Ciena Corporation (CIEN) Earnings Call Transcript & Summary

TMT west conference. My name is Jim Suva, I'm the IT hardware, telecom equipment and technology supply chain analyst here at Citi. I wanted to especially welcome Scott McFeely, he's from Ciena, and importantly, he wanted to do just a handful of slides to kind of set the stage. It's only going to take about 5 minutes or so for him to go through his slides. There are displays in the room on both this side and that side. And then after that, we're going to make it very interactive. For the interactive, we note that you do please press the microphone and you'll see a red light indicate. That way, everybody can hear you in the room. It's actually with the acoustics and the high ceiling, pretty difficult to hear the questions up here at the front of the room. We do want to mention that there are also are disclosures at the check-in desk. And finally, this is Day 1 of Citi's Tech conference and then it indeed continues on to Day 2 tomorrow. So without further ado, I'd like to turn the time over to Scott. Scott?

Thanks, Jim. Thanks very much. Thanks for having us. Folks in the room, thanks for your interest in Ciena. As Jim said, I'm going to just spend a couple of minutes just giving you a very, very high-level overview of Ciena. And for those of you that actually follow the company and know us a bit, I apologize, it'll be a bit remedial. But for those of you that may be new to it, hopefully, it'll give you a bit of context. Just who am I from a Ciena perspective. I have responsibility basically for the global products and services organization. So that's basically R&D, supply chain services, the portfolio investment decisions around our networking business in Ciena. So let me just start off by the usual disclosure statement. We'll click over that, I'm sure you've seen them all before. Our focus within Ciena really is on trying to be the best in the world at moving information over optical infrastructures. That's been her historical focus, and we'll talk a little bit about what that focus has driven from a financial performance perspective. Going back a couple of years, we augmented that performance. That focus was also trying to complement that networking capability with the ability to automate those networks in our customers' environments, particularly around our service provider and customers. And those 2 sides of the coin is basically 100% of what we do. And that focus is really, really important to us, we're not trying to be a generalist, that's what we do. I think the market opportunity there is big enough to flourish. And if we stay focused, despite the fact that we may be competing against some bigger competitors, we will not be outspent by those bigger competitors, we will be leading the way from an innovation perspective. And I'll talk about what that has driven from a financial performance in a second. We wrap that up in a network vision that we call the Adaptive Network, and I'll talk a little bit about that going forward. The foundation that I think sets us apart from the competitive landscape in our particular area of focus is we've consistently led from a technology innovation perspective, particularly around the area of optics and coherent optics, which has been basically the state of play in our industry for about the last decade. We've led in every generation of that, and we continue to invest to make sure we're going to have that leadership position going forward. That focus and that technology leadership position has allowed us to drive over the years a significant diversification in the business, which, if you've known Ciena in the past, we have a very concentrated piece of business, both customer-wise, geography-wise, segment-wise, we are a much different animal today, and has been able to drive the global scale that is required to continue to fuel where I started that investment in innovation, which is getting more and more expensive and more and more difficult to do every generation from an optical perspective. Talked about the Adaptive Network. If you go back in history, optical networks 15 years ago were basically, you plan them, you build them, and you let them there. They did not -- they were relatively static. The world has changed significantly to the point where it's got a lot of programmability, a lot of analytics data that gets produced by those. And we do believe one of the vectors of differentiation for us versus the competition is our focus on that programmability and the intelligence and the data, complemented by that automation software technology that we've been investing in to drive a fully automated network in a space as opposed to the history of a very static environment. The drivers for our business, they're well talked about in our industry. So I'm not going to really double-click on that. But at the end of the day, optical reach and bandwidth coming on to the network. Bandwidth in our industry, you can go back and depending on who you talk to, has grown pretty consistently 20% to 30% year-on-year for the last decade or so or maybe even more. You would say, why then hasn't the optical industry grown by that rate. The answer to that, of course, is price erosion. The optical industry in itself, and I'll show you a little bit of a chart, has typically grown in the low single digits. So you can do the math and you can see that the price erosion environment has been pretty dramatic in our environment. Those that have invested in innovation technology to be able to take step functions out of the cost have been able to flourish in that environment. Those that have not have struggled, and frankly, lost market share over time. And the dynamics, and again, they're well versed in our industry that are driving the bandwidth, I think, will continue in the future. And more and more of that bandwidth is coming on to optical infrastructure earlier in the touch points in the network than in the past as well with things like 5G and fiber deep, which is all about user experience through bandwidth, latency, et cetera, which drives fiber densification plans, which is all good for our business. More fiber, more balanced, all fundamentally good for our business. If I put all that together, and I look historically at our performance. What you see is a pretty consistent year-on-year growth. If I look at '17 to '18, we grew our top line 10%. If we look '18 to '19, we grew our top line 15%. We've just recently put out our 2020 targets, which we're saying on the aggregate is going to grow at about 6%. We put out 3-year targets stretching out to 2022, and the top line on the aggregate is going to grow 6% to 8% year-on-year. If I look at it from a operating margin perspective, we just finished our fiscal year in ending of October, so we're on our November 1 to October 31 fiscal year. Per fiscal -- our fiscal '19 at the end of October, our operating margins were at 13.1%, and you can kind of see in the graph how it's been a straight linear line up, but it's been a pretty consistent climb up from an operating margin perspective. Take it down to an earnings per share perspective, '18 to '19, our earnings per share growth was 50%, 5-0. And in our 3-year targets that we put out, we have said we're going to continue to grow that 20% year-on-year for the next 3 years. So we're pretty comfortable with the technology. We're pretty comfortable with the fundamental drivers in the business. We're very comfortable with the technology hand that we have. And we're comfortable in our continued ability to drive leverage in the business. If you want to look at it from a competitive perspective, what this graph shows here is our global market share mapped out. Now that's the bars on this graph. If you look at the line, that is the global optical market growth rates. So you can see that in some years, it's actually even negative, but in a world where the optical market is growing on average year-on-year for the last number of years in the low single digits, we've been gaining global share. If you go back sort of from the 2012 to 2017, that's been pretty consistently at 1 point of global market share a year, it's been consistent a march. '18 -- '17 to '18, that actually doubled. So 2 points of global market share year-on-year. And we -- when all is said and done in '19, we think that's going to be 3 points of global market share. And what's happening is basically you do a graph of the large Chinese players and ourselves, and put them in 1 color on the graph and you put everybody else in the other color of the graph, share has been shifting from everybody else into those first three. And we think that's going to continue to happen going forward. So that's sort of a really quick overview of a little bit of what we focus on, what we think is our differentiators and then the net result of those dynamics in terms of the financial performance. So Jim, maybe we'll go to some questions, I think maybe you wanted to start yourself.

