well. So that is also into our thinking around the blending of the margin, which is probably the most difficult thing for us to predict on a quarterly basis. Clearly, we are pleased with the progress that we are making in CESD and switching and we thought that the second half would be up on the first half and I think that that is proving to be the case.

And then just your thoughts on the operating margins, kind of how steady-state? Should we think of it rather as OpEx in absolute dollars at these levels after Q4?

It's hard to comment on 2012 as we sit here today. We are just now getting into our planning for 2012. I can say that the general comments that we have made about OpEx still are true. We think that we are not going to have to increase R&D significantly from current levels as we move forward. We feel the same way roughly about G&A. And the only element of OpEx that we think we might have to tweak upward as we grow our top line is the sales part, which is a pretty good chunk of the sales and marketing line of our OpEx.

So the point of that is we do expect a lot of operating leverage going forward. We have to look at things like where our roadmap is in R&D, we have to look at things like merit increases and incentive comp and that sort of thing, but we expect a lot of operating leverage as we grow our top line.

And just one thing I would say is I want to say that, at least right now, we are expecting operating margin in Q4 to be about where it was in Q3.

Helpful. Thank you, gentlemen.

Kevin Dennean, Citi.

Great, thanks and good morning. Gary, I guess this one is for you. You laid out a lot of reasons to be optimistic about the optical cycle and you said you have seen no change in customer behavior in North America, some slowness in Europe. But I am just wondering if you could try to help frame for us -- it seems like we have a lot of drivers ahead of us in 40G and 100G to move to OTN and packet optical, but yet there seems to be some clear hesitation in the cycle. And I think there is a lot of concerns out there that the optical cycle is almost over before it has basically begun.

So can you talk about -- we have heard some cautious commentary out of some of your telco equipment peers. Can you talk about what you are hearing from customers or are dollars flowing incrementally into building out optical and away from some other parts of the network? And how should we think about your growth trajectory? We saw a slowdown in growth this quarter. You grew 11%, I think it was, annually, but that is a bit of a slowdown from the prior quarter when you adjust for MEN, which I think was about 25%, 26%. So if you could just address that.

Yes, I mean I think sort of stepping back from the quarter, if you will, and looking at the overall sort of trends, I still feel that the drivers are incredibly compelling and I think you touched on it. It is not that the CapEx needs to go up; it is what they spend it on. And I think given the drive for cloud, for storage, for the growth we are seeing in video, etc., carriers have a very compelling event to move to again modernize their networks. And I think we are not seeing in our dialogue with them any pull-back from that at all. And I feel very confident that, all things being equal, that will happen.

Clearly, the industry is not immune to the macro environment and I think people are undergoing just a little more scrutiny on their CapEx. I would say we are not seeing it in a pronounced way. It is subtle. I think what we are seeing very clearly is some of that in Europe. We are not particularly seeing that elsewhere and I wouldn't say that we are seeing that in Tier 1s outside of Europe.

So I think the theory around OTN, 40 gig and 100 gig I think remains very compelling and we are seeing that in terms of our order flows and continued design wins. I think the overall CapEx spend clearly is -- we are mindful of that, but I think it is really what they spend it on. So CapEx does not have to go up for us to grow disproportionately. I mean our bets and our exposure, if you will, is to these higher growth markets of coherent high-capacity transport OTN and switching and really that is what we are exposed to. So unless really the macro environment deteriorates dramatically, I mean we still see that shift going on.

Great, thanks very much.

Ehud Gelblum, Morgan Stanley.

Hey, guys, thank you. A couple quick things. First of all, a clarification. I saw in your inventory you are breaking it out slightly differently now, taking finished goods and breaking them into both finished goods and deferred cost of sales. Just as a clarification, if you could explain how you looked at those before and just remind me what the difference is between the two. And then when you do add them together, you get a number that is down around $40 million, $45 million from the previous finished goods number. Just trying to understand what we should be reading into that with respect to future revenue growth and kind of what that is trying to tell us.

And then if you could talk a little bit about the pricing trends that you are seeing in transport right now. Is it the same as they were as you get to 100 gig versus 40 gig and you get larger there? Are you seeing different pricing trends? Just trying to understand kind of what that market looks like as well.

