1998 Annual Report How do you define a market leader? How do you define a market leader? CIENA Innovative. Agile. Revolutionary. Obsessive. Supportive. Before CIENA shipped its first MultiWave® dense wavelength division multiplexing (DWDM) system in 1996, the market for wavelength division multiplexers did not exist. We created it. Now we’re leading the way toward a next generation network… powering the Internet through light. We’re developing and delivering innovative products, moving quickly to capitalize on opportunity and gaining time-to-market advantage over our competitors; We’re revolutionizing the way networks are built; enabling a simpler, more cost effective network architecture with optics at the core; We’re obsessing about product quality and reliability because our customers’ networks are their business; and, We’re differentiating ourselves based on superior customer service and support. Everyone makes promises. CIENA delivers. Revenue in millions 96 97 98 Net Income in millions $600 $500 $400 $300 $200 $100 $ 0 $140 $120 $100 $ 80 $ 60 $ 40 $ 20 $ 0 96 97 98 Net Income per Common Share $1.2 $1.0 $0.8 $0.6 $0.4 $0.2 $0.0 96 97 98 Research and Development Expenditures in millions $80 $70 $60 $50 $40 $30 $20 $ 10 $ 0 96 97 98 exclusive of one-time charges inclusive of one-time charges How do you define a market leader? CIENA Fellow Shareholders: To say that 1998 was a challenging year for CIENA and our shareholders would be an understatement. During the year, we experienced first-hand the realization of a number of risks we face as a new player in a very competi- tive, rapidly evolving industry. News about customer wins and losses and the progression of events in our proposed, but unsuccessful, merger with Tellabs created extraordinary stock price volatility. These extremes in our business, both highs and lows, reflect the challenges of our dynamic industry, the purchasing strength of a highly concentrated customer base, as well as the impact of large potential competitors. Despite the hurdles we faced during the year, CIENA reported 1998 revenue of $508.1 million, an increase of 20% over 1997 revenue of $413.2 million and an increase of 470% over 1996 revenue of $88.5 million. As a result of pricing pressure that emerged during 1998, our operating margin dropped from 45.7% in 1997 to 24.4% in 1998, resulting in net income per share for fiscal year 1998 of $0.77 per share, excluding one-time charges, compared to $1.15 per share for the same period a year ago. In 1998, we made significant progress on our goal to diversify our customer base. Two customers, Sprint and MCI WorldCom (then WorldCom) were responsible for the substantial majority of CIENA’s revenues in 1996 and 1997. Our dramatic revenue growth and our unusually high gross and operating margins during that timeframe reflect the benefits of industry-leading technology and first-mover advan- tage. While margins have fallen in the latter part of 1998, our customer base has diversified, with 14 customers contributing revenue and approximately 23% of 1998’s revenue coming from international sources. CIENA’s Products Our dense wavelength division multiplexing (DWDM) equipment enables carriers to expand the capacity of fiber optic cable by dividing the light that traverses the cable into multiple colors, or channels, of light. CIENA’s products are now widely accepted for delivery of economical, scalable bandwidth. For the better part of two years, we benefited from being the only supplier s e l t t e N . H k c i r t a P capable of shipping DWDM equipment in commercial volume. WDM systems—systems CIENA doesn’t make. Given that, By the end of January 1999, CIENA will have shipped an esti- it becomes apparent that CIENA’s share of the global dense mated two million channel kilometers of virtual fiber. No other WDM, or DWDM market (made up of systems with a minimum competitor can claim a comparable base of real-world experience. of 16 channels), is much larger. We’ve also made good progress toward a more diverse Overwhelmingly, industry analysts like Ovum expect the product base. A year ago, the majority of our revenues came WDM market to grow significantly over the next several years, from a single product, the MultiWave® 1600. In 1998, we affording room for more than one player. More specifically, recognized revenue from four different products and from our analysts expect the majority of the growth will come from the CIENA services subsidiary, Alta, acquired in February. Our higher channel count segment of the market—the DWDM MultiWave Sentry™ 4000 provided significant competitive market where CIENA’s presence is strongest. With our installed advantage from the time we began shipping in April and base and continued innovation, we expect CIENA to be one quickly emerged as the leading seller in our product portfolio. of the players. Competition World-Class Reputation During the year, several incumbent equipment suppliers On the heels of all that happened during 1998, we were curious recognized that our success represented a strategic beach- to know what our customers and potential customers thought head that was quickly gaining steam. However, without of CIENA. Late in the year, we commissioned Yankelovich commercial product to ship, they had few options. In an Partners to conduct a blind survey of U.S. service providers. attempt to stall customer decisions and to buy market share, In this survey, CIENA was selected most often from among several incumbent suppliers touted future products in press all major equipment suppliers as the: releases and offered low future prices, especially where they • Best company overall in optical networking; had existing relationships. In some cases, these tactics were • Supplier providing best service and support; successful. But it leads to the question, why were these incum- • Leading supplier for DWDM systems; bent suppliers so threatened by CIENA’s early success? • Easiest supplier to work with; Market Share • Most credible for promised product delivery. It’s possible this positive market perception offers the basis It appears that one reason for concern on behalf of our competi- for further concern for our competitors. tors stems from the combination of the potential market size and CIENA’s early market presence. Ovum, a London-based The Internet Revolution telecommunications industry analyst, conducted the first-ever While turbulent for CIENA and our shareholders, 1998 was global wavelength division multiplexing (WDM) market study also a period during which the stage was set for dramatic in 1998; asking service providers worldwide about past and change, in fact some would argue revolution, in the telecom- anticipated WDM equipment spending. Ovum concluded that munications industry. The catalyst behind this revolution is, the global market for WDM equipment in 1998 was approxi- of course, the Internet and the accompanying growth in mately $1.2 billion. Based on CIENA’s revenue for fiscal year traffic it brings to communications networks worldwide. 