Yes. So we got a good group of people here that are obviously a lot smarter than I am, but I'll kick things off maybe to break the ice with one, and that is, again, to set the stage up. In 2018, your sales growth was 10%; in 2019, 15%; and now you're calling for 6% to 8% -- I'm sorry, 6% for the outlook. Obviously, law of large numbers, 2 years of fantastic growth. But when we think about that 6% outgrowth -- growth for the outlook, is there any difference between, say, service providers versus data center, is one outgrowing the other, is one stronger than the other or law of large numbers or network build-outs we should just be aware of?

Yes. I think you hit the nail on the head, like the 6% to 8% over our future 3-year plan is really off of a much bigger number than if we were -- we would have been talking 3 years ago because of the 10% growth and the 15% growth. So it's still significant growth, and it's on a backdrop of a market that we believe is growing 2% to 4%. So we continue to see the march towards share gain and share consolidation. If I look at -- and you looked at service provider versus web scale or hyperscale, whatever phrase you use for them, certainly, the webscale folks on the aggregate are growing faster than that overall growth number. The service provider growing a little bit less than that aggregate. That's at a market level. From a Ciena perspective, the dynamics are a little bit different for us in those 2 domains. In the web scale space, and this is in our numbers, you can go to the industry analysts, depending on which one you ask, they'll tell you that in the direct data center interconnect space we have somewhere between 50% and 60% market share, 5-0 to 6-0 percent market share. It's tough for us to come up with a hypothesis that says we're going to generate a step function to take that to 80% just because of procurement practices. But we do -- we're comfortable that they're going to continue to outgrow the overall aggregate spend in the market, and we're comfortable about our technical and incumbency position in those accounts that we're going to maintain that share. So that's the dynamic in the webscale space. On the service provider space, and it's accentuated from a North American sentiment, but it's true in other parts of the world as well. We see the service provider spend from an overall CapEx perspective where we play as being relatively flattish. But we do expect to have a great year in '20 in the service provider space because of share gains. And the number of those share gains are victories that we've put on the scoreboard through '19 that just haven't fully materialized into the P&L yet.

