Ciena Corporation (CIEN) Earnings Call Transcript & Summary

My name is Alex Henderson. I'm the networking and security analyst at Needham. I've been following Ciena for just 25 years plus, something in that range. And it's a pleasure to have them here at the Needham Growth Conference. Today, we were going to do a fireside chat with David Rothenstein, who's the Senior VP of Strategy at Ciena and therefore, uniquely positioned to talk about the broader trends and demand and supply dynamics and things of that sort. So thank you for joining us.

Thanks, Alex. Thanks for having me here.

So let's start off for people who don't know the company. You had a fabulous October quarter. You had a horrible July quarter. Can you talk about the last 2 or 3 years trajectory into that and where we are today looking at the rearview mirror just to make sure everybody is on the same page.

Sure. Thank you for the blunt honesty, Alex. Good afternoon, everyone. Yes, so I mean, it's been a choppy several years for Ciena, obviously, and for everyone, but particularly going into the pandemic and then the past 12 to 18 months of significant supply chain constraints have brought about a lot of different changes in our industry and in our business. And the way I kind of think about it over the past 3 years, after a couple of years of hyper growth in 2018 and 2019, the past 3 years have been largely flat in terms of top line growth for the company. And that was for a lot of different reasons, but particularly with COVID in the first few years, you had network operators really constraining their spending across the board. And so we've been around $3.6 billion in the past 3 years. In 2022, in particular, we started seeing some significant impact from supply chain challenges initially from semis broadly. And then in Q3 and Q4, Alex, what you're referring to is some specific challenges with availability of certain integrated circuits, particularly power management ICs that really gated the manufacture and shipment of modems for us. And what you've seen is even though the vast majority of our supply chain is actually performing to what they have told us in terms of volume, in terms of timing, the volatility of a small number of component suppliers for these integrated circuits can have significantly unfavorable effects like it did in Q3 or correspondingly favorable effect in Q4. What we are seeing kind of as we're into our Q1 now, where November to October fiscal year is continued movement from a supply chain standpoint. We are seeing more and more suppliers delivering what they said they're going to do, but still some degree of volatility amongst those. We have been able to start seeing the benefits of a lot of our mitigation efforts on the supply chain side in terms of qualifying alternative sources of supply, having some product engineering redesign efforts come through as well as improvements in production capacity. So all those mitigation efforts are bearing fruit and led us to result in Q4 significantly above our guidance.

So looking at the mechanics of that, a single de-commit late in the July quarter, uncertainty around the October quarter, your guide there almost by definition has to be fairly conservative because you're not sure what it's going to look like. And then better-than-expected results. Is that a function of them having de-committed and coming back in and if I average those, that's the rate of supply that you're getting? Or is it that they are in fact seeing better availability and more consistency, so you'll actually see sequential gradual improvement as we go forward quarter-to-quarter-to-quarter?

I'd love to say we had complete line of sight in terms of all those different dynamics. And in case how some of these suppliers do their own allocations, particularly among industries. I do think that, certainly in the middle part of last year, there was some allocation heavily toward under industries. And with some of the higher inflation and recessionary impacts, could that have an impact in terms of allocation going forward. I think directionally perhaps, but I wouldn't take that to the bank. I think overall, we can control what we can control, which is, as I said, really trying to continue to drive the mitigation efforts and offset whatever ongoing volatility, we'll continue to instantiate. What I do think is that overall, more broadly is from a supply chain standpoint, I think we are going to see continued improvement, but it's going to take time. There's not going to be a switch that gets flipped in 1 particular quarter or a month that says all of a sudden supply chain issues are behind us, and we can now just focus solely on demand. I think it's going to be a multiple quarter effort.

Probably a multiple year effort...

Potential multiple year...

So looking at the backlog, just to remind us, you entered a couple of years ago, your normal backlog is, what, 4 to 8 weeks. Is that kind of...

The normal product delivery times are -- have been before for all the supply chain issues were 4 to 8 weeks for the majority of our portfolio.

And what is it currently?

The average of the portfolio is around 8 to 9 months right now with variation.

So as supply improves, the duration of the orders should come in?

Yes. As supply improves, I think a couple of things are going to happen. One, I think you're going to start seeing our extraordinarily high backlog start coming down, which, by the way, is a very good healthy thing. It's -- we entered this fiscal year at $4.2 billion, which is a historical high for us, not just in terms of absolute numbers, but in terms of relative in terms of percentage of our demand plan for the year. It is almost the entirety of the demand plan for the year, which is highly unusual. And it's a function of the longer lead times and frankly, the forward ordering by several of our larger customers. And the hope and expectation is that as we start to service that demand, backlog will come down and order growth, I wouldn't say it's going to slow down or decelerate. I think it would normalize to where it can and should be going forward.