1998, we claimed an estimated 38% share of that market— To put the magnitude of the ‘Net’s impact in context, consider not so bad for a company launched in 1994! that it’s estimated that radio took more than 30 years to reach Further, a portion of the total $1.2 billion market (maybe 60 million people. Television took 15 years. In just a fraction as much as 40% to 50%) is made up of four and eight channel of that time, the Internet has surpassed that milestone with an Operating Highlights (historical results restated to include the financial position and results of operations of Alta Telecom, acquired on February 19, 1998) (in thousands, except net income per common share and number of employees) Revenue Gross profit Gross margin Operating income, inclusive of one-time charges Operating income, exclusive of one-time charges Operating margin, inclusive of one-time charges Operating margin, exclusive of one-time charges Net income, inclusive of one-time charges Net income, exclusive of one-time charges Net income per common share, inclusive of one-time charges Net income per common share, exclusive of one-time charges Total assets Total stockholders’ equity Employees (1996 and 1997 figures exclusive of Alta) 1998 $508,087 $252,073 1997 $413,215 $246,743 1996 $88,463 $41,148 49.6% 59.7% 46.5% $ 81,137 $123,767 16.0% 24.4% $ 53,194 $ 83,236 $ $ 0.49 0.77 $572,424 $474,949 1,382 $181,485 $188,985 43.9% 45.7% $115,967 $120,542 $ $ 1.11 1.15 $463,279 $372,414 841 $20,163 $20,163 22.8% 22.8% $17,263 $17,263 $ 0.19 $ 0.19 $79,676 $10,783 225 estimated 100 million people online worldwide by the end network infrastructure in which switches and routers have of 1998. And what’s more—analysts project that number will integrated optical interfaces directly connected to a fiber grow to more than 300 million by 2002. transport system such as CIENA’s. The traffic on the ‘Net is not just e-mail chatter. During 1998, To forward this vision, in April 1998, CIENA co-founded the Internet began to emerge as a business facilitator, the Optical Internetworking Forum (OIF) along with industry connecting companies with suppliers, consumers with new leaders Cisco, AT&T, Bellcore, Hewlett-Packard, Qwest, Sprint retail E-stores. No longer just a network used by the scientific and MCI WorldCom. The OIF is intended to provide a venue and educational community, the Internet economy is chang- for equipment manufacturers, users and service providers to ing the way we do business. Analysts tell us that $22 billion work together to identify and resolve issues and develop key worth of business, including direct sales to consumers and specifications to ensure the industry-wide interoperability of transactions between businesses, was done via the ‘Net in optical internetworks. With more than 90 members, the OIF 1998 with growth to $350 billion expected by 2002. is focused on areas that will impact the evolution of optical The resulting traffic growth rate far exceeds the traditional internetworks such as integrated management of all layers of an network growth rate and the demand for richer image capabili- optical internetwork; data-optimized interfaces between inter- ties could lead to skyrocketing traffic volumes. In addition, a networking and optical equipment; and coordinated protection growing mix of service providers is forcing lower prices, leaving and restoration between network layers. CIENA’s customers faced with critical challenges: runaway growth in bandwidth requirements, dropping revenue per unit CIENA’s 1999 Initiatives of bandwidth, a substantial shift in the traffic character (from So what does all this change mean for CIENA? Opportunity. voice to data), and increasing pressure for “last mile” band- Of course, opportunity does not come without risks and chal- width solutions. And that’s where CIENA can help. lenges, but we’ve identified some key strategic objectives; objectives we believe will enhance our long-term competitive Next Generation Networks positioning and improve shareholder value: Given the shift from dominant voice or telephone traffic to data-centric traffic, we anticipate a corresponding shift in Diversify the Customer Base. Continued customer diversifica- networks from circuit-oriented facilities to packet-based tech- tion will lessen our dependence on any one customer, enhance nologies designed to deliver data traffic via optical transport our visibility and ultimately we believe, smooth out revenue and systems. Through collaboration with industry leaders like earnings volatility. Domestically, we’ve increased our attention Cisco Systems, CIENA is already paving the way for this on emerging carriers in 1998, and we’ve already met some new, more efficient optical internetwork—a data-optimized success with wins at Enron Communications and GST. Going forward, we’ll continue to focus much of our domestic and qualifying second sources for components that were previ- international sales efforts on these up-and-coming carriers. ously sole-sourced, leveraging competitive forces in our favor. Meanwhile, efforts with the more traditional regional Bell Other cost reduction efforts are driven by design changes. In operating companies are beginning to pay off, and we’ll some cases, selecting alternative parts, eliminating components continue to pursue these opportunities as well. With the entirely or incorporating emerging component technologies introduction of new products, we anticipate reaching a new that consolidate the functions of several different components class of customers, including competitive local access providers into a single device can yield significant cost improvements. and Internet service providers. We believe the combination of these proactive cost-cutting efforts, along with naturally declining component costs will help Diversify Product Lines. Like a more diversified customer base, a us to stabilize our gross margins, perhaps with some prospects broader product base will expand CIENA’s opportunity. Among