Thanks, Scott. Lots of questions in the room. So why don't we see if anybody has any questions, you can also e-mail me if you have any questions, if you don't want to -- but please press the button and make sure that the light comes on, and then you can ask a question so we can all hear it. Any questions from the audience?

What do you see -- you mentioned fiber densification in one of your slides as a driver for growth. And can you talk a little bit about the secular trends you're observing there, seems to have taken a little bit of a pause in 2019? And what are you seeing now as we roll into 2020?

Yes. So the -- let me address the secular part of your question because I actually don't see it necessarily being a cycle. I talked about bandwidth growth coming onto the infrastructure part of these networks, that 20% -- the 30% a year, and that's been very consistent. And I actually see that to continue going forward. What's -- and that's the biggest part of our core business. The fiber densification piece is actually a opportunity beyond that for us, I think. And it'll materialize, if you know our portfolio and how we break down our portfolio, that will more materialize in our Packet Networking part of our business, which today is about 10% of our business, and it's largely concentrated in North America. And we think as people start to look at their architectures around 5G stand-alone and the fiber densification with that, there will be an opportunity outside of North America for us to compete, and that's a way to differentiation to start to look at share gains there as well. And that's why when you see our 3-year plans, and we actually have broken it down by portfolio. You'll see our Packet Networking portfolio growing in the teens versus our aggregate growth of the 6% to 8% because of that dynamic.

Additional questions in the room?

I'll go ahead. What have been the primary drivers of your strong gross margins you've had recently? And then what is your expectation for gross margins going forward?

So first of all, I'll start with the caveat, in any given period, our gross margin -- if you look at any line in our P&L, our gross margin is probably the most difficult one for us to predict. And that's maybe frustrating but that's just the dynamics of the business. And it's because there's so much that goes into it, and I'll give you some examples. If we have a major new build out in an account, the way our business works is typically we build out broad-scale infrastructure that comes at much lower margins than the lighting bandwidth and traffic onto that infrastructure, which will come later in the project. So that's one dynamic. Another dynamic will be the product portfolio and mix that we have. So for example, I talked about our packet portfolio tends to have higher margins than our optical portfolio. So we have a higher mix of packet in a quarter, it's going to drive the margins up. If we have higher mix of software, it's going to drive the margins up. Something as simple as if our quarter is nicely -- smooth in terms of month 1, month 2, month 3 in terms of the shipments, then our costs to -- actually, logistics costs will be much lower than if we have a totally skewed back end quarter. So it's a bunch of different dynamics there. I would say, at -- if you sort of take a longer-term perspective on it, the 2 things that will drive margin improvement, one is portfolio mix. So as we get more -- and you'll see this in our 3-year targets. We're sort of saying we're going to get more -- our packet business and our software business is going to grow faster than the aggregate. And that will give us a bit of a lift from a margin perspective. The other one, though, is if you look at our optical business, we've become more and more vertically integrated from a technology perspective. And that has a bit of a cost lever as well to it. So it allows us to live in that price erosion environment and still maintain those margins.

And then we had a question on the other side of the room here.

On tariffs, can you talk about the end demand dynamics given the recent Phase One deal. I'm not sure you have a large exposure to China or not. But maybe you can talk about the regional exposure to Asia as well as Europe?

Yes. So the tariff piece of -- so first of all, our business in terms of a sell to perspective, we have, consciously as a strategic decision for quite a while now, decided not to pursue China as a market into the service provider space. We do have some business, but it's not material on the edges, where one of my North American service provider partner may go into China and need to have a point of presence, we will support them there. But China is not a big part of our top line. And it's not a big part of our future plan. So any sort of retaliatory stuff there, we have no exposure there at all. On the inbound stuff in terms of the supply chain from a tariffs perspective. We have done a lot of work over the last decade to minimize our exposure from a China perspective on our supply chain, and we worked with our supply partners to make sure that they're doing the same. Not totally immune, by the way. Where we tend to have Chinese content is largely second sourced in our supply chain. So over time, we can mitigate that impact. If we had no mitigation at all, it's less than 1 point of margin hit at the full tariff rates right now. We've had -- basically, you saw -- you just commented on a nice margin quarter in Q4. You'll note that we had an impact of the group 4 tariffs for 2 of the 3 months in our Q4. And you saw essentially no impact on the margins. Group 1, group 2 and group 3 we had 0 impact at all. So it's just the group 4. So...

