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CIENA CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Some of the statements contained in this quarterly report discuss future events or expectations, contain projections of results of operations or financial condition, changes in the markets for our products and services, or state other "forward-looking" information. Ciena's "forward-looking" information is based on various factors and was derived using numerous assumptions. In some cases, you can identify these "forward-looking statements" by words like "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of those words and other comparable words. You should be aware that these statements only reflect our current predictions and beliefs. These statements are subject to known and unknown risks, uncertainties and other factors, and actual events or results may differ materially. Important factors that could cause our actual results to be materially different from the forward-looking statements are disclosed throughout this report, particularly in Item 1A "Risk Factors" of Part II of this report below. For a more complete understanding of the risks associated with an investment in Ciena's securities, you should review these risk factors and the rest of this quarterly report in combination with the more detailed description of our business and management's discussion and analysis of financial condition in our annual report on Form 10-K, which we filed with the Securities and Exchange Commission ("SEC") on December 20, 2013. Ciena undertakes no obligation to revise or update any forward-looking statements. Overview We are a network specialist focused on networking solutions that enable converged, next-generation architectures, optimized to handle the broad array of high-bandwidth communications services relied upon by business and consumer end users. We provide equipment, software and services that support the transport, switching, aggregation, service delivery and management of voice, video and data traffic on communications networks. Our Converged Packet Optical, Packet Networking, Optical Transport and Software products are used, individually or as part of an integrated, programmable solution, in networks operated by communications service providers, cable operators, governments, enterprises, research and education institutions, content service providers and other network operators across the globe. Our products allow network operators to scale capacity, increase transmission speeds, allocate network traffic and deliver services to end users. Our network solutions also include an integrated software suite that provides network and service management capabilities that unify our product portfolio, facilitating automation and software-defined programmability to enable efficient service delivery. To complement our product portfolio, we offer a broad range of Network Transformation Solutions and related support services that help our customers design, optimize, deploy, manage and maintain their networks. 28 -------------------------------------------------------------------------------- Table of Contents We believe that the close, collaborative partnership with customers enabled by our engagement model and services offering is an important component of our network specialist approach and a significant differentiator for Ciena with our customers. Rapid proliferation of, and reliance by end users upon, communications services and devices, together with increased mobility and growth in cloud-based services, have fundamentally affected the demands placed upon communications networks and how they are designed. Network operators face a challenging and rapidly changing environment that requires that their network infrastructures be robust enough to address increasing capacity needs and be flexible enough to adapt to new application and service offerings. Network operators are competing to distinguish their service offerings to end users and generate revenue, while managing the costs required to implement and maintain their networks. To address these business, infrastructure and service delivery challenges, we believe network operators need a flexible infrastructure that can be adapted to support a variety of applications and controlled through the use of software. Our OPn Architecture is designed to meet these challenges by providing increased scalability and programmability, as well as network-level software applications to control and configure the network dynamically. Through this network approach, we seek to enable high-capacity, configurable infrastructures that can adapt to the changing needs of end-users and the applications that they require, while providing flexible interfaces for the integration of computing, storage and network resources. By increasing network flexibility for service delivery, reducing required network elements and enabling increased scale at reduced cost, our solutions optimize networks. At the same time, our approach facilitates introduction of new service offerings, creating business and operational value for our customers. Our OPn Architecture, which underpins our solutions offering and guides our research and development strategy, is described more fully in "Strategy" below. Our quarterly reports on Form 10-Q, annual reports on Form 10-K, and current reports on Form 8-K filed with the SEC are available through the SEC's website at www.sec.gov or free of charge on our website as soon as reasonably practicable after we file these documents. We routinely post the reports above, recent news and announcements, financial results and other information about Ciena that is important to investors in the "Investors" section of our website at www.ciena.com. Investors are encouraged to review the "Investors" section of our website because, as with the other disclosure channels that we use, from time to