SECURITIES AND EXCHANGE COMMISSION
For the quarterly period ended January 31, 2004
OR
For the transition period from..................to.........................
Commission file number: 0-21969
CIENA CORPORATION
(410) 865-8500(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES (X) NO ( )
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES (X) NO ( )
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
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INDEX
FORM 10-Q
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Item 1. Financial Statements
CIENA CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share data)(unaudited)
The accompanying notes are an integral part of these consolidated financial statements.
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CIENA CORPORATIONCONSOLIDATED BALANCE SHEETS(in thousands, except share data)(unaudited)
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CIENA CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)(unaudited)
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CIENA CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(unaudited)
(1) INTERIM FINANCIAL STATEMENTS
The interim financial statements included herein for CIENA Corporation (the “Company” or “CIENA”) have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, financial statements included in this report reflect all normal recurring adjustments which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial position of the Company at the date of the interim balance sheet. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to understand the information presented. The operating results for interim periods are not necessarily indicative of the operating results for the entire year. These financial statements should be read in conjunction with the Company’s October 31, 2003 audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the fiscal year ended October 31, 2003.
(2) RESTRUCTURING COSTS
The Company is currently engaged in a program to reduce and restructure its costs in order to better align them with its market opportunities and changing product mix. The following table displays the activity and balances of the restructuring reserve account for the period ended January 31, 2004 (in thousands):
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(3) MARKETABLE DEBT AND EQUITY SECURITIES
Cash, short-term and long-term investments are comprised of the following (in thousands):
The following table summarizes maturities of debt investments (including restricted investments) at January 31, 2004 (in thousands):
(4) ACCOUNTS RECEIVABLE
As of January 31, 2004, the trade accounts receivable included two customers who accounted for 25.9% and 12.7% of the trade accounts receivable. As of October 31, 2003, the trade accounts receivable included three customers who accounted for 23.6%, 12.5%, and 10.1% of the trade accounts receivable.
CIENA performs ongoing credit evaluations of its customers and generally has not required collateral or other forms of security from its customers. CIENA maintains an allowance for potential losses on a specific identification basis. CIENA’s allowance for doubtful accounts as of January 31, 2004 and October 31, 2003 was $1.5 million and $1.5 million, respectively.
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(5) INVENTORIES
Inventories are comprised of the following (in thousands):
The Company writes down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based on assumptions about future demand and market conditions. During the first quarter of fiscal 2004, CIENA recorded a provision for inventory reserves of $1.0 million primarily related to excess inventory due to a change in forecasted sales for certain products. The following is a summary of the change in the reserve for excess inventory and obsolete inventory during the three months ended January 31, 2004 (in thousands):
During the first quarter of fiscal 2003, CIENA recorded a benefit for inventory reserves of $2.7 million primarily related to the realization of sales from previously reserved excess inventory. The following is a summary of the change in the reserve for excess inventory and obsolete inventory during the three months ended January 31, 2003 (in thousands):
(6) EQUIPMENT, FURNITURE AND FIXTURES
Equipment, furniture and fixtures are comprised of the following (in thousands):
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(7) OTHER INTANGIBLE ASSETS
Other intangible assets are comprised of the following (in thousands):
The aggregate amortization expense of other intangible assets was $3.9 million and $4.4 million for the quarters ended January 31, 2003 and 2004, respectively. The following table represents the expected future amortization of other intangible assets as follows (in thousands):
(8) OTHER BALANCE SHEET DETAILS
Other long-term assets (in thousands):
Accrued liabilities (in thousands):
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The following table summarizes the activity in the Company’s accrued warranty and other contractual obligations during the quarters ended January 2003 and 2004 (in thousands):
Deferred revenue (in thousands):
(9) CONVERTIBLE NOTES PAYABLE
On December 19, 2003, CIENA purchased the remaining $48.2 million outstanding ONI Systems Corp. convertible subordinated notes. The Company paid $49.2 million for notes with a cumulative accreted book value of $41.0 million, which resulted in a loss on early extinguishment of debt of $8.2 million.
(10) EARNINGS (LOSS) PER SHARE CALCULATION
Basic EPS is computed using the weighted average number of common shares outstanding. Diluted EPS is computed using the weighted average number of common shares outstanding, stock options and warrants using the treasury stock method. Approximately 37.6 million and 31.0 million options and unvested restricted stock were outstanding during the first quarter of fiscal 2003 and 2004 respectively, but were not included in the computation of diluted EPS as the effect would be anti-dilutive.
(11) COMPREHENSIVE INCOME
The components of comprehensive loss are as follows (in thousands):
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(12) PRO FORMA STOCK-BASED COMPENSATION
Had compensation cost for the Company’s stock option plans and employee stock purchase plan been determined based on the fair value at the grant date for awards in the first quarter of fiscal 2003 and 2004 consistent with the provisions of SFAS 123 as amended by SFAS 148, the Company’s net loss and net loss per share for the first quarter of fiscal 2003 and 2004 would have increased to the pro forma amounts indicated below (in thousands, except per share):
The above pro forma disclosures are not necessarily representative of the effects on reported net income or loss for future years.
(13) SEGMENT REPORTING
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 (“SFAS 131”), “Disclosures about Segments of an Enterprise and Related Information.” SFAS 131 establishes annual and interim reporting standards for operating segments of a company. It also requires entity-wide disclosures about the products and services an entity provides, the material countries in which it holds assets and reports revenues, and its major customers. The Company is not organized by multiple operating segments for the purpose of making operating decisions or assessing performance. Accordingly, the Company operates in one operating segment and reports only certain enterprise-wide disclosures.