Any additional...

And it's only to -- by the way, to U.S. -- to our U.S. customers.

We'll first go with the gentleman and then follow that.

Yes. Just trying to understand your comment earlier on, I guess, the revenue -- optical market growing at 3% price erosion was 16%, 17% versus the bandwidth market?

Yes. I think if you look at this chart, you can see that the I talked about bandwidth coming on to these networks that have been pretty consistent over the last decade at 20% to 30%. You probably can't read the numbers, but all those numbers range anywhere from 5% to negative in terms of the optical market growth. The difference between those 2 is actually the price erosion that's going on in the market. So if you look at it over a period of time, that's -- you can make yourself and do the math, it's north of 20% year-on-year.

So what is -- is there -- can you kind of drive down into that characteristic of price erosion? Could it change in the future as you take market share? Is there a kind of -- that's a little bit more than other parts of the tech food chain. I mean, you guys are probably right up there.

Yes. No, sure. The -- and by the way, this is not a new phenomenon. I've been in the optical business for multiple decades and it's gone on for my entire life. And all of our MBA textbooks would tell us as there's fewer and fewer players, we should get price leverage back. Frankly, I haven't seen it yet. That's a nice theory. I will tell you our 3-year targets, expect 0 change in that price behavior. So we continue to expect to see that price erosion. My hypothesis is that the only people that long term will survive in that is the folks that have the scale to invest in the innovation. So if their cost base is beating -- meeting or beating that price erosion curve, and fortunately, we've been able to do that, and I can tell you that we've got -- provided we execute, we certainly got the innovation engine fuel to continue to drive down that cost base.

So in terms of [indiscernible] portfolio [indiscernible]

Not much difference. But I think there's a big perception out there in the marketplace that says, as an example, all the webscale guys must just drive you crazy on price versus service provider x, y, z. At the end of the day, there's not much difference. They consume the technology a little bit differently. There's not much difference. What is different, and it's true across all the segments, is where are they in the project life cycle. Again, if they're deploying new infrastructure, tends to be at low margins. If they're putting channel adds on that infrastructure, we tend to have higher margins.

Could you mitigate the price decline [indiscernible]

Absolutely. That's why I think you see some of the smaller folks that are fueling this innovation piece, I don't know what -- I don't see an end game for them. I see an end game for them, but it's not pretty.

There was a question on this side of the room.

Yes. I was wondering at a high...

Before we go there, just to put it in perspective, by the way, the innovation engine, we'll spend just -- we'll spend north of $0.5 billion of R&D a year. Over $100 million of that is just on the core optical technology, forget productizing it. It's just on the core optical technology. And if you don't have the scale, there's no way you can justify doing that. And I can tell you, if you're having to buy that technology from somebody that wants to make margins at 35% to 40%. And you want to come play against the folks that have it. You might be able to play on a deal, you might be able to play for a year, but there's no long-term gain. Sorry.

I was wondering at a high level, you outlined the challenges of cost and complexity going forward, just at a very high technical standpoint. Has that changed your appetite for partnerships or collaborations as you talked about some of these smaller players not necessarily having a long life cycle in the business? Does it change your outlook for collaboration?

In what sense?

From an innovation standpoint, technology standpoint, very high level.

Yes. At a high level, we depend on a ecosystem, a partner from a technology perspective. And we'll continue to do that. We need partners from a supply chain perspective. What we will -- what we insist on doing, though, is the key components that we believe are driving the key piece of the cost that are requiring innovation. We want to at least have the option of controlling our own destiny. So I'll give you an example. As I said, one of the key levers of change in the share position has been the coherent technology. We're the most integrated provider of what we call a coherent modem, basically what takes -- puts light onto a fiber. If you go back 3 or 4 years, I wouldn't have made that statement because we would have depended a lot more on the different components. But what we saw was we weren't comfortable with the innovation cycles that were going on in some of those component places. So we went out and did an acquisition of a company called TeraXion, which people -- went largely unnoticed. But it is the reason why we're -- one of the reasons why -- one of the key reasons why we were able to beat market as fast as we can. Now even though we have our own capability, we'll probably second source ourselves. We'll have partnerships just for security of supply and whatnot, but we're not depending on them to get to market.