time we may post material information on that site that is not otherwise disseminated by us. AT&T Domain 2.0 In September 2014, we announced that AT&T had selected Ciena to participate in its Domain 2.0 supplier program. The Domain 2.0 initiative is the next generation of AT&T's Supplier Domain Program, intended to enable AT&T to quickly transition to next-generation, cloud-based network architectures that embrace Network Function Virtualization (NFV) and Software Defined Networks (SDN), and accelerate AT&T's time-to-market with new products and services. Our commercial arrangement relating to this opportunity includes certain commercial concessions that we expect to have a significant, short-term adverse impact on our revenue and gross margin. We expect these concessions primarily to affect our fourth quarter of fiscal 2014, with a proportionately lesser impact on our first quarter of fiscal 2015, and thereafter having a less significant impact on our quarterly results. We believe that this selection represents a significant achievement for Ciena, that AT&T's network objectives in this program align well with our OPn Architecture, and that this program potentially expands our addressable market with this key customer. Recent Product Announcements In June 2014, we announced the launch of our 8700 Packetwave platform, a multi-terabit packet switching platform for high-density metro networks. The 8700 combines Ethernet switching and optical transport to help network operators deliver on-demand, cloud-based services with improved economics. In July 2014, we also introduced our Agility software portfolio, which includes a multilayer software-defined networking (SDN) controller and new software applications for enabling on-demand, high-bandwidth wide area network (WAN) services delivered in an open network ecosystem. With Agility, our customers can better monetize cloud-based services and virtual network functions created in a traditional or an SDN environment. Our 8700 product will be included within our Packet Networking segment and our Agility software portfolio will be included within our Software and Services segment. Market Opportunity We believe that the shift that is underway in network architectures to next-generation, converged infrastructures represents a significant, long-term opportunity for Ciena. We believe that certain market dynamics, including the proliferation of devices running mobile web applications, the prevalence of video applications, the increase in machine-to-machine connections, and the shift of enterprise and consumer applications to cloud-based or virtualized network environments, are representative of the magnitude of changing demands being placed upon network architectures. At the same time, bandwidth requirements and the 29 -------------------------------------------------------------------------------- Table of Contents use and dependence by consumers and enterprises upon a variety of communications applications, services and devices continues to grow. We expect that these drivers will require existing and emerging network operators to invest in converged next-generation network infrastructures that are more automated, open and software programmable. This year we have seen certain service provider customers increase efforts to constrain capital expenditure budgets, resulting in a reduction in aggregate spending levels and adversely impacting certain segments of our market, including in the U.S. Notwithstanding these market dynamics. our specialist strategy to focus on certain higher growth and higher value segments of the network infrastructure market, combined with efforts to expand our addressable market and diversify our business, have enabled us to continue to grow revenue and take market share in fiscal 2014 to date. Competitive Landscape We continue to encounter a highly competitive marketplace. Our sales of Converged Packet Optical solutions reflect an intense and fragmented competitive environment, as we and our competitors introduce and enhance new, high-capacity, high-speed network solutions. Our sales of Packet Networking solutions, including our new 8700 Packetwave Platform, also face a competitive marketplace as we seek to promote the benefits of our OPn Architecture, as compared to alternative network approaches, and to secure network operator adoption of our solutions. We expect the current competitive landscape to remain challenging and dynamic. As networking technologies become more software-driven, and network features and layers continue to converge, our competitive landscape continues to broaden beyond traditional competitors. As a result, we are competing with, and expect to compete increasingly with, additional vendors focused on IP routing, information technology and software. Within these competitive dynamics, maintaining incumbency with key customers domestically and abroad, and securing new opportunities with network operators often requires that we agree to aggressive pricing, significant commercial concessions or other unfavorable commercial terms. These terms can adversely affect our quarterly results of operations and contribute to fluctuations in our results. These terms can also elongate our revenue recognition or cash collection cycles, add startup costs to initial sales or deployment of our solutions, require financial commitments or performance bonds that place cash resources at risk, and include onerous contractual commitments that place a disproportionate allocation of risk upon us. Strategy Our corporate strategy to capitalize on these market and competitive dynamics, promote operational efficiency and drive profitable growth of our business includes the following initiatives: Promotion of our OPn Architecture for Next-Generation Networks. The services and applications running on communications networks require that more of the traffic on these networks