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Edited Transcript of CIEN earnings conference call or presentation 6-Jun-19 12:30pm GMT

Q2 2019 Ciena Corp Earnings Call

LINTHICUM Jun 14, 2019 (Thomson StreetEvents) -- Edited Transcript of Ciena Corp earnings conference call or presentation Thursday, June 6, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gary B. Smith

Ciena Corporation - CEO, President & Director

* Gregg M. Lampf

Ciena Corporation - VP of IR

* James E. Moylan

Ciena Corporation - CFO & Senior VP of Finance

* Scott Alexander McFeely

Ciena Corporation - SVP of Global Products & Services

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Conference Call Participants

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* Alexander Henderson

Needham & Company, LLC, Research Division - Senior Analyst

* Catharine Anne Trebnick

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking

* Fahad Najam

Cowen and Company, LLC, Research Division - Associate

* Jeffrey Thomas Kvaal

Nomura Securities Co. Ltd., Research Division - MD of Communications

* Jim Suva

Citigroup Inc, Research Division - Director

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Michael Edward Genovese

MKM Partners LLC, Research Division - MD and Senior Analyst

* Paul Jonas Silverstein

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* Roderick B. Hall

Goldman Sachs Group Inc., Research Division - MD

* Samik Chatterjee

JP Morgan Chase & Co, Research Division - Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* Thejeswi Banavathi Venkatesh

UBS Investment Bank, Research Division - Associate Director and Analyst

* Timothy Paul Savageaux

Northland Capital Markets, Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Good morning. My name is Lisa, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Ciena Fiscal Second Quarter 2019 Financial Results Conference Call. (Operator Instructions) Thank you.

Gregg Lampf, Vice President of Investor Relations, you may begin your conference.

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Gregg M. Lampf, Ciena Corporation - VP of IR [2]

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Thank you, Lisa. Good morning, and welcome to Ciena's 2019 Fiscal Second Quarter Review. With me today is Gary Smith, President and CEO; and Jim Moylan, CFO. Scott McFeely, our Senior Vice President of Global Products and Services, will join us for the Q&A portion of today's call.

In addition to this call and the press release, we have posted to the Investor 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 current view of the market environment and our industry position, our fiscal second quarter financial performance as well as our guidance for the fiscal third quarter and an update to our revenue outlook for fiscal '19.

Before turning the call over to Gary, I'll remind you that during this call, we will be making certain forward-looking statements. Such statements, including our guidance and any commentary about our long-term financial targets, 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 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-Q filing, which is required to be filed with the SEC by June 13, and we expect to file by that date.

Today's discussion also includes certain adjusted or non-GAAP measures of Ciena's results of operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's press release. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events or otherwise.

With that, I'll turn the call over to Gary.

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Gary B. Smith, Ciena Corporation - CEO, President & Director [3]

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Thanks, Gregg, and good morning, everyone. Today, we've reported a very strong quarter across all of our financial and performance metrics. This included revenue growth in all major product segments and customer verticals. This reflects our balanced growth and continued market share gains. Order flow significantly exceeded revenue in the quarter, giving us strong visibility and increased confidence across our business. This performance is driven by the combination of our outstanding execution of a very deliberate and long-term strategy as well as favorable competitive dynamics.

Specifically, we consistently achieved technology leadership across our portfolio and continued to build a diversified customer base in high-growth markets, all at global scale and with deep customer relationships.

As a result, we continue to outpace the competition across multiple dimensions, and we believe that we represent the strongest and most stable partner to customers around the world. This combination, in turn, is driving consistent and differentiated financial performance, including better-than-expected performance in Q2 and is enabling us to significantly increase our revenue outlook for the remainder of the year.

Over the past few years, there have been several notable shifts happening in the communications industry, including evolutions in network design and technology as well as changes to the profiles of the customer base and the competitive landscape. Our Q2 results illustrate the very positive impact on our business of how these shifts are playing out today for Ciena.

Specifically, demand for capacity, in its various forms, remains robust across our customer segments, geographies and market verticals, and we are intensely focused on executing and delivering on this robust demand.

Also, the industry structure continues to currently be defined really by a flight to quality, where customers are more intently seeking out vendors, who are for leading innovation and engagement models, and who have the financial strength and sustainability to deliver on these over the long term.

Other industry dynamics also continued to occur, but with perhaps less of an effect overall on our business. In particular, customers in certain geographic markets continued to evaluate rebalancing their network spend in the face of an overdependence on certain Chinese equipment vendors.

Although the benefit of this to our business directly is difficult to discern, it has been a dynamic that has been in place for some time, and we believe it to be relatively minimal impact on our business at this stage.

As we have said consistently, in addition to these favorable industry dynamics, it is also the strong execution of our strategy to deliver the industry's leading innovation while diversifying our business and leveraging our global scale that is underpinning our success.

