Ciena Corporation (CIEN) Q3 2007 Earnings Report, Transcript and Summary

Good day, everyone and welcome to the Ciena Corporation third quarter 2007 results conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to the Chief Communications Officer, Ms. Suzanne DuLong. Please go ahead. Suzanne DuLong: Good morning and welcome, everyone. I'm pleased to have with me Gary Smith, Ciena's CEO and President and Joe Chinnici, our CFO. In addition, Steve Alexander, our Chief Technology Officer, will be with us for the Q&A portion of today's call. Our call this morning will be presented in four segments. Gary will provide some brief introductory comments, Joe will review the financial results for the third quarter, Gary will then discuss the business in the quarter and our outlook for Q4. Joe will wrap up our prepared remarks with our guidance. We'll then open the call to questions from the sell side analysts. To ensure we answer questions from as many participants as possible, we ask that sell siders limit themselves to one question. This morning's press release is available on National Business Wire and First Call and also on Ciena's website at Ciena.com. Before I turn the call over to Gary, I'll remind you that during this call we will be making some forward-looking statements. Such statements are based on current expectations, forecasts, and assumptions of the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in the context of the risk factors detailed in our 10-Q, filed with the SEC on June 1, 2007. We have until September 6th to file our 10-Q for our fiscal third quarter and we expect to do so by then or before. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events or otherwise. Gary Smith: Thanks, Suzanne and good morning, everyone. Consistent execution of our network specialist strategy has enabled us to benefit from two significant industry trends: the demand for increasing network capacity and the transition to Ethernet IP-based network infrastructures. We believe it's Ciena's relatively unique positioning that has enabled us to benefit simultaneously from both of these trends, driving our faster than market revenue growth. At the same time, we continue to drive actions resulting in improved financial performance across the company. Last quarter I spoke to you about our confidence in our ability to generate operating leverage. This quarter we were able to demonstrate proof of that ability. I'll talk to our business in the quarter and our outlook for the remainder of year after Joe reviews our Q3 results. Joe Chinnici: Thanks, Gary. Good morning, everybody. This morning we reported third quarter revenue totaling $205 million. This represents an increase of 5.9% sequentially and 34.4% year over year. Similar to the last several quarters, three 10% plus customers combined to represent 48.5% of total sales in the third quarter. All three are North American customers and two of the three were also 10% customers in Q2. Sales from international customers remain steady with international sales representing 29% of the total. Moving now to talk about quarterly revenue contribution across our portfolio. First on our converged Ethernet infrastructure group which incorporates all products previously in our optical networking and data networking groups, these revenues increased to $167 million, representing 81.5% of the total revenue. Ethernet access, which incorporates all of our access products, increased to $15.2 million, representing 7.4% of total revenue. Global network services, which encompasses all of our services-related offerings increased to $22.8 million, representing 11.1% of total revenue. On the gross margin front, Q3's overall gross margin was 47.7%, up sequentially from the second quarter, which was 42.3%. This is better than our target mid-40s range, primarily as a result of a favorable product mix and our ongoing product cost reduction efforts. Our product gross margin was strong at 53.7%. As was the case last quarter, we had a slight loss on our services revenue. In the remainder of my comments today, I'll speak to both the GAAP results and to what the results would have been if we excluded those items detailed in the press release. On the operating profit front, on a GAAP basis our operating expenses in the third quarter totaled $81.6 million. Adjusted for non-operating and non-recurring detailed in the press release, our R&D, sales and marketing, G&A expenses for the quarter would have been $69.7 million, up slightly from $68.5 million in Q2. Our income from operations on an as-adjusted basis totaled $28.3 million, representing an operating profit of 13.8%. This is a significant improvement from last quarter's level of 7.2%. Our Q3 GAAP net income of $28.3 million or $0.29 per diluted share compares to a GAAP net income of $13 million or $0.14 per diluted share in Q2. Adjusted for the unusual or non-operating items detailed in our press release, including 123-R related compensation expense, our third quarter net income would have been $40 million or as-adjusted net income of $0.41 per diluted share. Since first quarter of this year, we are using GAAP taxes in our as-adjusted net income presentation because we believe they more accurately represent our near-term cash tax obligation. Turning to the balance sheet, we were cash flow positive for the second straight quarter, generating $64.1 million in cash from operations. For the first nine months of 2007, we have generated $97.4 million in cash from operating activities. Cash, short-term and long-term investments at the end of the third quarter totaled $1.7 billion, reflecting the proceeds of our $500 million public offering of 0.875% convertible senior