Scott, I actually got e-mailed a question. It's like, can you ask him a little bit about incumbency, meaning currently supplying a certain service provider or hyperscaler. And then you have some of these smaller companies making some announcements of, "we're the first 1 to offer a 400-gig or 800-gig solution." I mean, just because Ciena hasn't made a public, big announcement on it, is it premature to say you don't have those products or you're working with under nondisclosure terms with some of your bigger customers on those? Or how should we think about the importance of incumbency versus some of these smaller companies who claim to be first to market with some stuff?

So first of all, if the claim was around coherent transmission on the LAN side, I would say that since the first generation of coherent, we've been first to mass commercialization of the technology, and I think 800 gig will be first as well, in fact, coming to a theater near you very soon. But your incumbency question is really, really good because it's -- when there's a new greenfield infrastructure opportunity, of course, you compete with your latest and greatest technology. But those don't happen every week. They don't happen every month, they don't even happen every year. Incumbency and the cost of actually introducing a vendor is not insignificant. They've got back office costs. They've got, obviously, building out the infrastructure cost. They've got training cost. They've got sparing costs. And that actually is a barrier to entry, even if you've got the greatest technology. So incumbency matters. And I think there's been a perception in the world that said that incumbency on the service provider space, yes, we get it. It's been there for a while. On the webscale side, it's not there, they'll switch out Friday. They've got a new solution Monday morning that's going in the network. May have been the case when they were just getting started building their networks, but they have built now on the LAN side, some very, very sophisticated networks. They've got very integrated back office capabilities. They have dependencies on us for deploying the services, the relationships are much more intertwined than they were 4 or 5 years ago. So do they look exactly like a service provider? No, they don't, of course, not. But they're starting to inch towards that and incumbency is another important factor.

But you see these announcements by some of the smaller companies, too, and they kind of go around bragging first and best in this, but...

I'd point to the market share.

Good rebuttal. That's factual, yes. Another person asked me, since Scott's more of a product guy and service guy, not talking numbers, but big picture, can you help him bridge the gap about how some companies like Corning had such big gyrations of good, bad, good, bad, yet Ciena consistently had very good results? And again, he pointed to 10% growth in 2018 and 15% in 2019 and some of the other industry players have seen some very big swings.

You had a couple of different examples. I think if I use Corning as more of a surrogate of when people put fiber out, and then when -- whether or not there's a direct connection of that to Ciena's business. I'd say yes and no. The yes part of it is, as we talked about fiber densification, that fiber, it eventually needs to get lit, and that's an initial opportunity for somebody -- and somebody like Ciena or others, and hopefully, more often than not Ciena, but for others. But that fiber stays in the ground for generations. I think we reuse that fiber and build -- overbuild it with new generations consistently. So even though people may not be putting new fiber out there, we're putting new electronics on the end of that fiber that maybe doubling the capacity of that fiber. That has huge economic value to our customers. The -- probably the most extreme example of that is in the submarine space. Up until fairly recently, like new cables weren't going in the water. These cables went in the water decades ago or decade or decades ago. And they went in at a certain capacity, and we have orders of magnitude to improve that capacity by going in and upgrading the electronics on the end of it. There wasn't a single incremental investment on the fiber plan. So you can't draw the direct correlation. And that comes back to the optical innovation we said. The other dimension of it, though, you said that some of the others, I won't point out, but I -- we've worked really hard over the last decade to diversify our business. So some folks, and more recently sort of reasonably famous -- and that actually created some drag on our stock back before our Q4 announcement around worries around where we're seeing the same effect as some of the others that went before us in announcing. What people I don't think understood about our business, even within that same sector, was the diversification that we have in the business. So are we immune to an individual customer having a -- getting a cold and slowing their spend? Of course, not. But we're a much more diversified business than we were even 5 years ago.

