Q4 2017 Ciena Corp Pre Recorded Earnings Call
LINTHICUM Dec 11, 2017 (Thomson StreetEvents) -- Edited Transcript of Ciena Corp earnings conference call or presentation Thursday, December 7, 2017 at 12:00:00pm GMT
TEXT version of Transcript
* Gary B. Smith
Ciena Corporation - CEO, President and Director
* Gregg M. Lampf
Ciena Corporation - VP of IR
* James E. Moylan
Ciena Corporation - CFO and SVP of Finance
Good day, ladies and gentlemen, and welcome to Ciena's 2017 Fourth Quarter and Year-end Review.
I would now like to hand the floor over to Gregg Lampf, Vice President, Investor Relations. Please go ahead, sir.
Gregg M. Lampf, Ciena Corporation - VP of IR 
Thank you, Karen. Good morning, and welcome to Ciena's 2017 Fourth Quarter and Year-End Review.
This morning's report will follow a different format than usual. Our prepared remarks have been recorded and transcribed and are being made available in advance of our live call.
While our comments today will touch briefly on market dynamics and our Q4 financial results, we intend to focus more on our current strategy and long-term strategic plans. Specifically, we will discuss where we see the business going over the next 3 years, the strategic drivers that will get us there, and some longer term financial targets that we've set for the company in the context of those drivers.
We have posted to the Investors section of ciena.com an accompanying investor presentation that reflects this discussion as well as certain highlighted items from the quarter and fiscal year.
We believe this approach will give you a clear understanding of how we intend to manage the business through the next phase of our transformation and what to expect from Ciena over the next 3 years.
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 include our guidance and long-term financial objectives are based on current expectations, forecasts and assumptions regarding the company and its markets that include risks and uncertainties that could cause actual results to differ materially from the statements discussed today.
These statements should be viewed in the context of the risk factors detailed in our most recent 10-Q filing and in our upcoming 10-K filing. Our 10-K is required to be filed with the SEC by December 27, and we expect to file by that date.
Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events or otherwise.
Today's discussion includes certain adjusted or non-GAAP measures of Ciena's results of operations. As Jim will review, there are important changes to our GAAP and non-GAAP tax provision that you need to be mindful of when comparing periods. A detailed reconciliation of our non-GAAP measures to our GAAP results, along with a comparison of our new method and prior method of calculating taxes for non-GAAP earnings, is included in today's press release available on ciena.com.
With that, I'll turn it over to Gary.
Gary B. Smith, Ciena Corporation - CEO, President and Director 
Thanks, Gregg. Last month, we celebrated the 25th anniversary of the founding of Ciena, marking a significant milestone in our history. Perhaps more importantly, we've reached an important inflection points in our business following several years of focus on transforming the company. A few years ago, we were primarily a hardware company that specialized in a single technology, with a very concentrated customer base, a highly leveraged balance sheet and operating losses. As the sector has evolved, we have executed to a clear vision to build from our small platform to create a powerful long-term leader in our field. Today, we are a global market leader with scale. We have a diversified portfolio. We sell into a broad set of geographies and customers and across a wide range of applications. And the business we've built is consistently delivering industry-leading growth and profitability with a strengthening balance sheet and meaningful cash generation.
The strong fiscal fourth quarter and year-end financial results we reported today are just the most recent evidence of this transformation, and of our ability to consistently outperform the industry and our peers despite the challenging set of industry dynamics and competitive forces.
In this environment, we've executed against a very deliberate strategy of being best-of-breed at scale, ensuring that we are the best in the world at moving bits and automating networks. And we do that by enabling choice for our customers for open leading technology that interconnects the world. This strategy is underpinned by our approach to vertical integration essentially ensuring that we control the key technologies in our integrated systems and offer a compelling portfolio across systems, components, software and services that address customers' preferred consumption models. We are unique in this complete capability.
Our strategy has been to scale and diversify our existing business by penetrating a broad set of higher growth geographies, customer types and applications and to expand our addressable market with logical extensions of our core competencies. Leveraging our global scale, technology leadership and vertical integration, we've also forced the pace of innovation in our industry, and are delivering greater value to our customers. As a result, we've captured additional market share and delivered differentiated financial performance that stands in stark contrast to other vendors. Both the smaller niche players, who lack the investment capacity to maintain forward innovation and who continue to atrophy; and the large generalists who, facing competing investment priorities within their portfolios, an inability to keep up with the pace of innovation.