notes. In addition, you'll notice an increase in our short-term investments as we prepare to repay $542.3 million of the 3.75% convertible notes due in February 2008. Our accounts receivable balance at the end of the quarter decreased from $145.5 million at the end of the second quarter to$117.8 million in Q3. Day sales outstanding also improved from 68 in Q2 to 52 in the third quarter. Going forward we expect our DSO range to be between 65 and 75 days. Inventory levels ended the third quarter down slightly at $105.1 million from $118.8 million level in the second quarter. The inventory breakdown for the quarter was as follows: raw materials, $31.2 million; work in process, $6.6 million; finished goods, $91.5 million; and a reserve for excess obsolescence of $24.1 million. Product inventory turns improved from 3.1 in Q2 to 3.2 in the third quarter. Finally, on headcount, we added 87 employees in the third quarter bringing our worldwide headcount to 1,770. Now I'll turn the call back over to Gary. Gary Smith: Thanks, Joe. I'll orient the remainder of my comments today around three key performance levers: revenue, gross margin, and operating profit. I'll focus first on the current business before talking about our outlook. Turning first to revenue. As noted in the press release, our revenue growth is coming from two important demand trends: increasing capacity requirements and the transition from multiple disparate networks to a converged multipurpose network infrastructure based on IP Ethernet. Several years ago we placed some strategic bets that our customers' networks would head in this direction. The result was our FlexSelect Architecture and Vision and thus far it looks like our bets are beginning to pay off. In addition, we're capturing share, selling more to customers in more market segments. The combination is fueling growth across our portfolio, but is particularly evident in our converged Ethernet infrastructure group, which as Joe noted, represented 81% of total revenue in the quarter. Within this group, at $61 million, core switching-related revenue was the largest revenue contributor in the quarter, growing more than 30%, sequentially. The adoption of Ethernet in network infrastructure is driving revenue, particularly in this family. At $59 million, core transport-related revenue declined sequentially, but given the lumpiness that's inherent in customers long haul deployments, that change is neither unusual nor unexpected given core transports more than 50% sequential increase from Q1 to Q2. The last platform within our converged Ethernet infrastructure group that I'll call out at this point is our CN 4200 Advanced Services Platform. Revenue from this product increased 15% sequentially to $23 million in the quarter. Turning now to gross margins. As Joe noted in his comments, our quarter-to-quarter gross margin improvement was largely driven by a favorable product mix and the effects of our ongoing product cost reduction efforts. For the reasons we described in detail last quarter, we posted another slight loss in our services business. At this point though, I'm confident we have taken the necessary steps to improve our services gross margin going forward. We expect a slight improvement in services gross margin in Q4 with a gradual improvement to the high teens as we move throughout fiscal '08. Finally on operating profit, we were very pleased to not only achieve but surpass the 10% operating profit milestone we set for ourselves by delivering 13.8% income from operations on an as-adjusted basis. As I said last quarter, even though we've posted sequential revenue growth for 14 straight quarters and are guiding for another, because of the nature of our customers, the way they roll out projects and revenue recognition criteria, we continue to see potential for revenue fluctuation quarter to quarter. As noted in this morning' press release, we continue to believe we can deliver up to 37% annual growth in 2007, which would mean our third sequential year of substantially better than market revenue growth. Looking forward, we're taking a hard look at our customers' demand drivers as we try to understand the sustainability of the growth in our markets and how it particularly applies to our business. Based on extensive interactions with our customers over the last few months, as well as a multitude of other industry inputs, we see three significant industry growth drivers. Firstly, we see the demand for additional capacity continuing, particularly in the metro aggregation segment of the network. Enterprises are demanding additional capacity to satisfy compliance needs, to deploy new applications in support of globalization and to support the increasing use of video. Wireless carriers are demanding additional capacity for their backhaul networks to support traffic growth, new services like 3G, and increased, often global, coverage. Finally, consumers are demanding more capacity as a result of the broad adoption of peer-to-peer Internet applications. Secondly, virtually all service providers are offering a broader portfolio of services and they need to be able to converge these services into a single network. Consequently, legacy networks primarily architected to support voice and private lines are being converted to packet networks focused on delivering data; or put differently, networks are shifting from multilayered architectures built on SONET SDH to converged networks where services are delivered using IP over Ethernet. Thirdly, the financial performance amongst the global carriers has also improved with debt decreasing, profitability increasing and new services fueling revenue growth. The combination of