for margin improvement, in the face of escalating price pressures. the announced products that we expect to begin delivering in 1999 are: MultiWave Metro™—our ring-based metropolitan DWDM system targeted at capacity constraints in the local-loop; The coming year will offer new challenges, without a doubt. The forces of consolidation are widely felt, both among carriers and equipment suppliers. It remains to be seen whether this trend results in meaningful advantage; this year should yield Next Generation MultiWave® system—the fourth genera- critical indicators. Regardless, we believe our success will tion of our long-haul transport system that further extends persist in the face of tough competition if we continue to deliver the limits of fiber bandwidth by providing the platform for timely value to our customers through innovation, quality prod- 96-channel configuration and beyond; ucts and superior service. We are deeply committed to this task. 10-Gigabits/Channel—a new feature set for our MultiWave systems will enable OC-192/STM-64 transmission, scaling network bandwidth beyond a terabit per second. How Do You Define a Market Leader? Innovative. Agile. Revolutionary. Obsessive. Supportive. All describe CIENA. We believe the achievements of our brief But we can’t stop there. We’ve already begun to push history, the continuing commitment of our customers, the DWDM technology beyond bandwidth expanding applica- dedication of our employees to customer satisfaction, as well tions and into true optical networking applications and we’ll as the apparent concerns of our competitors, all speak to our continue that push. From added intelligence in management market leadership. CIENA rose from nothing to become a systems to aid in fault diagnostics and service quality moni- major telecom player in little more than two and a half years toring to the broader requirements emerging for bandwidth by being willing to think big, to take risks, and to act on our management in the new network architectures, we have vision. 1998 wasn’t an easy year, but we haven’t stopped challenging work and rewarding opportunities to pursue in thinking big. We’re engaged at the core of a revolutionary the next few years. change in the telecommunications industry and we have products and services that are considered “best-of-class.” Leverage Time-to-Market Advantage. CIENA’s engineering I firmly believe the best is yet to come—for the industry, efforts emphasize time-to-market as a key competitive edge. As and for CIENA. we go forward, we will continue to invest in the best engineering talent in the industry, effective development tools and processes In closing, I offer my sincere thanks to CIENA’s employees. to maintain this advantage. It is your indomitable spirit and unfailing commitment that are making next generation optical networks a reality. My Reduce Product Costs. With strong pricing pressure emerging thanks also to the shareholders, suppliers and customers in the latter part of 1998, we’ll pay a lot more attention to who, through it all, continue to believe in CIENA, in our attacking product cost in the coming year. We’re rapidly vision and in our people. moving into fourth generation long-haul transport systems, while our competitors, in most cases, are rushing to complete first-generation efforts. We believe CIENA is therefore better positioned to begin to bring down product cost and we’ve already initiated significant efforts on that front. First, we’ve turned to our suppliers for component cost Patrick H. Nettles reductions. In several cases, we’ve gained improvements by President and Chief Executive Officer 6 How do you define a market leader? INNO By 1996 service providers were faced with a serious In 1996, that meant that on a single pair of fiber optic dilemma…the traffic on their networks was growing more cables with CIENA’s equipment a service provider could quickly than they could expand their capacity to handle it. carry the usual 30,000 transmissions multiplied by 16 times— Traffic that had grown a steady 10% per year was now or 480,000 transmissions—capacity that had previously been growing at several times that rate. Worse yet, there didn’t unheard of. Even better, CIENA’s systems required less equip- seem to be any signs that demand would slow. It appeared ment than more traditional solutions, so carriers realized the advent of the Internet and the connectivity it promised operational cost savings along with overall equipment savings to bring to the world would surely swamp existing telecom- and a tremendous boost in capacity. munications networks with an overwhelming demand In April of 1998, CIENA broke new ground again and our for bandwidth. customers became the first carriers to deploy long-haul CIENA’s MultiWave® dense wavelength division multiplex- systems which enable a 40-fold increase in capacity. And for ing (DWDM) equipment offered carriers a compelling solution. 1999, our MultiWave Metro™ system promises to bring the For significantly less than the cost of deploying new fiber optic economies and flexibility of DWDM to an entirely new market. cable a carrier could expand the capacity of existing fiber up CIENA didn’t invent the many technologies we brought to 16 times by using a CIENA MultiWave system. together, but we did design a system that took a new approach Wave division multiplexing allows carriers to separate the to an old problem. Because we were willing to look at the light that traverses the fiber into several different colors of world a little differently—to think outside the box—we were light, thereby enabling service providers to multiply the capacity able to see and capitalize on an opportunity. of their fiber assets by the number of colors, or channels, Ironically, by so efficiently solving the bandwidth problem for the equipment can deliver. our customers, we created a new dilemma…for our competitors. VATIVE Thinking outside the box 8 How do you define a market leader? AGILE Agility is more than speed. It’s more than flexibility. It also no longer enough. We have to stay ahead. In two years implies a sense of timing. CIENA has delivered three generations of our long-distance systems—a previously unheard of product cycle time. And CIENA took a new approach to an old problem. One that we’ve already demonstrated our fourth generation 96- our competitors were reluctant to pursue because they knew channel MultiWave system and our systems’ capability to it had the potential to dramatically alter the way service work