Ciena Corporation (CIEN) Earnings Call Transcript & Summary

Hello, everyone, and thank you so much for joining us here on Day 3 of Citi's Global Technology Conference, where we have had over 200 technology companies present and talk on fireside chats with investors. A few housekeeping items. This fireside chat will be with Ciena, stock ticker CIEN. If you are media or press, you are expected to disconnect immediately. No media or press are allowed on this call. This is for investors. If you are subject to MiFID II, please ensure you have that research applicable agreement in place. We also want to note there are disclosures associated with this, both on the Citigroup login, this conference site in the Velocity and I want to direct you to the Ciena Investor Relations website. At the Ciena Investor Relations website, there are safe harbor risks and forward-looking statements that you should be mindful of. If you do want to ask a question, there's a little button on the side of your screen, you can press ask a question. And if we have time, I'll get to those, I will not say who it's from. And we're going to keep all other lines muted. That way, we have good quality for sound and audio through this. I want to introduce from Ciena. We have a full lineup here. We have the Chief Financial Officer, Jim, as well as Investor Relations, Gregg and Patti joining us. So thank you so much for joining us on such an early morning here for you and all of us. But I do want to talk about overall big picture demand.

So Jim, maybe can you start out about talking about overall demand trends? And maybe have they changed compared to when we entered the year? Because I feel like a lot of things have changed with COVID and shipping and the pandemic, and we were going to do this in person, now it's virtually. Can you talk about overall demand and how it's progressed through the year?

Sure can, Jim. And that's one of the key questions that everyone is interested in. What I'd say is that the demand for our product, services and software is driven fundamentally by the demand for bandwidth on the networks. And although we have seen a change in demand for our products, and I'll talk about that in a minute, the fundamental driver, which is demand for bandwidth, has continued to grow at the pace that it's always grown. It grows at 30% a year or so, and it continued. During the pandemic, the flows have changed a bit for a little -- for a couple of reasons. One is, even before COVID, a lot of things were moving to the edge, to the metro and to the edge, a lot of data was moving to the edge. You're talking about 5G and Fiber Deep, Internet of Things, edge compute, all these phenomenon were driving data demand to the edge. COVID accelerated that because instead of flows going into enterprises in massive pipes, it's going to people's houses. And so that was a change and that created some consternation on the part of the service providers which they worked through. But that -- the point that I'm making is that the fundamental demand driver has not changed. In fact, it may have increased a bit. In the case of demand for our products, we saw at the end of last year, when COVID first became apparent, a great amount of concern on the part of service providers worldwide. Their concern partly was concern for their customers: would their customers be able to continue the services that they contract with them. The small to medium business and enterprise businesses of our big customers really took a hit immediately. There was also some concern about being able to install gear, all those kinds of things. So as we entered -- as we Ciena entered this year, everyone working from home, we were looking at a demand environment which demand for bandwidth was growing, but demand for our products really had dropped. We had very low order quarters, in our fourth quarter of last year and our first quarter of this year. However, we planned on the basis that with underlying demand continuing, we would -- for bandwidth, we would see service providers come back into the market. I'd also say that even the web scalers had some issues in continuing to build out data centers. So their spending actually dropped during that period of time. But we made a plan based on the assumption that as long as demand for bandwidth continued, people were going to have to come back into the market. And that's what's happened. The demand environment has changed abruptly. Starting in our second quarter, we had an extremely high orders quarter in second quarter. We had a very, very good orders quarter in Q3 and we're having a good orders quarter in Q4. So the situation around market [Technical Difficulty] well, come back into all the service [Technical Difficulty] into the market, the web scalers have come back into the market. There is some catch-up on the part of the service providers in their order flow because they were running their networks hotter than they like to. So there's some catch-up, there's some advance orders because the other thing that's happened as the world has come roaring back is that there has become an apparent shortage of semis. And it's not just affecting our industry, it's affecting global industries. So that has come into play, and that's affecting things, too. But I'd just say that the demand environment has sprung back nicely, and we're looking for a strong fourth quarter and a strong 2022.

Can you talk a little bit about your visibility with component shortages and the pandemic? I'm wondering is your visibility materially increased and maybe compared to what your discussions with customers pre-pandemic versus now are for timelines?