our customer's improving financial performance and the potential for new application drivers such as mobile video, IPTV, HDTV, and video peering provides a very robust macro outlook for the industry over the next two to three years. However, we believe that not all industry players are likely to benefit equally from this outlook. We believe Ciena's been able to grow faster than the market because of our exposure to both the capacity-related demand and the transition to Ethernet IP-based network infrastructure. But what does that mean for Ciena going forward? As a result of our positioning, we're confident we can continue to grow faster than our markets. Current First Call consensus revenue expectations show roughly 20% growth in FY08. At this point, those expectations seem reasonable. Acknowledging, of course, that FY08 is a long way off yet and consequently there are likely both risks and the potential for upside that we just can't see yet. FY08 will be a year of focus and leverage for us. We're going to focus on smart growth. By that I mean strategic growth that enables us to further our FlexSelect architecture and Vision and our converged Ethernet leadership by touching new customers and markets and expanding our footprint within new customers and existing customers and markets. We're going to do this while working to maximize the operating leverage in our business model. At this point we're targeting a sustained 15% as-adjusted operating profit. As a result of both gross margin fluctuation quarter to quarter and the realities of operating expense patterns that also moved quarter to quarter, the path to 15% is not likely to be a linear one, but I believe we will get there over time, not only via revenue growth but also as a result of actions we've had underway for some time, including productivity benefits from our India R&D facility and process and systems improvements, including reimplementation of Oracle at the end of our fiscal year. Our overall goal remains finding the right balance between investing strategically in our business to fuel longer-term revenue growth and maximizing short-term operating profit and net income. In summary, we believe we've been benefiting from a product portfolio that's enabled us to benefit simultaneously from two very significant industry trends: the need for additional network capacity and the transition towards IP Ethernet. Given our heritage and experience in optical transport and intelligent core switching and our leading edge converged Ethernet capabilities, we believe Ciena has a big role to play in what seems to be a significant network infrastructure upgrade cycle. In addition to being in a position to benefit from these market demand trends, the steps we've taken to improve our operating performance are becoming evident. With that, Joe, will you walk us through our guidance for Q4, please? Joe Chinnici: Certainly and thanks. Before I begin to offer our guidance, I will remind everyone that the statements Gary just made and those that I'm about to make are forward-looking. It is important to review the risk factors detailed in our most recent 10-Q in order to understand the factors that might cause actual results to differ materially from this guidance. As stated in the press release, we expect to deliver revenue growth of up to 37% for fiscal year FY07. On gross margin, as we've said in the past, gross margin is difficult for to us predict with accuracy and we expect it will continue to fluctuate from quarter to quarter. Our gross margin ultimately depends on a combination of factors, the primary ones being product and customer mix. But it also can be influenced by services revenue mix as well as volume, pricing, and the effects of our ongoing product cost reductions. We expect the fourth quarter's gross margin will be the high end of our target mid-40s range. We expect our fourth quarter as-adjusted operating expenses in absolute dollars will be roughly flat with the third quarter's level. As a result of our strong cash position, we expect other income/expense net in the fourth quarter will be income of approximately $16 million. With regard to our taxes, we expect our fourth quarter income tax expense will represent primarily foreign taxes, which we expect to be approximately $1.2 million. As we mentioned last quarter, as we move forward, we will continue to evaluate the need for a valuation allowance against our deferred taxed assets. Regardless of what happens with our deferred tax assets on a GAAP basis going forward, we will continue to present our tax expense on an as-adjusted basis. In other words, because we expect our cash tax obligation will be primarily from foreign taxes for some time to come, in our non-GAAP presentation we will continue to treat our tax expense as we have since the first quarter of this year. Including the shares underlying our 0.875% convert for the entire quarter, we estimate Q4's diluted share count at approximately 108 million total shares. Consequently, we expect to deliver a fourth quarter as-adjusted diluted EPS that's roughly flat with the third quarter's $0.41. Finally on cash, as you'll see noted in our 10-Q, early in our fiscal fourth quarter we paid $53 million in connection with the transfer and settlement of our lease obligations for some property in south San Jose, California. As a result of this transaction you'll see a gain on the lease settlement of approximately $5 million in our fiscal fourth quarter. Because of this one-time payment and other changes in our working capital, we expect to use cash from operating activities in the fourth quarter. Operator, we'll now take questions from the sell side analysts and thanks.