CIENA’s geographic distribution of revenues for the quarter ended January 31, 2003 and 2004 are as follows (in thousands):
CIENA’s revenues derived from products and services for the quarter ended January 31, 2003 and 2004 are as follows (in thousands):
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During the quarter ended January 31, 2003 and 2004, certain customers each accounted for at least 10% of our revenues during the respective periods as follows (in thousands):
* - Denotes % of total revenue
n/a - Denotes revenues recognized less than 10% for the period.
(14) COMMITMENTS AND CONTINGENCIES
The following is a summary of our future minimum payments under contractual obligations as of January 31, 2004 (in thousands):
Litigation
On October 3, 2000, Stanford University and Litton Systems filed a complaint in the United States District Court for the Central District of California alleging that optical fiber amplifiers incorporated into CIENA’s products infringe U.S. Patent No. 4,859,016 (the “`016 Patent”). The complaint seeks injunctive relief, royalties and damages. We believe that we have valid defenses to the lawsuit and intend to defend it vigorously. On October 10, 2003, the court stayed the case pending final resolution of matters before the U.S. Patent and Trademark Office (the “PTO”), including a request for and disposition of a reexamination of the ‘016 Patent. On October 16, 2003, the PTO granted reexamination of the ‘016 Patent, thus resulting in a continuation of the stay of the case.
On July 19, 2000, CIENA and CIENA Properties, Inc., a wholly owned subsidiary of CIENA, filed a complaint in the United States District Court for the District of Delaware requesting damages and injunctive relief against Corvis Corporation (“Corvis”). The suit charged Corvis with infringing four patents relating to CIENA’s optical networking communication systems and technology. A jury trial to determine whether Corvis is infringing these patents commenced on February 10, 2003. On February 24, 2003, the jury decided that Corvis was infringing one of the patents and not infringing two others. The jury was deadlocked with respect to infringement on the fourth patent. This trial was immediately followed by a trial on Corvis’ affirmative defenses based on the validity of two of the patents. On February 28, 2003, the jury in this trial determined that the patents were valid. In April 2003, following a third trial, another jury decided that Corvis had infringed the fourth patent on which the previous jury had deadlocked. Based on these favorable verdicts collectively holding that Corvis is infringing two valid CIENA patents, CIENA has moved for an injunction to prohibit the sale by Corvis of the infringing products. The court has not yet ruled on this motion.
As a result of the merger with ONI, we became a defendant in a securities class action lawsuit. Beginning in August 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York. These complaints name ONI,
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Hugh C. Martin, ONI’s former chairman, president and chief executive officer; Chris A. Davis, ONI’s former executive vice president, chief financial officer and administrative officer; and certain underwriters of ONI’s initial public offering as defendants. The complaints were consolidated into a single action, and a consolidated amended complaint was filed on April 24, 2002. The amended complaint alleges, among other things, that the underwriter defendants violated the securities laws by failing to disclose alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the initial public offering’s registration statement and by engaging in manipulative practices to artificially inflate the price of ONI’s common stock after the initial public offering. The amended complaint also alleges that ONI and the named former officers violated the securities laws on the basis of an alleged failure to disclose the underwriters’ alleged compensation arrangements and manipulative practices. No specific amount of damages has been claimed. Similar complaints have been filed against more than 300 other issuers that have had initial public offerings since 1998, and all of these actions have been included in a single coordinated proceeding. Mr. Martin and Ms. Davis have been dismissed from the action without prejudice pursuant to a tolling agreement. In July 2002, ONI and other issuers in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim, which was denied as to ONI on February 19, 2003. CIENA has participated, together with the other issuer defendants in these cases, in mediated settlement negotiations that have led to a preliminary agreement among the plaintiffs, the issuer defendants and their insurers. The settlement, which is subject to court approval, would result in the dismissal of the plaintiffs’ cases against the issuers. CIENA has agreed in principle to the terms of this settlement. Draft settlement documents were circulated for preliminary review in October 2003 and again in January 2004.
As a result of the merger with ONI, we also became a defendant in two substantially identical purported class actions on behalf of ONI security holders originally brought against ONI and members of its board of directors. The complaints allege that the director defendants breached their fiduciary duties to ONI in approving the merger with CIENA and seek declaratory, injunctive and other relief permitted by equity. The plaintiffs failed to obtain an injunction against completion of the merger. The first of these cases was filed on February 20, 2002, in the Superior Court of the State of California, County of San Mateo, and is encaptioned K.W. Sams, On Behalf of Himself and All Others Similarly Situated v. ONI Systems Corporation, et al. The second case was brought on March 19, 2002, in the Superior Court of the State of California, County of Santa Clara, and is encaptioned Steven Myeary, On Behalf of Himself and All Others Similarly Situated v. ONI Systems Corporation. On April 14, 2003, the plaintiffs in these cases filed a consolidated amended complaint and named four additional defendants: CIENA Corporation, James F. Jordan, Kleiner Perkins Caufield & Byers and Mohr Davidow Ventures. CIENA and the other defendants subsequently filed a demurrer and served a motion for sanctions on plaintiffs based on factual inaccuracies in the consolidated amended complaint. In response, the plaintiffs filed a corrected consolidated amended complaint, the demurrer to which is scheduled to be heard by the court in March 2004. We believe that these lawsuits are without merit and will continue to defend them vigorously.
(15) SUBSEQUENT EVENTS
On February 18, 2004, we entered into separate agreements to acquire Catena Networks, Inc. and Internet Photonics, Inc. Catena a privately held corporation headquartered in Ottowa, Ontario, develops innovative broadband access solutions that are designed to enable service providers to achieve mass-market deployment of “plain old telephone service” and broadband digital subscriber line service on a single access line and to facilitate network convergence. Internet Photonics, a privately held corporation headquartered in Shrewsburry, New Jersey, develops optical Ethernet transport and switching products designed to provide services such as next-generation video on demand for multiservice operators.
