Ciena Corporation (CIEN) Q1 2011 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Ciena's Fiscal First Quarter 2011 Results Conference Call [Operator Instructions] I'd now like to turn the conference over to your host, Mr. Gregg Lampf, Vice President of Investor Relations. Please go ahead.

Thanks, Allie. Good morning, and welcome to Ciena's First 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. This morning's remarks will be presented in two segments. Gary will provide a high level review of our Q1 financial performance as well as provide our views of the current market environment. Jim will then detail our Q1 financial results and provide our guidance for Q2 2011. We'll then open the call to questions from sell-side analysts. For this call and going forward, in order to be fair, we will provide for one question and one follow-up per analyst. We will come back for additional questions should time allow. This morning's press release is available on National Business Wire and on Ciena's website at ciena.com. Before I turn the call over to Gary, I'll remind you that during this call, we will be making certain forward-looking statements. Such statements are based on current expectations, forecasts and assumptions regarding the company that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. These statements should be viewed in the context of the risk factors detailed in our 10-K filed with the SEC on December 22, 2010. Our 10-Q is required to be filed with the SEC by March 10, and we expect to file 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 our website at ciena.com. Lastly, as a reminder, this call is being recorded and will be available for replay from the Investors portion of our website. Gary?

Thanks, Gregg, and good morning, everyone. We're extremely pleased with our first quarter results and the progress we are making on several fronts. The momentum in our business is strong and building as we approach the one-year anniversary of the closing of the Nortel MEN acquisition, and we have many integration milestones now behind us. The overall macro economy is not without its uncertainties. However, we believe it is improving overall, creating an environment where our customers can focus investments on next-generation technologies more suited to current and future traffic demands. Against this backdrop, we believe that the industry is finally at an inflection point in the shift away from legacy SONET and SDH to next-generation architectures, driven by the increasing end-user traffic growth resulting from video, Web and proliferating devices, the need for economically scalable and intelligent networks and services and capacity more aligned to revenue models. To deal with this demand, networks must grow capacity, properly allocate that capacity and use that capacity to deliver services and support applications. This shift uniquely suits our Coherent optical transport, OTN mesh and carrier ethernet portfolio. Indeed, Ciena's really our total strategy. Our construct and design point is to be the beneficiary of this evolution. This leverages our world-class innovation, focus and deep relationships. Ciena is positioned to capitalize on the direction the market must take to continue to meet the demands of the end-users. This trend and the value of Ciena's unique position and technology leadership is being validated by recent customer decisions and demonstrated by a number of key design wins with major carriers around the world. Big end user demand drivers, which I will discuss in greater detail in a few minutes, remain strong. Carriers’ reactions to these demand drivers reaffirm the distinct advantages of Ciena's approach and our focus on high-growth markets, coupled with the global scale and reach achieved through the MEN combination. And while we clearly recognize that more work lies ahead, we're also moving forward aggressively to deliver on our operating performance and model. We recently achieved a major milestone in integrating Ciena and Nortel MEN in that we successfully moved the MEN business into our back office systems. As a result, we're now operating from a single, unified foundation. And this platform really provides us with more opportunities for implementing process automation and operating efficiencies across the business, as we take the next steps towards maximizing our operating leverage. On reflection, 2010 was a year of transformation. 2011 will be a year of extending our technology leadership and leveraging our portfolio as we add market share around the world. Our first quarter results show how the new Ciena is beginning to deliver on this potential. Now moving to the results. Our first quarter revenue was $433.3 million, representing a 4% sequential increase. I remind everyone that this also follows a better than anticipated fourth quarter. Sales outside the U.S. represented 49% of revenue, reflecting the strong geographic diversity of our business and our success in capturing market share globally. On gross margin, our Q1 adjusted gross margin was 41.8%. As we predicted for some time, our focus on key Tier 1 design wins specifically gaining traction and footprint leveraging our leadership in high capacity transport is expected to affect margins in the short term, offset by an improved overall product mix later in the year. Additionally, this focus and our success in adding customers and geographies lays the groundwork for longer term growth and improved margin as customers add bandwidth and applications which also introduce intelligence into their networks. Our non-GAAP operating expense was $182 million. OpEx was down as expected, largely due to improved operating efficiencies and accelerated synergies. Lastly, I wanted to follow up on a financial milestone highlighted previously as being a key focus of the integration. I'm pleased to confirm that we achieved positive cash flow from operations on an as adjusted basis, less than one year from the closing of the combination. Jim will provide some more color on this later in the commentary. Clearly, many more milestones lie ahead, but we believe this is an important and encouraging achievement as we move towards our profitability goals. Turning now to the market environment, and as I've said, the market growth drivers continue to be strong. Consumer adoption of video, mobile, Web and Smart phones is proliferating, with a wave of tablet devices expected to have a major effect on network demand as well. Enterprises are focusing on initiatives such as IT virtualization, cloud computing and business continuity, which are also driving greater consumption of communication services and connectivity infrastructure. And with these trends in mind, we can look back and see the bandwidth requirements continued to grow despite the generally weak global economy during the last couple of years. An important change we're seeing today is service provider pricing plans becoming more closely aligned with actual usage. This shift will better enable carriers to make the investments that allow for faster, more intelligent and efficient networks. And these carrier investments, in scaling their networks both in capacity and economics, are estimated to total as much as $50 billion annually in the U.S. alone. Ciena's portfolio helps customers make the transition from older voice-orientated architectures to new higher capacity multiservice architectures, while enabling scalability and longer term