Your first question comes from Cobb Sadler - Deutsche Bank. Cobb Sadler - Deutsche Bank: A question on the product mix. It looks like you shipped a lot of 4200 as well as CoreDirector maybe into a North American account. Is that sustainable going forward? Thanks a lot. Gary Smith: Yes, we believe it is. It's part of the overall architecture that we've developed and I think that's very applicable to the demand we're seeing for converged networks. The 4200 and the core switching are really the underpinnings of our architecture that we're evolving. Cobb Sadler - Deutsche Bank: On the old CNX-5 product, what's the outlook there? It's tough for me to see exactly what it is in the breakout now, and I've kind of lost touch with it. How are things going in that business? Thanks. Gary Smith: Cobb, it's included in our access grouping. It was an uptick from last quarter. We've seen a fair amount of fluctuation there. The Ethernet access group in total was about $15 million, which is a mix of the CNX-5 product.

Your next question comes from Simon Leopold - Morgan Keegan. Simon Leopold - Morgan Keegan: I wanted to see if we could talk a little bit about the trends that you're seeing. I understand the guidance for the fiscal year of 20% growth, but if you could talk a little bit about the full year, understanding quarters will be lumpy, how you see your product mix trending and your focus? It sounds like you've been particularly strong in the long haul products this year, but you're highlighting metro. Maybe talk about how you see your product mix next year. Thanks. Steve Alexander: When you say we've been strong in the long haul, the thing you have to look at is what the strength that's been driven by capacity across the board, but maybe more importantly in some cases the transition over to Ethernet. You have to factor that most of the networks deployed today have some variation on SONET SDH in them. Many of those are making that transition. Simon Leopold - Morgan Keegan: So when we look at the trending that you've had this year, clearly there's some new projects, upgrade to networks that have helped the historical CoreDirector and long haul WDM. I think what I'm really trying to get at is, as those projects wind down and move into more of a maintenance mode and the new growth is coming out of the metro, that's how I'm envisioning it; I just want to see if that's accurate. Steve Alexander: I would offer a slightly different color on it. I would say that capacity additions, especially in large networks tends to be lumpy. The transition of services away from, let's call them more TDM oriented to become more Ethernet packet IP oriented, I think that's a ongoing worldwide trend that we can benefit from.

Your next question comes from Mark Sue - RBC. Analyst for Mark Sue – RBC: Can you just talk a little bit about the sustainability of the product gross margins? It seems like it is sustainable at these levels going forward given your operating margin guidance of 15%. Secondly, if you could just talk a little bit about your sequential revenue growth? Given your full year guidance of 37%, it seems that it would translate into about 2% sequential growth, which would seem to be a slowing of growth considering looking at past quarters. Joe Chinnici: Your first question which had to do with the sustainability of the gross margins, are they sustainable? It's going to be all pretty much a function of who we ship to, when we ship to them, and which products they take. The biggest key drivers are the products and the customer set that they go to. Depending on what that mix looks like, the numbers could be at the high end of our target range versus the low end or the middle. Right now what we see this quarter and we see for Q4 and going out even a little bit further is that the product mix is very good. In terms of what the revenue growth translates into for the fourth quarter, I don't know the exact number. You're saying it's 2%. We're sticking to the 37% is what we talked about. If you remember on the last call, we gave you almost the second half of the year all at once. As you can see, it's coming in true to form. The fact that we gave you some similar guidance is again bringing about some consistency and I think it bodes well for the strength of the business and our visibility into the business, because I'm sure the visibility question is going to come up before this call is out, so I'll try and tackle that one right now as well. So it's good and it's pretty strong and based upon that, we can give you some pretty good indication of where it's going to go. Analyst for Mark Sue – RBC: Could you just talk a little bit about the backlog for this quarter versus last? Joe Chinnici: Could I, yes, but we don't normally do that, so I can't go there and I apologize for that. But as a company, we've never done that so I won't go there. Analyst for Mark Sue – RBC: But given that you said the visibility is strong, I guess it's safe to say that the backlog is pretty healthy? Gary Smith: When we talk about visibility, that includes a number of factors. It is what orders you've got on hand, what have you got installed out there, what are you looking to revenue from, what's the revenue recognition terms, et cetera, so it's all of that. I think it's fair to say that we've had improving visibility during the year that enabled us to give the guidance that we've given. So I would say that visibility overall has improved.

