Ciena Corporation (NYSE:CIEN) Q3 2023 Earnings Call Transcript

Ciena Corporation (NYSE:CIEN) Q3 2023 Earnings Call Transcript August 31, 2023

Operator: Good morning, everyone, and welcome to Ciena’s Fiscal Third Quarter 2023 Financial Results Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please also note, today’s event is being recorded. And at this time, I’d like to turn the floor over to Gregg Lampf, Vice President of Investor Relations. Please go ahead.

Gregg Lampf: Thank you, Jamie. Good morning, and welcome to Ciena’s 2023 fiscal third quarter results conference call. On the call today is Gary Smith, President and CEO; and Jim Moylan, CFO. Scott McFeely, our Senior Vice President of Global Products and Services, is also with us for Q&A. In addition to this call and the press release, we have posted to the Investors section of our website an accompanying investor presentation that reflects this discussion as well as certain highlighted items from the quarter. Our comments today speak to our recent performance, our view on current market dynamics and drivers of our business as well as a discussion of our financial outlook. Today’s discussion includes certain adjusted or non-GAAP measures of Ciena’s results of operations.

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A reconciliation of these non-GAAP measures to our GAAP results is included in today’s press release. Before turning the call over to Gary, I’ll remind you that during this call, we’ll be making certain forward-looking statements. Such statements, including our quarterly and annual guidance and our long-term financial outlook, and discussion of market opportunities and strategy, are based on current expectations, forecasts and assumptions regarding the Company and its markets, which include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. Assumptions relating to our outlook, whether mentioned on this call or included in the investor presentation that we’ll post shortly after, are an important part of such forward-looking statements, and we encourage you to consider them.

Our forward-looking statements should also be viewed in the context of the risk factors detailed in our most recent 10-K filing and in our upcoming 10-Q filing, which will be filed with the SEC by September 7th. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events or otherwise. As always, we will offer as much Q&A as possible today, though we’ll ask that you limit yourselves to one question and one follow-up. Also, for those in the investment community who will be attending ECOC, Jim Moylan and I will be meeting with investors on October 2nd and 3rd. Please reach out to us if you’re interested. With that, I’ll call — turn the call over to Gary.

Gary Smith: Thanks, Gregg, and good morning, everyone. Today, we reported strong fiscal third quarter results, including quarterly revenue of $1.07 billion, an increase of 23% year-over-year. Our results included solid profitability metrics with quarterly adjusted operating margin of 12% and adjusted EPS of $0.59. We are delivering a very strong year with 22% revenue growth year-to-date as we continue to capture market share. And in fact, we are confident as we look forward, particularly given that secular demand for bandwidth continues to increase. In fact, bandwidth growth has remained consistent for years, even through the recent period of supply chain constraints. And the underlying drivers of that strong growth are very durable over the long term.

These include mobility, 5G, cloud, automation and more recently, artificial intelligence applications as they move out towards the network. These market dynamics in turn drive direct demand for our industry-leading technology and services, which we measure through three indicators: Number one is customer pipeline and forecasts; number two is orders; and number three, backlog and ultimately shipments, which collectively reflect demand in our business, not just a single element of these. So, I thought it might be helpful for me to provide some insights into what we’re seeing across each of these indicators of demand. Starting firstly with pipeline. We are very encouraged by the level of overall customer activity that we are seeing across all regions and segments.

Most notably, we are seeing early signs of near-term requirements with our cloud customers as they work to ensure their network readiness for machine learning and AI traffic coming out of the data center and into the WAN. With respect to orders, the flow of new orders in recent quarters has been directly impacted by several factors. Specifically, customers ordering decisions in the prior supply-constrained environment resulted in both large order backlog and then higher than typical customer inventory levels. In addition, the recent rapid compression of our lead times has reduced the need for customers to place advanced orders. As a result, new order flow over the past couple of quarters has been meaningfully below revenue and we expect this to continue for another couple of quarters.