There are several drivers playing a key role in our market share opportunities and our access to new and emerging markets. We've established specific financial targets for each of these drivers over the next 3 years and these are based on our expectations and current assumptions about market growth. Our primary strategic driver remains our Optical Systems business, which represents the majority of our current addressable market. We are the only company in the industry that can successfully address the key applications of today and tomorrow, including long-haul, ultra long-haul, submarine, metro, converged packet access and Data Center Interconnect.
The cornerstone for future growth of this business is our next generation coherent modem technology and our latest version, WaveLogic Ai, is now generally available in our 6500 and Waveserver platforms, both of which are already shipping to customers.
Highlighting our ability to automate the network is Liquid Spectrum, a unique capacity on demand solution that combines WaveLogic Ai, a reconfigurable photonic layer, and our Blue Planet software. We are seeing very high levels of interest in this solution and beginning to get market traction for this integrated value proposition. Based on our strong market position and the opportunities for growth afforded by these new offerings, we are confident that we will continue to grow revenue and capture additional market share in our Optical Systems business.
Accordingly, we are targeting annual revenue growth for our Optical Systems business of approximately 4% to 6% over the next 3 years. An important element of our Optical Systems business is our Global Network Services business or our attached services, if you will. These include network planning and engineering, deployment, training, support and managed services. Today, this part of our business comprises approximately 15% of our total revenues. Based on industry trends and customer buying patterns, we believe there is an opportunity to grow this high-margin business within our overall product mix.
As such, we recently appointed a new leadership team for our global services business, and have begun a multiyear transformation process to improve our delivery capability, expand our portfolio and drive greater incremental value for our customers in new ways. As a result of this transformation, we are targeting annual revenue growth for our attached services business of approximately 4% to 6%, with higher gross margin over the course of the next 3 years.
Beyond our Optical business, we continue to explore and invest in technologies, applications and business models that can serve to expand our addressable market, including at Packet Networking, software and component elements.
Our Packet Networking business has been a strategic imperative for us for some time, as you know. We had a strong performance from our Packet portfolio in fiscal 2017. Diversifying our customer base and applications for these solutions with record revenue and a number of significant customer wins. As a result, this business is now contributing in a meaningful way and we are very excited about the Packet opportunity going forward.
To address broadband and subscriber growth around the world, we've been investing in the convergence of Optical and Packet technologies deeper into the network, specifically by expanding into IP with our packet access and aggregation platforms. Adding capabilities to our portfolio to get closer to the network edge will enable us to play a strategic role in our customers' network densification initiatives, such as 5G and fiber deep.
As a result, we are targeting annual revenue growth for our Packet Networking portfolio of approximately 6% to 8% over the next 3 years. We see our Blue Planet software business and the network automation it enables as another driver of our growth, competitive differentiation and expanding profitability. As a reminder, Blue Planet encompasses our overall software business and related services, which is inclusive of domain management, orchestration software on apps, subscription services and associated professional services. This business totaled more than $160 million in revenue in 2017.
2 years since acquiring Cyan, we've had extensive Blue Planet engagements around the world, and have had the opportunity to learn even more about the nascent NFV and orchestration space. We've taken those learnings on board to hone the focus and go-to-market strategy of our software business around the automation of Packet-Optical infrastructure.
Specifically, we are focused on accelerating the transition from our legacy network management software platform to our Blue Planet network domain controller platform, positioning us to automate the transport domain as a whole. This also serves as a strong beachhead for our orchestration platform for Blue Planet.
In addition, we are concentrating on our Blue Planet analytics platform, which will become generally available this year and is showing solid early customer adoption. We are making good progress in executing on our new priorities in software and related services. As such, even while the industry ecosystem to drive network automation is still developing, we continue to believe that Blue Planet will serve as a competitive differentiator in the marketplace. Accordingly, we are targeting annual revenue growth for our total Software and Associated Services business of approximately 14% to 16% over the next 3 years.