With respect to innovation leadership, our competitive position continues to strengthen, particularly given our focused investments in Optical, Packet and Blue Planet Automation Software. And our strong financial results are a direct reflection of the fact that the market firmly believes Ciena has the strongest offering today and the most credible roadmap for the foreseeable future. Our current portfolio as well as our roadmap, including feature sets and the timing of market introductions, are frankly unmatched in the industry today.

As we head into the second half of the year, demand for WaveLogic Ai continues to grow, and we will further extend up that optical leadership with our WaveLogic 5 program, which remains on track to deliver single wavelength 800 gig systems later this year.

Just as importantly, this innovation and time-to-market leadership is enabled by our significant investment capacity, which ensures that we have the depth and flexibility in our development to remain ahead of the competition.

Moving to diversification. Q2, frankly, was yet another great illustration of the breadth of our customer base and the benefit it provides to our business.

We had a strong showing from North American Tier 1 service providers, webscale players and in Asia Pacific, specifically Japan. With North American service providers, we continue to benefit from their spending on densification initiatives, metro access and aggregation build-outs and ongoing long-haul investments.

In Q2, both of our 10% customers were North American Tier 1 service providers. The breadth of our webscale business is expanding, and our relationships with these customers are deepening. This is driving differentiated growth and continued share gains in this important vertical. Once again in Q2, 3 of our top 10 customers were webscale companies, including 1 that was just a fraction under 10% of total revenue.

We are also accelerating share capture and landing new wins with service providers globally, including in Asia Pacific beyond India. We expect these 3 customer groupings to be among the significant drivers of our business in the second half of fiscal 2019.

And finally, with respect to the market advantage, we have with our global scale. Because of how we've strategically grown our business around the world, including within key customer segments and with well resourced and focused innovation agenda aligned to their priorities, we essentially have strong exposure to higher growth markets. That, combined with our world-class go-to-market organization, including the largest optical sales team in the industry, positions us to foster the deepest and broadest customer relationships that exceed those of any other vendor.

In summary, it is the confluence and continued execution of these multiple elements, together with favorable industry dynamics, that are enabling us to deliver outstanding financial performance and continued share gains.

With that, I'll ask Jim to take us through the Q2 results and our higher outlook for the rest of the year. Jim?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [4]

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Thanks, Gary. Good morning, everyone. We delivered a very strong top line performance in Q2, with revenue of $865 million, representing 18% growth year-over-year. Some highlights in our Q2 revenue include Packet revenue of $73 million, up 15% from Q2 of last year; Blue Planet automation software and services revenue of $12.4 million, keeping us on track to achieve our fiscal '19 target of $50 million to $60 million.

With respect to Q2 revenue across customer verticals, non-telco revenue was $295 million, up 17% year-over-year. Direct webscale revenue contributed revenue of $167 million, up 31% year-over-year, and subsea revenue was $63 million, up 23% year-over-year.

Moving to gross margin. Our Q2 adjusted gross margin was 43.9%, above our estimated range due to higher cost reductions than expected and a confluence of favorable mix factors. Q2 adjusted operating expense was $269.7 million above our guidance range.

The increase in operating expense was related to the timing of certain R&D projects as well as slightly higher variable compensation given the strong quarterly performance. Year-to-date, we are essentially on plan for OpEx, except for the higher compensation expense just mentioned.

With respect to profitability measures in the second quarter, we delivered adjusted operating margin of 12.7%, adjusted net income of $76.2 million and adjusted EPS of $0.48. In addition, in Q2, our adjusted EBITDA was $131 million and cash from operations was $104 million. We ended the quarter with approximately $818 million in cash and investments.

Finally, we continue to execute on our share repurchase plans. During the second quarter, we repurchased approximately 1.2 million shares for $45 million. We are on target to buy back approximately $150 million in share value by the end of our fiscal year.

Before I move on to guidance, I want to comment briefly on 2 current geopolitical matters impacting markets in general and potentially, our industry.

First, regarding U.S./China trade tensions and overall relations, we have not seen any substantive impact on our business to date. While there are many elements to this situation, given the global nature of supply chains, it is important to note that, unlike many others in our industry, we have almost no revenue exposure to China.

Second, regarding the potential for tariffs on imports to the U.S. from Mexico, the situation is late-breaking, it's very fluid, and we can't be sure what, if anything, will ultimately put in place -- be put in place and for how long.

For now, we are evaluating a range of alternatives and mitigation strategies to address the potential effects on our manufacturing and distribution operations in Mexico. If the initial 5% tariff is put in place next week, as proposed, our preliminary analysis, which reflects several conservative assumptions around our ability to mitigate, indicates that it could impact our Q2 gross margins -- Q3 gross margin by as much as 1%. I emphasize that this is a preliminary and very conservative number.

The situations with China and Mexico are highly uncertain at the moment, and we will continue to monitor them carefully. Importantly, for you, we have not factored into our outlook today any significant potential effects of either of these matters, and we do not believe they will fundamentally alter our competitive position or the benefits yielded by our innovation leadership, diversification and global scale.