So when portfolio managers hear the word massive backlog, biggest in the company's history, there's almost a Pavlovian response to that, which is, "Oh my God, I'm selling the stock." That's probably been borne out of history. A lot of semiconductors and other component companies have seen significant corrections in their backlog is double or triple ordering have evaporated. That's not the case with Ciena. Historically, you've almost never seen backlog be canceled. Can you talk about the stability and predictability of actually shipping what you have in backlog because it's a critical piece of the puzzle?

Yes, it's a really good point. And I would caution anybody in terms of reading through the way semis are ordered and procured versus system solution sales, which is what Ciena does. The reality is our products, while the majority are commercial off the shelf, they are highly bespoke. We have over 11,000 SKUs in our product portfolio. And in the vast majority of cases, the solutions are specifically configured for a particular customer's network architecture or network application. And in many cases, it can be a multi-quarter effort on the part of the network operator to actually run an RFP or an RFQ and make a selection process and then do the network design as part of that. So you take that on top of the fact that, two, these are incredibly expensive system solutions. These are not jelly being commodity parts that can be easily replaced. And three, given the fact that during the pandemic, many of the operators did run their networks, particularly hot, you take all 3 things together with the fact that the vast majority of our order backlog is, frankly, contractually noncancelable. But even if it weren't, I'm not sure it would change the dynamic. But you take all those things together and you say, "You know what, they're really -- there really isn't where I think you're going, any material risk to degradation of the existing backlog."

So going back to the point of availability causing duration stretching that caused your backlog to go from $1 billion to $4.2 billion over the last 2 or 3 years, the worse is obviously going to happen at some point during the next 18 to 24 months. As that happens, how do we think about what happens when you get upside availability on components, then the duration by definition narrows. Therefore, the time they have to order ahead diminishes and therefore, the orders declined. So there's kind of a multivariable equation there that's a little bit difficult to solve. But if we assume, say, 5% or 10% upside due to the revenues, just hypothetically, you'd still have orders that are reasonably healthy in a typical year that would allow you to bring that backlog down, maybe bring it down a couple of 2, 3 months, but you'd still exit '23 with a backlog significantly above normal. Is that organically reasonable?

Yes, I think the thesis is absolutely correct, Alex. And frankly, your view in terms of having to thread the needle in terms of some of these forward expectations and projections is correct, right? I mean, I would keep pointing out though that all of this is frankly healthy, right? The backlog is inflated right now for the reasons that we know. Our inventory is inflated right now for the reasons that we know in terms of building up materials waiting for the golden screws to turn it into finished goods. All of that is and should normalize over the course of time. And that's a good thing. Where I think you're going is, where is it going to end up, anybody's guess. I think certainly for fiscal '23, I don't see a return to status quo ante. I don't see backlog returning to where it was before supply chain challenges. I don't see inventory returning back to where it was before supply chain challenges. I think it will start normalizing. And you layer that against the fact that we like, frankly, any global multinational who's worth their salt, they're rethinking their supply chain operations going forward. And so instead of this 25-year journey toward just-in-time supply chains focused on operational efficiency and cost, we're seeing and looking at how we balance that with a greater degree of resiliency and redundancy in our supply chain, which will likely need some degree of higher inventory to take account of some of the risks that exist.

So embedded in all of this is need to get parts that are often almost impossible to get and what parts became available are often at incredibly inflated prices. So how much cost are you absorbing currently as a result of the supply chain and logistics challenges that once it normalizes, we'll come back out of the margin structure?

Yes. So what we said about margins is our -- we've said for quite some time actually, our long-term target margin is in the mid-40s. We did see at the beginning of the pandemic, several quarters of very high margins in the high 40s as a result purely of product mix. I mean the reality, Alex, any question about margin, the answer is product mix, one way or the other. And so we saw virtually no operators undertaking new builds. And as a result, a huge proportion of the sales work where capacity adds, which carry higher margins. That has now regressed a bit specifically with the supply chain challenges that you're talking about, what we've seen is -- what we said generally with the semi shortage is about 400 bps of impact to the margin line, and that's a function of a couple of different things. One, it's -- instead of the typical cost reductions we would get on the supply chain, we've actually seen cost increases from some of our component suppliers as well as the fact that we've seen the need to pay to your point, higher premium to brokers on the open market to procure alternative components as well as for a time, higher shipping and logistics cost. It just cost more to get product anywhere around the world, given the shipping lane challenges that we had over the past year or so. So all of those things, as I said, about 400 basis points. And then on top of that, there was maybe an additional 100 or 200 bps of impact from the specific integrated circuit challenges that we've had. What we've said for 2023 is we've guided to a margin of around 42% to 44%, which is roughly flat year-over-year. We do expect and we are starting to see some of those supply chain challenges, as I said, improved, which is resulting in slightly lower costs but they're still elevated. So what we said is around 200 to 300 basis points this year of margin impact because of these ongoing dynamics.

