Ciena : Needham Growth Conference Transcript

Company Name: Ciena Corporation (CIEN)

Event: 25th Annual Needham Growth Conference

Date: January 10, 2023

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My name is Alex Henderson. I'm the networking and security analyst at Needham. I've been following Ciena for just 25 years plus, something in that range. And it's a pleasure to have them here at the Needham Growth Conference. Today, we were going to do a fireside chat with David Rothenstein, who is the Senior VP of Strategy at Ciena and therefore, uniquely positioned to talk about the broader trends and demand and supply dynamics and things of that sort. So thank you for joining us.

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Thanks, Alex. Thanks for having me here.

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So let's start off for people who don't know the company. You had a fabulous October quarter. You had a horrible July quarter. Can you talk about the last two or three years trajectory into that and where we are today looking at the rearview mirror just to make sure everybody is on the same page.

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Sure. Thank you for the blunt honesty, Alex. Good afternoon, everyone. Yes, so I mean, it's been a choppy several years for Ciena, obviously, and for everyone, but particularly going into the pandemic and then the past 12 to 18 months of significant supply chain constraints have brought about a lot of different changes in our industry and in our business. And the way I kind of think about it over the past three years, after a couple of years of hyper growth in 2018 and 2019, the past three years have been largely flat in terms of top line growth for the company. And that was for a lot of different reasons, but particularly with COVID in the first few years, you had network operators really constraining their spending across the board. And so we've been around $3.6 billion in the past three years.

In 2022, in particular, we started seeing some significant impact from supply chain challenges initially from semis broadly. And then in Q3 and Q4, Alex, what you're referring to is some [Audio Dip] with availability of certain integrated circuits, particularly power management ICs that really gated the manufacture and shipment of modems for us. And what you've seen is even though the vast majority of our supply chain is actually performing to what they have told us in terms of volume, in terms of timing, the volatility of a small number of component suppliers for these integrated circuits can have significantly unfavorable effects like it did in Q3 or consequently - correspondingly favorable effects in Q4.

What we are seeing kind of as we're into our Q1 now, where November to October fiscal year is continued movement from a supply chain standpoint. We are seeing more and more suppliers delivering what they said they're going to do, but still some degree of volatility amongst those. We have been able to start seeing the benefits of a lot of our mitigation efforts on the supply chain side in terms of qualifying alternative sources of supply, having some product engineering redesign efforts come through as well as improvements in production capacity. So all those mitigation efforts are bearing fruit and led us to result in Q4 significantly above our guidance.

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So looking at the mechanics of that, a single de-commit late in the July quarter, uncertainty around the October quarter, your guide there almost by definition has to be fairly conservative because you're not sure what it's going to look like and then better than expected results. Is that a function of them having de-committed and coming back in and if I average those that's the rate of supply that you're getting? Or is it that they are in fact seeing better availability and more consistency, so you'll actually see sequential gradual improvement as we go forward quarter-to-quarter-to-quarter?

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I'd love to say we had complete line of sight in terms of all those different dynamics and in case how some of these suppliers do their own allocations, particularly among industries. I do think that, certainly in the middle part of last year, there was some allocation heavily toward under industries. And with some of the higher inflation and recessionary impacts, could that have an impact in terms of allocation going forward I think directionally perhaps, but I wouldn't take that to the bank.

I think overall, we can control what we can control, which is, as I said, really trying to continue to drive the mitigation efforts and offset whatever ongoing volatility, we'll continue to instantiate. What I do think is that overall, more broadly is from a supply chain standpoint, I think we are going to see continued improvement, but it's going to take time. There's not going to be a switch that gets flipped in one particular quarter or a month that says all of a sudden supply chain issues are behind us, and we can now just focus solely on demand. I think it's going to be a multiple quarter effort.

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Well, probably a multiple year effort...

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Yes, potential multiple year. That's right.

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Yes. So looking at the backlog, just to remind us, you entered a couple of years ago, your normal

backlog is, what, four to eight weeks. Is that kind of...

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The normal product delivery times are - have been before - before all the supply chain issues were four to eight weeks for the majority of our portfolio.

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And what is it currently?

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The average of the portfolio is around eight to nine months right now with variation.

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So as supply improves, the duration of the orders should come in?

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Yes. As supply improves, I think a couple of things are going to happen. One, I think you're going to start seeing our extraordinarily high backlog start coming down, which, by the way, is a very good healthy thing. It's - we entered this fiscal year at $4.2 billion, which is a historical high for us, not just in terms of absolute numbers, but in terms of relative in terms of percentage of our demand plan for the year. It is almost the entirety of the demand plan for the year, which is highly unusual. And it's a function of the longer lead times and frankly the forward ordering by several of our larger customers. And the hope and expectation is that as we start to service that demand, backlog will come down and order growth, I wouldn't say it's going to slow down or decelerate. I think it would normalize to where it can and should be going forward.