Therefore, this order flow in isolation has not really been a good reflection of underlying demand. Now, however, we are starting to see an uptick in new orders, led by cloud providers. Overall orders were slightly up in Q3, and we expect higher orders in Q4. Importantly, we believe that this recent uptick in orders from cloud customers is a leading indicator of a rebalancing of supply and demand, which we believe will begin to flow through to our service provider customers in the coming quarters. And finally, backlog. We have had and continue to have an outsized backlog resulting from the previous period of supply constraints and the resulting elongation of lead times. I would remind everyone that our backlog is still larger in both absolute and relative terms than any of our competitors, which is testament to our increasing competitive advantage.

And as we turn this backlog into revenue, it is translating into significant market share gains, which so far this year have been in approximately the mid-single-digits. We now expect that we will exit FY23 with backlog that is approximately $2.7 billion, even with our strong revenue year. And I think this is very encouraging on several levels. Fundamental demand drivers for our business are strong and improving; customer activity is increasing; and supply versus demand is gradually coming into alignment. Against this backdrop, Ciena has never been better positioned to deliver faster than market growth through trusted customer relationships and increasing technology leadership, new platform introductions and considerable market expansions over time.

Before turning it over to Jim, I’ll run through some quick highlights from the quarter. Optical revenue was 27% up year-over-year. As expected, much of the growth in the quarter was in our optical line systems. Specifically, Q3 was a record quarter in revenue and shipments for our 6500 reconfigurable line systems, RLS, driven by cloud and content provider network expansions. RLS is, in fact, the only next-gen line system in the industry that is shipping at scale and serves as a strong indicator of future revenue growth and margin expansion opportunity. We added 18 new customers in Q3 for WaveLogic 5 Extreme, bringing our total customer count to 246. And we also received our first order for WaveLogic 6 in the quarter, well before it is even generally available.

Routing and Switching revenue was also up 27% year-over-year, with the addition of more than 30 new customers for the portfolio in the quarter, a clear example of our technology leadership and the growing pipeline. The increase in Q3 was primarily driven by sales of our access and aggregation platforms. We also continue to advance our TAM expansion efforts in this general technology area, and particularly around coherent routing, broadband access and PON opportunities. We also secured our first customer for the WaveRouter platform this quarter. Notably, our Platform Software and Services revenue was up 24% year-over-year. This reflects strong growth in software maintenance services, primarily related to our domain controller MCP. And as we know, MCP is the industry’s leading multilayer domain controller, now with nearly 800 customers worldwide and more than a quarter of those customers leverage the advanced apps on the platform.

In fact, in Q3, we added 18 customers for these advanced apps. Shifting to customers. We had one 10% customer in the quarter, which is a cloud provider. Overall, direct cloud provider revenue increased 39% year-to-date, well above our overall revenue growth in the same period. Panning out a little further, total non-telco revenue was 46% year-over-year in the quarter to $487 million, a record high. Further, subsea revenue was up 21% year-over-year in the quarter to $76 million. Revenue from service provider customers was up 9% year-over-year, which included one Tier 1 customer that came in just under the 10% threshold in Q3. And we continue to win with this important segment. By way of example, we have recently secured a multiyear strategic expansion of our relationship with a major U.S. Tier 1 service provider for our full portfolio, including Routing and Switching as they continue to enhance their network, another example of growing customer activity and pipeline.

And finally, with respect to geographic regions, Asia Pacific was again a solid contributor at nearly 16% of total revenue in Q3, up more than 30% year-over-year. And in that region, India remains very strong with year-to-year revenue in FY23 of just over $200 million compared to just under $170 million for all of last fiscal year, and we expect this growth to continue. EMEA also continued to perform well. Importantly, as our pipeline grows, we secured several new design wins across the region in Q3, which we expect to begin taking revenue on in FY24. So in summary, we believe we are executing well and are confident as we look forward. We are benefiting from strong secular demand and growing our pipeline with increased customer activity. We are increasing our competitive advantage, bringing new platforms to market and expanding our TAM, and we are converting backlog to revenue and gaining market share.

With that, I will turn it over to Jim to speak more about all of these elements and provide additional detail on the Q3 financial results. Jim?