at OC-192/STM-64 rates or 10 gigabits per second. providers build their networks, and thus—our competitors’ We’ve also delivered a short-distance product, MultiWave business. We took advantage of an opportunity. And it’s likely Firefly and have begun trials on our MultiWave Metro that even our competitors would agree…we surprised them. ring-based system. In 1996 CIENA took a bold step and created a new dense CIENA’s in a market with a host of larger, and, some would wavelength division multiplexing (DWDM) transport market. argue, more powerful competitors. In periods of revolution Based on results of market research conducted by Ovum, however, it is not always the largest player who wins. Look a leading international telecommunications research firm, at Cisco Systems; look at Sun; look at Compaq. When they in 1998 CIENA claimed an estimated 38% share of the started, all of these companies had larger, more powerful approximately $1.2 billion WDM market. Considering that competitors. They also had something else…vision and agility. a portion of that market is lower channel count systems (4 and All were able to see a dramatic shift coming in their respective 8 channel equipment) that CIENA doesn’t make, it is likely industries and all were able to act on that opportunity more that CIENA’s share of the DWDM market (16 channels and quickly than their competition. more) is significantly higher. CIENA may or may not be the next Cisco or Sun or The telecommunications industry is changing fast. And Compaq. But there’s no doubt the time was right for a new we’re part of the reason. Equipment providers have to company to break onto the telecommunications landscape— keep up or risk being left behind. In fact, keeping up is and CIENA did it. When bigger isn’t necessarily better 10 How do you define a market leader? REVOLU The Internet is changing our lives. Changing the way we through very large, very expensive middlemen—called SONET communicate. Changing the way we do business. It is also equipment. The combination of CIENA’s DirectConnect the catalyst for the beginnings of a revolutionary change in technology, advances in the speed of data communications the way telecommunications networks are built. equipment and the emergence of data-centric traffic as the The Internet brought traffic from computers onto networks predominant traffic type set the stage for a revolution in designed to handle telephone calls. Of course it works…but the way service providers build their networks. In data- then again, so do the railroads, although in most cases air centric applications, some carriers estimate they can save travel is more timely and more efficient. Service providers soon as much as 30% in capital costs and 60% in operating costs realized that there were better ways to handle and deliver this by building next generation networks connecting ATM or new sort of traffic—data—ways that enabled them to build IP directly to DWDM—without the additional SONET their networks more simply and therefore more cost efficiently. equipment layer. CIENA’s bandwidth expanding DWDM systems offer the CIENA’s MultiWave Metro is one of the first ring-based first step toward this network revolution. MultiWave systems DWDM applications in the industry and one of the first real made it possible to scale bandwidth economically. The next steps toward the promise of optical networking. Think of it step came with implementation of our DirectConnect technology. like this…DWDM brought bandwidth to the network, and CIENA made it possible for service providers to connect the bandwidth is good. But managed bandwidth, bandwidth that new equipment designed to handle data traffic—IP routers can be directed and redirected, switched and controlled, is and ATM switches—directly to CIENA’s DWDM transport better. That’s where we’re headed. equipment. Big deal, you say…but to service providers it is! DWDM is the first step toward optical networking. And It means the potential for tremendous capital equipment optical networking brings flexibility. Together, they will make and operational savings. it possible for service providers to build a more efficient, In the past, the connection between the IP routers and more robust network. One that is capable of handling the the ATM switches (also called data communications equip- virtual tsunami of information that will flow into our homes ment) and DWDM equipment like CIENA’s was only possible and businesses via the Internet. TIONARY Innovation enables revolution 12 How do you define a market leader? OBSES From day one, CIENA has been obsessive about product In addition to having what are probably the strictest quality and reliability. We have to be. Our customers component performance specifications in the industry, demand it. CIENA constructed the world’s most advanced ISO 9001 certified optical networking manufacturing facility. We CIENA’s equipment sits at the heart of a service provider’s demand the best from our suppliers, but that’s just the start. network. The systems must operate 24 hours a day, seven From the time it enters our inventory to the time it leaves as days a week—that’s the only way our customers can run part of a MultiWave system, we track and monitor the their business. performance of every component used in every product we As carriers shift network traffic to a data-centric network make…and in a MultiWave 4000 there are over 1,400 architecture, the reliability and performance of DWDM components! equipment like CIENA’s is likely to become even more critical. Obsessive? Well maybe. But we’re dealing with optics here. Several years ago, few would have noticed if the Internet Light. Consider for a moment that the core of the fiber optic went down. Now not only would a failure be noticed, it cable, the part through which the light actually passes, is would have an impact on real business. It’s estimated that smaller in diameter than a human hair. Consider also, that $22 billion of business was conducted on-line in 1998, includ- any fraction of loss at any point in the system could be ing direct sales to consumers and transactions between enough to disrupt tens of thousands of transmissions. Yes, businesses. That number is projected to grow to $350 billion we’re obsessive. That’s how we achieved an average mean by 2002. Data networks, once just overlay networks, are time between failures of 1,350,000 hours, or more than now carrying mission-critical traffic. 