Gary Smith commented, "CIENA counts twenty five to thirty (incumbent) customers that matter globally, and currently one of these is signed up as a CIENA customer. Taking a positive view, this translates as a huge growth opportunity."

Discussing the U.S. focus of the company thus far, Mr. Smith said that CIENA has in the past been dependent upon the North American market, specifically the new competitive carriers. The reduction of this dependence is now a significant challenge for the company. As a young company, CIENA naturally targeted this market sector as - apart from any other factors - such customers presented an 'easier' sale than the large, incumbent carriers. Further factors favoring this focus included the relatively narrow product range that CIENA then offered.

In earlier days, CIENA did in fact derive between 40 and 50 percent of revenues from markets outside of North America; this proportion subsequently declined to approximately 20 percent last year. According to Gary Smith, CIENA has now reached a state of 'critical mass,' in terms of overall size and breadth of product portfolio: "It is now a practical proposition for us to target the major PTTs."

ONI Systems

With a view to accelerating expansion of its product range, CIENA recently acquired ONI Systems, a developer of next-generation equipment for metro networks. ONI Systems brings to CIENA a strong customer base within this market sector. Of particular interest to CIENA are ONI's capabilities relating to solutions for deployment out to the network edge, which underlie services such as Gigabit Ethernet (GBE) and Storage Area Network (SAN) functions.

Mr. Smith noted that CIENA does already play in a segment of the metro market, although complementary to that of ONI. The acquisition is intended to give CIENA a leading position in the metro space, adding to its existing market-leading positions in the long-haul transport and next-generation optical switching sectors. The timing of this acquisition was due to a belief that there will be further consolidation in the optical equipment industry. Mr. Smith commented that ONI had perhaps been successful in exploiting the metro market, in part, due to CIENA's primary focus on other market research and development, especially its CoreDirector intelligent optical switch.

Impact of market downturn

CIENA has reviewed its operations in light of the present market downturn, which has had a major impact on the long-haul transport equipment market. As a result, there have been reductions in workforce within this product group and production processes have been outsourced to contract manufacturers. CIENA has agreements with a number of such companies, including Sanmina-SCI.

Commenting on this aspect of the business, Gary Smith added that agreements would vary on a case-by-case basis. In some instances, CIENA will simply submit a product design to the manufacturer; in others, a prototype will be built by CIENA, from which the manufacturer will develop the final production model. CIENA has said it does retain in-house certain production processes, where these are felt to add significant value to products - for example fibre Bragg grating components. In addition, some 'secret sauce' technologies, such as "enabling channel count and system reach," are retained within the company.

Mr. Smith was keen to point out that despite the cuts instigated in response to the market climate, no core strategic development projects have been affected.

"CIENA is committed to building on its present competitive advantage and that includes continued investment in all key development projects. The company is very much focused on the other side of the current downturn."

Differentiators

Despite CIENA's reputation as a technology-led company, the prime concern from the start has been carrier economics, identifying and meeting the needs of customers. As Gary Smith puts it, "CIENA began by developing DWDM equipment, and initially there was only one competitor in this space - Pirelli. We were very successful with these products, whereas Pirelli was not. One of the key differentiators may be that we concentrated on the needs of the customers - first and foremost the economics of building and operating a network. Many companies in this industry become hung-up on the technology aspects of their products, and customer requirements are relegated to second place."

Speed of product development is seen as a further strength of the company, illustrated by the fact that the DWDM platform is now in its fourth generation of development. Most major systems vendors, including Lucent, Nortel and Alcatel, are simply unable to cycle products as quickly. Gary Smith said that CIENA as a company has the agility and focus to develop viable products within very short timescales: "Basically, we do what we say we will do."

At its simplest level, Mr. Smith commented, current networks are designed to carry voice traffic, having been installed perhaps twenty years ago. Today, these same networks will be carrying mainly data traffic - a factor translating into a major financial issue for the carriers, as their networks are unsuited to the task that they must now perform. CIENA's systems are designed to improve economic efficiency for the carriers by incorporating leading-edge technology facilitating the construction of networks optimised for transmission of data. CIENA is confident that it has now attained a level of maturity that will allow it to approach and deal with the prime customers for such solutions - the incumbent carriers.

