Good day, and thank you for standing by. Welcome to the Ciena Fiscal Third Quarter 2022 Financial Results Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Gregg Lampf, Vice President, Investor Relations. Please go ahead.

Thank you, Michelle. Good morning, and welcome to Ciena's Fiscal Third Quarter 2022 Results Conference Call. On the call today is Gary Smith, President and CEO; and Jim Moylan, CFO. Scott McFeely, our Senior Vice President of Global Products and Services, is also with us for Q&A. In addition to this call and the press release, we have posted in the Investors section of our website an accompanying investor presentation that reflects this discussion as well as certain highlighted items from the quarter. Our comments today speak to our recent Q3 performance, our view on the current demand environment and supply chain conditions as well as discussion of our financial outlook. Today's discussion includes certain adjusted or non-GAAP measures of Ciena's results of operations. A detailed reconciliation of these non-GAAP measures to our GAAP results is included in today's press release. Before turning the call over to Gary, I'll remind you that during this call, we'll be making certain forward-looking statements. Such statements, including our quarterly and annual guidance, discussion of market opportunities and commentary about supply chain constraints on our business results, are based on current expectations, forecasts, and assumptions regarding the company and its markets which include risks and uncertainties that could cause actual results to differ materially from the statements discussed today. Assumptions relating to our outlook, whether mentioned on this call or included in the investor presentation that will post shortly after, are an important part of such forward-looking statements, and we encourage you to consider them. These statements should be viewed in the context of the risk factors detailed in our most recent 10-K filing and in our upcoming 10-Q filing, which is required to be filed with the SEC by September 8. We expect to file by that date. Ciena assumes no obligation to update the information discussed in this conference call, whether as a result of new information, future events, or otherwise. As always, we will allow for as much Q&A as possible today. So we do ask that you limit yourselves to one question and one follow-up. With that, I'll turn it over to Gary.