Yes. I mentioned, Jim that we were getting some advance orders. And that's because some customers are aware, in fact all customers are aware that there is a semi shortage, but some are acting on that by giving us visibility into their orders and needs in advance of where they had previously. What I'd say is that there is no shortage of demand, but the supply chain and the semis in particular has really created some questions about how much we can deliver. We have great visibility into the demand picture. And at the end of this year, we're going to report our backlog number, and I know people are going to be very pleased by that backlog number. We also have -- and I've said this many, many times, but we have with our top 50 customers, which make up 90-plus percent of our revenue, we have a dedicated sales team in each case, who talk to that customer at least weekly, if not daily, sometimes hourly. So we know what they're planning. The combination of backlog and that's [Technical Difficulty] [ relationships ] is what gives us a visibility and that's better than it's been in my memory anyway. But the supply chain has created this question about how much we can deliver.

And what we're seeing in the context of Q4 is it's accounted for in the revenue range, the gross margin range for that matter. With respect to revenue, what we're suggesting is the flexibility that we've had the past few quarters to outperform, which we have because we've done very, very well with management supply chain challenges, the flexibility is a bit reduced. And so it challenges our ability to approach the high end of the range or certainly beyond the high end of the range, but it's generally incorporated into the guide.

Okay. Then we'll talk a lot more about supply chain in a few more questions. But sticking just still kind of demand overall before we get down to the kind of cost and supply chain issues. Can you talk about the various demand issues of whether it be service provider versus Internet contact providers? Are there changes there, are dynamics different between ICPs and service provider spending?

There are. I mentioned earlier that the service providers very much contracted their spend for a couple of quarters. The data center guys did contract their spend, but not as much as the service providers. So the data center guys went from sort of a maybe, call it, a 9% or 10% growth rate in spend to a 3% to 5% increase in spend. And the service providers went from a small percentage to maybe no growth this year. And one thing you have to know is there's a little bit of a trick in the numbers because we had a low couple of quarters and now people have come back. So these growth rates are not -- they're year-over-year growth rates for the year. If you looked at individual quarter-over-quarter, you would see some changes because of that phenomenon. But I'm just sort of generalizing in response to your question about demand trends. As we look into the future, we think that this will be back to a 3% to 5% growth rate market. The service providers will be lower than that. They have constraints on their spending. The web scale guys will be back, we think, up in the high single digit or maybe low double digit. That's what we think is the likeliest outcome pending what happens with both COVID -- -- we don't have another upset with COVID -- and pending the ability of people in the networking business to deliver based on the supply chain.

And speaking of what's going on with networks and the cloud providers, can you talk about your 800-gig product, kind of how the rollout's going, expectations? And does it impact your 400-gig product sales?

Yes. We've been first to market with every generation of coherent product from 100 to 200 to 400 to 800. And each generation has been -- has had a faster take-up rate than the previous one. So -- and of course, when 800-gig ramps, then 400-gig is going to drop, and 100-gig is going to drop. It's just a -- it's a phenomenon. But I'd also say that this higher take-up rate has coincided very much with the growth of the hyperscale players as a spender in this industry. They have huge demands for bandwidth. They want the most capacity they can get between their data centers. And so there has been a direct correlation between the take-up rates and the spend by the hyperscale. But overall, we're very pleased with 800-gig. We've been in the market with 800-gig for like 1.5 years. 800-gig is based on what we call our WaveLogic 5 DSP. There will be other generations of DSPs. They sort of come at 2-year intervals or so. And I don't -- I guess I'd say, we're probably not going to have another chip out in 6 months, but 2- to 3-year intervals is the sort of interval between generations.

And then competitively, when we look at the marketplace, it's pretty widely known that in certain countries, Huawei is being kind of overlooked at the view of embracing others such as yourself. Has that opportunity fully played out? Or is it still at the early parts of you capturing share?