I believe that both of those items that you talked about were in finished goods before. We are breaking it out really just to give you a little more detail about our business. We do have some deferred revenue and the inventory associated with that is in finished goods at this time and is in this other element and it had been in finished goods before.

But I would just take this opportunity to say that we have very aggressively worked on our supply chain and our intent all along has been to drive down inventory from the levels that we saw coming out of the integration and we are starting to see those results. So we fully expect that our turns are going to go up over time.

In the past, having a high finished goods number was always a good thing for you guys because it meant that you had a lot of revenue sitting there at customer locations waiting to get recognized. Especially with the comments that, Gary, you made this morning, I would've thought almost that that finished good numbers would have been flat to up as product would be sitting there waiting to get recognized, but it seems like it is down. I am just trying to understand (multiple speakers).

I guess what I would say is I would look beyond that as an indicator of what revenue is going to be. Our guidance takes fully into account everything we expect about what is sitting at customer sites waiting to be accepted and all of the other things that go into revrec.

I would say that, from our point of view, we don't like to have inventory sitting out there a long time before we get to revenue. We'd like it to be a smaller number and we have to do what customers want and we do that, but our drive on inventory is across the board to try to get our inventory levels down.

So on the pricing, I would say just overall it continues to be a tough competitive environment. I think if you look at 40 and 100 gig, I mean clearly we are ahead on technology. Therefore, competitors compete on other bases with their 10 gig technology, etc. So we are not seeing any appreciable change and that has been tough for a while and continues. But I think the important thing for us is getting footprint onto this next-generation 40 and 100 gig and we are continuing to do that. But it is a tough environment.

No change though from last quarter?

Not particularly. It was tough last quarter too.

Okay. And then just last if I could, your OpEx level now in the 170s. It had been in the 180s. Is that a change from -- it seems like a change from your Analyst Day in June?

Well, what I would say is that the 175 did have a benefit.

Right. But it still gets you to the high 170s, right?

Yes. We think that is where we are going to be, but we are actually running OpEx a little lower than what we had sort of guided to in Q4. And that is because we know that there are some things that we have to do, but within that constraint, we are trying to hold down any unnecessary expense and I think we did a good job of that in Q3.

All I am getting at is the comments that we took away from you at your June Analyst Day, we should kind of add $5 million to the bottom line from all of them because we are now operating in a world with a roughly $5 million lower OpEx number?

Well, for Q4, you should add something to it because I think most people were running their OpEx around 181 or 182. Going into '12, I am not going to make a comment about '12; we are just now doing our planning.

Okay. I appreciate it, guys. Thank you.

John Marchetti, Cowen & Co.

Thanks very much. I was just wondering if you could spend a minute, guys, and talk a little bit about the guidance range that you are giving. You obviously talked about another good order quarter. You continue to see that book build for you. When you talk about having transport or expecting transport up in 4Q, how should we think about maybe CESD and your switching business given the big sequential increases we saw in Q3? And what kind of gets you from the $440 million to the $460 million range given that you are obviously expecting transport to be up? Is the variable the switching and the CESD business?

Yes, I think we are taking clearly a number of things into account on the guidance and I think looking to product mix. We do see strong transport in Q4 and I expect that to be up. CESD and switching, whilst overall the trend is up, might not be linear sort of quarter-to-quarter. Difficult to predict with exact precision given the amount of sort of moving parts. And also we are mindful of the overall environment and the fact that, for two quarters, we have been at the low end of our range given the macro environment and some of the international rollouts.

So I think in terms of the overall mix, I would continue to see growth in CESD and switching overall as we go through 2012, particularly as you have got a lot of new platforms coming into market, but I also expect transport to go up as well.

And then if you go back a quarter ago and you guys sort of were talking about approaching the lower end of your 7% to 10% operating margin target for 4Q, and you talk about obviously that needing to be done on revenue and whatnot, over the course of this last quarter and as you are looking out, has more of it changed in terms of it's taking longer for some of these larger products to actually come into revenue or is it maybe some of the other business that you had expected to materialize along the way has just taken longer to show up than you had thought?