Under the terms of the agreement to acquire Catena, all the outstanding shares of Catena common stock, preferred stock and outstanding stock options will be exchanged for 77.5 million shares of CIENA common stock valued at approximately $486.7 million based on our closing price on February 18, 2004.
Under the terms of the agreement to acquire Internet Photonics, all the outstanding shares of Internet Photonics common stock, preferred stock and outstanding options will be exchanged for approximately 24.4 million common shares valued at $150.0 million based on the average closing price of CIENA common stock for ten trading days prior to the signing of the merger agreement.
Subject to the necessary regulatory approvals and the approvals of the stockholders of Catena and Internet Photonics, we expect to complete these transactions by the end of our third quarter of fiscal 2004.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains, forward-looking statements that involve risks and uncertainties. Under the heading “Risk Factors,” we have described what we believe to be some of the major risks related to these forward-looking statements, as well as the general outlook for our business. Investors should review these risk factors and the rest of this quarterly report in combination with the more detailed description of our business in our annual report on Form 10-K, which we filed with the Securities and Exchange Commission on December 11, 2003, for a more complete understanding of the risks associated with an investment in the Company’s Common Stock.
Executive Summary
CIENA is a leading global provider of innovative network solutions to service providers and enterprises worldwide. Our customers include long-distance carriers, local exchange carriers, cable operators, Internet service providers, wireless and wholesale carriers, resellers, governments, large businesses and non-profit institutions.
In early 2001, the telecommunications industry began a severe decline, and our dominant customer base, service providers, responded by curtailing network build outs and reducing their overall capital expenses. After several years of significantly lower capital spending, most service providers’ operating costs remain high while their revenue is growing slowly, if at all.
As a result of this environment, we expect most service providers to strive to hold aggregate capital spending flat for the next several years. However, we also believe that a larger percentage of the dollars that are spent will be directed toward the purchase of next generation equipment, particularly equipment that resides toward the edge of service provider networks and enables the creation and delivery of new revenue-generating services. As a result, we have undertaken a number of efforts to expand our addressable market and the range of solutions we are able to offer both current and potential customers. As part of those efforts CIENA has made acquisitions and established partnerships with companies whose businesses we believe will benefit from this spending shift, particularly those whose products enable service providers to create and profitably deliver revenue-generating data services.
We reported revenues of $66.4 million for the first quarter of fiscal 2004. This was a decline of 6.0% from the fourth quarter of fiscal 2003 and 5.8% from first quarter of fiscal 2003. We had previously expected revenues for the first quarter of fiscal 2004 to be flat to 10% higher compared to revenues in the fourth quarter of fiscal 2003. These expectations were not met because a single order related to long haul transport products was not received by the end of the quarter. We now expect to receive this order in the second quarter of fiscal 2004.
Our gross margin for the quarter was 30.9%. Our gross margins tend to fluctuate from quarter to quarter based on the mix of products we sell during the quarter. We anticipate that our gross margin for the second quarter of fiscal 2004 will be somewhat lower than the first quarter of fiscal 2004.
Restructuring costs in the first quarter of fiscal 2004 were $3.4 million. These costs were primarily related to exiting a warehouse and work force reductions of approximately 52 employees. These actions were taken as part of our ongoing efforts to reduce and restructure our costs in order to better align them with our market opportunities and changing product mix. We expect to incur additional restructuring costs in future periods during fiscal 2004.
As part of our efforts to implement our strategy to increase our addressable market, we entered into separate agreements on February 18, 2004 to acquire Catena Networks, Inc. and Internet Photonics, Inc. Catena develops innovative broadband access solutions that are designed to enable service providers to achieve mass-market deployment of “plain old telephone service” and broadband digital subscriber line service on a single access line. Internet Photonics develops optical Ethernet transport and switching products designed to provide services such as next-generation video on demand for multiservices operators. We expect to complete these transactions by the end of our third quarter of fiscal 2004.
As of January 31, 2004, CIENA had 1,778 employees, which was a net reduction of 38 employees from the 1,816 employees on October 31, 2003.
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Results of Operations
Three months ended January 31, 2003 compared to three months ended January 31, 2004
Revenue, cost of goods sold and gross profit
The table below (in thousands, except percentage data) sets forth the changes in revenue, cost of goods sold and gross profit from the first quarter of fiscal 2003 to the first quarter of fiscal 2004.
* - Denotes % of total revenue** - Denotes % change from 2003 to 2004
The table below (in thousands, except percentage data) sets forth the changes in product revenue, product cost of goods sold and product gross profit from the first quarter of fiscal 2003 to the first quarter of fiscal 2004.
* - Denotes % of product revenue** - Denotes % change from 2003 to 2004
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The table below (in thousands, except percentage data) sets forth the changes in service revenue, service cost of goods sold and service gross profit (loss) from the first quarter of fiscal 2003 to the first quarter of fiscal 2004.
* - Denotes % of service revenue** - Denotes % change from 2003 to 2004
The table below (in thousands, except percentage data) sets forth the changes in geographic distribution of revenues from the first quarter of fiscal 2003 to the first quarter of fiscal 2004.
Historically, we have relied on a limited number of customers for a substantial portion of our revenue. During the first quarter of fiscal 2003 and first quarter of fiscal 2004, certain customers each accounted for at least 10% of our revenues during the respective periods as follows (in thousands, except percentage data):
* - Denotes % of total revenuen/a - Denotes revenues recognized less than 10% for the period.
Revenue
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Gross profit
Operating expenses
The table below (in thousands, except percentage data) sets forth the changes in operating expenses from the first quarter of fiscal 2003 to the first quarter of fiscal 2004.