flexibility to support evolving business strategies. We've seen early progress in our continued efforts to capture market share. We have also successfully penetrated new customer segments for our product set such as the submarine market and continued to gain traction in high-growth geographies. Validation of our portfolio cross-selling can be seen in multiple design wins, including our SEA-ME-WE 4 win that we recently announced. SEA-ME-WE 4 is one of the longest most heavily trafficked submarine cable systems in the world. This next-generation 20,000-kilometer system serves hundreds of millions of people, linking Southeast Asia to Europe via the Indian subcontinent and Middle East. I think this win, firstly, demonstrates our ability to penetrate the submarine network market, a significant market opportunity for us. And secondly, it validates our technology leadership in both VoD and switching and high-capacity 100 gig Coherent markets. In fact, well over a dozen of our 5430 OTN switches will be deployed as part of this contract. And perhaps most importantly, the SEA-ME-WE 4 consortium is comprised of 16 Tier 1 carriers, including some of the biggest service providers globally. Many of these carriers were not Ciena customers prior to this win. Clearly, we are focused on the opportunity presented by these new relationships and our ability to leverage this strategic footprint into their domestic networks. Another example of architectural design wins is Mobily. We recently announced our most significant cross portfolio win to date with Mobily, one of the fastest growing mobile operators in the Middle East and North Africa. Mobily is adopting solutions across each of our product segments, Packet-Optical Transport, Packet-Optical Switching and Carrier Ethernet Delivery. While utilizing our entire offering for their next-generation network, Mobily is taking advantage of the scale, economics and reliability afforded by the integrated deployment from Ciena. This new relationship demonstrates Ciena's ability to leverage our uniquely focused product portfolio and our ability to succeed across the globe as we build upon the trust of customers who are deploying the most advanced networks in the world. With SEA-ME-WE 4 and Mobily serving as terrific examples of our cross-platform wins, we also remain keenly focused on extending our leadership in each of the individual distinct portfolio segments. Beginning with CSD. I'm pleased to report that we can now call nearly every North American Tier 1 carrier our customer. And although this is a fragmented market, we retain our recent number one positions in the carrier ethernet access platform category and the fiber-based ethernet access segment. Each carrier is at various phases of adoption and the market itself, overall, is still at an early stage. But our customer footprint puts us in an excellent position to capitalize on applications such as LTE backhaul and business ethernet. And our CSD solutions are gaining traction globally as well with the design win at Mobily and others representing strong examples of how this solution is being adopted. While our largest initial anchor customers are still in the midst of deploying product purchased last year and we acknowledge the traction for this segment is taking longer than anticipated, our global pipeline of opportunities is growing, and we continue to enhance our capabilities. We are winning new customers and our order rate was, in fact, up in Q1, all of which will translate, we believe, into increasing revenues for the second half of the year. Moving to high capacity transport. As we engage with more service providers, enterprises and others seeking to install high-capacity 40 gig and 100 gig Coherent networks, we continue to find that our singular ability to deliver both of these solutions commercially and seamlessly upgrade existing networks today is a strong differentiator. In fact, roughly 40% of the revenue associated with the 6500, our flagship high-capacity transport platform, is now 40 gig and 100 gig. Our knowledge in technology in this space is unparalleled, with over 10 years of Coherent experience and many thousands of ports deployed by our WaveLogic technology in global use today. On that note, we are also proud to say that Verizon has completed its first year of commercial deployment with our 100 gig Coherent technology. After almost two years of being the only provider of commercial 100 gig Coherent technology, we expect others to join us and endorse this technology as they introduce their first generation products. Ciena, however, has already demonstrated one terabit speeds, and we will be delivering effectively our third-generation solutions during 2011. At the same time, we're also integrating our WaveLogic Coherent optical technology across our complete portfolio. So while creating new network capacity is critical, being able to properly manage that capacity is equally significant. As we mentioned before, something essential to understand is that traditional SONET traffic management simply does not extend beyond 40 gig. OTN will be the primary layer one traffic management technology as we move beyond 40 gig, and Ciena is a world leader in automated OTN mesh architecture with years of experience across multiple platforms. And I'm pleased to report that after we received our initial 5430 OTN switch order in Q4, the product delivered its first revenues in Q1, albeit modest, which we expect to see ramp up in the second half of the year. We now have four customer wins, all Tier 1s, including most significantly, two recent North American Tier 1 carrier decisions who incorporate the 5430 into their networks, and we are actively engaged with more Tier 1 carriers across the globe. And while the timing of customer deployments and meaningful revenues is difficult to predict, these recent decisions following on from the SEA-ME-WE endorsement, represent critical proof points for the platform’s adoption and proliferation. Notwithstanding revenue timing uncertainties, we are very encouraged by the traction we're witnessing and believe this will translate into increased revenues towards the end of this year. Looking ahead at the platform transition, we would also expect the bulk of our CoreDirector installed base to adopt the 5430 family over time as they augment their networks and shift to OTN high-capacity networks. In summary, we believe Ciena is in a very strong position across all aspects of its business. We have clear technology leadership and engagement in all of our solution segments. To summarize Q1, I am very pleased with our revenue progress, the OpEx efficiencies and how the business has operated through the integration, which could have been a very disruptive period. I want to take this opportunity to once again to thank all of our employees for their hard work and our customers and partners for their support in making the MEN integration so successful to date. As a result, we now have a solid platform from which to focus on achieving operating leverage and our operating targets. Profitability is in sight as we see revenue growth continuing. We are shifting more of our integration focus to process automation and streamlining operations in addition to furthering our product innovation and leadership, building on the momentum we're experiencing today. With that, I'd like to hand over to Jim, who'll take you through the details of our Q1 results and Q2 guidance.