Jim Moylan: Thanks, Gary. Good morning, everyone. We delivered outstanding fiscal third quarter financial results. Total revenue in Q3 was $1.07 billion at the high end of our expectations, up 23% over Q3 of 2022. Adjusted gross margin in the quarter was 42.7%, reflecting the product mix shift towards design systems that we expected, and Q3 adjusted operating expense was $328 million. With respect to profitability measures, in Q3, we delivered adjusted operating margin of 12%, adjusted net income of $89.1 million and adjusted EPS of $0.59. In addition, we generated $9 million in cash from operations and adjusted EBITDA of $151.3 million. Finally, we ended the third quarter with approximately $1.3 billion in cash and investments.

Inventory levels in Q3 went up $94 million from last quarter. As a result of changes in the mix of products delivered to customers from that which we expected, we also saw an increase in deferred cost of sales on product delivered to customers but not yet taken to revenue. We expect total inventory to be down in Q4. And at the end of this fiscal year, we expect it to be roughly equal to that of Q4 of ‘22. We repurchased approximately 1.4 million shares for $61 million during the fiscal third quarter. Since the end of Q3, we have repurchased an additional $40 million in shares, bringing our year-to-date total to approximately $100 million in value. We continue to expect that we will repurchase an aggregate of approximately $250 million in shares during this fiscal year.

Turning now to guidance. As a reminder, the outlook I’m about to provide reflects all the key assumptions that we detail in our earnings presentation. Our expectations for Q4 are consistent with the fiscal full year guidance that we provided on the last earnings call. Specifically, for the fiscal fourth quarter, we expect to deliver revenue in a range of $1.06 billion to $1.14 billion, adjusted gross margin in the low to mid-40s range and adjusted operating expense of approximately $335 million. With respect to fiscal year 2024, as is our normal practice, we will provide a detailed view of our expectations for next year when we report our Q4 results in December. But it’s important to remember the context we provided when we laid out our three-year targets last December.

Specifically, we said that revenue compound annual growth rate over the three-year period from fiscal year ‘22 to fiscal year ‘25 would be 10% to 12% and would not be linear, particularly given our expectations for outsized revenue growth in fiscal ‘23, which we will deliver. We are still comfortable with those projections for that three-year period. Specifically, we expect fiscal ‘24 to be a growth year. We also expect to grow faster than the market and to take market share. Before we close out the call, I want to highlight our recent announcement of science-based environmental targets, which support and strengthen our sustainability commitments to stakeholders. Our science-based targets commit us to reduce our direct and indirect greenhouse gas emissions.

They also align our decarbonization efforts with the Paris Climate Agreement to limit global warming to 1.5 degrees Celsius above preindustrial levels. Importantly, the achievement of our goals will help drive down the environmental impact both of Ciena and of our customers’ networks across the globe. I encourage you to review this recent announcement. In closing, I will say that demand for bandwidth is strong and growing, and that demand is reflected in our pipeline and in the recent trends in orders. We expect a strong close to the year in Q4 and continued growth in revenue going forward, both in absolute terms and in market share. Jamie, we will now take questions from the sell-side analysts.

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Q&A Session

Operator: [Operator Instructions] Our first question today will come from David Vogt of UBS. Please go ahead.

David Vogt: Great. Thanks, guys. Can you maybe talk about what you’re seeing directly from web-scale? What’s sort of driving sort of this inflection that you’re speaking of from an orders perspective? Is it just under investment and optimization that’s been sort of transpiring for the last four to six quarters, or is it maybe AI related or a combination of maybe the digestion in AI? I just would love to get some more color on what you’re seeing there in terms of the order inflection and then why you think maybe SPE orders follow closely thereafter from an inflection point perspective. Thanks.

Gary Smith: Yes. David, I would say, generally, the sort of chronology of the last few quarters as we’ve gone through this supply-demand alignment issues is the web-scale that were the first to kind of reschedule and pull back in terms of deployment for their absorption. They were the first to do that. I think what’s encouraging now is they’re working their way through that, probably still got a little more to go, but they’re beginning to see new applications and new drivers. And the specific things that we’re seeing for Q4, which are new orders to be shipped in Q4 in addition to their existing backlog that we’ve got, was driven by really the need to start preparing for machine learning and AI traffic coming out of the data center.

It’s the first time we’ve seen that sort of tagged, specifically in the cloud players. So, that’s super encouraging. And generally speaking, I think the sort of general flow of traffic and activity will reflect the fact that the cloud providers were the first to go into this challenge. They’re the first to come out of it, which makes sense. And typically, the service providers will flow through that. I mean, not least of which from the traffic growth in cloud generally spills through to the service providers a couple of quarters later, just generally. So I think our perspective is that this is very encouraging and is really the first leading indicator that we’re getting alignment now around orders, lead times and user ultimate demand.