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Other items
The table below (in thousands, except percentage data) sets forth the changes in other items from the first quarter of fiscal 2003 to the first quarter of fiscal 2004.
Liquidity and Capital Resources
At January 31, 2004, CIENA’s principal source of liquidity was its cash and cash equivalents, and short-term and long-term investments. We had $296.3 million in cash and cash equivalents, and $1.2 billion in short-term and long-term investments. Our investment portfolio consists primarily of fixed-income securities, with maturities of two years or less, diversified among industries and individual issuers. Our investments are generally liquid, investment grade securities.
CIENA’s operating activities consumed $38.3 million and $58.6 million net cash during the first quarters of fiscal 2003 and 2004, respectively. The primary reason for operating cash consumption was the net losses incurred during the periods. During the first quarter of fiscal 2003, we received a U.S. tax refund of $17.0 million. Under the current tax law, we do not anticipate receiving any substantial tax refunds in the future based on previous tax return filings.
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Excluding this refund, our operating activities consumed $55.3 million during the first quarter of fiscal 2003.
Our investing activities provided net cash of $87.8 million during the first quarter of fiscal 2004 and provided $104.5 million net cash during the first quarter of fiscal 2003. Investment activities included the net redemption of $86.5 million and $110.4 of short and long-term investments during the first quarters of fiscal 2004 and fiscal 2003, respectively. Also, included in investment activities were additions to capital equipment and leasehold improvements in the first quarter of fiscal 2004 and 2003 of $5.9 million and $5.8 million, respectively. The capital equipment expenditures were primarily for test equipment, sales demonstration equipment, and computer equipment. We expect to make additional combined capital equipment and leasehold improvement expenditures of approximately $12.0 million during the remainder of fiscal 2004. These capital expenditures will be used to support selling and marketing, manufacturing and product development activities. We will use our cash and cash equivalents and investments to fund these purchases.
Cash used in financing activities was $138.4 and $42.6 million during the first quarters of fiscal 2003 and 2004, respectively. The primary use of cash in financing activities during the first quarter of fiscal 2003 was related to the purchase of $154.7 million of the remaining $202.9 million outstanding ONI convertible subordinated notes. We paid $139.2 million for the notes and accrued fees of $1.1 million related to the purchase. Also during the first quarter of fiscal 2003, we received $0.5 million from the exercise of stock options and $1.2 million from the repayment of notes receivable from stockholders. During the first quarter of fiscal 2004, CIENA purchased the remaining $48.2 million of the outstanding ONI convertible subordinated notes. The company paid $49.2 million for notes with a cumulative accreted book value of $41.0 million, which resulted in a loss on early extinguishment of debt of $8.2 million. Also during the first quarter of fiscal 2004, we received $6.6 million related to the exercise of employee options.
Some of our commercial commitments, including some of the future minimum payments set forth above, are secured by standby letters of credit. The following is a summary of our commercial commitments secured by standby letters of credit by commitment expiration date as of January 31, 2004 (in thousands):
CIENA does not engage in any off-balance sheet financing arrangements. In particular, we do not have any interest in so-called limited purpose entities, which include special purpose entities (SPEs) and structured finance entities.
Based on past performance and current expectations, we believe that our cash and cash equivalents, short-term investments, and cash generated from operations will satisfy our working capital needs, capital expenditures, investment requirements, commitments, and other liquidity requirements associated with our existing operations through at least the next 12 months.
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Critical Accounting Policies and Estimates
The preparation of consolidated financial statements requires CIENA to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Those policies are described in our annual report on Form 10-K. On an on-going basis, we re-evaluate our estimates, including those related to bad debts, inventories, investments, intangible assets, goodwill, income taxes, warranty obligations, restructuring, and contingencies and litigation. CIENA bases its estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Among other things, these estimates form the basis for judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. During the first quarter of fiscal 2004, re-evaluation of certain estimates led to the effects described below.
Reserve for Inventory Obsolescence
CIENA writes down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based on assumptions about future demand and market conditions. During the first quarter of fiscal 2003, we recorded a benefit for inventory reserves of $2.7 million primarily related to the realization of sales from previously reserved excess inventory. During the first quarter of fiscal 2004, we recorded a charge of $1.0 million primarily related to excess inventory due to a change in forecasted sales for certain products. If actual market conditions differ from those we have projected, we may be required to take additional inventory write-downs or benefits.
Restructuring
As part of its restructuring costs, CIENA provides for the estimated cost of the net lease expense for facilities that are no longer being used. The provision is equal to the minimum future lease payments offset by estimated sublease payments. Due to the continued excess supply of commercial properties in certain markets where our unused facilities are located we have reduced our estimate of the total future sublease payments we will receive. As a result, we recorded an additional restructuring cost of $0.5 million in the first quarter of fiscal 2004. As of the end of the first quarter of fiscal 2004, CIENA’s accrued restructuring liability related to net lease expense and other related charges was $61.9 million. The total minimum lease payments for these restructured facilities are $101.9 million. These lease payments will be made over the lives of our leases, which range from seven months to fifteen years. If actual market conditions are less favorable than those we have projected, we may be required to recognize additional restructuring costs associated with these facilities.
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Risk Factors
Investing in our securities involves a high degree of risk. In addition to the other information contained in this quarterly report, including the reports we incorporate by reference, you should consider the following factors before investing in our securities.
Our business could continue to be adversely affected by unfavorable and uncertain conditions in the communications industry
The last three years have seen substantial changes in the communications industry. Most of our customers and potential customers have confronted static or declining revenue. Many have experienced significant financial distress, and some have gone out of business. This has resulted in a significant change in the structure of the equipment industry, with greater concentration of purchasing power in a small number of large services providers, combined with a substantial reduction in overall demand. Together these factors have adversely affected our revenue and operating results. In addition, most of our customers have become more conservative and uncertain about their future purchases which has made managing our business difficult.