Thank you, Gregg, and good morning, everyone. Today, we reported lower-than-expected fiscal third quarter financial performance, including revenue of $868 million and adjusted gross margin of 40%. In a moment, I will discuss the specific supply chain challenges that impacted our results and our continued actions to mitigate their effects on our customers and our business. Before doing so, however, I think it's important to understand the context of the current environment as it relates to Ciena and specifically demand. Despite supply chain challenges and elongated lead times, strong secular demand trends show no signs of abating. And we remain confident that the fundamental macro drivers propelling this demand are durable over the long term. As we all know, these include 5G, cloud and automation in addition to infrastructure spending, residential broadband funding and opportunities to displace Huawei. A combination of these secular drivers and our market leadership, including our technology, investment capacity, and global scale, is driving continued robust demand from customers in both absolute and relative measures. In fact, we had nearly 60% order growth in our last 4 quarters versus the same prior 4 quarter period. In Q3 specifically, orders outpaced revenue by more than 30%, and we continue to grow our backlog, which is now well over $4 billion. And we project further growth in our backlog in Q4. Obviously, as we convert this large backlog to revenue and continue to win new business in a strong demand environment, we have confidence in continuing to gain market share as the supply chain challenges ameliorate. Now let me talk about supply chain. In the face of this strong demand, challenging supply chain conditions persist. I would like to note that at a high level, the majority of our suppliers are delivering to their promised, albeit extended, lead times, and we are also starting to see higher volumes. And I think this is sort of consistent with recent market commentary that has pointed to some signs of improvement in the overall supply environment. However, we have recently been challenged by the unpredictable performance of specific vendors and their associated componentry. When we spoke to you after our second quarter, our outlook for the remainder of the year reflected commitments made to us by our suppliers in early June, which a very small number of them did not meet. Specifically, in the second half of our Q3, we experienced substantial delays and lower-than-expected component deliveries from this very small group of suppliers. These late notice decommits were primarily for certain integrated circuit components that represent a very small fraction of our overall materials. However, these delays and decommits impede our ability to build and deliver finished goods and systems such as modems for our customers. But in another way, this relatively small number of low-cost, low-value components is holding up a disproportionate amount of revenue primarily for our optical modems. As a result, our Q3 revenue and adjusted gross margin were both negatively impacted to a significant degree. And to size this for you, but for this specific challenge, we would have been at the high end of our revenue range and in line with consensus gross margin expectations for Q3. I would also say that certain of these supply dynamics have continued into our fiscal fourth quarter and are expected to negatively impact our current quarter's results, which Jim will discuss shortly. We remain very focused on our investments and actions to minimize the impact of these challenges on our customers. Firstly, we are working very closely with this small number of partners to resolve these acute challenges around delivery commitments and volumes; secondly, we continue to qualify engineering alternatives to expand our sources of supply and to pursue product redesign activities; and thirdly, we continue to invest in our readiness with respect to contract manufacturing capacity as well as our inventory levels to be prepared when these components do arrive. As a reminder, we also continue to place large advanced purchase commitments and their various falls, a premiums and expedite fees and access the broker market to secure additional supply. While these actions have obviously been ongoing for a long time and their benefits take time to be fully realized, we believe that we will start to achieve an improvement in volume and predictability with our suppliers as we move into fiscal 2023. At the same time, it's important to stay focused on the investments that we're making in our long-term strategy to further open the aperture of our addressable market. Our portfolio and solutions offerings are at the heart of our customers' network priorities, and our innovation has never been stronger or more competitive than it is today, evidenced by the strong order flows. In optical in Q3, we added 14 new customers for WaveLogic 5 Extreme, and despite the supply challenges, we had a record number of quarters for WaveLogic 5 shipments, bringing our total WaveLogic 5 Extreme modems shipped to date to more than 44,000. And for WaveLogic 5 Extreme specifically, Q3 was strong with North American Tier 1 service providers as well as web-scale customers. Also in the quarter, we were awarded sole vendor status with a large international Tier 1 service provider for a major network upgrade. I would also say that our switching and routing revenue grew 45%, not all organic, year-over-year as we continue to capture additional opportunities and expand our total addressable market in this important area with a differentiated Adaptive IP approach, which is clearly resonating with customers. In Q3, we added 25 new adaptive IP customers, bringing the total to nearly 200 as customers continue to seek alternatives to many traditional legacy IP vendors. Of those new customers, we had many more wins in key new areas, including 5G xHaul, cell-site routing, residential broadband and in enterprise with the uCPE SD-WAN solutions. Of particular note is the momentum with our universal aggregation and PON solution where our customer count has grown significantly this year, and we are now expanding globally. Indeed, as you can see in our Q3 results, our routing and switching portfolio has not been impacted to the same extent by supply chain challenges, certainly when compared to our Converged Packet Optical segment. Overall, we have tremendous momentum in the combination of significant secular demand drivers, our leading portfolio, and our total addressable market expansion opportunities. The business has never been positioned better. As we are increasingly able to service the unprecedented demand, we are confident in our ability to continue to gain share and expand our addressable market. With that, I'll turn it over to Jim.