Thanks, Gary. Good morning, everyone. We believe our Q1 results provide important validation as a long term value of the Ciena-MEN combination for the success of the largely completed integration and for our path to increasing profitability. As we continue to grow, we are absolutely committed to driving additional operating leverage. Most recently, we initiated steps to effect a change to our global distribution model, which will simplify our supply chain and reduce costs. With many integration milestones complete and the business operating on one ERP system, we can now accelerate our plans to consolidate our supply chain. With respect to the top line, we continue to add market share as the converged optical ethernet upgrade cycle gains momentum. This increased market share should provide us opportunities in the future for incumbent revenue and improved margins. In short, we feel very good about our market position. Now onto the results. As a reminder, last quarter, we said that, going forward, we would no longer distinguish between Ciena and MEN revenue on our conference calls. Instead, we will focus on segment results or where relevant, the solutions that customers are adopting. We are managing the business as a combined company, even more so now that our back office systems are integrated. Additionally, customers are now making buying decisions across the combined portfolio and we're delivering services that span both Ciena and MEN products. Gary talked about Mobily which is a prime example of how our total portfolio is increasingly being evaluated, accepted and deployed. We expect more of these wins in the future as our customers move towards simplified supply chains, engaging with fewer, more capable and focused vendors. I'll start with revenue. We reported first quarter revenue of $433.3 million, which was better than expected. Revenue was positively impacted by the acceleration of approximately $10 million of product shipments into the first quarter. This dynamic was specifically due to the impending shutdown of our operations early in the second quarter to allow for the integration of the MEN business into our back office systems. We had two 10%-plus customers in the first quarter, which represented a total of 25% of quarterly revenue. 49% of our revenue was from outside the U.S. On a segment basis, the revenue contribution is as follows: First, our Packet-Optical Transport segment, which includes all of our optical transport platforms plus associated operating system software and embedded software features. This segment accounted for $286.5 million in revenue in Q1, representing 66% of total sales. We believe the strength in transport is indicative of our technology leadership position in high-capacity coherent products and reflects customers’ increasing need to increase bandwidth. Additionally, this momentum speaks to our focus on gaining market share. Our Packet-Optical Switching segment includes CoreDirector, CoreDirector FS and our ActivFlex 5430 OTN switch plus associated operating system software and embedded software features. This segment accounted for $35.3 million in revenue in Q1 or 8% of total sales. While we will continue to be in a transition period between CoreDirector and the 5400 family of switches until later in fiscal 2011, we are pleased to report that we saw our first 5430 revenue in Q1. And we expect momentum for this product family to build during the year. Our third segment, Carrier Ethernet Service Delivery or CESD, includes our service delivery in aggregation switches and broadband access products, plus related operating system software and embedded software features. Sales of CESD contributed $27.6 million or 6% of total revenue in Q1. The applications for this segment are wide ranging and align well with current customer initiatives. In the near term, it is a segment that has tended to be lumpy, and we acknowledge the traction here is taking longer than we would like. However, we continue to believe the long-term growth trajectory for CESD will be strong as a result of the broad applications for this technology, including high growth areas such as Mobily backhaul and ethernet business services. And finally, our Software and Services segment which includes our integrated network and service management software, as well as all of our services’ related offerings was $83.9 million in Q1. In the remainder of my comments today, I'll speak only to non-GAAP results. Please refer to our press release on our website for the reconciliation to our GAAP results. On gross margin, Q1's overall non-GAAP gross margin was within the expected range at 41.8%. Similar to the revenue line, it is important that you understand an integration driven decision that impacted this result. Margin benefited this quarter as a result of our decision to consolidate certain support operations and business processes to integrate the practices of the two companies. As a result, we will realize lower costs to service warranty obligations in the future. This change resulted in the reversal of a $6.9 million loss contingency which had been included in our warranty liability. Excluding this change, adjusted gross margin would have been 40.2%. This margin is largely the result of our deliberate strategy to gain footprint. We are being aggressive in capitalizing on our time-to-market advantage with our transport solutions and capturing market share for what we see as a growing opportunity for optical infrastructure