We expect the factors described above to continue to affect our business for an indeterminate period, in several significant ways:
The result of any one or a combination of these factors could lead to further reduced revenue and increased operating losses.
We face intense competition that could hurt our sales and profitability
The market for networking solutions is extremely competitive. Competition in this market is based on varying combinations of price, functionality, manufacturing capability, installation, services, scalability and the ability of the system solutions to meet customers’ immediate and future network requirements. A small number of very large companies, including Alcatel, Cisco, Fujitsu, Hitachi, Huawei, Lucent, Marconi, NEC, Nortel, Siemens, Ericsson, and Tellabs have historically dominated the telecommunications equipment industry. They all have greater financial, marketing, manufacturing and intellectual property resources than CIENA. They also often have existing relationships with our customers and potential customers. We also compete with a number of smaller companies that provide significant competition.
Because we sell systems that compete directly with product offerings of these companies, and in some cases displace or replace their equipment, we represent a competitive threat. The decline in the market for communications networking products has resulted in even greater competitive pressures. We expect that the aggressive tactics we have confronted on the part of many of these competitors will continue, and perhaps become more severe. These tactics include:
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Tactics such as those described above can be particularly effective in a concentrated customer base like ours. Our customers are under increasing competitive pressure to deliver their services at the lowest possible cost. This pressure may result in the pricing of communications networking systems becoming a more important factor in customer decisions. This may favor larger competitors that can spread the effect of price discounts across a larger array of products and services and across a larger customer base than ours. If we are unable to offset any reductions in the average sales price for our products by a reduction in the cost of our products, our gross profit margins will be adversely affected. Our inability to compete successfully against our competitors and maintain our gross profit margins would harm our business, financial condition and results of operations.
New competitors continue to emerge to compete with our products. They often base their products on the latest available technology. They may achieve commercial availability of their products more quickly due to the narrower focus of their efforts. Our inability to compete successfully against these companies would harm our business, financial condition and results of operations.
The success of our strategy depends on our ability to increase our revenue substantially
We have deliberately chosen to continue to spend on research and development, sales and marketing, and other operating expenses at levels that will not permit us to return to profitability unless we can increase our revenue substantially. In order to do so, we plan both to continue to maintain and enhance our existing products and to expand and diversify our product portfolio. In addition we believe we must continue to maintain a significant sales presence in our principle markets and to spend on marketing our products and services. We are implementing this strategy through a combination of internal development, acquisitions of smaller companies, and strategic alliances with other vendors. If we fail to execute this strategy effectively, or it does not produce substantial revenue growth, we will be required to modify the strategy, which would likely have an adverse effect on our financial condition.
Our future success will depend on our ability to sell our products to our existing incumbent carrier customers and add additional incumbent carriers as new customers
Historically, a large percentage of our sales were made to emerging carriers, many of which no longer exist or have experienced severe financial difficulties and have reduced their equipment purchases. We expect that our sales to emerging carriers will continue to be at a lower level than they were at one time. Consequently, our future success will depend, to a large extent, on our ability to increase our sales to large domestic and international incumbent carriers.
We have limited experience in selling to incumbent carriers relative to many of our larger competitors. Many of them have long-standing relationships with incumbent carriers, which present additional challenges to the sales process. The sales cycle for these larger customers is often substantially longer than for sales to smaller customers; and they often require extensive testing of products before deciding to purchase them. In addition, even after a product has been selected for an incumbent carrier’s network and a contract has been signed, we are typically unable to recognize revenue until final network certification tests are completed satisfactorily, a process that is often lengthy and difficult. Complying with these certification requirements may involve unanticipated delays that could adversely affect our ability to sell to larger carriers or the timing of recognition of revenue. If we do not succeed in increasing our sales to our existing incumbent carrier customers and adding additional incumbent carriers as customers, our business will suffer.
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We may not be successful in selling our products through new channels or to government customers
We believe that, in order to succeed, we must enter new markets and build a larger and more diverse customer base. Therefore, we are beginning to sell some of our products to large enterprises and federal, state and local governments. To succeed in these markets, we believe we must develop and manage new sales channels through resellers, distributors and systems integrators for sales of those of our products that are suitable for those markets. Since we have only limited experience in developing and managing such channels, it is uncertain to what extent we will be successful.
Sales to federal, state and local governments often require compliance with complex procurement rules and regulations with which we have little experience. We may be unable to increase our sales to government contractors if we cannot comply with these rules and regulations.
Our failure either to develop and manage new sales channels or to sell to government customers would adversely affect our ability to achieve our planned levels of revenue, which would adversely affect our profitability.
Our strategy involves pursuing strategic acquisitions and investments that may not be successful
Our business strategy includes acquiring or making strategic investments in other companies to expand our portfolio of products and services and to acquire or accelerate the development of new or improved products. To do so, we may use cash, issue equity that would dilute our current stockholders’ ownership, incur debt or assume indebtedness. In addition, we may incur significant amortization expenses related to intangible assets. Strategic investments and acquisitions involve numerous risks, including:
In addition, acquisitions and strategic investments may involve risks of entering markets in which we have little or no prior experience and competitors have stronger market positions.
We may not succeed in completing our proposed mergers with Catena and Internet Photonics.
On February 18, 2004, we entered into separate agreements to merge with Catena and Internet Photonics. The mergers are subject to obtaining approval of the stockholders of Catena and Internet Photonics and certain other closing conditions. There is a risk that we may not be successful in consummating the transactions because of the failure to meet one of these conditions. If the mergers are not completed, we could suffer a number of consequences that would adversely affect our business including:
We may not be able to achieve the benefits we anticipate from our proposed mergers with Catena and Internet Photonics.