150 years, in the circuit packs used in our MutliWave SIVE Attention to detail 14 How do you define a market leader? SUPPO Ultimately, it’s what the customers think that counts. For CIENA, So far, it looks like our efforts are paying off. In November, shipping our customers industry-leading products in record- the Company commissioned Yankelovich Partners to do a breaking time isn’t enough, we want our customers to like us. blind survey of service providers. The survey included multiple No, strike that. We want them to love us! We believed from types of carriers, some of which are current customers of the start that superior customer service and support could CIENA, some of which weren’t. In the survey, CIENA was separate us from our competition…and it has. rated best among competing equipment suppliers for overall With the network changing so quickly carriers often need service and support. CIENA was also rated the easiest assistance with things like equipment test and turn-up in supplier to work with. Needless to say we’re pleased, but addition to on-going product support. CIENA’s purchase of don’t worry, we won’t let it go to our heads. It’s only the Alta Telecom, Inc. in February of 1998 gave us a leg up in start! our efforts to build the critical customer service and support Since 1996, CIENA has shipped equipment representing component of our business. an estimated 2 million virtual fiber kilometers to our customers. Through the combination of our in-house efforts and the This kind of installed base offers CIENA an advantage over addition of Alta, CIENA has built a portfolio of service capa- our competitors—experience. Because we’ve installed more bilities. We’re able to offer full turnkey system deployment and DWDM equipment than any of our competitors, we have a maintenance for our customers. Not just for CIENA’s products, knowledge base of how it works, not in the lab, but in real but for a whole host of equipment such as wireless, data networks, running real traffic. communications and traditional telecommunications gear. RTIVE It’s all about the customer 16 EXECUTIVE OFFICERS OUTSIDE BOARD MEMBERS Patrick H. Nettles, Ph.D. President and Chief Executive Officer and Director Jon W. Bayless, Ph.D. General Partner Sevin Rosen Funds Steve W. Chaddick Senior Vice President, Strategy and Stephen P. Bradley, Ph.D. Chairman of the Board of Directors Corporate Development Joseph R. Chinnici Senior Vice President, Finance and Chief Financial Officer Mark Cummings Senior Vice President, Operations G. Eric Georgatos William Ziegler Professor of Business Administration Harvard Business School Harvey B. Cash General Partner InterWest Partners Clifford W. Higgerson General Partner Senior Vice President, General Counsel Vanguard Venture Partners and Secretary Communications Ventures Lawrence P. Huang Billy B. Oliver Senior Vice President, Strategic Independent Communications Consultant Michael J. Zak General Partner The Charles River Partnerships Account Sales Jesús León Senior Vice President, Products and Technology Gary B. Smith Senior Vice President, Worldwide Sales Stephen B. Alexander Vice President, Systems and Technology, and Chief Technology Officer Andrew C. Petrik Vice President, Finance and Controller Rebecca K. Seidman Vice President, Human Resources Development 17 CIENA Corporation TABLE OF CONTENTS 18 SELECTED CONSOLIDATED FINANCIAL DATA 19 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 29 CONSOLIDATED BALANCE SHEETS 30 CONSOLIDATED STATEMENTS OF OPERATIONS 31 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) 32 CONSOLIDATED STATEMENTS OF CASH FLOWS 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 43 REPORT OF INDEPENDENT ACCOUNTANTS 44 HISTORIC STOCK PERFORMANCE 18 CIENA Corporation SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the notes thereto included in “Financial Statements and Supplementary Data.” (in thousands except share and per share data) Statement of Operations Data: Revenue Cost of goods sold Gross profit Operating expenses: Research and development Selling and marketing General and administrative Purchased research and development Pirelli litigation Costs of proposed merger Total operating expenses Income (loss) from operations Other income (expense), net Income (loss) before income taxes Provision for income taxes Net income (loss) Basic net income (loss) per common share Diluted net income (loss) per common and dilutive potential common share Weighted average basic common shares outstanding Weighted average basic common and dilutive potential common shares outstanding Year Ended October 31,(1) 1994 1995 1996 1997 1998 $20,890 15,638 _________________________________ 5,252 1,287 1,339 2,352 — — — _________________________________ 4,978 _________________________________ 274 (180) _________________________________ 94 942 _________________________________ $ (848) _________________________________ _________________________________ $ (0.12) _________________________________ _________________________________ $21,691 16,185 ________________________________ 5,506 6,361 1,907 3,034 — — — ________________________________ 11,302 ________________________________ (5,796) 172 ________________________________ (5,624) 824 ________________________________ $ (6,448) ________________________________ ________________________________ $ (0.51) ________________________________ ________________________________ $88,463 47,315 ________________________________ 41,148 8,922 5,641 6,422 — — — ________________________________ 20,985 ________________________________ 20,163 653 ________________________________ 20,816 3,553 ________________________________ $17,263 ________________________________ ________________________________ $ 1.25 ________________________________ ________________________________ $413,215 166,472 ______________________________________ 246,743 23,308 22,627 11,823 — 7,500 — ______________________________________ 65,258 ______________________________________ 181,485 7,185 ______________________________________ 188,670 72,703 ______________________________________ $115,967 ______________________________________ ______________________________________ $ 1.53 ______________________________________ ______________________________________ $508,087 256,014 ______________________________________ 252,073 64,536 45,945 17,825 9,503 30,579 2,548 ______________________________________ 170,936 ______________________________________ 81,137 12,292 ______________________________________ 93,429 40,235 ______________________________________ $ 53,194 ______________________________________ ______________________________________ $ 0.52 ______________________________________ ______________________________________ $ (0.12) _________________________________ _________________________________ $ (0.51) ________________________________ ________________________________ $ 0.19 ________________________________ ________________________________ $ 1.11 ______________________________________ ______________________________________ $ 0.49 ______________________________________ ______________________________________ 7,317 _________________________________ _________________________________ 12,717 ________________________________ ________________________________ 13,817 ________________________________ ________________________________ 75,802 ______________________________________ ______________________________________ 101,751 ______________________________________ ______________________________________ 7,317 _________________________________ _________________________________ 12,717 ________________________________ ________________________________ 92,407 ________________________________ ________________________________ 104,664 ______________________________________ ______________________________________ 107,895 ______________________________________ ______________________________________ 1994 1995 1996 1997 1998 October 31,(1) (in thousands) Balance Sheet Data: Cash and cash equivalents Working capital Total assets Long-term obligations, excluding current portion Mandatorily redeemable preferred stock Stockholders’ equity (deficit) $ 4,440 5,485 12,076 1,901 3,492 (300) $ 8,261 7,221 17,706 2,074 14,454 (6,662) $24,040 42,240 79,676 3,465 40,404 10,783 $268,588 333,452 463,279 1,885 — 372,414 $227,397 366,108 572,424 1,414 — 474,949 (1) The Company has a 52 or 53 week fiscal year which ends on the Saturday nearest to the last day of October in each year. For purposes of financial state- ment presentation, each fiscal year is described as having ended on October 31. Fiscal 1994, 1995, 1997, and 1998 comprised 52 weeks and fiscal 1996 comprised 53 weeks. 19 CIENA Corporation MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in con- excess of $500 million. The Company believes this represents junction with the consolidated financial statements and related a considerable achievement, particularly given the substantial notes included elsewhere in this report. The information in this portion of revenues derived from the sale of its now third- annual report contains certain forward-looking statements that generation DWDM product, the MultiWave Sentry 4000. involve risks and uncertainties. The Company’s actual results Nevertheless, the termination of the Tellabs merger represented may differ materially from the results discussed in the forward- a setback for the Company. looking statements due to risk factors discussed briefly in the The outlook for fiscal 1999 is challenging. The price “Risk Factors” section of this annual report and in detail in the discounting offered by competitors striving to catch up to the Company’s Form 10-K filed with the Securities and Exchange Company and acquire market share has placed pressure on Commission (SEC) on December 10, 1998. gross margins and operating profitability. But market demand for high-bandwidth solutions still appears robust, and the Com- OVERVIEW pany believes that its product and service quality, manufacturing CIENA Corporation designs, manufactures and sells open experience, and proven track record of delivery will enable it to architecture, dense wavelength division multiplexing (DWDM) endure the gross margin pressure while it concentrates on efforts systems for fiberoptic communications networks, including long- to reduce product costs and maximize production efficiencies. distance and local exchange carriers. CIENA also provides a The Company intends to continue this strategy in order to range of engineering, furnishing and installation services for preserve and enhance market leadership and eventually build telecommunications service providers. on its installed base with new and additional products. Pursuit Fiscal 1998 was a year of dramatic events affecting the of this strategy, in conjunction with increased investments in Company. Soon after the close of the first fiscal quarter, MCI selling, marketing, and customer service activities, will likely limit WorldCom, the Company’s largest customer of fiscal 1997, the Company’s operating profitability over at least the first half surprised the Company with an announcement of a major of fiscal 1999, and may result in near term operating losses. change in purchasing practices—a change that meant materi- ally reduced revenue for the Company. This adverse event was HIGHLIGHTS OF THE FISCAL YEAR 1998 followed in the second quarter by the Company’s successful, The Company recognizes product revenue in accordance with large scale commercial introduction of the Company’s industry the shipping terms specified. For transactions where the Com- leading 40-channel MultiWave Sentry 4000. The third quarter pany has yet to obtain customer acceptance, revenue is deferred included resolution of the Company’s longstanding Pirelli SpA until the terms of acceptance are satisfied. Revenue for installa- (“Pirelli”) litigation, which was followed on June 3, 1998 with tion services is recognized as the services are performed unless the announcement of a planned merger with Tellabs, Inc. In the the terms of the supply contract combine product acceptance fourth quarter, just prior to consummation of the merger, AT&T with installation, in which case revenues for installation services advised the Company that it would no longer consider CIENA’s are recognized when the terms of acceptance are satisfied and long distance DWDM products for deployment in AT&T’s installation is completed. Revenues from installation service fixed network. The planned merger with Tellabs was later terminated price contracts are recognized on the percentage of costs on September 14, 1998. incurred to date compared to estimated total costs for each The Company’s final results for fiscal 1998, its second contract. Amounts received in excess of revenue recognized are full year in the DWDM marketplace, show total revenues in recorded as deferred revenue. For distributor sales where risks 20 CIENA Corporation of ownership have not transferred, the Company recognizes of engineering, furnishing and installation services for telecom- revenue when the product is shipped to the end user. munications