Looking ahead, in fiscal third quarter 2019, we expect to deliver revenue in a range of $915 million to $945 million, and adjusted gross margin in the 42% to 43% range. Given our strong results in the first half of fiscal '19 and our projections for the second half of the year, we are in a position to increase our revenue guidance for the full fiscal year. Specifically, we now expect to achieve annual revenue growth this year in the range of 13% to 14%.

As I said before, we are on plan for OpEx year-to-date, except for some variable compensation expense booked in Q2, and we expect to be essentially on plan for the rest of the year, except for the potential for higher compensation expense if we perform to our revised expectations.

With our new guide, we anticipate incurring higher compensation related expense of approximately $10 million per quarter in the second half of the year. With that, we expect operating expense in the third quarter to be approximately $270 million.

In closing, we posted a very strong set of results today for our fiscal second quarter, including continued market share gains in every vertical. In addition, our strong visibility gives us increased confidence for the fiscal year, reflected in our higher revenue outlook for 2019.

In a market that continues to grow in the low- to mid-single digits range, continued execution of our strategy and a strong set of industry dynamics are positively influencing our business and enabling us to advance our competitive position.

With that, Lisa, we'll now take questions from the sell-side analysts.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Paul Silverstein from Cowen.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [2]

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Jim, first, a clarification. I assume your 42% to 43% gross margin guidance that incorporates the potential for that 1% adverse impact, is that correct?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [3]

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No, it does not. 42% to 43% is our range of gross margin that we believe we'll see for the third quarter and the rest of the year for that matter.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [4]

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So with the Mexican, let's say, 5% proposed tariff's been placed, so that would be an additional 1 percentage point of that, just to be clear?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [5]

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Yes. Yes -- No, very -- I'd emphasize that, that's a very conservative number.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [6]

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All right. Now for the question. Gary and Jim, it sounds like you've had a pretty decent futures in your outlook for the webscale folks (inaudible) talking about back with the customers being soft during the second half of the year, based on the growth you just put up and I think that Gary commented that you're expecting a strong second half of the year out of that group? And obviously, well, the investment community of your peers have cited issues of 1 type or another. Can you revisit that? And give us some insight what's going on there? And then one related question, on the 600 gig versus 800 gig concern, that it's now gotten competitors shipping 600 gig based platforms in the rest of Ciena. It doesn't sound like that (inaudible) guide? If you could address those 2 issues.

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [7]

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Let me start, Paul. Just to be clear, we never spoke of weakness with respect to the webscale. We said that we were going to have a good year with webscale, but that we were not going to grow for this year as much as we grew last year. Remember, we grew 140% or something in that vertical last year. We said we were going to have a good year and we're going to grow. All of the comments about weakness in our webscale business came from other places, not from us. I'll now let Gary address the other questions.

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Gary B. Smith, Ciena Corporation - CEO, President & Director [8]

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Yes. So specifically, we still think the webscale market is growing in the single to low double digits. We're going to grow above that market rate. Basically, we're going to continue to take share, and that's driven by 2 elements: one, the technology and innovation leadership that's appreciated there, and the embedded relationships that we have with them as well.

But I want to be clear, the growth that we're talking about in the second half is multifaceted. It is not just webscale, we've done very well in webscale and we have a very good visibility to that. But service provider business in North America, very strong. The wins that we've had with global Tier 1s are also beginning to play through, specifically markets like Japan are very strong. So it is a balanced growth strategy that we've been pursuing, and we're seeing the benefits of that in our broad-based projections that, frankly, are going to be better than we had anticipated going in based on those set of dynamics. Scott, you want to talk about the 600 gig?

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [9]

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Yes. Paul, it's Scott. In terms of the competitive dynamics, I'd say this, in Q2, we had a record quarter in terms of demand and shipment for our existing WaveLogic product portfolio. As we look in the second half of the year, that is accelerating off of that record high. So that's a window into the competitive dynamics if you like. If you couple that with our announcement around WaveLogic 5 and the market-leading innovation that, that brings and the fact that we're well on the execution path of that as we thought we would be when we made the announcement, we're very comfortable in terms of our competitive position. But more importantly, I think, if you look at the second half guidance we have here, that's backed up with great visibility and demand across that portfolio.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [10]

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Scott, can I just ask you to clarify on the webscale and (inaudible) speaking loosely, was the flattening that you'd previously referenced relative to the explosive growth that you've enjoyed, what -- can you give us insight as to what you're expecting in terms of growth from that customer base in the second half of the year?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [11]

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We were up 31% for the quarter. I'm not going to comment on the growth rate. It's going to be good this year, but it's not going to be 140%, it will be strong, we're going to take share.

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [12]

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What we said in the past, Paul, I think is that the spend in our space that the webscale players do from a market perspective, our perspective was that, that was growing year-on-year high single digits, low double digits. We haven't changed that perspective. And if you look at our growth rates that Jim referenced, it's clear that we're taking share in that space.