Additional questions from those in the audience? There's a question on this side of the room.

Could you explain the strategic logic behind Cisco buying Acacia?

It's probably a better question for Cisco, but I'll give you Scott's per -- warped answer to it, I guess. So this is Scott's view. I obviously, don't sit around Cisco's strategy table. My view of it is it's 100% driven or largely driven by protecting their data center switching business. And if I look at -- they clearly lost share to an A company as the technology cycle went through the 100-gig technology cycle. And I think they're hell-bent on making sure that, that doesn't repeat as you go 400-gig and 800-gig. And I think they think the optics is going to be a big lever of that. I don't think it's driven because they think they want to be #1 market share in optical transport.

Do you think that they will continue to supply other vendors with Acacia product?

I mean, publicly, they clearly said that they would. Privately, in my mind, I go, it doesn't seem like the DNA of Cisco to be an optical component supplier, but doesn't seem to be in their stock price and margin profile either, but again...

Additional questions?

Yes. Regarding customer diversification, do you have a target nontelco revenue number in mind? Or...

The diversification comes from a number of different dimensions. So you went to the sort of segment dimension, and I'll talk about that in a second, but it's also a geographical dimension, even within a segment, and it's a portfolio dimension. So we talked about trying to grow our packet and our software and our services business faster than we're growing our optical business on our 3 target plants. So that's one dimension of the diversification. We certainly put a focus on our go-to-market investment to try to -- we're going to continue to grow in North America. We're going to continue to do great in North America, but to -- try to overweight growth outside of North America. So on our go-to-market investment, and that's paid dividends for us through '18 and '19, and we think it will going forward as well. And then the segment diversification. If I go back in time a couple of years, we were -- and I'm looking at [ Aaron ] to keep me honest here. We were probably in the mid-20s to 30% nontelco revenue back in a few seasons ago. In '19, that was 39%. So we've done a good job. Now what we count in there is everything from the direct web scale. So when we sell them direct, not when we sell them through the service providers but we sell it direct; our cable MSO space; our enterprise private build, some of our enterprise. There are some enterprise customers that are private build optical networks. Our government and our research education segments.

Additional questions? Somebody e-mailed me one, but I want to see if there's additional questions in the room? And I didn't know if this is better for you, Scott, or for Aaron, but somebody said, what are they going to do? They got a lot of cash. I don't know which one of you want to talk...

I haven't found out what's [ George ] Moylan, our CFO, keeps that in by the way, but...

I know you are more of a product guy. So I didn't...

No, no, no. I will give you the answer. So obviously, we've had a great couple of years. By the way, in our cash position and our balance sheet is in great shape because of that. We're going to continue to generate cash going forward and part of our 3-year targets we put out there in terms of what we think our cash flow rates would be. We've got a share buyback program in place. We actually increased that about 12 months ago. We will continue that going forward, by the way, but I think it'll be from a target perspective is likely to try to keep the share count flat -- flattish. We would prefer to use it for acquisitions to grow the business. And I'm not really going to comment on where that -- those targets would be, so...

And then I got one more question. It says, "Jim, can you ask him a little bit about how, not just Corning, but also Arista, Cisco, Hewlett Packard Enterprise, Dell, all talked about a noticeable decline in enterprise spending as well as hyperscale spending?"

Yes. Again, I'll go back to what we saw. We had a great year in '19 with the hyperscale folks that continued in Q4. Are there ebbs and flows in the spend on an individual account? Absolutely, there is. Our perspective is where we play with them, that their spend going into '20 is going to grow in the area of high single digits to 10% at a market spend perspective. I think we commented already that our share -- our market share position there, depending on which industry analyst you ask is either in the area of 50% to 60%, have a hard time telling you that we're going to significantly grow that share position, but our competitive position and our incumbency that you mentioned, we're pretty comfortable we're going to maintain that share position. So that's sort of the plan that we've got in place for 2020.

Great. Well, ladies and gentlemen, thank you so much for joining us here today for Ciena. I do want to note we're ending about 2 minutes early, and Scott and Aaron will hang around for a couple of minutes in case you have any last minute lingering questions. We thank you so much for your participation and for attending Citigroup's TMT CMS Conference. Thank you, Scott.

Thanks, Jim.