Thank you, Gary. Good morning, everyone. As Gary mentioned, revenue in Q3 came in at $868 million, reflecting the impact from the late and incomplete delivery of key components by a small number of suppliers. Adjusted gross margin was 40% in Q3, which was at the low end of our range. Overall, gross margin continues to reflect the negative impact of higher component costs and expedite fees. In addition to that dynamic, in Q3, gross margin performance also reflects the specific supply chain in the quarter as the key components mentioned before are primarily related to our higher-margin modem technology. Had it not been for the lack of those key components, revenue would have been approximately $60 million higher in the quarter and at the high end of our outlook range, and adjusted gross margin would have been in line with expectations. Adjusted operating expense in the quarter was $273 million. This is below our expected range. During the quarter, we reduced our accrual rate for our annual incentive compensation plan given our expected financial performance for the year. With respect to profitability measures, in Q3, we delivered adjusted operating margin of 8.5%, adjusted net income of $49 million, and adjusted earnings of $0.33 per share. In addition, in Q3, cash used for operations was $205 million. Free cash flow was a use of $227 million, and adjusted EBITDA was $96 million. We ended the quarter with approximately $1.3 billion in cash and investments. On the balance sheet, our current inventory levels reflect the current demand environment as well as the impact of the supply dynamics Gary mentioned. Since 2021, we have been ordering all of the components and subassemblies required to meet our backlog based upon vendor published lead times. And other than a handful of our vendors, the supply chain is delivering at 90% reliability. Lack of performance by that handful of vendors is preventing delivery to customers. Therefore, we are accumulating components while we wait for delivery of those specific remaining items that are necessary to produce finished goods. We expect our inventory levels to reduce over time as the delivery performance for these key components stabilizes. Finally, in Q3, we repurchased approximately 3.2 million shares for $155 million. We have now completed our goal of repurchasing $500 million in shares in fiscal 2022. With respect to guidance, as we said last quarter, in today's market environment, our revenue is not a function of demand; it is a function of supply. And as Gary said, and we repeat it, we have a very small number of suppliers that are not meeting their commitments or our expectations in terms of delivery times and volumes for a handful of low-cost, low-value parts. These decommits are having a disproportionate impact on our revenue. We saw that in Q3, and we are seeing these dynamics continue in Q4. As a consequence, in Q4, we expect to deliver revenue in a range of $800 million to $880 million. This range is lower than previously expected and incorporates a wider set of potential outcomes, reflecting our expectations for a continuation of key component supply challenges in the quarter. Adjusted gross margin of approximately 40%. We expect similar dynamics to impact gross margin in Q4, including lower modem volume and continued higher component costs and logistics expenses. And finally, adjusted operating expense of approximately $315 million. This reflects a return to more normalized levels from the atypical Q3. Q3, as I remind you, was below our original outlook due to the reduction in the accrual rate for our annual incentive compensation plan. Additionally, in Q4, we expect a higher level of variable sales compensation reflecting the extraordinary level of demand we've described. For the year, we will be approximately on the guide we gave at the beginning of the year, absent the changes in our annual incentive compensation plan, which I discussed. As we look to next year, we remain set up well for outsized growth next year and continue to expect to deliver revenue growth significantly above our annual long-term target of 6% to 8%. The strong demand environment and our backlog reinforce our confidence in these expectations for fiscal year '23. And our current revenue expectations for 2023 remain at the level we referenced when we reported Q2 90 days ago. With that, we'll now take questions from the sell-side analysts. Michelle?

The first question comes from George Notter with Jefferies.

I guess just sort of stepping back and looking at the bigger picture here. Can you talk about how you're dealing with these issues in terms of customer conversations? I guess one thing I'm curious about is just on a relative basis, it seems like you guys are doing worse vis-a-vis your competition in terms of deliveries here. And I'm kind of wondering, is this going to impact long-term market share, long-term opportunity for Ciena? Like how permanent do you think the damage is here in terms of your customer relationships?

So George, let me address that. We have very close relationships with all our customers, many of which have lasted for decades. This has built a strong foundation of trust and transparency. We're open about the supply chain challenges and difficulties we're facing, and I believe the best way to summarize our situation is that we are continuing to receive robust orders. We haven't experienced cancellations, and orders are surpassing revenue. The statistic of 60% year-on-year order growth over the last four quarters reflects this trend. Our customers understand the challenges we're encountering. Given our technology and relationships, we believe that once these issues are resolved, we will increase our market share due to the high demand we're seeing.

I'm going to comment on the vendor side, George. On the vendor side, I can tell you that we do see some improvement on most components. In fact, for the majority of our vendors for everyone except these key components that we're talking about, we're seeing about a 90% deliverability performance against promised lead time, which is pretty good. So we're focused, of course, on this very small number, less than a handful of vendors that are not delivering. In fact, they've been quite unreliable and have caused us great difficulty. We're dealing with them appropriately at all levels of the company. We are hoping that, that performance improves as we move through time. And in the meantime, we're taking a lot of steps to deal with in case it doesn't, such as respecified parts on our boards, et cetera.

Yes. That's what I wanted to ask about. So where are you in the process of redesigning these components out? How many components specifically are we talking about? When might those redesigns be done? Just give us any more detail there, that would be great.

George, it's Scott. So just in terms of dimensioning it, as Jim said, the vast majority of the supply chain is pretty much delivering to their promises. We're talking about a very focused set of components here. And to put it in perspective, when we say that it's a couple of handfuls of component parts on a handful of vendors. Obviously, we have a significant amount of redesign work going on as a vehicle to get at those problem components in addition to working with the existing component suppliers to get a better answer out of them as well. On the design side, George, they fall into 2 categories. One is a sourcing exercise where you may be able to find alternative components that are plug replaceable. In that case, you still have to get in line to lead times from those component providers, but it's a less of a heavy lift on our side. The second category, of course, is where you need to redesign in order to take advantage of those component parts, and those are hardware redesigns, and those are multi-quarter activities. All of that activity, I think, starts to come on board in 2023, and we'll start to see gradual benefit from that as we go throughout the year in addition to continuing to work with the existing component suppliers.