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Operator [13]

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Our next question comes from the line of Simon Leopold from Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [14]

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Great. It seems as if you're putting a lot of emphasis on sort of the non-telco, but I'm hoping maybe you could double click on the majority of the business, its Telco, and maybe give us a little bit more detail as to the sources of the upside surprise in the quarter. Specifically, I'm trying to get a better sense of whether this is your traditional North American customers? Or whether this is evidence of the increased traction in Japan. You did highlight that, but I imagine India is declining and Japan is growing. So if you could help us understand really the sources of the strength versus your guidance.

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Gary B. Smith, Ciena Corporation - CEO, President & Director [15]

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Yes. Simon, I would sort of start with answering this around the overall, what I would call, the flight to quality that you're seeing amongst the global service providers. And that is multidimensional, it's around innovation, the technology, the relationships, the scale and the sustainability. I think there's a lot of concern around the global service providers, the big Tier 1s around the sustainability of many competitors and also the technology and the ability to sustain that roadmap. And I think, overall, you're seeing those dynamics very favorable towards Ciena. So I think that's the sort of macro market dynamic. It's not brand-new, we think it's accelerating though, this year, and it's showing up in our results.

In terms of the geographic elements for that, North America, we had a very strong quarter and order flows. And we have a good strong forecast for the remainder of the year, that's with the big Tier 1 service providers.

Cable, I would say, is stable. I think it will probably be a little bit of growth for us this year with new logo wins that we've had in that space. Internationally, we grew most of the regions. EMEA was up for the year, Asia-Pacific, seeing good growth. India, given the election and the rest of it, is kind of -- will be, I think, sort of flat for the year. But I think it talks to our broad-based growth strategy. We've got other markets that are picking up the load. Japan, in particular, very strong growth out of Japan.

And again, I think that also is about the flight to quality and the concerns around the longevity of their indigenous vendors as well and they're well-placed to take advantage of that. So Simon, that's how I'd summarize it. It's very broadly based. We're also getting some of the benefits of the Tier 1 wins that we've had over the last 18 months now beginning to come to revenue and that gives us good visibility into the second half of the year with the service providers. We feel very good about service provider business in 2019.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [16]

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What would you consider the single biggest surprise for you in terms of these results?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [17]

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I think, really, the advancements of the competitive position, Scott talked to this. And I think the desire for WaveLogic in its various forms, I think has been extremely robust. We expected it to be good for the year, but I think it does talk to the competitive position that we have.

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Operator [18]

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Our next question comes from the line of Tejas Venkatesh from UBS Securities.

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Thejeswi Banavathi Venkatesh, UBS Investment Bank, Research Division - Associate Director and Analyst [19]

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I have another question on the sources of strength. If I have got my math right, it looks like your North American revenue outside of direct webscale, AT&T and Verizon, grew about $25 million year-over-year, particularly strong. So I'm curious if you could comment a bit on that?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [20]

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Yes. I'd say that we're doing well with a whole set of customers in addition to AT&T and Verizon. We're down in -- we're in the enterprise market. We had a good enterprise result for the quarter and for the half. Smaller Tier 1s and Tier 2s, we're doing well in. So it's very broad-based, Tejas. We're doing very well, and government, excuse me.

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Thejeswi Banavathi Venkatesh, UBS Investment Bank, Research Division - Associate Director and Analyst [21]

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Got it. And then would you comment on your AT&T expectations for this year? And what that could look like versus historical patterns?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [22]

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As we said at the beginning of the year, we expect a year of growth out of AT&T. We've been sort of flattish to down in AT&T for several years. That had more to do with their spend on optical than certainly any loss of share on our part. We expect a good year out of AT&T. They're buying -- they buy pretty much everything off the truck.

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Operator [23]

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Our next question comes from the line of Rod Hall from Goldman Sachs.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [24]

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Nice job on the execution here. I guess I wanted to start with the WaveLogic 5 product and just ask if you guys are still on track to deliver that by the end of the year? And then, more importantly, are you expecting to ship it in volume, at least, on the Waveserver on this 5,500 platform in the March quarter? That's the first question. The second thing I wanted to ask about was OpEx, just to clarify your comments there. The R&D numbers, I mean, I'm assuming that what you mean, Jim, when you talk about the R&D is that you should still see that growing slower than revenue, but I just want to be sure about that. And then maybe 1 follow-up to this as well?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [25]

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Yes. I'll address the OpEx piece first, and then Scott or Gary will talk to your revenue question. On OpEx, the timing of R&D spend is -- can be somewhat volatile quarter-to-quarter because we do projects, we do [NRE], we do lots of things, which happen during a quarter and can either inflate or deflate the OpEx number. The important thing to note is we gave guidance at the beginning of the year that we were going to be running OpEx between $255 million to $260 million a quarter. We're on track for that. We will spend a bit more on compensation expense for this year if we deliver the guidance that we gave you.