builds. As we have said, the margin on common equipment is typically lower than on channel heads. Over the next several quarters, we expect to add revenue and realize improved margins as a result of an improved CESD and switching mix. Moving on to OpEx. Q1's operating expenses totaled $182 million, coming in significantly lower than Q4. This $13 million sequential improvement reflects our ability to manage OpEx tightly, create efficiencies across our business, and deliver operating leverage and synergies ahead of plan. For the remainder of 2011, this will be complemented by the impending TSA savings and additional synergy efforts that will continue into 2012. Some of these efforts include supply-chain rationalization, further product integration and internal process automation. All of these projects are important elements to our ongoing operating plan. We will keep you informed as we begin to see their benefits. Moving to other income and expense, this includes a $0.9 million loss from foreign currency transactions and interest expense of $9.6 million. Our as adjusted Q1 net loss was $13.3 million or a loss of $0.14 per common share. Now onto cash flow and the balance sheet. At January 31, 2011, we had approximately $626 million in cash and cash equivalents. I'll point out that during the quarter, we received $33.5 million associated with the early termination of the lease related to our R&D center in Nortel's Carling Campus in Ottawa, which shortened that lease from 10 years to five years. With this in mind, we used $63.7 million in cash from operations during the first quarter. This includes a use of $43.6 million resulting from an increase in working capital. Absent the working capital increase and integration costs of $24.2 million, the operations of the business actually generated cash of $4.1 million. This is a significant milestone for Ciena as Gary mentioned earlier. We will continue to monitor and report on this metric going forward. At the end of Q1, our accounts receivable balance was $369.7 million from $343.6 million in Q4. Days sales outstanding was 77 from 74 days in Q4. Inventories totaled $267 million at the end of Q1, up from $262 million at the end of Q4. Product inventory turns were 3.2x in the quarter, down from 3.1x in Q4. The inventory breakdown for the quarter included raw materials of $28 million, work in progress of $5 million and finished goods of $265 million. This total was reduced by an accrued reserve for excess and obsolescence of $31 million. Finally, with respect to headcount, on January 31, our worldwide headcount was 4,254. I'll close our prepared remarks today with guidance for the fiscal second quarter. We expect revenue to be in the range of $415 million to $435 million. As you think about this range, it is important to recognize that there are still a lot of moving parts that we are managing. The back office integration impact we discussed earlier plays a role in future guidance. As we mentioned, approximately $10 million of revenue occurred in Q1 instead of Q2 as part of the scheduled ERP shutdown that took place in the beginning of our fiscal Q2. As part of our plan to derisk any customer impact during the temporary supply-chain shutdown, we increased inventories and communicated extensively with customers. This resulted in a dynamic where we were able to meet requests for earlier shipments so as not to impact customers with our temporary close down. I would stress that the ERP integration went extremely smoothly and completely as planned. We are now consolidated on a single information systems platform and are shipping normally. However, we did somewhat constrain our supply chain capacity in the beginning of Q2 which reduces some of our flexibility to respond to the normal changes and churn within this quarter. Importantly, I would stress that after combining our Q1 revenue with what we would anticipate for Q2, our first half 2011 revenue should be very much on track with our expectations for the period. Moving on to adjusted gross margin, we expect this to be in the low 40s range. With respect to adjusted operating expenses, we are targeting approximately $180 million for Q2. Moving on to other income and expense. We expect other income expense net in the second quarter will be an expense of roughly $9.6 million related to the interest on our convertible notes. Finally, I'd like to reiterate that we remain committed to achieving our target operating model exiting fiscal 2011. As I've discussed previously, achievement of our target operating model is dependent on key assumptions relating to revenue growth, product mix, cost reductions and operating expense control, and we are currently moving in the right direction on all fronts. As for taxes, we expect our tax obligation for Q2 will continue to be related purely to foreign taxes. Depending upon your assumptions, you may need either our diluted share count or our basic share count. We estimate Q2's basic share count at approximately 95 million total shares. We estimate Q2's diluted share count with all convertibles assumed reconverted at approximately 150 million total shares. That concludes our prepared remarks, and with that, we will move on to the Q&A portion of the call. As a reminder, in order to try to be fair to all, we will be taking one question and one follow-up per sell-side analysts. We'll come back later on and allow for additional questions, if we have time. Allie, we'll now open up the line for questions.