be packet-oriented. The traditional approach to this problem has been to add IP routing capability at many points of intersection in the network. As capacity needs grow, this approach becomes unnecessarily complex and costly. We reduce the cost and complexity of growing networks with a programmable infrastructure that brings together the reliability and capacity of optical networking with the flexibility and economics of packet networking technologies. Combining these attributes with network level applications creates an approach we call our OPn Architecture. Our OPn Architecture leverages the convergence of optical and packet networking to enable network scale, applies advanced control plane software for network programmability, and enables cloud-level applications to integrate and optimize network resources - along with computing and storage resources - in a virtualized environment. The software-driven aspects of this architecture become increasingly important as network operators increasingly seek to leverage an open ecosystem of virtualized resources to enable the real-time analytics and network agility required for on-demand, next-generation network architectures. Our OPn Architecture offers network operators scalability, programmability, flexibility and cost-effectiveness, and we see opportunities in offering a portfolio of solutions that facilitate the transition to next-generation networks that are optimized to create new services rapidly and to meet end user demands. Alignment of Research and Development Investment with Growth Opportunities. We seek to ensure that our product development initiatives are closely aligned with changing dynamics in our markets, network operator and end user demands, and growth opportunities for Ciena. We are investing in our OPn Architecture with current development efforts focused on expanding packet capabilities in our Packet Networking and Converged Packet Optical products for metro and service aggregation applications. We are also focused on optimizing our existing core networking solutions for application in metro networks. Our research and development efforts seek to extend and converge our existing technologies, including our WaveLogic coherent optical processor for 40G and 100G optical transport, and to introduce 400G and greater transmission speeds. In the packet area, we are increasing the scale and capability of our packet offerings and integrating standards-based open control interfaces. In the software area, we are enhancing our network management and planning applications. We are also focusing on initiatives to increase software-defined programmability and control of networks, including through our joint 30 -------------------------------------------------------------------------------- Table of Contents development initiative with Ericsson, and working to develop network-level software applications that configure networks and support new service introduction. Evolution of our Go-to-Market Model. We seek to evolve our go-to-market sales model, from both coverage and engagement perspectives. Coverage. Our coverage model is focused on selling into key customer segments, penetrating high-growth geographic markets and addressing additional network applications with our solutions. To complement our existing service provider customers, we continue to pursue opportunities to diversify our customer base into key market segments. We are expanding our sales efforts to capture opportunities arising from enterprise migration to cloud-based services, and promoting our reputation with government agencies and research and educational institutions as a trusted network equipment supplier. We are also focused on further penetrating significant Web 2.0 players, including Internet content providers and other emerging network operators, who are changing the ways in which information is accessed and shared. To expand the geographic reach of our direct sales resources, and to broaden the role our solutions play in communications networks, we have pursued strategic channel opportunities enabling sales through third parties, including service providers, systems integrators and value-added resellers. Through our packet-optical distribution relationship with Ericsson, we are seeking to expand our geographic reach as well as the applications for our products. Our direct and indirect selling efforts are focused on the sale of our solutions into additional applications, including metro aggregation and submarine networks, and in support of cloud-based services, business Ethernet services and mobile backhaul. Engagement. Our strategy is to leverage our close, collaborative relationships with customers in the design, development, implementation and support of their networks and to promote a close alignment of our solutions with customer network priorities. We believe that this engagement model is a key differentiator for our business and provides us with unique insight into the business and network needs of our customers. We seek to expand our Network Transformation Solutions offering to address the network modernization and service delivery demands of our customers, as well as their desire to derive additional value from their network infrastructures. We believe this services-oriented solutions offering shifts our value proposition beyond the sale of our next-generation communications networking equipment and allows us to play a key role in the design and evolution of our customers' networks to support their strategic business objectives. By understanding our customers' infrastructure and business needs, and the evolving markets in which they compete, we believe our engagement approach creates additional business and operational value for our customers and enables us to go to market with a competitive solutions offering that is well aligned with customer business needs. Business optimization to