Still in the early days. What I'd say is that the Huawei phenomenon was -- they came into the market 12 years ago maybe, and maybe a little more, and just really took a lot of share around the world. Not in the U.S., where they're not allowed to play for the most part. But in Europe, South America, Asia, they've taken a lot of share. About 4 years ago, maybe 5 years ago, there came to be a concern in some parts of the world, chiefly Europe, that they -- that Huawei had too large a market share, that there was too much dependence upon Huawei as a supplier. And so that became the talk. Then maybe 3 years ago, they -- or so, maybe a little bit longer. There came to be grave concerns not just about their market share, but security concerns and the level of tension between the West and China has ratcheted up. What countries have done -- by the way, that's been exacerbated by 5G, because 5G is seen as a critical technology for the future for all countries. So in the last couple of years, what you have seen is a number of countries speaking out publicly, privately or legislatively, against the Chinese. India, for example, was an early mover, and they -- of course, there have been wars between India and China or at least kinetic activity. India is pretty much going to eliminate Huawei as a future supplier. And we can talk more about that if you'd like. But that's been great for us. There have been a number of RFPs over the last 1.5 years -- during the COVID period, by the way -- and we've done very well in those RFPs. In Europe, it's more complicated because the Europe -- the countries in Europe have a lot of trade with China. And so the geopolitical situation is just more complicated. But what you have seen on the part of most European countries, is a refusal to deal with Huawei as a 5G vendor. Of course, we don't play in the 5G market per se in the RAN business. But now, more and more now you're seeing European players no longer contract with Huawei. This is -- we've always said this is going to be a long-term competition, that mainly it's going to be between ourselves and Nokia for that share of Huawei in Europe, that it's going to play out as infrastructure deals are done, that no one's going to rip and replace Huawei. That's too expensive and no one can afford it. But there will be opportunities over the next 5 years, 6 years for big infrastructure deals with European carriers. It's starting. We've won a number of deals in the Scandinavian countries, in the U.K., and on the continent. But really, it's early days of this and we're going to see a lot more of these opportunities come our way.

Speaking of changes, opportunities or even competition, can you talk about 400ZR? There's a big debate about what's going to happen with pricing in ZR and pluggables. What's your thoughts on that?

Yes. First thing I'd say is that people should know that pluggables have been a part of the landscape for a long, long time. But to date, or at least up until the last couple of quarters, all the pluggables have been of the noncoherent variety. 400ZR is the first coherent pluggable and 400ZR is a spec. That means that a 400ZR plug has a certain range of required performance and, importantly, required power consumption. In that range of power consumption and performance -- of reach, I should say, there is an application for the 400ZR. It is our view that, that is not -- at least for the next few years, a big application. We think it's a $300 million to $500 million piece of a $13 billion market. There are going to be -- there are 3 players today. That might be the only players, but it's ourselves, we've just become GA with our 400ZR, Acacia, who's been in the market for a couple of quarters, and Infi, who has been in the market for a couple of quarters. The first 2 big movers here in terms of customers are web scale players, who want -- because of the setup of their data centers, they want inter data center connections of less than 80 kilometers, which is what the 400ZR spec is, and with a power consumption of 16 to 18 watts or something like that. And that enables them to plug the 400ZR into a switch or even a router and make that application work. As I say, we think that that's -- for the near term, a $300 million to $500 million market. There are a couple of data -- a couple of web scalers that are the first movers. We have opportunities with both of them. We're going to work those, and we hope that we'll get our share of the market. We do think that our pluggable has superior power performance and superior reach. So there are going to be applications that we should be a favorite vendor.

Jim, I got a clarification question from a couple of investors about earlier when you made a comment about some catch-up for service providers. Does that mean that they're actually going to grow above the 3% to 5% range in the medium to near term? Or is that kind of going to -- of course, depends upon component and supply constraints if that happens. But does that mean they're actually going to be better with that catch-up?

We're not thinking that. I mean who knows. But the issue with service providers is that they are naturally -- generally naturally constrained by their business model. They are very much judged in the investment community by their capital spending. That's a feature of how the investment community views them. And so they -- and their revenue growth has not been stellar. So they've been naturally constrained. Now, it will be interesting to see what 5G does, perhaps that puts their revenue on a better growth track. But so far, we haven't seen that happen. I'd give you a couple of exceptions to that general rule, but it doesn't detract from our view that we're not going to see them above that low single percentage -- single-digit percentage range. But the 2 exceptions are Verizon and AT&T, both of them for slightly different [Technical Difficulty] have [Technical Difficulty] their normal money, but they're [Technical Difficulty] a little bit more. Verizon said they're going to [Technical Difficulty] $1 billion over [Technical Difficulty]. And AT&T, I think they said they're going to spend another couple of billion or $3 billion or something like that. So they have said that, and that's directly correlated to the fact that there's been a big spectrum auction at the beginning of this year. They have a lot of spectrum. They want to light it up because it's useless to them unless they can light it up and get revenue. First spend is going to be with fiber and with the RAN, but they're going to have to connect all that stuff back into the network. And so those 2 in particular have said they might spend a little more, but we don't see it, generally speaking, around the globe.