[Operator Instructions] Our first question comes from Mark Sue of RBC Capital Markets.

With the moving parts of the supply chain, how should we think about the second half revenues versus this first half of revenues, maybe your confidence of the second half ramp? And is there a way we can quantify kind of the growth in the pipeline and perhaps how you see the dynamics in your backlog?

With respect to the second half revenue, Mark, obviously, we're not in a position to give guidance right now, but we clearly expect growth in the second half. We expect a mix shift in the second half. And in order to get to our target model, we're going to have to see top line growth and we think that everything is in place for that to occur. With respect to the backlog, we do not disclose backlog except as required at the end of the year in our 10-K. It can move around, it's not necessarily indicative of near-term results but I can say that we feel really good about our pipeline. We feel great about our momentum in the marketplace and we think that bodes well for future growth.

Okay. So indications are everything that you're seeing should show sequential growth after the second quarter into the third and into the fourth?

The design point for the year and for the target operating model is for increases in particularly into CESD and into switching. We can't guarantee the timing of those given the lumpy nature of them, but the traction that we're seeing right now, we're extremely encouraged by and also the footprint that we're gaining in the high-capacity transport as we get to channel adds and those kinds of dynamics on it, I think that's all going to be helpful as we leave the year.

Got it. And my follow-up is just on OpEx. Kind of is $182 million kind of the run rate or how should we think about OpEx from what Ciena plans to spend on a quarterly basis?

Mark, what I'd say about that $182 million number is that there are still things moving around in it. We have TSAs which we’ve started to exit and you'll see some result of that. We have the whole question of incentive comp and all those questions. We have additional things that we want to do in terms of process automation, so I'm not going to answer the question directly but I don't think our ongoing number is going to be too far from that number.

Our next question comes from Jess Lubert of Wells Fargo Securities.

First, I was hoping you might be able to quantify the impact of the supply issues in the guidance and where these supply issues currently stand? And then secondly, it sounds like you're taking an aggressive pricing standpoint in some of your businesses, as you seek to gain share. Can you perhaps discuss where you expect Q2 gross margins to be? Flat, up or down sequentially and do you still think gross margins can get back up to the mid-40% range by the end of the year?

Jeff, why don't I take that. On the supply chain impact, I think as Jim articulated in Q1, because of the dynamics related to the switch over to the ERP system, we recognized $10 million more of revenues in Q1 than we'd anticipated because of customer pull forwards related to that. In terms of the impact in Q2, clearly, you’re $10 million down from where you would have anticipated and also, with the switch over, you had some downtime, in terms of our overall ERP supply chain management. So I would stress, it is not a component related shortage of any kind. We've got those on an ongoing basis, but no more than we'd normally have. So it is not that, it is purely self-inflicted, if you will, and it's purely around our desire to get onto a single system which can allow us leverage going forward, and it was a very large and complicated transition that was executed, I have to say extremely well. But we're very pleased with how it was affected and that really is behind us now. But if we look at Q2, we have to consider that without essentially supply chain capacity for a number of days, and that does impact, as Jim indicated, our ability to be flexible during the quarter and that's reflected in the -- what we think is realistic guidance going forward. So I wanted the opportunity to make sure that folks understand it's not a component supply-chain issue. Your second element to your question, Jeff, was really related to pricing and margin and footprint. I think this is largely related to high capacity transport and I think we've seen all of this before. It's a dynamic around the segment where you put a footprint out there, which is essentially shattered, which are higher costs and tend to be lower margin, and then you fill over time with cards and other software which tend to be higher margin. So we've seen this dynamic many times in our industry. We go through these cycles and because we have a technology leadership in 40 gig and 100 gig Coherent WaveLogic technology, we are, clearly, being afforded plenty of opportunities to increase market share and gain footprint. So we are taking those in a very disciplined way and focusing them on the Tier 1 carriers that we think will yield the most benefits going forward.

And we did say, Jeff, the last couple of quarters, that when we experienced margins a bit higher than we thought, it was because we were selling a higher proportion of channel cards early in the combination of the two companies and we predicted that margins would come off. We still feel good about margins coming back. It will take an improvement in our mix towards CESD and switching which we do expect.

Our next question comes from Rod Hall of JPMorgan. Rod Hall - JP Morgan Chase & Co: I just wanted to clarify the [indiscernible] 5430 included bonding, it sounded to me like you guys got it in Q4 from material revenue there. So can you just clarify what do you mean by the back end of the year and all that?

I’m sorry, Rod, you’re not coming through very clearly there. We heard the 5430. I think I'll answer the question I think I heard, so please forgive me. We did recognize our first 5430 revenues, albeit modest in Q1. We now have awards from four Tier 1 customers worldwide, two of which are North American, and we do anticipate as we get to the second half of the year for us to see a ramp in revenues for the 5430. But again, it's in the context of an improving overall mix as we gain more traction from these 5430 OTN platforms. Rod Hall - JP Morgan Chase & Co: Okay. Just to clarify that question, what I was asking is on Q4, is Q4 the first quarter that you expect to see material revenues from the 5430 or does it actually fall in Q3 and Q4?

I would think you'd see and again, difficult to predict, but I mean, I would think we'd see steadily improving as we get to sort of Q3 and ramp up a little more in Q4. That'll be my best guess, Rod. Rod Hall - JP Morgan Chase & Co: And then my follow-up is just a quick clarification on the $6.9 million reversal. Is that pertinent to the other income of the expenses net and other income or such lower [indiscernible] is in there. Is it correct?