But theoretically, that could fall out over, say, '24 and then into '25...

We think it will. And as we've said, we expect in that time frame to return to our target mid-40s margins.

And in addition to that, it sounds like there was a pent-up demand for footprint build, which obviously the chassis are much lower margin than the blades and transceivers. So to that extent, are we seeing a mix that stays that way over the next year? Or is it going to start to normalize on the mix as well as we exit '23?

I think there's a lot of different dynamics at play. We had both in Q4, what we're seeing at least at the beginning of Q1 with the increased availability of some of these integrated circuits, our ability to manufacture and ship more modems than we had certainly in the middle part of last year. But we're also starting to see, and it's 1 of the reasons why we guided to margin what we did, a shift in product mix where we're starting to see more and more line systems and early builds and new deployments coming online, which is great because now we're starting to see some of these new wins we've had over the past few years come to fruition, which is a good thing. It's a healthy thing. And so the mix shift, again, trying to predict it quarter-over-quarter is super difficult exercise. But we do see that dynamic starting to normalize a bit better.

So based off of what you're saying, it sounds like supply -- if the economy decelerates, most -- I think portfolio manager would argue that the S&P Industrials got earned 235, 240 in forecast, but actually, the estimates are all too high and they're going to have to come in the 200 to 210. That's the mindset that's out there. So the Street is bracing for estimate cuts. But if the economy decelerates, you would think you would get more parts, maybe even at a better price resulting in potential upside to your revenues, some upside to your gross margins, and you're leveraging your OpEx. So you could theoretically beat and raise because the economy slowed, logically speaking, that's a reasonable premise, yes?

It's not a bad silos -- I think a couple of things. Yes, we have postulated that with potentially the higher inflation rates and recessionary impacts, certain industries, look, for example, consumer electronics. Could that be an opportunity for some of the key integrated circuits to be allocated to other industries, including our own? I will tell you we're not privy to exactly how the component suppliers allocate among industries. So I can't predict exactly how that has happened and will happen. But there's certainly any more allocation that we would get would certainly go a long way toward accelerating a return to some degree of normalization on supply chain. The flip side, of course, is trying to predict what impact current macro dynamics we'll have on any particular customers, CapEx decision-making is a different story.

But ironically, an industry that's known to be a cyclical industry, it actually looks like it's because of the supply chain problems over the last 2 years, it may actually be countercyclical this year, which is [indiscernible] in there, right? So let's shift over to the demand side of the equation. That's obviously an area that people are concerned about. Why don't we start off with the cloud side of the business? There's been fair amount of discussion about potentially some of the cloud companies having overstocked inventory. There's been some comments from some of the cloud companies that they're going to slow data center builds and maybe even cancel a few of them. So have you seen any of that? And do you think you will see any of that, not just in '23, but as we go through '23 and get the orders for '24?

Yes, like you, Alex, we're certainly watching very closely in terms of what our customers are doing and saying. And there's been a fair amount of media attention as of late in terms of things like mass layoffs and travel freezes and hiring freezes and talk about different spending changes. Honestly, at this point, we are not seeing any of that have any visible impact to us, not just now, but going forward. Given the size of our backlog, this really isn't issued to 2023 for us. But certainly in terms of what our sales account teams are saying, who are closest to our customers, at the end of the day, I think what's really important to remember, Alex, with any customer, it's not overall what they're doing or how much they're spending. It's where they're spending their money on, where their investment efforts and intensities are going to. And as of right now, we see with the cloud providers, and they're not a homogeneous market segment. I know that, but I'll talk about them as 1 for now. We are not seeing any change in their demand profile at all. Because the reality is the amount of cloud applications and cloud services that they're going to need to host on their platforms continues to proliferate. They're going to continue to have to refresh their data centers. Yes, they may slow or cancel a data center build in the future, but that's a leading indicator. It doesn't change their demand needs right now. And what we're seeing is they are continuing to invest in their cloud infrastructures. Their cloud revenues are up. I mean, some of them, their ad revenues are down, but cloud is up.