Operator: Our next question today will come from Tim Long of Barclays. Please go ahead.

Tim Long: Thank you. I was hoping kind of a two-parter on the service provider piece. First, Gary, you mentioned the U.S. Tier 1 kind of renewal, which included some Switching & Routing. Could you just talk a little bit to that as far as kind of scope of that extension or new agreement? Any new use cases, particularly on the Switching & Routing side, any changes there? And then secondly, maybe just following on, as you were talking about the cycle for the web-scalers, where do you think we are in that for the service provider and telco service providers? When do you think they’ll get to the phase with — it looks like the web-scale players are at currently? Thank you.

Gary Smith: Yes. Tim, let me take the last one first and then I’ll address the issue about the Tier 1 service providers. Our best view of it, and we’re pretty close, obviously, with a lot of the large. I mean, really when we talk about Tier 1, let me qualify a little bit more service providers. We’re really talking about North America. This dynamic of further ordering out ahead, given supply chain, we did not really see that dynamic internationally with the service providers. So, I would really target my reply here to the Tier 1 North American players. I think we’re very close with them and understanding around what their absorption challenges are around deployment of people, equipment, et cetera. I would suspect, really, Tim, that we’ve got another couple of quarters of that.

So sort of mid-’24, something like that with the Tier 1 service providers. We’re beginning to see some increasing signs with them as well. But I do think it will be a couple more quarters before we see them catch up and get into alignment with the reduced lead times that are now in market for us. Scott, do you want to take that?

Scott McFeely: Yes. And, Tim, on the scope of the relationship agreement with the Tier 1 service provider, the way to think of it basically is an extension of a relationship that we have with them for their fiber-based infrastructure across their core and their metro. And it includes transitioning that infrastructure to all of our next-generation technologies and extension obviously in time as well. So, it’s a very whole cost relationship with, not so much new use cases, but the next-generation technology evolution.

Operator: Our next question today will come from George Notter of Jefferies. Please go ahead.

George Notter: I was definitely interested in the commentary about the content provider strength and the order improvement. Can you talk about the magnitude of the order improvement? You said that orders were soft — quite soft, it sounds like the last few quarters, and they’ve improved, I presume, sequentially here. Is it a significant sequential improvement? Maybe you can give us a book-to-bill ratio? Just give us some kind of sense for the scale of the order improvement? And then also, I’m just curious about where backlog levels wound up at the end of the quarter and then also where you are on product lead times. Thanks.

Jim Moylan: Hello George, it’s Jim. I’ll take that. First of all, backlog at the end of Q3 was $3.1 billion, very much in line with our expectations. We believe now that backlog at the end of the year will be more like $2.7 billion plus or minus as opposed to the slightly lower backlog that we had called last quarter. And that really expresses the higher orders that we expect to get in Q4. We do believe that orders in Q4 will be below our revenue. As Gary said that phenomenon is going to continue for a few quarters. But with those numbers, I think you can sort of back into the range of what the increase in orders is from Q3 to Q4.

George Notter: Got it. That’s great. And then product lead times, just curious about where those are now.

Scott McFeely: Yes. George, on product lead times, as you’ll remember, we said we entered the year — into our fiscal year at approximately 52 week lead times. Last quarter, we said that — in half and we’d expect them to continue to improve. As we sit here today, there — the average is probably in the high-teens across the portfolio, there’s standard deviations on that, but it shows continuous improvement there, and we would expect those to continue to real in quarter-over-quarter.

Operator: Our next question today is from Simon Leopold of Raymond James. Please go ahead.

Simon Leopold: I wanted to sort of get a little bit more granularity on how you see the hyperscale is trending in that. It sounds like you had strength this quarter and you’ve got long-term optimism. I’m just wondering whether or not there’s any kind of pause or transition over the next couple of quarters before the ramp or whether it’s a more linear expectation. And just a quick clarification, on the 10% customers, is that a customer that has been over 10% full year in the past, if you could let us know? Thanks.