Not in other income. It's actually in our margin, Rod. Just to clarify, this has to do with the way that we affect repairs in the field and how we manage that equipment. In the past, we did it a certain way within Ciena and a certain way within MEN. We've put those two processes together into one process and the way we used to do it meant that we had to accrue a loss contingency for future repairs, and the way we are doing it now means that we no longer have to keep that accrual up. So we reversed the $6.9 million. It came in through margin. So our 41.8% would have been 40.2% without that $6.9 million. Rod Hall - JP Morgan Chase & Co: Jim, could you just clarify then why the other income line trended [ph] so much lower than the $9.5 million than you guys guided?

Well, there was a $900,000 loss related to an FX transaction. Rod Hall - JP Morgan Chase & Co: Okay, but weren’t they like [ph] $3.3 million [indiscernible]

If you look at our GAAP results, Rod, which I think you are, I hesitate to discuss this, but we have embedded derivatives in one of our convertible notes that resulted in a reversal and that was about a $7.1 million gain. I'd be glad to answer that in detail offline. Maybe we can talk later on today, but that's what it is. It's $7.1 million gain for GAAP purposes, we exclude that for as adjusted purposes.

Our next question comes from Nikos Theodosopoulos of UBS.

My question is on the TSAs, if I think I heard this right, there was little or no impact on gross margin and OpEx in the quarter reported. But I believe that you're coming off those now. So as I look to the next quarter guidance, your OpEx and gross margin, why wouldn't we see a more positive impact from the TSAs coming off in the guidance that you give, especially for OpEx?

Well, we did see some in Q1. We have moved very aggressively to get off TSAs. We were the first company to get off of the NBS surfaces. I will say that they did a good job for us during the transition period, but we were glad to get off those. We got off some of them earlier, and so we did see some effect in Q1. Similarly, on the gross margin side, we saw a bit of an effect. We will see an effect in Q2, but as I said, there are things that move around in OpEx. We have incentive comp, we have other things that we will -- other decisions that we're going to take, so we think that our guidance at around $180 million is a reasonable number.

Okay. So that embeds whatever final benefit is left on the TSA. You're not expecting any further benefit in the third quarter, for example, from that?

Very slight.

Okay, all right. And then my follow-up is on the Switch business. If I look at that whole unit, the revenues were up sequentially and I know 5430 was a very small part of it. But as that business shifts more and more to the 5430, should the gross margin of that unit overall stay flat, improve or decline? What will the 5430 do to the gross margin of that business unit?

It should be flat because you're essentially importing the mesh software across.

Okay. So no material change on profitability from 5430 versus CoreDirector?

No.

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

My question is on CSD. Last quarter on the call, you said that you have better visibility for CSD and you thought that last quarter was the bottom for the revenues and it went down sequentially. And I'm wondering if in the commentary, I think also on the call is more cautious now about this division than last quarter, and I'm wondering if there was any change or any project that was pushed out with regards to this?

Yes, Tal, I would say that I'm not more cautious about it other than the fact that I was incorrect in terms of the revenue, calling the bottom on it. I would say that, in fact, the order momentum was improved in Q1. We didn't take that to revenues and it was down slightly at $27 million versus $30 million. It has taken longer than we'd -- certainly I would have anticipated and, yes, I see strong momentum across the globe. Now we're attacking global markets with this portfolio. We've also increased the addressable market as we've expanded the portfolio with features and functionality as well. So our available market has got bigger. We're also winning a number of new customers. Really, I think the point is the initial revenues with them has taken longer to ramp than I would have anticipated. But I feel good about the space overall and I think, certainly, my own perspective is, I think the second half will be stronger than the first half on CESD. I absolutely think that.

My second question is about, again, just comparing it to last quarter. Last quarter, you reiterated the 7% to 10% margin for the end of the year, operating margin targets for the end of the year. And the question I have is, given that the OpEx was down so substantially this quarter, what are the assumptions that you have for the 4Q? First, do you still believe you're going to get there? And then, is it based on further decline in OpEx or from that point onward, it's based mostly on revenue growth? I'm just trying to see how do I get to even the bottom of the range or mid of the range, and what kind of assumptions I have to have to hit this number.

Yes, I mean, they absolutely remain our targets and as Jim said in his commentary, we're moving in the right direction on all of the aspects that we think as we leave the year, and it requires all of the levers that we have to be pulled in the right direction. And so there's a whole set of assumptions around that, but I think the predominant element from where we're sitting right now is revenue growth. We've got further, I think, synergies that we can recognize going forward onto the OpEx that will also help COGS. But we really need to get the revenues up.

And the mix change.

Yes.

Those two things.

And just on this particular issue, if margins were now a little bit below 42%, where could it go with better mix? I'm just trying to understand the low end, kind of the low case and the high case for gross margins.