Finally, we see the component space as a new strategic driver for our business. You've already seen our announcement earlier this year that we're making our coherent modem technology available to the market through 3 leading optical component vendors. This strategic move positions us to secure a larger portion of the world's wavelengths and to gain access to new geographies and market segments. This business, which we are now calling our Optical Microsystems Division, is focused on enabling our market-leading WaveLogic-based coherent modem technology to be consumed directly by end users or indirectly by integrating into third-party transport switching or routing platform.
As expected, we are focused at this early stage on driving the initial business development efforts with our current partners and enabling development work on the new module. These efforts are on track with alpha units now in the hands of our partners and some of their potential customers. We continue to believe that we can become a meaningful participant in this $1 billion-plus market over the next few years by offering flexibility and choice in modem technology to a wide range of customers. Indeed, our expectations for this business haven't changed and we still believe that we're positioned to generate initial revenue towards the end of calendar 2018.
Given that our entry in this nascent market is in its early stages, we want to be realistic in setting longer term financial expectations for this business. Accordingly, we are targeting to generate approximately $50 million in revenue annually from Optical Microsystems by the end of the next 3 years. When viewing these strategic drivers together, again, it is worth noting that we are the only vendor able to address the systems, services, software and components market. As such, we are delivering innovations ahead of the competition that directly address the changing business and consumption models of our customers. Essentially, we are leveraging our core technical leadership and relationships across a diversified range of market segments.
Peeling back on our strategy even a layer further, there are important market verticals and geographies that intersect with one or more of these strategic drivers. In particular, our service provider customers are now placing greater importance on partnering with strategic suppliers who have this combination of scale, focus and capability to deliver innovation across a complete range of optical applications. In contrast to our competitors, we are well positioned to meet those requirements and provide greater value to our customers.
This has resulted recently in several significant new wins around the world, including some new Tier 1 service providers, many of which represent share gains at the expense of our competitors. When combined with the expected long-term build out of NexGen metro networks, we see the opportunity to continue taking share with service providers and we intend to press down our advantage in the market against weakening competitors.
We are equally optimistic about the web-scale space, or global content network provider customers, over the next several years. With #1 market share with this important customer segment already, we continue to expand our global footprint and relationships with the large U.S.-based providers, including by connecting their data centers in the U.S., submarine and international markets, where we bring the unique ability to traverse all segments through our global Tier 1 customer base. And we are beginning to develop relationships with those content providers that are based outside of the U.S. As a testament to our early success, we exceeded our revenue goal for Waveserver in fiscal 2017, ultimately delivering approximately $110 million for this purpose-built DCI platform and securing the #1 market share in every application of the optical DCI market.
In the submarine space, we've gone from 0 to #1 market share in the cable upgrade market in the span of only 6 years, and we continue to build upon this success. We are winning new submarine cable upgrade business, including through expanding our relationships with our global content providers, who are increasingly important customer segment in this submarine market. And we are complementing that success with new cable build opportunities through our partnership with TE SubCom.
From a geographic standpoint, Asia-Pacific has become our fastest-growing region in recent years. Whilst it is a highly competitive region in our industry, we have outstanding market traction and several new customer wins, including in Japan and South Korea. In fact, we believe that certain long-standing local preferences for domestic vendors may be eroding in some Asian countries, and we are well positioned to take advantage of that shift. We are also looking to enter several new countries in the region during the next couple of years. Accordingly, while there may be quarterly ebbs and flows, we expect our growth in APAC to be robust over the next several years.
India in particular has been an outstanding success story for Ciena. We now have #1 market share in this important country and more than 20% of our global workforce is now based in India. This market is in the very early stages of modernizing a massive network infrastructure to support its 1.2 billion people and is the fastest-growing market for the Internet in the world. Indeed, India is the fastest-growing country in the world for our business. We are deploying our complete portfolio and full range of applications across a broad set of customers in India, including every major service provider, content network and the national government. We are clearly seeing the benefits of our early commitment to the India market more than 12 years ago, and with nearly 100% year-over-year revenue growth in fiscal 2017.