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If we successfully complete the mergers, the process of integrating Catena and Internet Photonics into CIENA will be complex and exposes us to a variety of risks, including the possible loss of key personnel and failure to integrate their product lines. It is possible, therefore, that we will not achieve all of the benefits we anticipate from these mergers.
In addition to these operational risks, the mergers create additional risks that could have a material adverse effect on our business, results of operations and financial condition. For example, the mergers will result in CIENA succeeding to all known and unknown liabilities of Catena and Internet Photonics. These liabilities may include liabilities to stockholders, customers, suppliers or employees, as well as liabilities related to intellectual property disputes.
Product performance problems could limit our sales prospects
The development and production of new products with high technology content often involves problems with software, components and manufacturing methods. If significant reliability, quality or network monitoring problems develop, including those due to defects in software or faulty components, a number of negative effects on our business could result, including:
Although we maintain accruals for product warranties, actual costs could exceed these amounts. From time to time, there will be interruptions or delays in the activation of our products at a customer’s site. These interruptions or delays may result from product performance problems or from issues with installation and activation, some of which are outside our control. If we experience significant interruptions or delays that we cannot promptly resolve, confidence in our products could be undermined, which could cause us to lose customers or otherwise harm our business.
Economic and business conditions will require us to reduce the size of our operations further
Since November 2001, we have taken several steps, including reductions in force and dispositions of assets to reduce the size of our operations to better match the reduced sales of our products and services. Weakness in the telecommunications equipment market continues to affect our business. Accordingly, during the next twelve months we believe that we will be required to reduce our costs further. This could cause a disruption in our business, could result in lost revenue and will require us to incur expenses. If we fail to execute effectively on a program of cost reductions, our business could suffer.
Selling our products requires substantial investments of our resources that may not produce anticipated benefits
In order to sell our products to both potential and existing customers, we must invest in financial, engineering, manufacturing and logistics support resources, even though we are unsure of the volume, duration or timing of customer purchases. Our customers are generally technically sophisticated and demanding. Consequently, we may incur substantial expenses and devote resources to potential relationships that never materialize or fulfill our expectations, in which event our investment may largely be lost.
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Our results can fluctuate unpredictably
Purchases by many of our potential and existing customers can be unpredictable, sporadic and subject to unanticipated changes. Our results, in turn, can fluctuate unpredictably. A decision to purchase our products requires a significant investment and commitment of resources by our customers. As a result, the sales cycles for many of our products are long, often as much as a year or two between initial contact with a potential customer and the recognition of revenue from sales to the customer. Further, purchases by our existing customers tend to be large and sporadic, depending upon their need to build a customer base, their plans for expanding their networks, the availability of financing, and the effects of regulatory and business conditions in the countries in which they operate. Current economic and market conditions have made it even more difficult to make reliable estimates of future revenue.
Fluctuations in our revenue can lead to even greater fluctuations in our operating results. Our budgeted expense levels depend in part on our expectations of long-term future revenue. Any substantial adjustment to expenses to account for lower levels of revenue is difficult and takes time. Consequently, if our revenue does decline, our levels of inventory, operating expenses and general overhead would be high relative to our revenue, resulting in additional operating losses.
Other factors can also contribute to fluctuations in our revenue and operating results, including:
We may not be successful in enhancing and upgrading our products
The market for communications networking solutions is characterized by rapid technological change, frequent introductions of new products, and recurring changes in customer requirements. To succeed in this market, we must continue to develop new products and new features for existing products. Doing so is difficult and costly, and there is no assurance that we will continue to be successful. In addition, we must be able to identify and gain access to promising new technologies. Failure to keep pace with technological advances would impair the competitiveness of our products and eventually do serious harm to our business.
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Our products are based on complex technology that could result in unanticipated delays in developing, improving, manufacturing or deploying them. Modifying our products to enable customers to integrate them into a new type of network architecture entails similar development risks.
Certain enhancements to our products are in the development phase and are not yet ready for commercial manufacturing or deployment. The maturing process from laboratory prototype to customer trials, and subsequently to general availability, involves a number of steps, including:
Each of these steps, in turn, presents serious risks of failure, rework or delay, any one of which could decrease the speed and scope of product introduction and marketplace acceptance of the product. Specialized application specific integrated circuits (“ASICs”) and intensive software testing and validation are key to the timely introduction of enhancements to several of our products, and schedule delays are common in the final validation phase, as well as in the manufacture of specialized ASICs. In addition, unexpected intellectual property disputes, failure of critical design elements, and a host of other execution risks may delay or even prevent the introduction of these products. If we do not develop and successfully introduce products in a timely manner, our business, financial condition and results of operations would be harmed.
We depend on a limited number of suppliers, and for some items we do not have a substitute supplier
We depend on a limited number of suppliers for components of our products, as well as for equipment used to manufacture and test our products. Our products include several high-performance components for which reliable, high-volume suppliers are particularly limited. Furthermore, some key optical and electronic components we use in our products are currently available only from sole or limited sources, and in some cases, that source also is a competitor. Any delay in component availability for any of our products could result in delays in deployment of these products and in our ability to recognize revenue. These delays could also harm our customer relationships and our results of operations.
Furthermore, the market for optical components has recently been consolidated resulting in reduced competition, which could lead to higher prices. In addition, the loss of a source of supply of key components could require us to re-engineer products that use those components, which would increase our costs.
On occasion, we have experienced delays in receipt of components and have received components that do not perform according to their specifications. Any future difficulty in obtaining sufficient and timely delivery of components could result in delays or reductions in product shipments, which, in turn, could harm our business.