It's purely a question of timing there, Tal. But what we said is that we thought that the initial quarters of the combination would be in the low 40s. We've actually done better than that every quarter, except this one, and we're still in the low 40s. We said that we should move to the mid-40s by the end of this year. Now depending upon how you interpret mid-40s, that's a long leap from where we sit today, but we expect margins to improve as our mix improves.

Our next question comes from Ehud Gelblum of Morgan Stanley.

Just a couple of quick ones. First of all, on the 5400, you've got four customers now, you said two recent ones in North America, are they all on the same deployment time frame? Mobily sort of appears to be ahead of the other ones, I think. So as your 5400 revenue grows throughout the year, should we see it sequentially go up every single quarter or could it be more lumpy as some come in, then fall back and others come in? How should we be modeling out and not just the next three quarters, but into 2012 as well?

The profile in this business sector, having gone through when we did the initial CoreDirector piece, I would definitely describe it as lumpy and they have very different profiles. Certainly, the four that we're talking about here have very different profiles in terms of their adoption and rollout. So it's a case of getting multiple customers to balance that out. So I would absolutely anticipate it to be lumpy as we get going here.

So we shouldn't necessarily assume that the switching piece is sequentially up every quarter on out but when you hit the fourth quarter this year, you're expecting it to be at a high, I assume, to hit your target range?

Well, I mean, I guess as we turn out of the year, I would expect, as we turn into 2012, to have those revenues higher and particularly in the second half, Q3 and Q4, yes. Whether it'll be absolutely sequential or not is very difficult to predict. But if I look at the first half versus the second half, well, I would absolutely expect switching to be higher in the second half than the first half.

So there's not that much lumpiness given that we have one quarter under our belt, maybe one quarter or so but as we get into the Q3, Q4 and into next year, it should be at a much higher range?

Yes.

As we look at gross margin now, when you take off that reversal, you're down at 40%. As you layer in and feather in this extra piece from switching and from CESD as it gets going, are we still in a 41%, 42% range as we get into the fourth quarter to get to the 7% to 10% range? Or to get there, do we have to be at 45%, 46% and that's what happens when CESD and 5400 get going?

You don't have to be at 45% or 46%, but you do have to be up from 41%, 42%. These increments are getting smaller and smaller already.

But it really helps kind of frame what it is, and you think that's pretty much a sustainable gross margin going forward and the right mix as you get into 2012 and beyond?

I would describe it as we go forward. I mean these are a set of milestones and targets. I don't think that's where we're ultimately going to end up and our ambitions are more than that, but that requires a lot of other things to happen. So these were goals that we set ourselves. Bear in mind, we set these goals about a year ago when we were coming into this integration. So we'll look at other targets as we move through '12.

Okay. That’s actually helpful. A clarification, you said 40% of transport was 40G and 100G, you have that number for last quarter?

What we said was 40% of the 6500 platform which is the premium long-haul platform. And it is up, I haven’t got the exact figure, but it's up on Q4. I think it was a metric that somebody -- I think it was Paul asked for last quarter...

He did and you didn't give -- you said it was greater than 10%, but you didn't say what it was.

It was 40%, greater than 40% this quarter and that's significantly up from last quarter. So you can see the trend of 40 gig and 100 gig gathering momentum now.

Our next question comes from Alex Henderson of Miller Tabak. Alex Henderson - Miller Tabak & Co., LLC: So last quarter, you indicated what the book-to-bill was and specifically indicated what the book-to-bill was on the 40 gig, 100 gig piece, and I was wondering if you'd give us a little bit more clarity on that. And then second, as we're looking out into the growth rate, there was an indication last quarter that there was 22 customers delivering system on 40 gig that you'd deployed and in the press release for RFC [ph] there was an indication of 77. Can you enunciate what you meant by those two numbers? And then finally, along the same lines, can you give us a little bit better clarity on what's going on in the uptake on 40 gig and 100 gig? How much of the current demand is showing up in the reported numbers and how much of it is deferred as a result of acceptance criteria? What is the structure of that ramp as we go into the back half of the year? I mean I think the upgrade cycle is probably the most important variable here.

Alex, I'm not sure that we gave a book-to-bill number for anything. Now what we did do was, we gave our backlog number in our 10-K, which is as required. We talked about the fact that our order flow has been strong, particularly Q3 and Q4. Q1 is a seasonally weak quarter for orders but we still felt good about those. So that's what I'd say about the book-to-bill. As far as the cycle for 40 gig and 100 gig, it's very clear to us that 40 gig is going to be a stronger and probably longer deployment than people might have thought a couple of years ago. They’re operators who really like our 40 gig. They're adopting it quickly. They can actually upgrade to 100 gig very easily, if they need to or if they choose to. So 40 gig is a popular product. 100 gig, we're early days in that, but we see a nice ramp on that. Is the percentage of 40 gig and 100 gig going to ramp significantly from here? That's hard to answer. It's going to grow, but I don't know that it's going to ramp a lot from now to the end of the year. It will grow. Alex Henderson - Miller Tabak & Co., LLC: Can you talk to the number of customers that you currently have orders from in that space with some other metrics to track it?