I would say overall on the top line probably impacted transport more than switching and CESD just as a general rule. If I look at what we had expected in sort of Q2 and Q3, it is largely transport and largely international.

I would say that the other thing that we are focused on that we were able to overachieve on, if you will, was sort of the optimization efforts that we have been talking about as we go to this next phase to better utilize our expenses in G&A, etc. as we came off the TSA services. So I think there is a lot of other levers that we can pull in the business and we are pulling those. So we are not purely dependent upon revenue growth.

Thank you.

Jeff Kvaal, Barclays Capital.

Yes, thanks very much. I have got one for you, Jim and one for you, Gary. I think, Jim, could you talk a little bit about that longer-term operating model and what kind of revenues we might need to see in order for you to be in the range or 7% or even 10% operating margin? And then, Gary, I was wondering -- it sounded like you were a bit chagrined by being at the low end of the revenue range the last couple of quarters. Does that suggest that you have put in an extra dose of conservatism into your October numbers? Thanks.

As we have said before, there is a lot of different ways to get to 7% to 10% and beyond. I think fundamental to it though is that we have got to have a margin in sort of the mid-40s. I think that is the fundamental piece of it and we have got to hold our OpEx not exactly flat, but relatively flat. And so we have got to enjoy operating leverage as we move through time and we have got to grow at a market rate or maybe even slightly better, all of which we have been able to do so far. But I do say that I emphasize that we have got to see margin -- continued progress on margins as we go through time.

In terms of the chagrined element to it, I mean I think with the benefit of hindsight, we have to look back on the quarters and what went well and what didn't as was expected. I think the two things that we are mindful of is just the impact on the overall macro environment, particularly internationally in some of these international projects where I think we were overly optimistic in terms of thinking that we were going to be able to take them to revenue.

So I would say we have certainly considered those as we put the guidance out, but I would say, when we give guidance, we try and give the best balanced view that we can. Be conservative or overly optimistic, we really try and give a balanced view to it and I think over the years on a quarterly basis, we have been pretty accurate around that. So we try and give the best possible view that we can. And I think particularly right now with just the uncertainties on the macro side, I think it was appropriate.

Okay, makes sense. And then, Jim, just to follow up on gross margins. The transport margins have been under pressure. I know there was a lot of footprint activity out there. You have got to get your products in. To what extent do you think over the course of the next say two to four quarters we will see a mix shift from say chassis to line cards that should help the transport gross margins? Is that a factor?

It clearly will be a factor. We are continuing to win deals and some of those deals are going to be priced aggressively and will result in putting out chassis. So I guess I would say that our guidance is going to try to fully reflect all of those things and they go in sometimes different directions. So I am just pleased with the progress we made this quarter with respect to our margins and I think we will continue to do well and our mix will look good as we move through time.

Okay, thank you both very much.

By the way, just as a comment here, we are going to have to enforce the one question rule a little more tightly because we have got a lot of people that want to ask questions. So if you could hold it to one, please do.

Tal Liani, Bank of America-Merrill Lynch.

Hi, guys. One question, three segments. But I will stick to one question; it is all about the same issue. Federal, what is your exposure to federal spending and federal budgets and if federal budgets go down, do you think you're going to be impacted? Second point is I want just to understand the growth in CESD and switching this quarter. Is it all booked and recognized this quarter or is there an element there of things that were shipped and deployed last quarter and there is only revenue recognition hitting this quarter? Thanks.

Okay. On the federal spending point, that is an area of focus for us. We think we have some very interesting opportunities in federal spending. I would say that right now it is a pretty small piece of our revenue and we have a pretty small marketshare of that spend. So regardless of what happens at the top line, I think we can do well on the federal side. And I am not going to speculate on what the government is going to do with respect to their spend.

On the CESD and switching side, I don't believe there was a lot of delayed stuff in the quarter. There probably was some, but I think pretty much the stuff that we have out there we are booking now. I would make one exception to that, which is, on some of our big submarine projects on which we have won switching, that has a very long revenue recognition cycle. So that is one area that we didn't book any revenue this quarter, but it is out there.

Excellent. I will stop here.

Paul Silverstein, Credit Suisse.