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [26]

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And Rod on the question on WaveLogic 5. The short answer is yes. So we announced it to the marketplace back in calendar Q1, we said it would be available at the end of the year, and we would be shipping on Waveserver products and 5,500 products in volume in calendar Q1 next year. And that's all on track. The execution of the program has been bang on from our expectations.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [27]

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Could you comment -- just on the WaveLogic 5, could you just talk about maybe just a little bit of color of what you're hearing back, particularly from the DCI market on that? Back to this 600 gig versus 800 gig question, it just seemed like if that's available in volume, it's hard to believe that people wouldn't pretty rapidly shift over to that technology. But I don't know, maybe the price per bid is going to be significantly higher and that would keep people buying 600 gigs. So just a little bit of color maybe on how you see competitive dynamics there developing, particularly in DCI early next year as you start shipping that in volume.

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [28]

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Yes, I'd say it this way, Rod. The 800 gig versus 600 gig is the tagline for the comparison, but it's really outperformance at every application in the network. And if you look at the specs on WaveLogic 5, it outperforms anything that is advertised from the competition now or in the foreseeable future, at every application space.

So we have execution in front of us, no question. We've got a great track record of doing that, and we're confident about that. But we're very, very confident in terms of the competitive spec on that. And by the way, as I said in the past, we deal with a very sophisticated set of buyers, and they buy not only existing stuff on the roadmap, but they're also buying the roadmap, and they're very aware when we say we've got very robust demand in the second half of the year for our capability set, it's partially with visibility of those roadmaps as well.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [29]

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And could you guys also -- this will be my last one. But could you just comment on the North America trends? I know you've already said a few things, but we were surprised to see year-over-year growth there accelerating so much in April. And just wondering whether -- do you think that is a particularly good quarter as you look out the next couple of quarters? Or do you think that North America, because of the project visibility, you guys are just going to continue to be stronger and stronger than what you saw in April?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [30]

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The answer to your question is yes. We continue to expect North America to be strong, both in terms of existing relationships and our strong visibility and for that, the order backlog. Some of the new wins that we've had, there's a couple of Tier 1s as well that are now -- that have got a fair amount of publicity that will not be ramping up in the second half. So we've got very high degree of confidence in a strong North America and I think, Rod, it talks again to not necessarily whether the total CapEx increases or not, it's who they spend it with. And I think they're being way more discerning around their desire to have a sustainable player in there than ever they have been before.

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Operator [31]

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Our next question comes from the line of Michael Genovese from MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [32]

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Great. Can you help us understand how you beat the second quarter gross margins by as much as you did? Software was not particularly strong and Packet was sort of in-line. So what was the dynamics there behind those GMs?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [33]

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Yes, Mike, as we've said before, it's -- gross margin is difficult for us to call within -- in a very narrow band, because there are a lot of things that impact gross margin in any given quarter; customer mix, early stage of projects, specific projects, which have good margins or less than good margins.

And so what I'd say, generally speaking, you'll note that services have a higher gross margin than -- in Q2 than Q1, and that had some sort of unusual things in both quarters, which accentuated the differences. And then, generally, a favorable mix and cost reduction, so that's what I can tell you.

I still think we're a 42% to 43% gross margin company today, as we said. I think we're going to go up from that range next year, but I think we're 42% to 43%.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [34]

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I want to follow up on that. Because it sounds like 42%, 43% is conservative, but it would be even more conservative to assume that these Mexican tariffs go into effect this quarter, but you're not assuming that? So I'm trying to sort of understand what you're saying about 42% to 43%? It kind of sounds to me like you're saying you could be at 42%, even with a partial quarter of Mexican tariffs, is that fair?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [35]

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I'm saying that 42% to 43% is our base gross margin. And then we said that the estimate -- conservative estimate of what Mexican tariffs being in place for Q3 could impact our margin by 1%. Now there's 100 assumptions based into that, that we haven't tested. We're going to do a lot of work on mitigating that effect if they come into place. And so that's why it's there. Our base gross margin is 42% to 43%, we believe.

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Operator [36]

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Our next question comes from the line of Samik Chatterjee from JPMorgan.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [37]

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Just want to start off with the tariff topic itself. There is probably a proposal as well that the 5% tariff [it cliffs] to 25% in October, I believe. So if that were to happen, what are the alternatives in terms of footprint that you can evaluate over the short term to mitigate that impact?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [38]

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You can imagine that we are looking at all the alternatives if the tariffs are put in place at all because we'd like for there to be no effect on our results even if the tariffs are put in place. That does include things like moving manufacturing, changing some flows out of our supply chain, and other things that we would do. But beyond Q3, it's very, very difficult to predict what's going to happen to these tariffs. But I can assure you, we're going to do the right thing.