As noted previously, CIENA has been highly reliant upon the North American market but has taken steps to address this situation. Global or non-North American sales revenues accounted for approximately 20 percent of the total in 2001, and it is expected that this proportion will be raised to between 40 and 50 percent over the next two years. Such an outcome, Gary Smith believes, would be counted as a significant success in this area.

The company has in fact already achieved successes in global markets, with substantial sales into Japan and Europe being of particular note. Discussing the global push, Gary Smith pointed out that CIENA invested in a global sales and support infrastructure early on in its history, in marked contrast to many U.S. companies. To date operations have been centered on the major countries in Europe and in Japan, while expansion to China and Latin America is now in progress.

"Selling into major carriers worldwide requires an approach comprising direct sales and a local presence. With this in mind, CIENA has from the start followed a policy of building up an international workforce, including within our U.S. operations."

Market share

CIENA claims a leading position in terms of market share, as well as in customer numbers, revenues and technology, in both the long-haul transport and next-generation optical switching sectors. With the acquisition of ONI Systems the company expects to attain that same status in the metro sector. Mr. Smith reiterated that the founding theme underpinning CIENA's product range is the application of technology to address key concerns of the customers - primarily capital expenditures and operational costs. With regard to carrier economics, Mr. Smith noted that it is anticipated there will be a shift from the current preoccupation with capital expenditure to concern with reducing operating expenditure. "Such cost reductions will not be delivered by deploying legacy equipment", he said.

In light of recently announced quarterly results, Gary Smith stated that the company's share of the market will vary depending upon how sales data is cut: defining the market as encompassing the complete next-generation product portfolio, CIENA has not lost market share, whilst separating out individual product lines may give a different picture. Amongst CIENA competitors, the large system vendors may have suffered to a lesser degree within specific market segments, and perhaps overall, due to their broader product range.

It was acknowledged that certain of CIENA's key customers have recently cut expenditure more sharply than have incumbent carriers at large. By this criterion, the company could be construed to have lost some market share. However, Mr. Smith reiterated that this is not the case, and that the situation would be addressed through gaining further global PTT carriers as customers.

Summing up the present situation, Mr. Smith said that any actual loss of market share that CIENA has suffered is tempered by the dramatic contraction of the optical networking equipment market as a whole, and by the decline of certain sectors in particular.

Market size

According to Gary Smith, there is presently no clear view on the total addressable market for CIENA products. This is extremely difficult to estimate with any degree of confidence, particularly in the present climate. Analysts tend to segment the market, without giving top-level figures for the market as a whole. The situation is further muddied within the segment in which CIENA plays, by vendors labeling as 'next-generation' systems that are basically 'traditional'. As a result of the diverging messages originating from market research companies and from its own discussions with customers, CIENA has formed a small market intelligence unit. This team analyses and evaluates both top-down and bottom-up data to form a view of the market for internal consumption. The market intelligence unit estimates CIENA's current total addressable market globally to be in the order of $10 billion.

However, CIENA is now engaged in expanding its addressable market. The company has conquered the long-haul and optical switching product sectors, has made significant headway into the next-generation SONET metropolitan switching market (with its MetroDirector K2 product), and has gained a leading position in the next-generation metro market with the ONI Systems acquisition. CIENA now aims to integrate its product lines more closely to create a coherent portfolio centered around distributed intelligence throughout the network, which it calls "LightWorks Architecture," whilst continuing development of solutions for the network edge.

Market climate

Gary Smith believes the current market downturn will result in permanent changes to the telecommunications industry. A key factor driving both the boom and the bust within the sector has been deregulation, which resulted in a massive influx of capital into the industry, combined with a transition from voice to data traffic. Prior to deregulation, the telecommunications market was highly predictable, with linear growth in volumes of voice traffic. Subsequent to it, volumes of data traffic began to grow massively and unpredictably.

From the consumers' perspective, these changes have delivered needed services at lower cost. For the carriers, the challenge is now the formulation of sustainable operating models - primarily through reduction of capital and operating expenditure achieved largely through consolidation. Mr. Smith added that at the height of the boom, carriers' capital expenditure budgets often reached in the order of 30% of revenues: "This level of investment is simply unsustainable in the longer term."