I have the same multipart question as Tal. So literally just a couple of clarifications and I apologize if you went over this. The 5430, can you tell us how many of the nine were actually in revenue? Can you also tell us how many trials you have ongoing?

Here is what I would say, Paul. We are starting to build a very nice pipeline on the 5430. To me, the issue of what is number of trials is going to become less and less important as we move through time. And I think the revenue progression is something that we ought to watch more carefully than the number of trials. I would say that -- one way I can describe it though is that we have 25 plus engagements on the 5430 or 5400 family, I should say, of which nine we have taken POs and I frankly don't know how many of those nine we had revenue in the quarter, but it would be a few of them.

So Jim, last quarter, you all said only one of the, I think, then six were in revenue and that one was de minimis. In this quarter, some of the nine are in revenue, but not all nine. Are any of them at full flow yet?

No, no, I don't believe so.

We did get another three -- three are new in the quarter, if that helps.

So unlikely that we have any revenue from those three.

All right. And on 4100, can you tell us what the revenue in either dollars or percentage in the customer count? If you gave it, again, I apologize.

This is Tom, Paul. It is pretty similar to what we talked about last quarter. It is approaching 50% of the transport. WDM revenues are in 40 and 100 gig.

So it is approaching 50% of the transport?

Pretty much the same as last quarter.

Okay. Finally --

Thank you, Paul. We do have to move on.

Hey, Gregg. Just one quick. On the European projects, can you tell us how many projects we are talking about and what the revenue opportunity is?

I think it is a few. It is three to four of them that were larger type projects and probably the total revenue to it that we would expected and didn't take was sort of between $10 million, $20 million.

Thank you.

Brian Modoff, Deutsche Bank.

Hi, guys. Can you talk a little bit -- give us a little more color around demand trends on the -- you mentioned that the 40 and the 100 is 50% of revenues. What percent of that is 100 gig? And then kind of on a customer basis, give us a little more color around 5430, what are you seeing particularly with US operators in terms of demand? And do you expect to have two significant operators up and running this year in North America? And then any color you might have on other regions of the world for the 5430. Thank you.

Let me try the first one, Brian. We haven't really talked about specifically the amount of the 40 and 100 gig, which is 100 gig, but by far, 40 gig is the largest percentage today. We have more than a dozen 100 gig customers and so that product is growing nicely, but it is still -- we are still early stages. Gary, do you want to --?

Yes, the 5430, Brian, we have got I think three Tier 1 carriers in North America have ordered 5430 at various stages of maturity rollout, but I think it is fair to say it is nascent at all three. So I think it will be sort of 2012 as we roll that out and then we have secured other Tier 1s outside of North America as well. But I think all of the major, the three major carriers in North America we have been successful with so far.

One point I would add to that, Gary, is that a number of the 5430 customers aren't traditional CoreDirector customers, so we're actually beginning to expand that into other applications. As we look at where 5430 fits, it does fit clearly in the traditional optical switching space. It also fits in the infrastructure space where we are actually able to help service providers do router offload and then finally OTN switching broadly, some cases 5410, some cases embedded in the transport products, is also getting traction as a traffic management tool in the metro market.

Blair King, Avondale Partners.

Yes, hi. Thanks for including me. Just I will ask one quick question. As we kind of look through next year on the trends that unfold in Europe and perhaps spill into other geographies as well, can you just give us a sense, Jim, as to what the exposure to Europe is on a holistic basis at Ciena?

It moves around from quarter-to-quarter, but Europe has generally been 25% of our revenue plus or minus. Sometimes more and sometimes less. We have limited exposure, in fact very little, to the countries that have had -- that have been talked about most widely as having a debt issue. Our exposure to Europe is -- well, EMEA, I should say, is in Britain, it is in France and it is in the Middle East.

Okay, all right. Thank you.

Nathan Johnsen, Pacific Crest Securities.

Yes, hi. Thanks for taking my question. I just wanted to come back on the gross margin guidance. If you could identify mix as the primary culprit for the sequential downward trend on gross margin. But I want to see if basically all of that was mix or if there are other things like the impacts from pricing pressure or the mix between line card and chassis? Thanks.