And to be clear, again, this handful of suppliers has been very reliable in the past. This is a new phenomenon. Of course, we're in unusual times. But when we have spoken to guidance in past quarters, we have always based our expectations of revenue upon their published lead times and the fact that they have met those lead times in the past. So that's how we came up with our view of the world. And that's why we've guided where we have.

And a number of those vendors, George, they supply multiple parts to us. And in many cases, many of their parts are performing as they promised. This is a very focused subset.

Our next question comes from Meta Marshall with Morgan Stanley.

Great. Maybe just kind of jumping on George's question. Is there a way to size kind of the impact of products already redesigned, so we can just get a sense that given that we're a year through this that you've already redesigned and that's made x number of revenue available just to kind of balance out some of the downdraft that we're seeing? And the second piece would be just as you kind of continue to express confidence of this goal '23, I mean, what are you basing kind of that confidence on would be helpful.

Why don't I answer that second part first, Meta. We're basing that confidence on, first of all, incredible visibility and backlog. So that's number one; number two, the actions that we've taken, which are multifaceted, and we try to get out ahead of this. This is not a reactive piece. I mean, we've talked about this for a while. We knew that demand was going to increase substantially this year, and we planned, as we shared with you, for a well double-digit growth this year, and we took a lot of what we thought were the right supply chain actions in place for that in terms of placing orders, in terms of actually engineering work to reduce our dependency. Those things start, I think, to kick in as we come out of this year into '23. And whilst we're cautious, given the impact that we're seeing both in Q3 and Q4, we believe that they will ameliorate from the actions that we've taken and the work that our partners are doing also to ameliorate the issues. So we have very good confidence as we turn the year that this will start to improve. It won't be an on-off switch. It will be a process that improves as we start in Q1, but it does give us confidence in the year as we start to grow out of this.

Meta has engaged in multi-sourcing activities for our entire portfolio, qualifying alternative parts that have increased our approved vendor list by about 10%, specifically targeting areas with challenges. However, identifying new components means placing new orders and navigating the lead times of those suppliers. These activities were ongoing throughout 2022, and industry lead times indicate we should see a positive impact on our supply components in 2023. Currently, we have numerous redesign activities underway, which are about ten times what we would typically manage in a normal year. These redesigns are set to impact 2023 positively. To clarify further, if we did not face issues with that small number of components, our revenue could have aligned with our original yearly guide and potentially exceeded it simply by resolving those few component problems. I hope this provides further insight.

Our next question comes from Paul Silverstein with Cowen & Company.

Guys, what exactly did the backlog increase to? I heard it was significantly greater than $4 billion, but what was the sequential increase? What was the book-to-bill ratio this quarter? If I remember correctly, it was 1.5 or over 1.5 last quarter. What was it this quarter? Go ahead, I'll ask the next question.

Ask your second question as well, Paul.

I see headcount was up almost 500 sequentially, that's massive relative to the total headcount, and it's more than we've seen in a long time. What's that all about?

Let me address the first part, and then Jim can discuss the headcount growth. In the third quarter, orders were roughly 30% higher than revenue. We anticipate that orders will also exceed revenue in the fourth quarter, leading to an increase in backlog. Currently, the backlog stands at approximately $4.4 billion, Paul.

I apologize, Gary. That was up from the previous quarter?

Yes. Yes, yes. Absolutely. Yes. It's up a few hundred million, yes.

Yes. Please go ahead, Jim.

We're going to limit you to 2 questions, Paul. So I just want to.

Well, Jim, before you respond, let me clarify something. The real question is about the order and the backlog. What is the risk for Ciena? You mentioned that you're just masking weakness by relying on the supply chain. Given the robust orders and backlog, what is the risk that this indicates customers are hesitant to place orders? Meanwhile, they are still placing orders, which relates to the continuously tight supply chain. Is the real demand not truly represented by what seems to be extremely strong orders in the backlog?