We've gone through things like this before, and we've always been able to mitigate potential effects. That's why when I give a number like about 1% we're giving you a conservative number before we put in place the things that we will do, if necessary.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [39]

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Okay. Got it. And can I just follow-up on -- related to the EMEA customers and their overdependence on a Chinese supplier. You mentioned there's not a material impact right now on the business. I just wanted to see if you can -- if you have any comments on, particularly, win rates in Europe. And if you've seen an acceleration there in the win rates this year?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [40]

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I think a couple of comments that I would have on it, Samik is, whilst this is getting a lot of publicity, obviously, right now, this is a dynamic frankly that we've -- that has been in play for a couple of years. And I think it's driven by a number of elements, not least of which is just the large market share that these Chinese vendors have taken within certain customers and customers are very aware of that and very sensitive to it and are looking to decrease their dependency.

We began to see some of these dynamics come into play about 2 years ago. Difficult to discern exactly which customers, which revenue, et cetera. But I think it has been a factor over a period of time here. And I also think it plays into this overall sort of flight-to-quality piece that I talked about earlier.

So it's difficult to discern exactly what the impact has been to us, but definitely there is a concern amongst a number of large carriers, particularly in Europe that they just actually have an overdependence on Chinese vendors, and they are looking to mitigate that over time.

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [41]

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And just to be clear, there's another element to this whole U.S./China situation, which is a prohibition on American component makers selling into Chinese vendors, which would be a serious problem. There's security concerns that the U.S. is talking with companies around the world about. But it's that element, the sort of set of security concerns and trade concerns for which we've seen no real effect on our revenue. Where we've seen effect on our revenue is the high market share that Huawei holds in certain markets. We have no way of knowing how the first thing that I was talking about will affect our future.

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Operator [42]

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Our next question comes from the line of Jeff Kvaal from Nomura.

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Jeffrey Thomas Kvaal, Nomura Securities Co. Ltd., Research Division - MD of Communications [43]

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Yes. I've got a question and a clarification. I think on the question, would you all mind helping us through how sticky the Huawei gear proves to be? Or is it [E-gear]? Is this a general -- how long is the process of switching from any vendor to another? And how would we be able to gauge that impact on your revenues? Like over what timeframe? And then, I guess, the clarification is, Jim your 1% impact from Mexico tariffs for 1/2 a quarter at a 5% rate, would that apply -- would that essentially mean a 2% for a full quarter? Is that the implication there?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [44]

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I think we're giving you a conservative number for Q3 because it's topical. I'm just not prepared to give you much more than that today, Jeff. And our base gross margin excludes any of that impact. On the Huawei, Scott, do you want to address that?

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [45]

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Yes, I think they're -- it's a tough one to give you a black-and-white answer to because each of our customer bases has different new product introduction processes that take anywhere from, in some cases, a relatively short period of time. With other cases, a 1 year, a very expanded period of time. So it's difficult to give you a hey, here's the model perspective. They're typically -- and there are also different approaches in terms of how they may go about this. Totally overbuild the network, run foreign wavelengths over existing systems. And those also derive a lot of variability to the answer to that question. So it's difficult to give you a black-and-white one.

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Jeffrey Thomas Kvaal, Nomura Securities Co. Ltd., Research Division - MD of Communications [46]

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Well, if one is speaking about a telco, in general, I mean these decisions are made over many years, in some cases. So -- and they did all, obviously, welcome Huawei into their networks at some points in the past. So it sounds like it's a slow process if they wanted to switch share back and forth. But I'm trying to gauge your commentary on that with -- just add a shade more visibility into that or detail.

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Gary B. Smith, Ciena Corporation - CEO, President & Director [47]

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Jeff, maybe I can share a bit more color to it. I alluded to it when I said this has been going on for many years. This is sort of a 2- to 3-year thing that we've seen. We've had wins, particularly in Europe and certain parts of Asia that I can probably point to and say, that's because of the concern about their dependency on a particular vendor. So we have seen that. But the most public one that I would offer you is Deutsche Telekom, who has been a very big Huawei customer and has not been a Ciena customer. And last year, we won both the international and the domestic business with them, and we're just beginning to roll that out right now. So to your point, that has taken about a year or so in terms of the back-office integration, et cetera. But that's one example that I can give you we talked about publicly of that kind of a shift.

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Operator [48]

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Our next question comes from the line of Alex Henderson from Needham.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [49]

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You guys are clearly having, what I would describe, as halcyon days with 3 quarters in a row averaging about 20% revenue growth. I don't think you've seen those kind of conditions for a very long extended period of time. Within the backdrop, you've got the Japanese Olympics and displacement of the Japanese vendors. You've got strength at AT&T and Verizon. You've got a number of positive tailwinds, all kicking in to give you growth way above historical trend lines. I guess my question is, to what extent do you think some of those start to reverse against the tougher comparisons, as we get past the next couple of quarters and we're looking at tough comps and your growth rate for the 3-year period of 6% to 8%? How should we think about -- is this so far above trend line that it starts to revert back to it? Or is there so much pipeline built because of the things you've just talked about in terms of share gains versus Huawei and other weakened competitors that this continues? And if you could put some thoughts into around 5G into that, I would appreciate it.