Nate, I am going to take that? I mean there is lots of moving parts to the margin piece, but I think it is largely attributable to just pure mix at the macro productline level. Now even within the productline level, to your point, the mix of cards and chassis is the simplest manifestation to that. But you have got that going on as well, so there is a lot of considerations into the overall gross margin. But I think it is really -- our view is it is really at the macro level on the productline mix.

So if I was to look at the individual business units, you would expect relatively flat gross margin in Q4?

Well, you have got increase in transport, which is typically, not always, but typically lower. Though over time, if you have got OTN and other things coming in there, the lines are going to blur there. But for the purposes of simplicity, transport tends to have lower margins than switching and CESD. So therefore, if we are expecting higher transport revenues, that would lower the margin somewhat.

Sorry. But I guess I mean if I was to look at transport specifically, you would anticipate those gross margins to stay relatively even?

Yes, yes, I would. Sorry, I misunderstood your question.

Greg Mesniaeff, Kaufman Brothers.

Yes, thank you, good morning. I was wondering if you can add some color on your cost of goods sold item in terms of how that will impact gross margin improvement. You mentioned the integration, some cross-platform software integration for optical transport for managing the products. I am wondering if that can contribute to any improvements on the cost of goods sold side. And also if you can maybe comment on your supply chain management and what efficiencies you are getting there. Thanks.

I think our overall longer-term gross margin is to get it -- view is to get it solidly into the mid-40s consistently. Now there is a number of threads to that, and I think you have touched on most of them. One is we are doing a lot of work in terms of cost reductions on the actual products and next generation of products that are coming out, much more software inclusion across the product range as we put OTN on it, one control, etc. Those tend to be higher gross margins, so we are very focused on making strong progress along that.

Also, I think the supply chain progress we have made, you saw that this quarter. We have got a plan that we are rolling out over the next 18 months, which is basically to look at improved efficiencies across our complete supply chain, more strategic partnerships and fewer vendors, basically, as we do that, a certain amount of vertical integration as well. And things like direct order fulfillment, again there is a lot of things we can do to make progress on our optimization plan going forward.

We started with three distribution centers. At the beginning of '12, we will be down to one. Contract manufacturers, we are looking at that question. We still have a fairly large number of spares depots around the world that I think we can consolidate as well. So we are working down the chain of things that we can do here, and so far we have made great progress and I think we will continue to make progress.

Thank you. That's very helpful.

Tim Long, Bank of Montreal.

Thank you. Gary, could you just give us a little update on what you're seeing across some of your Asian markets, any kind of spillover or commonality with Europe? And related to that, I think you mentioned two new CESD customers in Asia. Could you just give us a little color on those, how meaningful they could be, what type of operators are they? Could they possibly grow to be the size of some of your existing bigger CESD customers? Thanks.

Asia overall I would say, you know, we're not seeing the same kind of issues that we're seeing in Europe. Now clearly it's larger and fragmented and we're a little more nascent there in terms of getting into some of these newer markets. And also, specific to us is we're not in China and have no plans to be in China because of the various dynamics of that market.

We're strong in India. Korea which I think one of the CESD wins, we're making good progress in Korea overall and I think with a couple of carriers into CESD. I don't think they can take on -- though they're larger carriers, I don't think at this stage we expect them to be of the scale of a couple of the North American ones, but it is very encouraging.

Similarly, we have won a couple of the smaller carriers in India and continue to make progress with CESD into India. But we are not seeing the increased scrutiny and slowdown in Asia that we are seeing somewhat in Europe.

Okay, thank you.

Alex Henderson, Miller Tabak.

Hey, guys, so just a couple of quick clarifications. The book-to-bill number, did you give it for the quarter? And then second, do you have the operating segment operating margins by packet optical, CESD and the like?

And then going back to -- and the primary question is on the 4100. So sequentially flat as a percentage of sales implies a decline -- your 4100 declined quarter-to-quarter, which is certainly counterintuitive going from a seasonally weak quarter to a seasonally stronger quarter and that is hardly what people were expecting. Most people were looking for double-digit growth.

So first off, is flat at 48% the right way to think about that segmentation percentage and is it in fact declining quarter-to-quarter the way you are implying by saying the percentages are flat or was it more in a steeper decline in 10 gig and a little bit better numbers in 4100? Can you please clarify that with a little bit more granularity, please?