I would respond to your second question, Paul. Yes, the order book consists of three elements from my perspective. One is some catch-up from the impact of COVID, which has largely been resolved. There is a bit of forward ordering due to supply chain lead times, but it's not nearly as significant as one might think. This applies mainly to specific customers who are eager to secure their revenue for next year, and we do have some orders lined up for 2023. However, that does not represent the majority of our backlog. Most of our backlog consists of customers who would take the orders right away because they have immediate needs. We're seeing a significant uptick in demand, unfortunately coinciding with a constrained supply chain. If you consider the actual demand from our customers, they would quickly integrate this product into their network and start using it. Therefore, I'm confident that the demand characteristics we observe in our substantial backlog are not solely tied to alleviating supply chain lead times. While that is true for a few customers, most of them would definitely utilize the equipment. This gives us a lot of reassurance.

We know our customers well and communicate with them daily. Their systems and networks require this equipment, and we have experienced virtually no order cancellations, which leads us to believe there is minimal risk in that area. Regarding our workforce, our headcount aligns with the plan established at the start of the year. As I mentioned earlier, without changes to the accrual rate for our incentive compensation plan, our operating expenses will likely match our initial guidance for the year, consistent with our objectives. Additionally, as we previously discussed, as networks integrate across various layers, enhancing our capabilities in the routing and switching layers becomes crucial. We are recognized as leaders in optical technology, and we believe we will offer the best converged solutions as we advance these capabilities. To achieve this, we need to recruit more talent for our R&D teams globally and expand our sales force to promote these advancements, which explains the increase in headcount. However, this growth rate is unlikely to continue at the same pace next year, as I believe we are nearly at the optimal level needed.

So the bulk of those people are going through.

R&D and sales.

For routing and switching.

Generally, yes, not all, but generally, yes.

I'd say routing and switching, Paul, but also the off-box software capabilities to manage those forward-looking solutions as well.

The next question comes from Simon Leopold with Raymond James.

I have two questions as well. The first is regarding the recent 5G spectrum awards in India. Historically, you've had a significant business presence in India. Could you discuss the current opportunities you see there and what you anticipate in terms of contributions from the region for fiscal '23? I'll ask my follow-up after that.

Simon, yes. No, we're seeing very strong cyclical activity in India after a very challenging set of years. We are incredibly well placed there with all of the major players and including all the web-scale; it's a very focused area for the major web-scale players to the fastest Internet growth country in the world. You could see now things are very turbulent given all the supply chain challenges, but we were up pretty robustly in the quarter and in fact, 44% from a revenue point of view. I wouldn't sort of bear too much to that because you've got ebbs and flows, largely driven by supply chain at this moment in time. But I think it is a moniker around the growth that we see there, and we expect a very robust 2023 in India, driven by all of the spectrum stuff with Jio and Bharti, et cetera.

Great. And then on my follow-up, I hate to talk more about supply chain, but I need to get a better understanding of these sort of low-end parts that ended up being the constraints. Are these parts that are unique to the vendors and therefore, you did not have an option to multi-source and that's what's leading to redesign? Or was there some misstep on your part that you didn't multi-source because these seem to be readily available parts? I just need to understand a little bit better about this particular component you're talking about.

Sorry, sorry, sorry. I categorize some of those multi-industry low-cost ICs that we've used in that family for many years across many generations of our products and have been very consistent in terms of their availability. Challenges are unique. And yes, in perfect hindsight, I wish we had design multi-sourcing there. Of course, we have. But frankly, going back a year, that wouldn't be the area of the product portfolio we would have concentrated our multi-sourcing activities on because it's been a very reliable part of the supply chain ecosystem in the past. As we sit here now, obviously, we are working on those multi-source activities, both in terms of alternative sources that can be plug replaceable. Those are few and far between, but also the physical redesigns of the boards to be able to accept multiple alternatives.

Our next question comes from Alex Henderson with Needham & Company.

I want to revisit the cancellation topic. It seems you haven't experienced cancellations in this environment that would be illogical, such as customers accelerating orders only to cancel them later. Can you share your history with cancellations? What were the rates like during the last recession? I've heard that your net cancellation rate is consistently below 1% in nearly every quarter throughout your company's history. Is that correct? Additionally, to what extent does the order depend on the service provider or vendor putting in significant work to set up the order and the RFP, which could make consultancy costly for them? On another note, Jim, what’s the latest with your pricing? You've mentioned past price increases. Do these factors help to mitigate the risk of cancellations?