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [50]

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Yes. And you know -- or you must be referring to beyond this year because we've given guidance for this year. Just to put some context to that, we are in the market which is growing, we believe, low to single digits, and -- low- to mid-single digits, I should say. That's been the case for the last 8 or 9 years. In that context, we have grown 2 to 3 points above that range, and we've taken about a point of share per year until the last couple of years, when, as we've said, we've had a confluence of factors, which are really driving our growth rate up beyond what we think we can sustain.

So our belief is, beyond this year, we will revert to 6% to 8%. Now that will be off a much higher base, so our numbers are going to be higher, and your numbers should be higher. And I'd also say that our EPS growth, we think we can continue at 20% a year, although, if you just run our guidance out and we achieve it, we're going to be above 20% EPS growth rate this year.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [51]

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One more question, if I could. Again, longer-term. Clearly, 800 gig is going to be a big cycle and the 400 to 800 is a nice round feed into it so that always helps the dynamics. As we start getting past the 800 gig, are we moving away from an environment where, over the last decade plus, virtually everything has been driven by the DSP, whereas, going forward, in order to push higher baud rate, it starts to become more important on indium phosphide and are you all concerned about the health of that supply chain?

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [52]

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Yes. This is Scott. I'll take that one. So first of all, to your question about the DSP, we still think there's performance we can eke out beyond what we've announced in terms of the next generation, so there's still work to be done there. But you're quite right. The innovation on the local here in drivetrain doesn't just include the DSP. And one of the reasons why we actually went out and acquired TeraXion a couple of years ago was actually to get control over the intellectual property and the execution capability around the electro-optics piece of that drivetrain, including indium phosphide, but also silicon photonics. And then I'd say we have control over of our own destiny in that place and that is actually what has allowed us to be extremely aggressive in terms of the innovation cycle that we're putting on the table for WaveLogic 5.

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Operator [53]

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Our next question comes from the line of Jim Suva from Citi.

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Jim Suva, Citigroup Inc, Research Division - Director [54]

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A pretty basic question. Given the pending Mexico import tariffs, have you seen an acceleration or pull-in to orders thus far?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [55]

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I think the quick answer to that is no, we haven't. I think it's a fluid situation, but no, we have not seen any forward ordering based on that, I think given the uncertainty of it.

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [56]

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Early days for sure.

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Jim Suva, Citigroup Inc, Research Division - Director [57]

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Got you. Okay and then my last question is kind of a bit of an accounting question. In the past, you've had some restructuring costs and it looks like they went up this quarter to about $4 million versus the past few quarters kind of lower. And that line item after impairments and right after impairments and stuff, is that more on the restructuring side, what's going into there? Why would it go up when you're having revenues and earnings and profitability going up? I would expect to actually be going in the other direction.

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [58]

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Yes. The answer to that is that we talked about this earlier in the year. We said that we are looking at a number of efficiencies in our OpEx. We said that we still felt confident in our -- I should say, we have a target of getting to 15% operating margin in 2020. But we said that in order to do that, we did have to reduce the intensity of our expense. And so we have a number of initiatives across just about every function to try to take costs out. And these restructuring costs reflect the outcome of those actions. There will probably be more as we move through this year. But we will, again, reduce the percentage of -- the OpEx as a percentage of revenue in 2020.

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Operator [59]

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Our next question comes from the line of Meta Marshall from Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [60]

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First question from me maybe just on kind of the more public smaller Tier 1 win. You mentioned that, that will kind of get towards run rate in the second half. And just -- should we consider what we see in kind of the second half to be full run rate? Or will that continue to ramp in calendar year 2020? And then maybe just some reflections on 400ZR timing and just your timing and when you see the market developing, is the second question.

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Gary B. Smith, Ciena Corporation - CEO, President & Director [61]

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The Tier 1 you alluded to, I would expect to continue to ramp for '20. So we'll see a little uptick to our forecast, I believe, for the second half. But it's relatively small, relative to the size of our business, for sure. But we would expect most of that to come in '20.

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Scott Alexander McFeely, Ciena Corporation - SVP of Global Products & Services [62]

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And on the ZR question, I'd say the market timing, I think is late 2020. We announced with our WaveLogic 5 family, we fully intend to be in the marketplace in that timeframe. I'd also remind you, though, what we said on the last call, the ZR spec as it is and just sort of look at the different applications that make up the optical market space. We do believe it's a relatively small portion of that market. I think the last time we said, it's something like 5% of the overall market.