Your next question comes from Tim Savageaux - Merriman. Tim Savageaux - Merriman Curhan Ford: You ran through the typical customer commentary rather quickly at the front of the call. I wonder if you might be able to go back and describe real quickly the major customer shipments? Also stepping into the revenue performance, it does seem like perhaps the access group saw a fairly sharp uptick. I wonder if we can ascribe that to maybe AT&T/BellSouth coming back and is that something you expect to continue going forward? Thanks. Gary Smith: Similar to last quarter in terms of the overall profile, we had three 10% plus customers, which combined to the late 40s as a percentage of total sales in Q3. They fluctuate in terms of who they are quarter to quarter. All three were North American, I think, this quarter, and two of the three also featured as 10% customers in Q2. We are trying to broaden out the amount of tier 1 large carriers that we have and we've certainly got more than we had before which enables us to have a broader base business. In terms of the access piece, yes, I think if you look at it, it's almost entirely North America and I think we've seen it's not huge for us, but we have seen an uptick in the last quarter around some of the access deployments, principally as they continue to roll broadband out. Tim Savageaux - Merriman Curhan Ford: Just one very quick follow-up on overall market trends. At least what we've been hearing pretty recently coming out of some of the major carriers is still feedback that suggests that by the time these guys are installing new Lambdas, they're pretty much exhausted in a sense that bandwidth demand forecasts are pretty rapidly and vastly exceeding what these carriers would have said, say a year ago, about their overall network bandwidth demand. I wonder if you can talk about whether that's what you're seeing among some of the major carriers and long haul guys or an overall comment on that trend, bandwidth demand relative to expectations. Gary Smith: I would say it's tracking overall as you talk to the carriers, I think they're getting a little more confident around the sustainability of their demand. I would caution, though, that it is a little patchy. I think, as Steve alluded to in terms of the growth that we're seeing, the metro part of the market is clearly showing I think probably the largest growth in terms of overall capacity, which is logical. But we're also seeing that cascade into the core of the network as well. I think you've got that dynamic going on at the same time as folks looking to converge their architecture as well, particularly in the metro part of the network. Tim Savageaux - Merriman Curhan Ford: Congrats once again on the operating margin and earnings power performance here in the quarter.

Your next question comes from Tim Long - Banc of America. Tim Long - Banc of America: First, can you just discuss a little bit the comments that you made about being more selective with some of the revenue growth next year? What does that mean, exactly? Should we read into that we're starting to see some more price-sensitive deals that potentially you're walking away from now? Is there anything to read into that? Could you just clarify? Second, on the OpEx side, using your numbers of a comfortable 20% revenue growth next year and that 15% operating margin target, it seems to me like we could see an acceleration in OpEx dollar spending next year as adjusted. Is that true? If so, where is the focus on the incremental OpEx spending coming in 2008? Thank you. Gary Smith: Why don't I take the first part of that and then maybe Joe can talk about our investment strategy for going forward next year. The approach to the market around a sort of smart growth is really, we want to make sure that we consolidate and further our position, really, in the converged Ethernet space. That's really what that's about. I don't think we're seeing in that space, particularly, we're seeing price pressure, it's tough. It's nothing different than we've seen for the last couple of years. I wouldn't describe it any differently to that. I think as we get more and more of our portfolio addressing converged Ethernet, that's really where we want to focus. We want to make sure that we're positioned within the strategic customers that we perceive are the important ones going forward and the strategic markets that we perceive as important ones going forward. Not just to get FY08 growth, but really to position the company as a real leader in that converged Ethernet space, so very targeted on certain customers and markets. Joe Chinnici: Let me take your question around OpEx. I think in terms of using the word acceleration, I wouldn't necessarily agree with that concept. I think if you take a look at the numbers that you're looking at for '08 and if you're going to go up 20%, the revenue number's moving substantially enough that you could start to afford to spend some more money, especially in the areas of R&D. I know Steve is sitting across the table from me here. He would like to continue to increase the headcount in India, which we as a company would like to do. The group's doing really well. They're getting to the point where what they can do and how they can do it and how quickly they can do it is improving as each day goes by. Then if you look forward into future years, '09 and '010, you're going to have to continue to spend some money in operating expenses otherwise you're not going to be able to drive the revenue number. It's a pretty simple situation like that. So, yes, you could probably see the OpEx starting to go up sometime in '08. To what degree, it'll be measured, it'll be calculated, and it will be done where we think we can get a higher return on it. But there's going to be a good balance and it'll be a smart investment.

Your next question comes from Brandt Thompson - Goldman Sachs. Brandt Thompson - Goldman Sachs: I was wondering if you guys could give us an idea of what you feel that market growth rate is? So when you were talking about 20% seeming reasonable for fiscal '08 growing faster than the market, to what degree are you actually outgrowing the market? On the gross margin front, as you're looking at that mid 40% range and talking about the services margins obviously improving over the next year and given how strong your customer mix and your product transitions have been, when we look further out, is there an opportunity? How should we think about that? In any given year, are we going to have more than a couple of quarters at the high end of that range, is there room for that range to move up over time? Do you feel like there's other pressures in the market that my ultimately hold that range exactly where it is? I'm just trying to get an idea of exactly what the levers is there. Thank you. Gary Smith: Brandt, why don't I take the market growth first? It's hard to pinpoint, especially as you look into the future. You look into comparing '07, which we haven't finished yet to '08. But as we synthesize down the various industry analysts perspective of that and look at our own inputs as well, generally the overall market in telecom equipment infrastructure, I'd say, it's 3% to 5% globally. If you look at the spaces that we're exposed to, that growth is higher, anywhere between 10 to 15%, in that kind of a range. So we do believe that if those are the numbers that we believe we'll be able to continue to outperform the market. In terms of the gross margins, we're still in that mid-40s range as best we can tell. It's difficult to predict, a lot of moving parts to it, as Joe alluded to, the various customers and products that we have and the confluence of those. The services margin, if you think about that as a product line, I would caution that it's about 10% of our business. We do see it improving, as we talked to. We think we can get it in the mid to high teens during '08 but we also have a particularly favorable product mix right now, which is clearly helping the overall gross margin. If you look to the strategy of the company and it's back to what I was talking about with smart growth, Steve talked about the portfolio as we continue to develop that in converged Ethernet, clearly over a longer period of time all things being equal, we would expect to improve our gross margin position as we move more into converged Ethernet. But in terms of putting a number on that right now, I think you're probably looking more to the end of '08/'09 before we'll really have confidence that that's sustainable.

