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Ciena's Way: "Invest in a Down Market"

When Ciena reported results for its first fiscal quarter on Feb. 20, the world's largest supplier of equipment used in next-generation optical transport networks gave Wall Street a pleasant surprise. Revenue for the quarter ended Jan. 31 reached $70.5 million, up 14% on the fourth quarter of 2002. And while Ciena lost 11 cents per share, that was 2 cents less than the consensus estimate compiled by Multex.

True, compared with the first quarter of 2002, Ciena's sales were down 56%, and losses had widened. But these are tough times in the telecom industry, so the fact that the numbers marked Ciena's second consecutive quarter of sales growth was deemed good news, particularly at a time when telecom gearmakers continue to struggle mightily.

Ciena (CIEN) contends that it's uniquely positioned to derive maximum benefit from an upturn. According to CEO and President Gary Smith, carriers are more likely to go with his outfit's wares because they allow new services -- and open fresh revenue opportunities -- at a time when sales growth is tough to come by. True, Ciena's equipment often requires a complete network overhaul, while gear from some of the more established telecom suppliers, such as Nortel Networks (NT) and Lucent Technologies (LU), offers easier technological migrations. But Nortel and Lucent don't foster the introduction of new revenue sources, says Smith.

BusinessWeek Online's Olga Kharif spoke with Smith on Feb. 20 about the company's strategy of taking advantage of the downturn by broadening its reach and building market share (Ciena held 6% of the global transport market in 2001, according to telecom consultancy RHK). Edited excerpts of the interview follow:

Q: Has the industry hit bottom?

A: I think it's important to distinguish between Ciena and the industry. I don't think we're the best barometer. We're uniquely positioned into the next-generation of network architecture space, and we've had two quarters of growth now, albeit from a fairly low base. But I think telecoms' capital spending overall is still going down. We're just taking market share from the existing, more established equipment players.

Q: Why is your equipment more in demand today?

A: The key is economics. It's all about automating the network, lowering the capital requirements, and lowering the operating expenses. As you've gotten more intelligence and automation on the network, you can then create new services that customers will pay for. That's why Ciena -- which makes such intelligent networks -- is starting to show some growth, even in a down market.

Q: To reach breakeven, you need to triple your sales, assuming the current level of expenses. Is that doable?

A: Firstly, the strategy we're pursuing is focusing on the large, incumbent carriers, where we don't have a large market share right now and see an opportunity to gain market share. Secondly, we're increasing our addressable market by investing into research and development, developing products that take us further to the edge of the network and further up the network into the data layer.

Thirdly, we're managing our operating expenses and our cash burn very carefully. You saw good progress in that in the latest quarter [when Ciena's spending, excluding charges such as taxes, fell to $60 million, vs. the $100 million most analysts expected]. But we've got a long way to go.

Q: And when do you hope to reach breakeven?

A: We haven't given guidance on that. It's still a volatile market. With $1.9 billion in cash and equivalents, we have a very strong balance sheet that allows us to pursue this sustained investment strategy. We think that it's the right strategy to continue to invest in a down market.

Q: You have dramatically increased your R&D, from 40% of sales in the first quarter of 2002 to 76% of revenues in the latest quarter. What's the focus of your R&D?

A: We're continuing to invest in providing more intelligence and automation on the networks, more software features and functionality, more integration of the products to lower the overall costs. For example, we're putting additional functionality within our CoreDirector switch, [used to direct voice and data traffic on a telecom network, it accounts for the largest portion of the company's revenues]. As we continue to invest while others are slashing their R&D, we see even further competitive advantage for CoreDirector.

Q: In the past, you've also expanded your products portfolio through acquisitions. Last year, you acquired competitor ONI Systems. The big question in many investors' minds: Are you planning more acquisitions?

A: Historically, we have invested in R&D and acquisitions, and we'll keep doing that. We'll always look for appropriate opportunities, whether to buy or build. We would continue to look for opportunities for acquisitions that get us places faster and broaden our addressable market.

Q: How do you expect the inner workings of the industry to change when it comes out of the downturn in a year or two?

A: I think what you are likely to see is probably more partnerships among the bigger players with specialization in certain areas of expertise. Some will own the service and support it, and sell products from other vendors. Basically, they will move toward a system-integration-type model. But we will continue to sell hardware and software.

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