service providers in the areas of transport, switching For the fiscal year ended October 31, 1998, the Company and wireless communications. Under the terms of the agree- recorded $508.1 million in revenue of which $266.9 million ment, the Company acquired all of the outstanding shares of was from sales to Sprint. The Company increased the total Alta in exchange for 1,000,000 shares of CIENA common number of customers for DWDM systems from five customers stock. The transaction constituted a tax-free reorganization in fiscal 1997 to fourteen customers in fiscal 1998. Revenue and has been accounted for as a pooling of interest under from sales to MCI WorldCom declined from approximately Accounting Principles Board Opinion No. 16. Accordingly, all $184.5 million in fiscal 1997 to an amount less than 10% of prior period consolidated financial statements presented have the Company’s total fiscal 1998 revenue. Substantially all of the been restated to include the combined results of operations, revenue recognized from the sales to MCI WorldCom occurred financial position and cash flows of Alta as though it had in the Company’s first quarter ended January 31, 1998. In always been a part of CIENA. addition to Sprint and MCI WorldCom, during the fiscal year In March 1998 the Company announced an agreement to ended October 31, 1998 the Company recognized revenue supply Bell Atlantic with DWDM optical transmission systems. The from Cable and Wireless; Hermes; Enron; Racal; Telia of supply agreement has no minimum purchase commitments and Sweden; TD of France; DTI; GST; and, through the Company’s includes the Company’s MultiWave 1600, Sentry and Firefly distributor, NISSHO Electronics Corporation (“NISSHO”), systems. Deployment and revenue recognition is expected in the sales to Teleway, Japan Telecom and to DDI. The Company first half of calendar 1999, subject to successful completion of also recognized an immaterial amount of revenue from one ongoing testing. The Bell Atlantic DWDM deployment is expected undisclosed customer. to mark the first time a regional Bell operating company (RBOC) During December 1997 the Company acquired Astracom, has committed to deployment of DWDM equipment. an early stage telecommunications company located in Atlanta, During April 1998 the Company acquired Terabit, a Georgia. The employees of Astracom were immediately deployed developer of optical components known as photodetectors or to assist with the Company’s development efforts from its Multi- optical receivers. The Company believes the technology Wave Metro product. The purchase price was approximately currently under development at Terabit may give it a strategic $13.1 million and consisted of the issuance of 169,754 shares advantage over its competitors. Terabit is located in Santa of CIENA common stock, the payment of $2.4 million in cash, Barbara, California. The purchase price was approximately and the assumption of certain stock options. The transaction $11.5 million and consisted of the issuance of 134,390 shares was recorded using the purchase accounting method with the of CIENA common stock, the payment of $1.1 million in cash, purchase price representing approximately $11.4 million in and the assumption of certain stock options. The transaction goodwill and other intangibles, and approximately $1.7 million was recorded using the purchase accounting method with the in net assets assumed. The amortization period for the intangi- purchase price representing approximately $9.5 million in bles, based on management’s estimate of the useful life of the purchased research and development, $1.8 million in goodwill acquired technology, is five years. and other intangibles, and approximately $0.2 million in net In February 1998 the Company acquired Alta, a Canadian assets assumed. The amortization period for the intangibles, corporation headquartered near Atlanta, Georgia, in a transaction based on management’s estimate of the useful life of the valued at approximately $52.5 million. Alta provides a range acquired technology, is five years. 21 CIENA Corporation From December 1996 until June 1998, the Company Subsequent to August 28, 1998, further adverse investor reac- was involved in litigation with Pirelli. On June 1, 1998, the tion raised serious questions about the ultimate ability to obtain Company announced the resolution of all pending litigation shareholder approval for the merger. An agreement to terminate with Pirelli. The terms of the settlement involved the dismissal of the merger was announced on September 14, 1998. Pirelli’s three lawsuits against the Company that were pending In June 1998 at the SUPERCOMM trade show in Atlanta, in Delaware, dismissal of the Company’s legal proceedings Georgia, the Company demonstrated its MultiWave Metro™ against Pirelli in the United States International Trade Commis- (Metro) DWDM system for metropolitan and local access appli- sion, payment to Pirelli of $30.0 million and certain running cations. Metro enables carriers to offer multi-protocol high- royalties, a worldwide, non-exclusive cross-license to each bandwidth services economically using their existing network party’s patent portfolios, and a 5-year moratorium on future liti- infrastructure. The Metro product is expected to be commercially gation between the parties. The Company recorded a charge available in the first or early second quarter of calendar 1999. of approximately $30.6 million for the year ended October 31, The Company also demonstrated at the SUPERCOM trade 1998, relating to legal fees and the ultimate settlement to show a 96 channel DWDM system. The 96 channel DWDM Pirelli. The payment of future royalties due to Pirelli is based system is expected to be commercially available during the first upon future revenues derived from the licensed technology. The half of calendar 1999. See “Risk Factors.” Company does not expect the future royalty payments to have a The Company had previously announced that AT&T was material impact on the Company’s business, financial condition evaluating a customized version of its MultiWave Sentry 1600 or results of operations. system. In July 1998 AT&T indicated to the Company that On June 3, 1998 the Company announced an agreement capacity requirements of its network had grown to such extent to merge with Tellabs, Inc. (“Tellabs”), a Delaware corporation that the delays in final certification and approval for deployment headquartered in Lisle, Illinois. Tellabs designs, manufactures, of the Company’s