Historically, our order cancellation rate has been well under 1%. There have only been a few instances in the past where we've seen order cancellations. Generally, customers place orders because they need the products, not just in anticipation of needing them. When orders are specifically tailored for their systems or networks, customers are likely to follow through and take the products. However, our extended lead times are currently causing dissatisfaction among our customers. We aim to improve this in the future and will fulfill the existing backlog.

The other thing I think to point out is that these aren't commodity items, and for the most part, in our customers. These are networks that are designed to our specifications. These are solutions that are integrated into their back office. And we've talked about it in the past in a totally different context, the length of time it takes to do new product introductions into these large-scale service providers or web-scale. That is the stickiness that also permits them from just saying, okay, I'm going to take order X, Y, Z and take it down the street to somebody else.

The second piece of that question was around price, which I don't hear you mentioning. And I do have a follow-up question on the supply chain, which is to what extent, given additional lockdowns in China that are alarming the market right now, are you at risk that those ICs, those low-priced ICs, which tend to be more commoditized and may be sourced in China are exposed to risk due to those lockdowns.

At the beginning of this calendar year, we went out to our customer set and negotiated a price increase, which was consistent really across the customer base. We did it to cover the costs, the increased costs that we were seeing. Now we chose not to reprice the backlog. We placed the price increase on orders after a certain date. And it so happens that we have not seen any effect of that price increase yet because we have not yet completed delivery of the backlog that was in place before the price increase went into effect. We think that late this year and in early next year, we will see a positive impact from that. I was very pleased with the way our customers reacted to it. It was a negotiation. And do you want to answer the second part, Scott?

Yes. I mean COVID in general, obviously, has been difficult to predict around the world. So there is that overriding risk to some degree for everybody in the industry. But the specific news that was out of China over the last 24 hours in that particular province. We don't have any direct operational exposure to that and certainly haven't had any signals at this point in time from our suppliers that they have exposure either, but that's something that we're going to have to monitor in relatively new news. And subjectively, it's not a province that has ever come up in any of my dialogues traveling around the supply base.

Just to clarify, the question is how much of those ICs are sourced specifically from China rather than from that specific province. No one anticipates that the $21 million, or 20 million Chinese, will be a problem. However, if there is a widespread shutdown in China, are these ICs being produced there?

Yes. The general statement I would say is the direct supply from those component providers is not from China. That's not to say though that they don't have subcomponents in there that if I trace their supply chain, the tertiary effect comes from China. But the direct components from the vendors that we deal with are not sourced out of China.

The next question comes from Jim Suva with Citi.

I believe you mentioned that fiscal '23, your sales outlook is unchanged from like 90 days ago. But if you just had weakness this quarter because you couldn't meet it with supply, and then that's continuing to get into Q4. Why wouldn't actually fiscal '23 be a stronger outlook than 90 days ago?

We are currently taking a balanced perspective on 2023. We haven't provided guidance for the year yet, but the consensus number stands at $4.2 billion, which I don't see as a bad figure for reference. We'll offer guidance as time goes on. However, it's important to note that we don't expect the supply issues we’ve encountered to resolve immediately. We anticipate some improvement, but not to the extent that we could fulfill our entire backlog next year. I hope I'm mistaken, and if we can obtain more of these key components, we will be able to generate more revenue, but that's not our current expectation.

Jim, this is Gary. We're not providing guidance for 2023 at this time since we haven't completed this year, and the challenges with the supply chain make it difficult. However, considering our backlog and the improvement efforts we have in place, if everything goes as planned, we anticipate seeing improvements as we move into 2023. It's a bit premature to confirm that. Currently, the consensus estimate is around $4.2 billion, which seems reasonable based on our observations. Our initial plan for this year was to aim for double-digit growth, but if we look at the midpoint of our guidance in Q4, we've effectively reduced that figure by about $0.5 billion, all due to supply chain issues. I acknowledge the concern about whether this will carry over to next year, but it doesn’t work that way as we don’t expect a quick fix to the supply chain situation. That's the best number we have at this point.

And then my follow-up is other companies have gone to the broker market or secondhand market when they've had some shortages of part. I assumed you probably tried to, but it just happened so late in the quarter that would happen? Because if you said they're low-priced parts and a handful, why not pay up a bit of a premium and still get your product out the door into sale?