Your next question comes from Tim Daubenspeck - Pacific Crest. Tim Daubenspeck - Pacific Crest: In terms of 4200 revenues, I think you showed some improvement, but it's probably not at the level some of us are looking at. You've talked in the past about order patterns around 4200. Can you give us a little more color on 4200? Gary Smith: Certainly, Tim. We had 15% sequential growth, but I think that comes off a lower number. Principally, the challenges there are around revenue recognition. We continue to expand our customer base. We've got over 100 customers now and I think adoption of that in Europe where we first launched it has been excellent and we're beginning to see a similar kind of take-up in North America so that should start to get a sustainable growth in that platform. But we think it's got a lot of head room. The order flow is very positive for that platform. So to your question, Tim, are expectations higher than the $20 million? I would say yes and they certainly should be. What we're seeing out there is consistent with that. Tim Daubenspeck - Pacific Crest: You talked about metro as a big focus and a big opportunity going forward, is that any type of commentary in terms of growth on long haul? I know the two networks are converging, but relative expectations on long haul versus metro as you look at '08? Steve Alexander: As you would imagine, it kind of is a seesaw. You can add a lot of capacity into the metro that drives more demand into the backbone and the long haul and vice versa. It adds to the fluctuations that you see in the build patterns. Clearly it's all driven by the edge of the network by the consumers and businesses as they demand more broadband services, so it does flow back and forth.

Your next question comes from John Marchetti - Morgan Stanley. John Marchetti - Morgan Stanley: I just wanted to touch base on a couple of housekeeping items. Joe, I was wondering if you could talk a little bit about the sequential decline in the finished goods line this quarter and then just maybe update us on maybe what percent of that settlement revenue may have been recognized in the quarter? Joe Chinnici: The finished goods going down is primarily a function of the rev rec. If you take a look at the $90 million plus in finished goods that we do have, a lot of that is off-site on the customer prems, either in the process of being installed or it's been installed waiting for revenue accepted. As that number moves around, it's really a function of the geographic location of the customer. Going back to Tim's question on the 4200, a big piece of that number is 4200, because it's out there waiting to be accepted, so to speak. In the case of the settlement, that's kind of a curve ball. Very little of it has been recognized, per se. Maybe about $4 million, $5 million. John Marchetti - Morgan Stanley: When you talked about OpEx in '08 potentially going up, are you thinking of that in terms of dollars or as a percentage of revenue? Joe Chinnici: At this point in time, and we'll talk more about it in the future, but it's more absolute dollars than I would talk about in terms of percent relationships.

Your next question comes from Jonathan Keys - Bear Stearns. Jonathan Keys - Bear Stearns: I just had a quick follow-up question to that 4200and then I had a question of my own. In the past you had talked about ramping up your supply chain for the 4200 for around $40 million a quarter. Is that still a target? Are you looking to ramp that up, especially since this is one of your metro products? The other question I had was, you're talking about good visibility and you're in a significant upgrade cycle. Would you say you're at the beginnings innings of that, like second or third inning, or more like the fifth or sixth inning for that cycle? Gary Smith: Let me perhaps talk about the 4200 first and maybe Steve, who's more versed in baseball than my particular favorite sport. First of all 4200, in terms of the supply chain and the anticipation for that, I still think we're on track for the $40 million. A lot of the challenges that we're having right now are related to revenue recognition, but as we work through those and we see the broader demand, particularly as we move the product and begin to introduce it into North America, I think the $40 million looks certainly around the right kind of numbers. Steve Alexander: In terms of where we are in the game, as it were, I would say it's early innings here. You look at the networks that are out there, some of them are very large, some of them will take many, many years to make the transition from a DDM base to let's call it a carrier grade Ethernet base. I would advertise we're in the early innings here.