And before we start to talk about margins and profitability, one last question kind of on sales or opportunity. Can you talk about your routing and switching portfolio and kind of the outlook there?

Yes. We have seen coming a change in -- or an evolution, I should say, in the architecture of the network. And it's driven by what I was talking about earlier, which is demand is moving to the edge and access part of the network, and not all demand has to go back into the core. And it's driven by all the things I've talked about, including edge compute, the web scalers are -- a combination of the web scalers and service providers are moving compute to the edge. So as a result of that, because there's going to be so many more nodes and so much more volume of data. The old way of building networks, which generally speaking was to put a router at every node, is no longer economic. They can't do that anymore. Now I'm not saying that's going to end edge routing and there are not going to be any routers out there, because that's not true. There will be some. But generally speaking, the evolution will be toward a harder optical box, which has some IP capability. The ability to note where the next most optimal node is to send the data. And that converged box is going to be part of our routing and switching portfolio. We started spending on this product -- on this set of products, I should say, because it's not just 1 product -- about two years ago, we started. We see it coming. By the way, it's not too much a feature today. There have been some movement on the part of some companies, Verizon in particular, with their Metro a couple of years ago have moved in this direction. But the full sort of instantiation of this architecture will happen over the next several years, and we intend to be ready. Now what that does is that it increases the TAM available to us from about a $13 billion TAM to a $22 billion TAM. I will be quick to say, though, that, that $9 billion increase in TAM is not unoccupied, it's routing and switching. And it's occupied by some big players. Cisco is there, Nokia is there, Juniper is there, others, but those are the big ones. And so there will be a competition for that TAM as we move through the coming years and the operators start making those decisions. That's why we have spent heavily over the last couple of years and will spend heavily in developing our IP capabilities. I'll mention as an aside, that that's one of the key reasons why we bought the Vyatta assets. Vyatta has 60 IP engineers, we were interested in Vyatta when it came on the market a couple of years ago, AT&T bought them. And when AT&T suggested that they would -- they'd like to divest, we were very interested and entered into a deal with AT&T to buy the asset. We did it mainly because we wanted the IP capability and the IP-conversant people. It also deepens our relationship with AT&T, which is never a bad thing. Although the revenue from the company is not material, it still is -- it's a great strengthening of our relationship with AT&T. And it should advance us even more rapidly with respect to our IP journey.

Why don't we work down your income statement a little bit? And first of all, talk about supply chain disruptions or shipping costs. I live in San Francisco, and there's been a lot of boats coming in, but they can't unload them fast enough due to labor shortages. And I looked at the cost of shipping a container from Taiwan or Hong Kong to San Francisco and the costs have materially gone up. Can you talk about supply chain disruptions and the impact to you and your company and financials?

No, the first thing I'd say is that we have managed to navigate supply chain issues very well and I think better than most. This supply chain set of disruptions really began several years ago. We had an upset caused by the ZTE situation. We had questions about Huawei as a buyer, which upset the supply chain. We had a shortage of jellybean parts 2.5 years ago. Then we had a shortage of optical components, ROADMs, et cetera. And now what's happened is that semis have become very, very tight. We've seen all of that, and we've navigated through that and including the fact that the shipping lines have become congested. We always said that we were not immune to these things. And we showed that, frankly, because we said that in our Q4, we're going to be impacted by a few tens of millions of dollars as a result of all of the supply chain things that we see, mostly the semi shortages, our semi shortages. With respect to shipping, the other thing that's happened is that because of COVID and because there are fewer planes flying, the amount of air cargo capacity is down from where it was. And so we're seeing the cost of shipping by air, which we do a fair amount of, be impacted by COVID. So all of these things are affecting us. We know that it's going to impact our revenue by a few tens of millions in Q4. We also know that because of the cost of buying semis, we're going to spend more money to get the band that we need. And that's one of the reasons why we called our gross margins down from the 48.5% to the 45% to 47% in Q4. So that's what I'd say. We're working through it. Everybody is working through it. Customers know about it, but they want to get their networks working. And so it's up to us to keep working the problem and solve it.

So you talked about the supply chain disruptions impact to margins. Can you talk about maybe business segment or product mix on margins, so we can be mindful of that also?