Yes. So what was AWS' growth last quarter? Was at 37%. And oh, by the way, their backlog went from $100 billion to $105 billion.

Aren't too many companies who wouldn't take that.

I think that's the largest backlog in the history of anything. I mean I don't know if there's ever been a larger backlog. So what about on the service provider side? Obviously, people can make their decision on cloud. I think it stays reasonably healthy and continues to grow at least at the rate your guys are forecasting growth at. But service providers' spending is more constrained to start with and their business model is more constrained. Have you seen any change in their behavior? And how do you think -- how should we think about what they're doing? Verizon, in particular, was mentioned as a company that's talked about cutting back on CapEx a little bit as we go forward. How what are we seeing in there?

I think I did deliberately talk about cloud provider homogeneously, service provider can't be spoken about in that way because Tier 1s in North America are fundamentally different from tiers in 2, 3s versus international service providers. So I think it's hard to generalize Alex, in that regard. But if you're insisting that I do so, I think by and large, it's the same answer. We are not seeing really any significant shift as of right now in CapEx spend. Could there be a pushout of a route or a build here or there? Absolutely. Could there be a redirect of a route to a competitor who's offering a quicker delivery lead time? Sure. But by and large, the discussions that we're having in, we rely heavily upon our sales force who are as close to our customers as anybody and in fact, in many cases, know our customers' networks better than they do, are continuing to say and believe that the demand is there. The demand is robust. So just like the cloud providers have demands upon them, the service providers are going to have to continue to invest to figure out a way to modernize and monetize their network assets at the edge to automate connectivity. That is not going to change. And so you could have here or there, you mentioned Verizon in particular. It's a good example. Verizon to quite a lot of fanfare took their CapEx down year-over-year, but it was actually inflated in 2022 because of the spend on wireless spectrum. And in fact, their spend on cloud infrastructure is not going to change. So again, it's another example of where they're spending is what's really important to think about when you're thinking about Ciena.

One of the areas that people don't spend a lot of time thinking about is the subsea market, which are 3-, 4-, 5-year projects. You guys have had a lot of success in subsea. It's -- what percentage of your business now, what 15%, 20%?

It's a bit lower than that. So submarine stand-alone. And again, we only play in the SLTE, the Submarine Line Terminal Equipment is about high single digits, 8% to 9%, but it is a really important proxy as well for the cloud providers because we talked about cloud providers in terms of direct data center interconnect, but cloud providers also come through in terms of carrier managed services with a carrier owns the fiber and provides a managed service for the cloud provider, which shows up as carrier revenue and subsea, right, where in many cases, the cloud providers are now being the primary dictators of where that submarine cables are going and where they're being upgraded. So we feel very good about subsea. We see a significant number of new build opportunities out there around Africa, in particular, ones that are interesting for us. So we're very excited about the subsea space.

The access side of the business is an area that you've spent a lot of time building capabilities in and expanding into somewhat of a new TAM. And that's growing much faster than the company's whole. Can you give us some sense of the size and growth rates of demand on that side? And what have you done to create that opportunity?

Yes. I mean it's good question. I mean I think the way I think about -- I think about routing and switching more specifically, you talked about access, it's a component of it. And we refer to it more locally as next-generation metro and edge which is covering everything from fiber broadband access to cloud connectivity, software-defined edge and of course, convergence of IP and optical. All of that we see as far and away the fastest-growing TAM expansion opportunity for Ciena over the next several years. Now that optical won't grow in terms of its TAM, not that software won't grow. But in terms of the CAGR, we see next-gen metro and edge significantly outperforming and outpacing the other areas. And as a result, for the past several years, we've been doing a couple of different things. One, we've been undertaking a number of organic growth initiatives. So you've seen us come out over the past few years with us at a purpose-built sell-side routers for cross-sell applications, which we hadn't had in previous cycles. You've seen us talk more heavily about the conversions of IP and optical and looking at some form of purpose-built switch routers. You've seen us build out our broadband access solution now with the acquisitions of Tibit and Benu. So it's a combination of organic and inorganic things that we're doing to really solidify our position where if optical we're the hunted in routing and switching, we're the hunter. We're looking to be the disruptor and the challenger against some very big, well-established players. We're not naive about the opportunity, but we see huge TAM expansion opportunities for us in the [indiscernible].

So what size is that business at this point? And what kind of growth rate are you seeing in orders of that business over the last year?