Your next question comes from Amitabh Passi - UBS. Amitabh Passi - UBS: Could you provide a little bit more color on the $2.25 million litigation expense in the quarter? Was that related to the ongoing Nortel litigation issue, was there something entirely different and is it truly one-time? I just wanted clarification on your gross margin guidance for the fourth quarter. I thought you said it was in the mid 40% range and was just wondering why it would be significantly lower than the 47.7% you did this quarter. Gary Smith: In terms of litigation, we settled Nortel last year. This is another litigation, it's a small litigation, it's a one-off and it's done. Joe Chinnici: You'll see some dialogue in the Q on it. On the margin question, I think the prepared remarks we shared with you talked about it being at the high end of our range, which we talked about a mid-40s, it's 44- 46, the high end of that range is 46. But as a function of it potentially being down, yes, because we've always talked about the margin as a function of the customer mix and as the customer mix moves, everything else moves along with it. We seem to think it's a good number and we're pretty pleased with it, as long as it stays within that range. We consider it a pretty successful outcome. So I don't know how else I could answer your question there. Amitabh Passi - UBS: Just a very quick question on your account receivables, DSOs. I think previously you said you expected the range to be 75 to 80 and today you lowered that range. Just any color in terms of what might have changed? Joe Chinnici: What's the best way of putting that? What drove it up were some folks that were dragging out the payments. Now those payments are more current and we're more comfortable with it. The other piece of it is, again, just like the gross margin it's all about customer mix.

Your next question comes from Vivek Arya - Merrill Lynch. Vivek Arya - Merrill Lynch: I just wanted to revisit this issue of gross margins. There's a period that margins are high because you're expanding at existing customers, but as you win new footprint, that gross margins could perhaps decline back to the low 40% type level which is consistent with the margins at some of your larger competitors. What are your views on this theory? Gary Smith: Vivek, I would say that gross margin expansion that we're seeing is coming from both new customers, particularly as we roll out some of the newer products and enhancements to the existing products. That's expanding our footprint clearly within existing customers, but also we're winning new customers as well. So the improvements in our gross margins are not just skewed to leveraging existing footprint. I think we have considerable differentiation around the portfolio, particularly around converged Ethernet. So that's what's helping us drive more value than some of our competitors. Vivek Arya - Merrill Lynch: So how many new CoreDirector customers have been won, significant tier 1, tier 2 in the last six months to a year? The other part of that is what is the competitive landscape now, with [Intenara] coming into the market and winning some significant deals? Also Alcatel, Lucent, and Nortel are going through restructuring issues, hopefully they recover sometime. So these are the two questions. How many new customers for CoreDirector in the last six months to a year and what is the competitive dynamic now in the market? Gary Smith: I would say that what we're seeing across the board, demand for this kind of architecture, which is really a mesh-based architecture which is better suited to converged IP and infrastructure, Ethernet does not really run very well on rings. We are seeing leverage from our existing customers as they expand their deployments of the CoreDirector-type architecture and we move towards mesh. We are also winning some new customers. I can't off the top of my head, I don't think we've divulged how many customers that we're winning, but we are seeing significant expansion of that platform, specifically within the tier 1s, but also some of the newer, emerging carriers as well. So it's a mix of new business, new accounts, and expansion within the existing customers as well. Steve Alexander: Vivek, I'll give you a little more color on it. One of the ways that you can look at the transition that's going on out there and where the value is, there isn't necessarily a whole lot of value in just providing lots and lots of raw capacity. You have to turn that into a service and one of the things that Ethernet convergence allows you to do is provide capacity and service together. So the value that you get from just moving bits around isn't nearly as much or nearly as great a value as you get if you can turn those bits into a service. Add quality of service to it, add some things that customers look at as their end service delivery. That's one of the things Ethernet convergence allows for. Vivek Arya - Merrill Lynch: The 15% operating margin goal, is that something you expect to achieve in 2008 or 2009? Can you actually sustain that level if gross margins stabilize in the 45% or so range? Thank you. Gary Smith: Vivek, it's a next kind of goal for us. We haven't putting a timing on that. Clearly, we're coming off a significant quarter of improvement on our operating leverage. As we look at the business going forward, we're going to balance the investment. We're in a very good position. We want to make sure that we continue to maximize our competitive advantage and we'll continue to invest in the business strongly, balancing that with our operating leverage. If over time we can get sustainable and improved gross margins, then that clearly will improve our operating leverage going forward. So no simple answer to this; it's all three levers, the portfolio that we're trying to put out there, we believe is garnering more value and higher gross margins, and also we're looking at various things on the operating expense side that gives us more leverage going forward and continuing to grow the revenue line as well.