Yes. Yes, one thing I'd say is that our -- we have a lot of different products, and we have a lot of different customers. If you look into our revenue stack at any one point in time, you'd see probably 350 or 400 customers, all doing projects and many in very different stages of the projects from early stage where we're laying out line systems in Photonics, which tend to be lower gross margin. And then later stages of the product -- projects in which we are putting out capacity cards, which are going to be typically higher gross margin. So that fact in and of itself is a driver of our gross margins, and what has been the case over the past few quarters is that the percentage of our revenue which is made up of capacity adds, the cards, has been higher. So we've enjoyed a very, very nice gross margin. The other thing I'd say is that our products have different margin profiles. If you look at routing and switching, typically that's going to be a little higher gross margin. Services, we've had -- we've enjoyed very good gross margins for services, over 50% for a number of quarters. And so the mix within our business between 6500, Waveserver, routing and switching, services and software is going to move our gross margins around. But the fundamental mover is this difference between early-stage projects and later-stage projects. That probably has the single biggest impact today.

And Jim, as Chief Financial Officer, CFO, you're also in charge of capital allocation. Can you remind investors about your priorities and intended uses for cash and cash flow?

Yes. We published these priorities here 2 or 3 years ago and they really haven't changed except in 1 area that I'll mention. We said that the first thing and most important thing for us is we want to fund our business. We are in a very competitive business. And in order to stay competitive, we have to spend on R&D and keep ourselves current on technology. As I said, we've been the first to market with every generation of coherent technology, and we intend to continue that first to market. We think it's an advantage for us. That's the first thing. We're going to spend the money we need to spend on R&D. By the way, along with that is, as we grow, you must spend money to make sure your products are getting to market with our sales force, et cetera, and we're going to do that as well. But after we do that, and we've been able to do that quite successfully and keep our OpEx growth below our revenue growth for a long, long time, the next sort of priority is we want to have about $1 billion of cash on our balance sheet. And that's for rainy days. It's if we see opportunities and we don't necessarily want to go to the capital markets, it's in case there's upsets in our business, and this can be a volatile business. So we have to be careful for that, so $1 billion. Now when we first announced these policies, we said $700 million to $800 million. So COVID has sort of reminded us and me of the fact that things can go bump in the night. So we'll keep at least $1 billion in cash. We also said that we wanted to maintain about a 2x or no more than a 2x leverage ratio, which keeps us in the range of where we are as a Ba3 and BB+ credit. That's a good place for us to be. Now as we sit here today, we have about almost $1.5 billion of cash. We are also well below the 2x leverage ratio. We're at 1.2 or 1.3 or something like that. So we have a lot of flexibility with respect to our balance sheet, probably we're running it a little too conservatively. And part of that is because of COVID and the fact that we have reduced, out of caution, the amount of stock we're buying in. But that's something that we're going to have to address as we move through time because I think we've got a heavy balance sheet, and we've got, hopefully, some uses for that stuff.

So Jim, as we wrap it up, what's maybe the 2 or 3 things that you'd like to leave investors with about why you're excited to be CFO of Ciena and why they should be owning the stock?

Yes. Well, I think that Ciena has proven itself to be a leader and -- a leader in the networking business and the leader in optical capability. Optical capability has become more and more important because all of these architectural changes that we talked about demand high-quality optics in order to keep the data flowing around the network. We have never been in as good a position as we are today. Over the past 10 years, we've driven from sort of a $2 billion company to approaching $4 billion. And hopefully, next year, we're going to be somewhere in that range. I'm not giving you any guidance, I'm just saying that if you look at this year, we're going to do 3.6 and we'll grow from here. We've come from a breakeven set of financials to a very strong profitability range. We did 19% last quarter. We set our long-term target of 16% to 17%. So we've done that. And we've generated cash, really starting about 3 or 4 years ago, we started generating a lot of cash. So we have never been in as strong a operating position, market position, or financial position. And I think we're going to continue to grow, and we're going to continue to be profitable.

Well, I sincerely want to thank Ciena for joining us here today, Jim, Gregg and Patti, and we know you have a great lineup of meetings and schedules, and we sincerely hope that next time when we do this, it will be live in person, and we're on stage having a coffee or tea with the audience literally in front of us physically. Until then, I want to express my sincere appreciation, and we thank you so much for your time.

We echo your sentiments. We'd love to do this live next year.

Thank you.