yield operating leverage. We are actively pursuing the transformation and redesign of certain business processes, systems, and resources. These initiatives include additional investments, re-engineering of enterprise systems and automation of certain key business processes. In addition, we are focused on optimizing our supply chain, including efforts to reduce our material and overhead costs in an effort to increase efficiency and reduce the cost to produce our product solutions. These initiatives include portfolio and process optimization, reducing our fulfillment, shipping and logistics expense, and identifying ways to drive improved efficiencies in the design and development of our solutions. We seek to leverage these opportunities to promote the profitable growth of our business and drive additional operating leverage. Term Loan and Asset-Based Credit Facilities On July 15, 2014, we entered into a credit agreement that provides for senior secured term loans in an aggregate principal amount of $250 million (the "Term Loan"). We expect to use the approximately $246 million in net proceeds to repay, in whole or part, the outstanding principal amount owing under our 4.00% senior convertible notes due March 15, 2015 in the event the holders thereof do not elect to convert such notes into common stock prior to maturity. In the event the holders of such notes elect to convert their notes into common stock upon or prior to maturity, we may elect to repay the Term Loan, in whole or in part, or may utilize the net proceeds for other general corporate purposes, including the repayment or refinancing of other existing indebtedness. See Note 13 to our Condensed Consolidated Financial Statements included in Item 1 of Part I of this report for a summary of the material terms and conditions of the Term Loan and the related security documents. On July 15, 2014, we also amended the terms of our existing senior secured asset-based revolving credit facility to, among other things, increase the total commitment under the ABL Credit Facility from $150 million to $200 million and extend the maturity date from August 13, 2015 to December 31, 2016. See Note 14 to our Condensed Consolidated Financial Statements included in Item 1 of Part I of this report for a summary of the material terms and conditions of the amendment to this credit agreement and the related security documents. Financial Results 31 -------------------------------------------------------------------------------- Table of Contents Revenue for the third quarter of fiscal 2014 was $603.6 million, representing a sequential increase of 7.8% from $560.1 million in the second quarter of fiscal 2014. Revenue-related details reflecting sequential changes from the second quarter of fiscal 2014 include: • Product revenue for the third quarter of fiscal 2014 increased by $35.1 million, reflecting increased sales of $25.2 million in Converged Packet Optical, $5.6 million in software, $2.9 million in Packet Networking and $1.4 million in Optical Transport. • Service revenue for the third quarter of fiscal 2014 increased by $8.4 million. • Revenue from the United States for the third quarter of fiscal 2014 was $368.1 million, an increase from $324.0 million in the second quarter of fiscal 2014. • International revenue for the third quarter of fiscal 2014 was $235.5 million, a decrease from $236.1 million in the second quarter of fiscal 2014. • As a percentage of revenue, international revenue was 39.0% during the third quarter of fiscal 2014, a decrease from 42.2% during the second quarter of fiscal 2014. • For the third quarter of fiscal 2014, one customer accounted for 21.6% of total revenue. This compares to one customer that accounted for 21.5% of total revenue in the second quarter of fiscal 2014. Gross margin for the third quarter of fiscal 2014 was 43.7%, an increase from 42.4% in the second quarter of fiscal 2014. Operating expense was $227.0 million for the third quarter of fiscal 2014, a decrease from $230.5 million in the second quarter of fiscal 2014. Third quarter fiscal 2014 operating expense primarily reflects decreases of $5.8 million in research and development expense and $1.7 million in sales and marketing expense. These decreases were partially offset by an increase of $4.4 million in general and administrative expense. Reflecting the improvements in revenue and gross margin above, income from operations for the third quarter of fiscal 2014 was $37.0 million, compared to income from operations of $7.2 million during the second quarter of fiscal 2014. Our net income for the third quarter of fiscal 2014 was $16.2 million, or $0.15 per diluted common share. This compares to a net loss of $10.2 million or $0.10 per diluted common share, for the second quarter of fiscal 2014. We generated cash from operations of $51.1 million during the third quarter of fiscal 2014, consisting of $80.9 million in cash provided by net income adjusted for non-cash charges, offset by a $29.8 million use of cash related to changes in working capital. This compares with $2.0 million of cash generated from operations during the second quarter of fiscal 2014, consisting of $49.5 million in cash provided by net losses adjusted for non-cash charges offset by a $47.5 million use of cash related to changes in working capital. As of July 31, 2014, we had $532.9 million in cash and cash equivalents, $120.3 million of short-term investments in U.S. treasury securities and commercial paper, and $65.0 million of long-term investments in U.S. treasury securities. This compares to $378.2 million in cash and cash equivalents, $100.0 million of short-term investments in U.S. treasury securities and $15.0 million of long-term investments in U.S. treasury securities, at July 31, 2013, and $346.5 million in cash and cash equivalents, $125.0 million of short-term investments in U.S. treasury securities and commercial