Any delays in component availability for any of our products or test equipment could result in delays in deployment of these products and in our ability to recognize revenue from them. These delays could also harm our customer relationships and our results of operations.
We rely on contract manufacturers for our products
We rely on a small number of contract manufacturers to perform the majority of the manufacturing operations for our products. The qualification of these manufacturers is an expensive and time-consuming process, and these contract manufacturers build modules for other companies, including our competitors. In addition, we do not have contracts in place with some of these manufacturers. We may not be able to effectively manage our relationships with our manufacturers and we cannot be certain that they will be able to fill our orders in a timely manner. If we underestimate our future product requirements, the contract manufacturers may not have enough product to meet our customer requirements, and this could result in delays in the shipment of our products which could harm our business. If we overestimate product requirements, we may have to write off excess inventory.
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One contract manufacturer recently notified us of the closure of one of its facilities at which one of our product lines, and a key component for another of our product lines, is manufactured and assembled. We intend to outsource the manufacture and assembly of both the product line and the key component to other contract manufacturers. Until new contract manufacturers have completed our training qualification process, however, we will be forced to manufacture and assemble these items in-house. If we are unable to expand our internal manufacturing capability, or if the contract manufacturers are unable to complete qualification, in a timely manner, we may not have enough product to meet our customer requirements. This could result in delays in the shipment of our products which could harm our business.
We are constantly reviewing our contract manufacturing capability to ensure that our production requirements are met in terms of cost, capacity and quality. Periodically, we may decide to transfer the manufacturing of a product from one contract manufacturer to another, to better meet our production needs. It is possible that we may not effectively manage this transition or the new contract manufacturer may not perform as well as expected and, as a result, we may not be able to fill orders in a timely manner which could harm our business.
We rely on service delivery partners
We rely on a number of service delivery partners, both domestic and international, to complement CIENA’s global service and support resources. The certification of these partners incurs costs and is time-consuming, and these partners service products for other companies, including our competitors. We may not be able to effectively manage our relationships with our partners and we cannot be certain that they will be able to deliver our services in the manner or time required. If our service partners are unsuccessful in delivering services:
Our ability to compete could be harmed if we are unable to protect and enforce our intellectual property rights or if we infringe on intellectual property rights of others
We share our proprietary information and intellectual property, including our source code, with other parties as necessary to meet the needs of our business. We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We enter into non-disclosure and proprietary rights agreements with our employees and consultants, license agreements with our corporate partners, and we control access to and distribution of our products, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. This is likely to become an increasing issue as we expand our operations and sales into countries that provide a lower level of protection for intellectual property.
Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology. If competitors are able to use our technology, our ability to compete effectively could be harmed. We have filed a patent infringement lawsuit to enforce our intellectual property right, and may become involved with additional disputes in the future. Such lawsuits can be costly and may significantly divert the time and attention of our personnel.
We have been subject to several claims of patent infringement, which in some cases have required us to pay the patent holders substantial sums or enter into license agreements requiring ongoing royalty payments. The frequency of assertions of patent infringement in the field of telecommunications networking solutions is increasing as patent holders seek alternative sources of revenue. There is a possibility that we may again find ourselves required to take patent licenses or to redesign or stop selling products that allegedly infringe patents belonging to others. If we are sued for infringement and are unsuccessful in defending the suit, we could be subject to significant damages, and our business and customer relationships could be adversely affected.
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We face risks associated with our international operations
We market, sell and service our products globally. We have established offices around the world, including in North America, Europe, Latin America and the Asia Pacific region. We will continue to expand our international operations and enter new international markets. This expansion will require significant management attention and financial resources to develop successfully direct and indirect international sales and support channels. In some countries, our success will depend in part on our ability to form relationships with local partners. We cannot be sure that we will be able to identify appropriate partners or reach mutually satisfactory arrangements with them for sales of our products. There is a risk that we may sometimes choose the wrong partner. For these reasons, we may not be able to maintain or increase international market demand for our products.
International operations are subject to inherent risks, and our future results could be adversely affected by a variety of uncontrollable and changing factors. These include:
Such factors could have a material adverse impact on our operating results and financial condition.
We face risks in reselling the products of other companies
We have recently entered into agreements that permit us to distribute the products of other companies and may enter into other agreements in the future. To the extent we succeed in reselling the products of these companies, we may be required by customers to assume warranty and service obligations. While these suppliers have agreed to support us with respect to those obligations, they are relatively small companies with limited financial resources. If they should be unable, for any reason, to provide the required support, we may have to expend our own resources on doing so. This risk is amplified by the fact that the equipment has been designed and manufactured by others, and is thus subject to warranty claims whose magnitude we are currently unable to evaluate fully.
If we are unable to retain and attract qualified personnel, we may be unable to effectively manage our business
If we are unable to retain and motivate our existing employees and attract qualified personnel to fill key positions, we may be unable to effectively develop our existing products, make timely product introductions and increase sales. Since we generally do not have employment contracts with our employees, we must rely upon providing competitive compensation packages and a dynamic work environment to retain and motivate employees. In response to the decline in our revenue and weakness in the telecommunications equipment market, we have not increased salaries for most of our employees since the end of fiscal 2001. In addition, we have paid our employees significantly reduced or no quarterly bonuses under our bonus program since the end of fiscal 2001. Since our compensation packages include equity-based incentives, pressure on our stock price could affect our ability to continue to offer competitive compensation packages to our employees. In addition to these compensation issues, we must continue to motivate employees to execute our strategies and achieve our goals, which may be difficult due to morale challenges posed by the workforce reductions and uncertainty in our industry.
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If we lose members of our management team or other key personnel, it may be difficult to replace them. Competition for highly skilled technical and other personnel can be intense. As a result, we may not be successful in identifying, recruiting and hiring qualified engineers and other key personnel.