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So when portfolio managers hear the word massive backlog, biggest in the company's history, there's almost a Pavlovian response to that, which is, oh my God, I'm selling the stock.

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Yes.

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That's probably been borne out of history. A lot of semiconductors and other component companies have seen significant corrections in their backlog is double or triple ordering have evaporated. That's not the case with Ciena. Historically, you've almost never seen backlog be

canceled. Can you talk about the stability and predictability of actually shipping what you have in backlog because it's a critical piece of the puzzle?

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Yes, it's a really good point. And I would caution anybody in terms of reading through the way semis are ordered and procured versus system solution sales, which is what Ciena does. The reality is our products, while the majority are commercial off the shelf, they are highly bespoke. We have over 11,000 SKUs in our product portfolio. And in the vast majority of cases, the solutions are specifically configured for a particular customer's network architecture or network application. And in many cases, it can be a multi-quarter effort on the part of the network operator to actually run an RFP or an RFQ and make a selection process and then do the network design as part of that.

So you take that on top of the fact that, two, these are incredibly expensive system solutions. These are not jelly bean commodity parts that can be easily replaced. And three, given the fact that during the pandemic, many of the operators did run their networks, particularly hot, you take all three things together with the fact that the vast majority of our order backlog is, frankly, contractually non-cancelable. But even if it weren't, I'm not sure it would change the dynamic. But you take all those things together and you say, you know what, there really - there really isn't where I think you're going, any material risk to degradation of the existing backlog.

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So going back to the point of availability causing duration stretching that caused your backlog to go from $1 billion to $4.2 billion over the last two or three years, the worse is obviously going to happen at some point during the next 18 to 24 months. As that happens, how do we think about what happens when you get upside availability on components, then the duration by definition narrows. Therefore, the time they have to order ahead diminishes and therefore the orders declined. So there's kind of a multivariable equation there that's a little bit difficult to solve. But if we assume, say, 5% or 10% upside due to the revenues, just hypothetically, you'd still have orders that are reasonably healthy in a typical year that would allow you to bring that backlog down, maybe bring it down a couple of two, three months, but you'd still exit 2023 with a backlog significantly above normal. Is that mechanically reasonable?

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Yes, I think the thesis is absolutely correct, Alex. And frankly, your view in terms of having to thread the needle in terms of some of these forward expectations and projections is correct, right? I mean, I would keep pointing out though that all of this is frankly healthy, right? The backlog is inflated right now for the reasons that we know. Our inventory is inflated right now for the reasons that we know in terms of building up materials waiting for the golden screws to turn it into finished goods. All of that is and should normalize over the course of time and that's a good thing. Where I think you're going is, where is it going to end up, anybody's guess.

I think certainly for fiscal 2023, I don't see a return to status quo ante. I don't see backlog returning to where it was before supply chain challenges. I don't see inventory returning back to where it was before supply chain challenges. I think it will start normalizing. And you layer that against the fact that we like, frankly, any global multinational who's worth their salt, they're rethinking their supply chain operations going forward. And so instead of this 25-year journey toward just in time supply chains focused on operational efficiency and cost, we're seeing and looking at how we balance that with a greater degree of resiliency and redundancy in our supply chain, which will likely need some degree of higher inventory to take account of some of the risks that exist.

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So embedded in all of this is a need to get parts that are often almost impossible to get and what parts became available are often at incredibly inflated prices. So how much costs are you absorbing currently as a result of the supply chain and logistics challenges that once it normalizes, we'll come back out of the margin structure?

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Yes. So what we said about margins is our - we've said for quite some time actually, our long- term target margin is in the mid-40s. We did see at the beginning of pandemic, several quarters of very high margins in the high 40s as a result purely of product mix. I mean the reality, Alex, any question about margin, the answer is product mix, one way or the other. And so we saw virtually no operators undertaking new builds. And as a result, a huge proportion of the sales were capacity adds, which carry higher margins.

That has now regressed a bit specifically with the supply chain challenges that you're talking about, what we've seen is - what we said generally with the semi shortage is about 400 bps of impact to the margin line, and that's a function of a couple of different things. One, it's - instead of the typical cost reductions we would get out of the supply chain, we've actually seen cost increases from some of our component suppliers as well as the fact that we've seen the need to pay to your point higher premium to brokers on the open market to procure alternative components as well as for a time, higher shipping and logistics cost. It just cost more to get product anywhere around the world, given the shipping lane challenges that we had over the past year or so.

So all of those things, as I said, about 400 basis points. And then on top of that, there was maybe an additional 100 or 200 bps of impact from the specific integrated circuit challenges that we've had. What we've said for 2023 is we've guided to a margin of around 42% to 44%, which is roughly flat year-over-year. We do expect and we are starting to see some of those supply chain challenges, as I said, improved, which is resulting slightly lower costs but they're still elevated. So what we said is around 200 to 300 basis points this year of margin impact because of these ongoing dynamics.

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