We have indeed turned to the broker market, which is a primary reason our margins have declined from the mid-40s level. However, I want to emphasize that the broker market is not as strong as it was a year ago since many companies are now sourcing their parts from there. We are utilizing this option when possible, and we will continue to do so.

The next question comes from Tim Long with Barclays.

Yes, I have two questions as well. First, I apologize for bringing this up again, but I understand the challenges you've been facing with the supply chain. It's clear that it has taken a significant amount of time to address these issues. While many in the industry are showing improvements, I would like to know more about your procurement strategies and your ability to estimate and redesign processes. What steps have you taken internally, and what investments are you making in your team and processes to prevent these problems from recurring? I also have a follow-up question regarding web-scale.

Tim, let me outline the steps we’re taking to address the situation, particularly regarding our processes and personnel. First, we are placing a significant demand on our supply base, which is leading to extended lead times. We are intervening directly with component suppliers, which is a shift from the past when our contract manufacturers handled that process during quicker turnaround times. We have allocated additional resources to manage and expedite the acquisition of parts ourselves. We are focusing on the governance of key components that present challenges. To aid our redesign efforts throughout the year, we have increased our engineering resources. Although the benefits of these actions will take time to materialize, we have also invested heavily in our manufacturing capacity. This means that once we resolve the issues with specific constrained components, we will be able to quickly convert them into finished goods and better serve our customers than we could have previously. We're examining every aspect of this situation. The investments will yield results, but they require time to be realized.

Tim, I want to add that we have taken all the right actions and approached this very proactively, starting 18 months ago. Reflecting on our efforts, I truly believe we have made the right choices. Our supply chain team has faced remarkable challenges and has excelled beyond expectations. In hindsight, we might have considered bringing in some engineering talent earlier for multi-sourcing, but realistically, we wouldn't have known which components to prioritize. While we could speculate, I don't believe there was much more we could have done. Additionally, I want to emphasize that we're not satisfied with our current performance, which has resulted in about $0.5 billion in losses affecting our customers. However, we are seeing stronger demand—more than any of our competitors—and we continue to ship more equipment than anyone else in our industry. I want to remind everyone of that.

Okay. And just a follow-up on the web-scale. I noticed kind of was down a little bit more sequentially, particularly as you compare to service providers. So curious about that. And related to that, I would guess web-scalers are probably your most impatient customer base. With all this stuff going on, it seems like once you introduce an optical system, there's a lot of drama around the componentry where in a pluggable, it's not as much, much lower bill of material, much smaller part count. So is there a risk to that customer base that the potential transition to more pluggables in their network could accelerate because of the more difficulty around a system sale?

Tim, I'll let Scott address the pluggable aspect. My response is that we are not experiencing that at all. Revenue from web-scale was down this quarter, primarily due to supply chain issues. What was the question? The answer relates to the supply chain. We are witnessing strong order flow for our systems, specifically the 6500 architecture for web-scale players, and I expect that demand will remain strong throughout 2023. Scott, would you like to discuss the pluggable side further?

Just, Tim, where we are deployed today from a web-scale perspective is not the patch where pluggables have applicability. As we said in the past, that pluggable conversation in the web-scale space for the most part for us is new territory and potential upside. So what you're seeing when you look quarter-over-quarter or period-over-period is 100% supply chain-related. We referenced one of the key challenge areas for us is modems. They're obviously a big consumer of modem. So the two correlate very well. On pluggables in general, as we said consistently, we think it's very early innings for that ZR pluggable application. We're confident that we have the best plug available. We've shipped them to 45-plus customers, including the large web-scale pieces of it. We think that's going to be a growing piece of our business as we go into 2023 as well.

Our next question comes from Rod Hall with Goldman Sachs.

I guess I wanted to come back to the range of outcomes that's possible in 2023. I think what you guys have said is your long-term growth model is 6% to 8%, and that would begin in 2023. And obviously, now the supply situation has become much less predictable and certainly could run into the beginning of '23. I think you would agree with that. And on the other hand, you have this huge backlog, and you could see much higher growth in that range in 2023. So I wonder if you would be willing to at least say from a breadth of outcomes point of view that it's a possibility if this supply situation were to persist in the beginning of the year that you might even be below that 6% to 8% range and acknowledging that it's also possible you could be well above consensus. But I think when I hear back from investors this morning, some of them are saying, hey, this is a stock I would like to own, clearly, the demand situation is great. But given the supply uncertainty, the 2023 numbers could be a little bit punchy if this supply thing continues to be a problem in the beginning of the year. So I just wonder if you could kind of comment on how that range looks to you and what the risk to the maybe even the 6% to 8% growth might be. And then I have a follow-up.