paper, and $15.0 million of long-term investments in U.S. treasury securities at October 31, 2013. As of July 31, 2014, we had 5,136 employees, an increase from 4,754 at October 31, 2013 and an increase from 4,680 at July 31, 2013. Consolidated Results of Operations Operating Segments Ciena's internal organizational structure and the management of its business are grouped into the following operating segments: • Converged Packet Optical - includes networking solutions optimized for the convergence of coherent optical transport, OTN switching and packet switching. These platforms enable automated packet-optical infrastructures that create and efficiently allocate high-capacity bandwidth for the delivery of a wide variety of enterprise and consumer-oriented network services. Products in this segment include the 6500 Packet-Optical Platform and the 5430 Reconfigurable Switching System, which feature Ciena's WaveLogic coherent optical processors. Products also 32-------------------------------------------------------------------------------- Table of Contents include Ciena's family of CoreDirector® Multiservice Optical Switches and the OTN configuration for the 5410 Reconfigurable Switching System. These products include multiservice, multi-protocol switching systems that consolidate the functionality of an add/drop multiplexer, digital cross-connect and packet switch into a single, high-capacity intelligent switching system. These products address both the core and metro segments of communications networks and support key managed services, Ethernet/TDM Private Line, Triple Play and IP services. This segment also includes sales of operating system software and enhanced software features embedded in each of these products. Revenue from this segment is included in product revenue on the Condensed Consolidated Statement of Operations. • Packet Networking - principally includes Ciena's 3000 family of service delivery switches and service aggregation switches, the 5000 series of service aggregation switches. This segment also includes Ciena's new 8700 Packetwave Platform, a multi-terabit packet switching platform for high-density metro networks. The 8700 combines Ethernet switching and optical transport to help network operators deliver on-demand, cloud-based services with improved economics. In addition, this segment includes Ciena's Ethernet packet configuration for the 5410 Service Aggregation Switch. These products support the access and aggregation tiers of communications networks and have principally been deployed to support wireless backhaul infrastructures and business data services. Employing sophisticated, carrier-grade Ethernet switching technology, these products deliver quality of service capabilities, virtual local area networking and switching functions, and carrier-grade operations, administration, and maintenance features. This segment includes stand-alone broadband products that transition voice networks to support Internet-based (IP) telephony, video services and DSL. This segment also includes sales of operating system software and enhanced software features embedded in each of these products. Revenue from this segment is included in product revenue on the Condensed Consolidated Statement of Operations. • Optical Transport - includes optical transport solutions that add capacity to core, regional and metro networks and enable cost-effective and efficient transport of voice, video and data traffic at high transmission speeds. Ciena's principal products in this segment include the 4200 Advanced Services Platform, Corestream® Agility Optical Transport System, 5100/5200 Advanced Services Platform, Common Photonic Layer (CPL), and 6100 Multiservice Optical Platform. This segment includes sales from SONET/SDH, transport and data networking products, as well as certain enterprise-oriented transport solutions that support storage and LAN extension, interconnection of data centers, and virtual private networks. This segment also includes operating system software and enhanced software features embedded in each of these products. Revenue from this segment is included in product revenue on the Condensed Consolidated Statement of Operations. • Software and Services - includes Ciena's network software suite, including the Agility software portfolio which includes a multilayer software-defined networking (SDN) controller and new software applications for enabling on-demand, high-bandwidth wide area network (WAN) services delivered in an open network ecosystem. With Agility, our customers can better monetize cloud-based services and virtual network functions created in a traditional or an SDN environment. This segment also includes the OneControl Unified Management System. These software solutions can track individual services across multiple product suites, facilitating planned network maintenance, outage detection and identification of customers or services affected by network performance. In addition, this segment includes the ON-Center® Network & Service Management Suite, Ethernet Services Manager, Optical Suite Release and network level applications. This segment includes a broad range of consulting, network design and support services from Ciena's Network Transformation Solutions offering. This segment also includes installation and deployment, maintenance support and training activities. Except for revenue from the software portion of this segment, which is included in product revenue, revenue from this segment is included in services revenue on the Condensed Consolidated Statement of Operations. Quarter ended July 31, 2013 compared to the quarter ended July 31, 2014 Revenue The table below (in thousands, except percentage data) sets forth the changes in our operating segment revenue for the periods indicated: 33 -------------------------------------------------------------------------------- Table of Contents |