Overall, we've got about 70 total customers in that space and I think it's about seven are deploying our 100 gig specifically. And just to clarify, something I talked about earlier on, in fact, if we do the math, it's actually 50% of 6500 is 40 gig and 100 gig. And if you look at all of our Transport segment including all of the portfolio, interestingly, it's 40% of all of our Transport segment is now 40 gig and 100 gig. So I think that gives you an even better indication around the traction we're getting. Alex Henderson - Miller Tabak & Co., LLC: Just to clarify, it was 22 at the end of October and it's 70-plus now?

I'm not sure we're comparing like-for-like on that, Alex, so I need to go check it. I know we've got 70 now, but I think we have more -- if you're saying at the end of October, we had 22 customers then, we have more than that now. We'll follow up with you.

Our next question comes from Cobb Sadler of Catamount Advisors.

I just had a question on the long term operating margin potential of the business. I know that some initial deals or lower gross margin initially, but then you've got some merged synergies that should help on the OpEx line. And then I look at your component suppliers, and they're in the high teen range. And traditionally, the equipment vendor operating margins have been higher than component suppliers’. So why shouldn't we be modeling super long term above high teens operating margins for the business?

Cobb, that is a great thought. I think you've seen us when we -- if we go back into the history when we're firing on all cylinders, particularly before the recent recession, I think our operating margins did get into that range, albeit briefly. So certainly as we -- we’ve set ourselves for a target and goals coming out of this year, to get this operating model and then we'll look at perhaps even more ambitious stuff longer term on that.

Okay, great. And the follow-up on CESD, make sure I got that correctly, you have both North American carriers announced now for the CESD business. How many Tier 1s globally do you have? And how many of those are contributing to volume today and what's the wireless backhaul versus business services split?

Cobb, I don't think we've split out how many Tier 1 carriers that we have as actual customers within CESD. We can certainly look to provide some of that insight going forward. But I can tell you, it's about 130-plus customers overall and that covers very small customers, Tier 2, Tier 3, even enterprise and government, even local government, and some of the major Tier 1s as well. Wireless backhaul is about 75% of the overall market. I think generally speaking, the business services has been much slower adoption than certainly what we would have anticipated, but we're beginning to see some movements there now.

Our next question comes from Michael Genovese of MKM Partners.

Is Stephen Alexander on the call?

No, he isn't today.

Okay, I'm wondering does anybody here want to talk about the relationship between MPLS switches and OTN switches and converge core networks. Just coming off of one of the router companies’ Analysts Day, I think they were talking more about MPLS rather than OTN as being the solution going forward and I was wondering what your view on that was.

Mike, I think we continue to believe that OTN is a key part of that, it's a key element in how router also gets done and it's a key element in minimizing the amount of router ports that are required to implement a network. That said, I suspect you're talking about the recent announcement that Juniper made around their new architecture and their PTX product. One of the points I'd point out about that is, one of their key messages was that just doing MPLS in routers alone is too expensive as a way to implement a network and what they were looking at is shifting some of the routing burden over to switching and that's basically what the PTX product does. The PTX product starts out initially with MPLS switching and then ultimately goes to OTN-type switching. So I'd say we would concur with that view, a mix of different switching types is required and in places in the network where you can switch rather than route, that always results in a more economic solution.

Would it make sense to you or the customer would put both the PTX and the 5430 in the network?

Given that the PTX initially is only an MPLS switch, I think it would because remember that a good part of carrier network traffic today is circuit based, be it product lines or certain types of ethernet services or storage services. So trying to do that all within MPLS network, it just ignores the multiservice aspect that a lot of carriers face today.

Our last question comes from Simon Leopold of Morgan Keegan. Simon Leopold - Morgan Keegan & Company, Inc.: Nonetheless, quick questions here. First, is just trying to make a little bit of sense of the mix implications during the January quarter, specifically, the switching products up significantly as a percent of sales and I typically would think that they would be very favorable towards your gross margin. So I want to see if I can understand whether this is an indication of the mix of switching products, that it was largely chassis and that's the effect or whether there's something else we should be thinking about. And the second part of that one is, the $10 million accelerated revenue, I'm just wondering if that's also switching products.

Well, the $10 million was not switching. It was a combination of stuff. There was some switching in it, but there was also transport in it. We did have a reasonably good switching mix. It does need to get better. We expect it will get better. But I just want to point you to the fact that we are aggressively trying to gain footprint in the transport space. We think it'll be good for the long term. We're doing it selectively with the kind of customers that we think are most important for our future growth and margin. And that's how I would answer that question, Simon. Simon Leopold - Morgan Keegan & Company, Inc.: Just a quick follow-up, is if we could get a little bit more color on your two 10% customers, sort of the typical, what kind of business applications, geographies?

I think it's fair to say that customers that have taken multiple product segments from us and I think it's fair to say that both of them were North American at this time.

Thank you, everybody. As a reminder, please call or e-mail me directly with any questions at glampf@ciena.com or my phone number is (410)694-3169 and I'll respond as soon as possible. Thanks, everybody.

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