CIENA believes that a key enabler in the development of sustainable carrier operating models is the deployment of next-generation optical switching systems to replace traditional network components, such as cross-connects and add-drop multiplexers, and to provide low-cost SONET access. However, true next-generation systems, and the operational efficiencies that they offer, have only very recently become available to carriers. Mr. Smith noted that next-generation systems, in addition to allowing expenditure reductions, also bring intelligence to the network, thereby enabling automated provision of the types of advanced services that end-users require at a price they are prepared to pay.

Mr. Smith added that as long as two years ago it was becoming clear that the incumbent carriers would in all probability be the ultimate winners in the carrier space, accompanied by a very small number of survivors amongst the new operators. Thus, CIENA's targeting of these large carriers now does not represent a strategic change of direction.

With regard to less established system vendors, CIENA feels that in general it holds an advantage in having developed a high quality, reliable solution with a proven track record in the market. Mr. Smith added that many of the start-up companies in the optical equipment sector that went through an IPO prior to the market downturn, failed to first reach critical mass with respect to product maturity and company size, resulting in difficulties within today's market.

The view was put to Gary Smith that CIENA had, at times during the past few years, engaged in a race against competing system vendors to develop products with ever higher specifications simply to prove a point, such as an ever-increasing channel count in DWDM systems. Mr. Smith responded that where CIENA was concerned, such developments were a response to customer demand, whilst maintaining focus on production of viable, deliverable systems. Regarding channel count specifically, the increases aided contract wins with carriers such as Qwest. For customers, the key measure of system performance has now moved on from channel count to one of link-range without need for regeneration. Mr. Smith said that channel count will vary dramatically from customer to customer.

Mr. Smith believes that the telecommunications industry is now entering uncharted waters. "Every company is struggling to rationalise what has happened, and predict future developments in order to plot their own course. Ultimately, no one foresaw the magnitude of the present crisis that the industry is experiencing. However, longer term, the indicators are encouraging - the bottom line is that data traffic is continuing to grow, driven by end-user demand for services. In the short-term, there remains in the system excess capacity that has yet to be flushed out."

CIENA's performance has so far (up to the 2002 second quarter) been affected to a lesser extent than many companies in the industry. Mr. Smith pointed out that company revenues have continued to climb, in sharp contrast to a majority of players in the industry. During the 2001 financial year, revenues increased by 90 percent over those for 2000.

Generally, on financial reporting, Mr. Smith feels there is inevitably a focus on the short-term arising from the requirement for quarterly reporting, to the detriment of the longer term. This factor is believed to be particularly unhelpful within an industry where product and sales cycles are very long - far in excess of three months. Mr. Smith asserted that CIENA does not allow short-term issues to interfere with long-term objectives.

"A perfect illustration of these worries would be Marconi in Europe. CIENA is very well positioned in these respects, having a healthy balance sheet and broad portfolio of advanced next-generation products. The only question remaining is how quickly business with these carriers can be developed."

A key differentiator for CIENA is perceived to be its focus on the long-term, illustrated by its commitment to a sustained investment model. The company is not fixated on its day-to-day survival. CIENA takes the view that markets are cyclical. The recent boom and present slump merely represent a spectacularly severe cycle, although when a recovery does come about, the landscape will be radically different to that prior to this cycle. The company also benefits from an established position in the market, with a substantial number of customers, many of which are not based in the U.S. The push to build business outside of North America will be aided by an established presence in many markets worldwide. "For CIENA it is not a matter of suddenly setting up operations overseas from scratch. We already have a presence in many countries worldwide."

Regarding the positioning of CIENA products, Gary Smith noted that the transition to intelligent next-generation optical systems will not occur overnight: "There are several factors that must be addressed before next-generation systems will be widely adopted in carrier's networks. Key concerns for customers are backwards compatibility of the product, and demonstration of a clear migration path from legacy networks. Carriers are not about to ditch all of their investment to date to rush to install next-generation equipment - the case for this transition must be developed, primarily through promoting the cost advantages in terms of both capital and operating expenditure, combined with the enhanced revenue generating opportunities offered."