The relentless execution of our strategy has truly enabled us to come of age. While our industry can be challenging in dynamic for sure, our improving annual results proved that we can adapt to changing market conditions, develop new markets and grow both top and bottom lines. Our once single-threaded optical product is now a broad networking platform and supported by adjacent technologies that form a highly complementary portfolio. We are a market leader with #1 or #2 share in every market segment in which we participate. We have scaled to more than 1,300 customers in over 80 countries around the world, spanning service providers to global content networks, MSOs, Fortune 2000 Enterprises, governments and other private network operators.
Our strategy has also enabled us to achieve our desired combination of financial performance in recent years, including above-industry average revenue growth, with an 8% CAGR over the past 5 years; adjusted EPS growth of over 30% CAGR over the past 4 years; a significant improved balance sheet, with a decrease in gross debt-to-EBITDA leverage ratio from 12x to 2.5x; and increased cash generation, having generated $150 million to $200 million of free cash flow over each of the past 2 years.
In short, we have transformed our business in recent years and believe that we are now the only Western systems vendor that is both growing and profitable. The point is that we have a proven and durable model that can deliver strong financial results in a challenging market. We believe the execution of our strategy positions us to continue outperforming the industry and delivering consistent value for our long-term investors.
James E. Moylan, Ciena Corporation - CFO and SVP of Finance 
Thank you, Gary. Having provided that detail on our strategic drivers and key market verticals, our intent to continue exerting our influence across the industry is clear. As is our path to building a bigger, more resilient and more profitable business. To that end, I will offer detail on several financial-related matters as well as provide new long-term targets for the company's financial performance.
Let's begin with our Q4 performance. Overall, we delivered a strong quarter. Total revenue was $744 million, towards the high end of our guidance range. We achieved strong order flow in Q4, significantly higher than revenue, which enabled us to close the quarter and the fiscal year with backlog of $1.1 billion. Q4 adjusted gross margin came in at 44.2%. This was down slightly from recent quarters, largely as a result of several new Tier 1 customer wins that are now coming to revenue. As we've said, the early stages of these deployments often carry correspondingly lower gross margins. We expect this dynamic to continue for the next couple of quarters as we continue to press down on the market, and to leverage our competitive advantage by aggressively targeting market share through new footprint opportunities around the globe.
Operating expense in the quarter was $241 million. And we achieved $88 million in adjusted operating income in Q4, or 11.9% adjusted operating margin. We will provide guidance for our fiscal first quarter of 2018 during today's live call with the investment community. Before going through our long-term targets, including with respect to profitably, I want to spend a moment to discuss how they are affected by tax matters. Today's press release details important changes that impact how taxes are going to be reflected in our results. You should view these changes as a strong indicator of our positive sentiments about the future, and further evidence of the company hitting an inflection point in our transformation. As many of you know, we have large deferred tax assets resulting from net operating losses accumulated organically and by acquisition. However, in recent years, we provided a valuation allowance against these tax assets on our books because, in our judgment, it was not certain that such tax assets would be realized. Based on our projections of sustained future taxable income and expectations for increasing profitability in fiscal 2018 and beyond, we determined that it is appropriate to reverse the majority of the valuation allowance against these assets because we now expect that we will utilize these tax assets to reduce future taxes. As you've seen in our press release, this resulted in a one-time tax benefit of $1.1 billion on our Q4 income statement, substantially increasing our GAAP net income and EPS for Q4 and fiscal 2017. Going forward, as required by GAAP, we will be making a full U.S. tax provision of approximately 36% to 37% against our GAAP net income. This will be a change in the presentation of our income statement.
However, it is important to note that we do not expect to pay cash taxes in the U.S. for the foreseeable future, again due to the utilization of our deferred tax assets.
In addition, as shown in our press release, we are changing how we calculate our provision for income taxes in our non-GAAP net income. We are making this change in accordance with recent SEC guidance. Historically, we have provided only cash taxes paid on our non-GAAP earnings and EPS. Going forward, we will provide a full 36% to 37% tax rate against non-GAAP earnings and EPS. This change will not affect our adjusted income before income taxes, our actual cash tax payments or our cash flows. But it will, of course, result in significantly higher non-GAAP provisions for income taxes. This, in turn, will impact our adjusted net income and adjusted earnings per share, and we'll require you to adjust your models for fiscal 2018 accordingly.