We are exposed to the credit risk of our customers
Industry and economic conditions have weakened the financial position of some of our customers. To sell to some of these customers, we may be required to take risks of uncollectible accounts. While we monitor these situations carefully and attempt to take appropriate measures to protect ourselves, it is possible that we may have to write down or write off doubtful accounts. Such write-downs or write-offs, if large, could have a material adverse effect on our operating results and financial condition.
Our stock price is volatile
Our common stock price has experienced substantial volatility in the past, and is likely to remain volatile in the future. Volatility can arise as a result of divergence between our actual or anticipated financial results and published expectations of analysts, and announcements that we, our competitors, or our customers may make.
Divergence between our actual results and our anticipated results, analyst estimates and public announcements by us, our competitors, or by customers will occur from time to time in the future, with resulting stock price volatility, irrespective of our overall year-to-year performance or long-term prospects. As long as we continue to depend on a limited customer base, and particularly when a substantial majority of their purchases consist of newly introduced products, there is substantial chance that our quarterly results will vary widely.
Forward-looking statements
Some of the statements contained, or incorporated by reference, in this quarterly report discuss future expectations, contain projections of results of operations or financial condition or state other “forward-looking” information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The “forward-looking” information is based on various factors and was derived using numerous assumptions. In some cases, you can identify these so-called “forward-looking statements” by words like “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of those words and other comparable words. You should be aware that those statements only reflect our predictions. Actual events or results may differ substantially. Important factors that could cause our actual results to be materially different from the forward-looking statements are disclosed throughout this report, particularly under the heading “Risk Factors” above. We do not undertake a duty to update any of our forward-looking statements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The following discussion about the Company’s market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and foreign currency exchange rates. The Company does not use derivative financial instruments for speculative or trading purposes.
Interest Rate Sensitivity. CIENA maintains a short-term and long-term investment portfolio. These available-for-sale securities are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at January 31, 2004, the fair value of the portfolio would decline by approximately $91.6 million.
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Foreign Currency Exchange Risk. As a global concern, CIENA faces exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and if our exposure increases, adverse movement in foreign currency exchange rates could have a material adverse impact on CIENA’s financial results. Historically CIENA’s primary exposures have been related to non-dollar denominated operating expenses in Europe and Asia where CIENA sells primarily in U.S. dollars. CIENA is prepared to hedge against fluctuations in foreign currency if this exposure becomes material. As of January 31, 2004, the assets and liabilities of CIENA related to non-dollar denominated currencies were not material. Therefore, we do not expect an increase or decrease of 10% in the foreign exchange rate would have a material impact on CIENA’s financial position.
Item 4. Controls and Procedures
The Chief Executive Officer and Chief Financial Officer of CIENA have evaluated the effectiveness of our disclosure controls and procedures and have concluded that, as of the end of the period covered by this report, they were effective.
There was no change in CIENA’s internal control over financial reporting during CIENA’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, CIENA’s internal control over financial reporting.
PART II. - OTHER INFORMATION
Item 1. Legal Proceedings
On October 3, 2000, Stanford University and Litton Systems filed a complaint in the United States District Court for the Central District of California alleging that optical fiber amplifiers incorporated into CIENA’s products infringe U.S. Patent No. 4,859,016 (the “’016 Patent”). The complaint seeks injunctive relief, royalties and damages. We believe that we have valid defenses to the lawsuit and intend to defend it vigorously. On October 10, 2003, the court stayed the case pending final resolution of matters before the U.S. Patent and Trademark Office (the “PTO”), including a request for and disposition of a reexamination of the ‘016 Patent. On October 16, 2003, the PTO granted reexamination of the ‘016 Patent, thus resulting in a continuation of the stay of the case.
As a result of the merger with ONI, we became a defendant in a securities class action lawsuit. Beginning in August 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York. These complaints name ONI, Hugh C. Martin, ONI’s former chairman, president and chief executive officer; Chris A. Davis, ONI’s former executive vice president, chief financial officer and administrative officer; and certain underwriters of ONI’s initial public offering as defendants. The complaints were consolidated into a single action, and a consolidated amended complaint was filed on April 24, 2002. The amended complaint alleges, among other things, that the underwriter defendants violated the securities laws by failing to disclose alleged compensation arrangements (such as undisclosed commissions or stock stabilization practices) in the initial public offering’s registration statement and by engaging in manipulative practices to artificially inflate the price of ONI’s common stock after the initial public offering. The amended complaint also alleges that ONI and the named former officers violated the securities laws on the basis of an alleged failure to disclose the underwriters’ alleged compensation arrangements and manipulative practices. No specific amount of damages has been claimed. Similar complaints have been filed against more than 300 other issuers that have had initial public offerings since 1998, and all of these actions have been included in a single coordinated proceeding. Mr. Martin and Ms. Davis have been dismissed from the action without prejudice pursuant to a tolling agreement. In July 2002, ONI and other issuers in the consolidated cases filed motions to dismiss the amended complaint for failure to state a claim, which was denied as to ONI on February 19, 2003. CIENA has participated,
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together with the other issuer defendants in these cases, in mediated settlement negotiations that have led to a preliminary agreement among the plaintiffs, the issuer defendants and their insurers. The settlement, which is subject to court approval, would result in the dismissal of the plaintiffs’ cases against the issuers. CIENA has agreed in principle to the terms of this settlement. Draft settlement documents were circulated for preliminary review in October 2003 and again in January 2004.
Item 2. Changes in Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Item 4. Submission of matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
(b) Reports on Form 8-K:
• Information furnished in this Form 8-K is not deemed to be filed herewith or incorporated by reference into any filing.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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