Here would be my more response to that, Rod. First of all, we're not giving guidance for '23. We haven't finished '22 yet. So we normally give that as we turn the year. You're absolutely right. I mean look, what happened in '22, supply chain, et cetera. I would say that given what we're seeing now, if that does not deteriorate, then we have very high confidence in exceeding our 6% to 8%. If you look at sort of $4.2 billion, let's just take that as the current consensus based on our midpoint there, that's more than 20% growth. That's entirely possible if the supply chain set stays with some stability and we fix some of these particular issues that we're seeing right now, more than that right now would be kind of speculation.

The key point is that the figure of 6% to 8% is not significant at this moment. We are experiencing a low level of revenue this year, so that range is not applicable. Additionally, as Gary mentioned, we haven't provided guidance for next year, making it difficult for us to share a range that hasn't been established. However, I can say that we have a substantial backlog, and it could be much higher if we receive the necessary parts.

Yes. Makes sense. Okay. And then the second question I had, I guess, is mostly for you, Gary, but it's related to the sales force. You had mentioned that you're accruing less for the cost plan and or incentive-based compensation. I wonder, are you worried that it's going to be tough to retain salespeople? The labor market is still pretty tight. There are, I guess, other peripheral companies maybe not in optical that are having better luck on supply. So I wonder how you're feeling about retention of salespeople, what the plan there is.

Listen, that's a good question. The large amount of our bonus accrual that we changed, for Jim is actually non-sales related, and most, not all, of the sales force there actually comped on orders. So I mean we've had an extraordinary order year. So I feel pretty good, Rod, that the sales force quite rightly have been on the whole well compensated. And we have a highly tenured sales force. We have the largest and best equipped optical sales force in the world. And I'm talking about systems engineering and the sales folks as well. So I think they are largely compensated on orders. So they generally had a pretty good year.

The question relates to our general employees, and naturally, we are not pleased to reduce the accrual range for this group. Over the past few years, we have provided substantial payouts under the incentive compensation plan. This year, however, may not be as favorable as reflected in our accrual, but we are striving to address the situation as effectively as possible through merit increases and other measures.

The next question comes from Amit Daryanani with Evercore.

Perfect. I'm glad I was able to join. I have two questions, but I'll start with the first. In the July quarter, you mentioned a $60 million miss due to supply chain issues. For the October quarter guidance, I understand it was indicated that it could be $240 million below what analysts expected. Is this all due to the same supply chain problems, or is there something else affecting it? It seems like the impact is four times greater for the October quarter compared to July. Also, what are you hearing from your suppliers about when we might see recovery? Do you expect it to happen in the first quarter, or will it take a longer time for the bottleneck to clear?

Amit, if I understood your question correctly, the challenge remains consistent between Q3 and Q4. It's the small number of IC components we've discussed that is hindering our ability to maximize production. The situation is slightly different in Q3. We had a clear view going into our Q3 guidance regarding the commitments for all components, including those IC components. Unfortunately, those commitments were not fulfilled, and it was too late for us to address that issue going into Q4. We're experiencing a similar dynamic with the same components, and we're providing our insights based on the current environment and commitments.

Got it. Could you discuss how you expect free cash flow to perform in Q4 and for the fiscal year '23? Will working capital still be a use of free cash flow in Q4? It could potentially be negative, impacting our free cash flow improvement. I would like to understand the expectations for free cash flow in Q4 and more broadly for '23.

Yes. What I'd say is that we consumed a fair amount of our free cash in Q3. We built a lot of inventory. My guess is that we will probably build a little more inventory as we move through the next couple of quarters. And hopefully, as '23 progresses and if we get to the kind of numbers we're looking at, then that inventory level will start to decline. And our free cash flow will start to build next year. So I think next year, we'll have a good free cash flow. I won't qualify that in any other way except to say we'll have a good free cash flow next year.

Thank you, everybody, for joining us today. We do look forward to connecting with everyone during the day today as well as a few events next week. Enjoy the Labor Day weekend, and look forward to connecting with you.

This concludes today's conference call. Thank you for participating. You may now disconnect.