CIENA CORP quarterly report, Q2 FY2013

Business context and reporting period

Ciena Corporation is a communications-networking equipment, software and services provider. This unaudited Form 10-Q reports the quarter and six months ended April 30, 2013, for fiscal 2013, and compares results with the corresponding 2012 periods. In Q1 fiscal 2013, Ciena reorganized its reporting into Converged Packet Optical, Packet Networking, Optical Transport, and Software and Services.

Financial results and liquidity

Q2 revenue grew 6.3% year over year. Product revenue was $413.2 million and services revenue was $94.5 million. Six-month revenue increased 7.4%. Gross margin improved year over year in both periods, reflecting better product mix, lower warranty and inventory charges, and supply-chain efficiencies. Sequentially, however, Q2 gross margin fell to 41.3% from 43.2% in Q1, attributed to product mix and startup costs on early international deployments.

Q2 operating expenses were $220.1 million, up 13.2% year over year, driven mainly by research and development, selling and marketing, and general and administrative costs. Six-month interest expense was $22.1 million. The six-month results include a $28.6 million loss on extinguishment of debt from the convertible-note exchange; this was non-cash.

Cash flow from operations was negative $0.9 million for the first six months, versus positive $73.4 million in the prior-year period. Management attributed the current-period result primarily to working-capital use, including a $76.5 million increase in accounts receivable and a $34.0 million increase in prepaid expenses and other. At April 30, cash and cash equivalents were $356.5 million and short-term investments were $100.0 million, totaling $456.5 million, compared with $692.5 million at October 31, 2012. Current assets were $1.264 billion and current liabilities $520.2 million.

Total liabilities were $1.791 billion; long-term convertible notes had a net carrying amount of $1.210 billion. There were no borrowings under the $150 million revolving credit facility, which supported $48.1 million of letters of credit. Stockholders’ deficit was $97.9 million. Ciena paid the remaining $216.2 million of its 0.25% convertible notes at maturity on May 1, 2013.

Material changes versus prior comparable periods

• Q2 revenue increased $30.1 million year over year. Converged Packet Optical revenue rose 11.2% to $294.3 million and Packet Networking rose 81.1% to $54.2 million; Optical Transport declined 32.0% to $57.4 million. Software and Services increased 3.2% to $101.8 million.
• For the six-month period, Converged Packet Optical revenue rose 14.5% and Packet Networking 94.5%, while Optical Transport fell 40.1%. Management described the decline in stand-alone optical transport as part of customers’ transition to converged next-generation architectures.
• Six-month operating cash flow swung from positive $73.4 million to negative $0.9 million, while cash and short-term investments fell $236.0 million from fiscal year-end, principally reflecting the note maturity payment, capital spending, and working-capital movements.
• Two customers each represented more than 10% of Q2 revenue and together accounted for 31.3%, versus 26.9% in Q2 2012. Two customers also represented 28% of receivables at April 30.

Outlook, commentary, risks and unusual items

Ciena gave no specific revenue or earnings guidance in the provided filing text. Management said it expects operating expenses in the second half of fiscal 2013 to exceed the first-half level, partly due to variable compensation. Management believed cash, cash equivalents and investments would cover working capital, capital expenditures and other liquidity needs for at least the next 12 months.

Management cited improving network spending, particularly among large North American service providers, and demand for high-capacity, converged architectures, while cautioning that the long-term market impact remained uncertain. Key risks include customer concentration and variable service-provider spending, intense competition and pricing pressure, macroeconomic uncertainty, product deployment/startup costs, supply-chain dependence, inventory obsolescence, foreign-exchange exposure, and substantial convertible-note obligations. Approximately 48.4% of first-half operating expenses were non-U.S.-dollar denominated.

Unusual and contingent items include the $28.6 million debt-extinguishment loss; restructuring charges of $6.5 million for the first six months; and a $9.0 million inventory obsolescence provision, primarily related to design changes and discontinued components. A conditional Ontario grant had produced C$13.7 million of cumulative benefits, including C$2.8 million in the first half, and is subject to recoupment if milestones are not met. In a Mexican tax dispute, Ciena had accrued $2.0 million and estimated possible additional losses up to $6.1 million that were not accrued because management did not consider them probable. The Cheetah Omni patent case remained in discovery, with trial scheduled for March 2014; the Graywire case remained stayed after the asserted claims against Ciena were canceled. Management did not expect ordinary-course tax and legal matters to materially affect results, financial position or cash flows.

Management reported effective disclosure controls as of quarter-end and no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

• Whether revenue growth in Converged Packet Optical and Packet Networking can offset continued Optical Transport declines, and whether reported margins hold up as product and geographic mix changes.
• Second-half operating expense expectations and the impact of incentive compensation, restructuring and international deployment startup costs.
• Cash conversion and working-capital trends, particularly receivables, prepaid expenses, and the effect of debt payments on liquidity.
• Convertible-note terms, maturities and potential dilution, as well as the conditions and availability of the revolving credit facility.
• Exposure to major customers, the Cheetah Omni litigation, Mexican tax assessments, and the conditions attached to the Ontario grant.