Let me start with -- on the book-to-bill, we don't disclose that number precisely. I will say that our backlog has come up a bit as we have moved through this year and you will see -- in the fourth quarter, we will disclose our backlog in our 10-K and so you will see -- I think you will likely see that that will be up.

On productline operating margin, it is always -- let me back up. It is generally the case that we see transport margins in high 30s, sometimes higher and CESD has been sort of 40s. And then switching has been higher than that. And that is the way this quarter as well. Even within those products though, because of things like -- in the case of transport, we have a number of transport products. In the case of the others, we do have this razor and razor blade phenomenon, which occurs. And so there is going to be movements with respect to the operating margin in any given quarter. But generally speaking, the mix of CESD and switching will be the strongest driver of our margins as we move through time. And Gary, do you want to address the 40 and 100 gig growth question?

Before you move on, you put the segment operating margins in the Q. We forecast generally right after the quarter. It would be very helpful if we could have the operating margins to go with the forecasting timing rather than having to wait for the Q to come out. Do you have any guidance on the trajectory whether the margins improved or declined in any of the four segments?

Let's see. Hold on a moment. I can tell you -- unfortunately, I cannot give you that information. I am looking at quarter-to-quarter over last year, so I can't really tell you that. We can address that offline if you would like to.

That would be great. It would be really helpful if you put it in the press release so that people could have the basis to forecast on. Anyway, thanks.

Okay, it's a fair point.

Alex, on the 4100 question you asked, we have talked in both quarters about the percentage of 40 and 100 business approaching 50%. It actually is up this quarter as a percentage. And as we have also talked about, we expect transport broadly to be up next quarter. And since 40 and 100G is a healthy contributor to that, we expect that to be up looking forward. The other thing I would point out is we continue to have the leading share in coherent, which is 40 and 100 G primarily globally and especially in North America.

Thank you. We will take one more question.

Simon Leopold, Morgan, Keegan.

Thank you. I appreciate getting in last and possibly least in terms of this question. But I was hoping you could give us a little bit more color on the gross margin improvement you incurred in the quarter. I clearly -- I can understand the CESD and switching business being bigger contributors helping, but my simple math suggests there is more to it than simply mix. And I would like to get an understanding of the contributions by reporting segment in terms of just degree of what gave you the three points of upside, how much was mix, how much was volume and how much was cost-reduction by product group? Thanks.

By the way, I am glad you got in this time. That is good. This new format is contributing to getting a lot of good guys into the call. So anyway, on the question of gross margin improvement, there are lots of things that happen in gross margin. As Gary said, there is lots of moving parts. And in transport, in particular, we have four right now -- we are still recognizing revenue in four productlines, CoreStream, 4200, 6500 and 5200.

The mix within that segment can change from quarter-to-quarter, as well as the razor/razor blade thing can change from quarter-to-quarter. So we are not going to get into a specific discussion about individual transport product margins. I can just say that it is a complicated calculation. It is going to continue to affect the margin, but the biggest single margin influencer and the way we are continuing to make progress on margins is to improve the mix of CESD and switching going forward.

Do you have the ability to tell us something like mix was 200 of the 270 basis points, something on that order, to help us understand the factors weighting?

I don't think we have that degree of granularity to be honest. I would say that we made good progress on supply chain and cost reduction across all of the productlines. And I think even transport gross margins were actually up in the quarter as well. So even though, as Jim says, it is switching and CESD and the software that has the major impact to the macro level on the mix, even within the productlines, because of cost reductions and supply chain and we reduced the overhead rate because of those efficiencies as well, that impacted transport positively as well.

Right. And that is what I am sort of getting at. It seems to me that maybe that can go underappreciated and also suggests that you are being conservative in the October guidance for gross margin.

I understand the point fully and I think it is a good one. I would caution you around that. I think we are trying to be, as I said, balanced on it. We do see increases in transport and we are looking at the kind of projects that they are and that was built into our guidance. But I think longer term, we are clearly very focused on optimizing the business around cost reductions across the portfolio, getting the supply chain to be more efficient. All of that will help play into an improved COGS and gross margin.

Thank you, Simon. We have to end the call at this point.

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