You will note that we have provided our calculation for the fourth quarter and fiscal 2017 under both the prior method and the new method in an Appendix to our press release. To be clear, this noncash tax provision against our non-GAAP net income is required by the SEC, and our cash flows will be the same as they would be before this provision.
But to summarize, overall, you should view all of these changes to our financial statement presentation of tax expense as a reflection of our increasing optimism and confidence in our future.
Turning now to our long-term outlook. We believe that we are uniquely positioned in the industry to continue delivering a combination of topline growth, profitability and cash generation, and our longer-term strategic plan is designed around that construct. With that confidence, we are now in a position to provide some longer term financial targets that we believe are achievable in the next few years.
We expect to continue growing our revenue faster than the market. Based on our current estimates of market growth, if we combine all of our expectations regarding future revenue, which Gary cited, we expect to grow our annual revenue approximately 5% to 7% per year over the next 3 years. Also, as we previously indicated, we have a long-term target of achieving 15% adjusted operating margin on an annualized basis, and that still remains an important and achievable goal.
We also expect to grow our adjusted earnings per share at an average of approximately 14% to 16% per year over the next 3 years. This performance includes the effect of our new method of reporting taxes in the calculation. And we expect annual free cash flow generation to be approximately 60% to 70% of adjusted operating income over each of the next 3 years. More specifically, with respect to our balance sheet, we've made substantial progress over the past 5 years. We have reduced our convertible note balance from $1.4 billion to $540 million. We've improved our net debt position from $712 million to an actual net cash position of $33 million, and we substantially decreased our gross debt-to-EBITDA leverage ratio from 12x to 2.5x.
The combination of these 2 items resulted in 2 ratings upgrades over the past year from both Moody's and S&P. We've also been proactive in managing dilution. This summer, we completed an exchange offer for our 2018 convertible notes, which provided us the option to cash settle the majority of those notes at maturity. And we have since disclosed our intent to use cash on hand to settle approximately $288 million of these notes when they come due in October of 2018. Given our current balance sheet and our expectations for cash generation over the next 3 years, we are now in a better position to incorporate the return of capital to shareholders as part of our overall strategic and operational plans.
As reflected in a separate press release this morning, I'm pleased to announce that our Board of Directors authorized a program to repurchase our common stock. The timing of these purchases will be based on our stock price, general business and market conditions, our liquidity and cash flow and other factors. We intend to finance the share repurchase program with cash on hand, or our cash generated from operations. These actions reflect our continued confidence in our long-term growth strategy and our strong balance sheet and cash flow generation.
As we think broadly about capital allocation, we still believe it is important to retain a meaningful percentage of our capital for the business and to maintain a healthy balance sheet and leverage level. First, for organic reinvestment to sustain and drive our R&D innovation engine and expanding our go-to-market efforts, which is clearly creating value as we use this competitive advantage to grow revenue and take market share. Second, for opportunities to go through accretive M&A. It is our intent to retain minimum liquidity in the range of $700 million to $800 million for these purposes. However, we are committed to driving shareholder value over the long-term, and intend to continue to incorporate the return of capital to shareholders in our plans as the business continues to grow and generate cash.
In closing, we're pleased with the maturity and strength of our business. It allows us to confidently provide greater clarity on our view of the current operating environment and, importantly, share our longer-term goals and how we plan to manage the business over the next several years. As we've said before, given industry dynamics and other factors, our overall financial performance and individual financial metrics may vary from quarter-to-quarter. However, we continue to manage the business for the longer-term. When viewed over longer periods, it is clear that we have delivered consistent financial performance with respect to top line growth, profitability and cash generation and we expect to continue to do so in the future. The combination of our leading technology and global scale has afforded us indisputable strong market leadership position and we continue to see our competitions struggle to keep pace. We intend to take full advantage of those dynamics and to continue executing on our strategy to grow both our top and bottom lines and to generate cash. We have proven our ability to do that time and time again. And today, we've never felt more confident about our future. Thank you for your support and interest in Ciena.