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Operator [63]

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Our next question comes from the line of Catharine Trebnick from Dougherty.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [64]

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Great quarter. One clarification. Was that 34% of total revenue for non-telco, Jim?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [65]

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Yes. Yes, it was Cathy.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [66]

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And then the other question is, I've heard some chatter during the quarter that there was an organizational change in North America, and could you address some of that chatter if you wouldn't mind?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [67]

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We're sitting here and wondering what you might have heard, but we're always having changes in our organization. But there were no major changes at the senior executive positions that I'm aware of unless Gary knows something I don't know.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [68]

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No. To be clear -- to be fair, it was around AT&T that there's been some change in leadership around AT&T, to be totally fair.

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [69]

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Yes. It's part of a larger restructuring of our go-to-market group in which we have just changed how the organization works. The fellow who runs -- who ran the AT&T account is still active in the account. He has taken another position in a revised organization. There's nothing to see here, not to worry, we're having a great time with AT&T.

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Operator [70]

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Our next question comes from the line of Fahad Najam from Cowen.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [71]

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My question was on your North American commentary. Can you provide us a little bit of details as to what's driving the outlook other than when you said AT&T is going to be flat but growing? So what's the other growth driver besides webscale that's fueling your outlook, is it (inaudible) CenturyLink that's fueling your outlook? Can you expand more on what's happening in the North American market?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [72]

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I would describe the share growing across-the-board. It's Tier 1s, it's new Tier 1s. You mentioned CenturyLink. It's new logos into the cable space as well, strong Tier 2, Tier 3 performance, webscale, government, the enterprise business as well. So it really is very broad-based in North America. And we think it's sustainable obviously, given the visibility that we have into the second half of the year. So it's extremely broad-based.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [73]

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Okay. And how much of these new footprints wins do you have relative to your previous wins? How much of the -- how much is the software content? Is it larger than previous wins that you've had recently?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [74]

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I would say it's sort of consistent. We've got some good opportunities on the Blue Planet side in North America, but obviously, from an overall revenue point of view, that's relatively modest, but important strategically to us. We've had some significant progress there, which I think bodes well for the validation of that platform. But, obviously, from a materiality point of view on revenue, it's not hugely impactful. But we've had a number of new wins in North America into the cable space. Obviously, a couple of the Tier 1s that you alluded to, and we continue to take share, and I think I'd summarize it again by saying sort of flight to quality.

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Operator [75]

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Our final question today comes from the line of Tim Savageaux from Northland Capital.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [76]

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All right. Congrats on the great results. My question, it looks like Tier 1 -- revenues with your 2 largest Tier 1s may have increased something in the order of 50% year-over-year in the quarter. I wonder if you can kind of comment on that number?

And the question is as you look at that increase, which seems to be responsible for a fair bit of the upside, can you characterize that growth relative to increased spending at those customers on whether it's pre-5G or access or Metro, or what have you relative to any potential share gain from competitors in those accounts. Which would you say was sort of more central and driving -- what I think was the real focus of kind of the unanticipated growth in the quarter at least from our perspective?

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James E. Moylan, Ciena Corporation - CFO & Senior VP of Finance [77]

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It certainly did impact the quarter. I would say that we started the year expecting growth out of both of those accounts, but certainly not 50%. And I don't think that they will grow 50% year-over-year. I think we had an exceptionally good quarter with both of those customers. And so I would not -- we've always said don't look at any individual quarter as a trend. And I would highly emphasize that in this situation. We're engaged -- we're involved in just about every big project that they're doing, maybe it is every optical project that they're doing right now. And in both cases, I think their spend is up a bit this year. But don't expect 50% growth in those 2 customers. And we emphasize, those aren't the only North American customers that are doing extremely well.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [78]

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Understood. But it seems at least some of that is forward looking in terms of the new wins, in terms of what impacted the quarter. It does seem like your current customers are more central to that and just wrapping it up for me. With regard to international, I think I missed some of your comments earlier, I mean it looks that it pretty much flattened out. I assume India was a drag in the quarter, and maybe, I guess, partially offset by Japan. Is that a fair summary?

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Gary B. Smith, Ciena Corporation - CEO, President & Director [79]

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Yes. That's a fair summary. We kind of expected -- India has been on a massive investment program, and I think we expected this year some digestion of that frankly, particularly given the election year as well. So I think that would be -- our view was just sort of flat for the year. But other markets have taken up the weight on that, particularly Japan and some of the other Asian markets, who are looking strong for us for the remainder the year. Also, we feel pretty good around Europe as we go into the second half as well. We feel that some of the growth we will see will be -- will come out of the European market place. So we think it's sort of pretty balanced.

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Operator [80]

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We have no further questions in queue. I'll turn the call back to Mr. Lampf for closing remarks.

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Gregg M. Lampf, Ciena Corporation - VP of IR [81]

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Thanks, everyone, for joining us today. We appreciate your interest. We look forward to catching up with everyone over the next several weeks. Have a good day.

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Operator [82]

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This concludes today's conference call. You may now disconnect.