Your next question comes from Samuel Wilson - JMP Securities. Samuel Wilson - JMP Securities: Joe, can you just explain why for your pro forma as-adjusted numbers you add back in interest expenses back into that? For Gary, just a general comment on the market. If you could, is RFP activity up year over year? If so, can you just give us some color on the magnitude or the quantity that just general carrier activity is up? Thank you. Joe Chinnici: On the interest add back question, it has to do with when you factor in the shares for the convert. They're treated on an as-converted basis, so you add the interest back. Gary Smith: General commentary, I would say overall activity is up from 12 months ago. We began to see an uptick probably 30 months ago, probably almost three years ago and we've seen that steadily increase and we've put it into two buckets. One is folks just want more capacity and as they're driving that up, I think that's also driving the need to generate that capacity in a more efficient way, which is driving them to next gen architectures, converged Ethernet, IP, et cetera. We're seeing both and clearly they're not mutually exclusive. Certainly, as the capacity drivers increase, I think that's driving faster transition of the carriers into converged Ethernet. Clearly, RFP is not the only indicator. A fair amount of business comes from outside of necessarily formal lodge RFPs. So I think we're seeing activity overall up on the year as well as probably RFPs.

Your next question comes from Hasan Imam - Thomas Weisel Partners. Hasan Imam - Thomas Weisel Partners: My question is really on the OpEx line. Gary, you've talked a number of times about being focused on operating leverage. So I guess beyond the October quarter, did you foresee a period of strong OpEx ramp again, or do you feel you have adequate headcount at this point to drive 25%, 30% top line growth? And are there any areas where you see an opportunity to reduce significant OpEx at this point? Gary Smith: Hasan, it's a balance between all three of operating expenses, gross margins, the desire to consolidate and continue to push our competitive advantage that we've got in the marketplace. We will do the right thing for the business to create value in the medium to long term as well as balancing that in the short term. We think we've got operating leverage in the things that we put in place, improvements in our infrastructure that will automate things and allow us to scale the business more efficiently. We've got a development center in India that's beginning to come online and up to speed and that will help us in terms of really increasing our capacity for development. So you look at all of that and I think we're in a good position to benefit from the investments that we've made, not just in the product portfolio in the last two to three years, but also in a lot of the groundwork we've done, the foundations we've done to be able to scale our infrastructure in an efficient way. Now, do I see operating expenses go up in dollar terms? Yes. But also that will be balanced around the operating leverage and the goals that we have in terms of operating profit. I think we've clearly demonstrated that this quarter, that there's operating leverage in the business. We've got to balance that with continuing to grow and make sure that we consolidate our market position. Hasan Imam - Thomas Weisel Partners: As a follow-up, do you feel that your headcount is at an adequate level right now to drive 25%, 30% growth? Gary Smith: We will continue, Hasan, to expand our India operation, so we'll continue to expand head growth there. But it's all about efficiency. Hasan Imam - Thomas Weisel Partners: One other product-related question. On the 40 gig front, you guys announced a few months back your product portfolio. Are you already in some trials with that product and is that really a calendar '08 type of revenue contributor? Thanks. Steve Alexander: We are in trials. It is announced, we do think it will add revenue. I will also comment, there's a lot of growth in 10 gig, there's a lot of growth in Ethernet in general, and there are interests now in the 100 gig standards that the IEEE is working on.

Your final question comes from George Notter - Jefferies. George Notter - Jefferies: Just to clarify an earlier question on visibility, I heard you certainly say that visibility was strong here. But would you say, as we look at visibility now versus where you were exiting Q2, would you say it's the same or it's gotten better or it's gotten worse relative to Q2? Any comparison there? Gary Smith: George, if you're comparing it to Q2, probably the same, slightly better. George Notter - Jefferies: Then on services gross margin, I guess I'm wondering if you've changed your longer-term expectations there? I think I heard you say mid to high teens. If memory serves me, you previously thought that was a 20% to 25% gross margin chunk of your business. Did I hear that correctly and has there been a change there? Gary Smith: I would say we have touched in that business, historically depending on again the product mix within that services batch, I would actually expect us longer term to be able to get that over 20% and back to that level. I think given where we're at right now, we're being a little cautious around saying we're going to get back there during '08 because we've got a lot of work to do to get there. I think more realistically saying sort of mid to late teens as an objective during '08 is probably more appropriate. But if you ask me longer term, could this business get back to 20 to 25, I would say yes.

At this time I'll turn the conference back to Mr. Smith for any additional remarks. Gary Smith: Thanks, everyone, for their time this morning and for your continued support. We really appreciate it. We look forward to seeing many of you at our upcoming financial conferences during the next several weeks. Specifically at our analyst day, which is scheduled for October the 2nd in New York. Folks will be getting more details about this event in the coming weeks. Thank you.