customized 16 channel system would make markets and services voice and data transport network access actual deployment of that system inadvisable, and that AT&T systems. Under the terms of the original agreement, all outstand- would accordingly shift to an accelerated evaluation of commer- ing shares of CIENA stock were to have been exchanged at cially available, higher channel count systems. The Company the ratio of one share of Tellabs common stock for each share believed AT&T would evaluate the Company’s MultiWave® of CIENA common stock. On August 21, 1998 the Company 4000 system positively in this context, particularly because the was informed by AT&T that AT&T had decided not to pursue Company believes it is the only manufacturer in the world with further evaluation of CIENA’s DWDM systems. Following the operational 40 channel systems ready for prompt delivery on impact of the AT&T announcement on the market prices of the an “off-the-shelf” basis in substantial manufacturing volumes. common stock of the respective companies, the Company and However, on August 21, 1998 the Company was informed Tellabs management renegotiated the terms of the merger agree- by AT&T that AT&T had decided not to pursue further evaluation ment, and on August 28, 1998 announced an amendment to of CIENA’s DWDM systems. the original merger agreement which was approved by the During the first quarter of 1998 the Company continued respective companys’ boards of directors. Under the terms of its effort to expand its manufacturing capabilities by leasing an the agreement as amended, all outstanding shares of CIENA additional facility of approximately 35,000 square feet located stock were to have been exchanged at the ratio of 0.8 share of in the Linthicum, Maryland area. This facility is used for manu- Tellabs common stock for each share of CIENA common stock. facturing and customer service activities. In April 1998 the 22 CIENA Corporation Company leased an additional manufacturing facility in the purchasing volume in either of the last two years. The Company Linthicum area of approximately 57,000 square feet. With also expects the percentage of fiscal 1999 revenue derived the addition of this new facility the Company has a total of four from foreign sales to increase relative to fiscal 1998. Based facilities with approximately 210,000 square feet that can be on overall new bid activity as well as expected deployment used for manufacturing operations. In April 1998 the Company plans of existing customers, the Company believes revenue completed the transfer of its principal executive, sales, and growth in fiscal 1999 over fiscal 1998 is possible, but will marketing functions located in Linthicum in a portion of its be highly dependent on winning new bids for shipments from 96,000 square foot facility to an approximately 68,000 square new and existing customers during the year. Competition for foot facility also located in Linthicum. During the third quarter new bids is intense, and there is no assurance the Company of 1998, the Company completed the process of renovating will be successful in winning enough new bids and new the vacated portions of the 96,000 square foot facility for the customers to achieve year over year sequential growth. purpose of accommodating expanding research and develop- See “Risk Factors.” ment functions. The Company began shipping MultiWave 1600 systems As of October 31, 1998 the Company and its subsidi- for field testing in May 1996 with customer acceptance by aries employed approximately 1,382 persons, which was an Sprint occurring in July 1996. For fiscal years 1996 and 1997 increase of 541 persons over the approximate 841 employed all of the Company’s DWDM system revenues were derived on October 31, 1997. from the MultiWave 1600 product. During fiscal 1998 the Company began shipments of and recognized revenues from RESULTS OF OPERATIONS sales of MultiWave Sentry 1600, MultiWave Firefly, and Multi- Fiscal Years Ended 1996, 1997 and 1998 Wave Sentry 4000 systems. The amount of revenue recognized Revenue. The Company recognized $508.1 million, $413.2 mil- from MultiWave 1600 sales declined in fiscal 1998 as com- lion and $88.5 million in revenue for the years ended October 31, pared to fiscal 1997. This decline in MultiWave 1600 sales 1998, 1997 and 1996, respectively. Sales to Sprint accounted in fiscal 1998 was offset by revenue recognized from sales of for $266.9 million (52.5%), $179.4 million (43.4%) and MultiWave Sentry 1600, MultiWave Firefly, and MultiWave $54.8 million (62.0%), of the Company’s revenue during fis- Sentry 4000 systems. cal 1998, 1997 and 1996, respectively. While MCI World- Gross Profit. Cost of goods sold consists of component Com accounted for $184.5 million (44.7%) of the Company’s costs, direct compensation costs, warranty and other contractual revenue during fiscal 1997, it was not a significant contri- obligations, royalties, license fees, inventory obsolescence costs butor to fiscal 1998 revenues. There were no other customers and overhead related to the Company’s manufacturing and who accounted for 10% or more of the Company’s revenues engineering, furnishing and installation operations. Gross profit during fiscal 1998, 1997 and 1996. Revenue derived from was $252.1 million, $246.7 million and $41.1 million for foreign sales accounted for approximately 23.0%, 2.8%, and fiscal years 1998, 1997, and 1996, respectively. Gross 4.0% of the Company’s revenues during fiscal 1998, 1997 margin was 49.6%, 59.7%, and 46.5% for fiscal 1998, and 1996, respectively. 1997, and 1996, respectively. The increase in gross profit The Company expects Sprint’s purchases in fiscal 1999 to from fiscal 1997 to fiscal 1998 was attributable to increased be focused primarily on filling out installed systems with addi- revenues. The decrease in gross margin percentage from fiscal tional channel cards and therefore substantially below the 1997 to fiscal 1998 was largely attributable to lower selling 23 CIENA Corporation prices. The increase in gross margin percentage from fiscal for fiscal 1998, 1997, and 1996, respectively. The approxi- 1996 to fiscal 1997 was primarily the result of a change in mate $23.3 million or 103% increase from fiscal 1997 to product mix from revenues largely derived from lower margin 1998 and the approximate $17.0 million or 301% increase engineering, furnishing and installation sales to higher margin from fiscal 1996 to fiscal 1997 in selling and marketing MultiWave product sales. This year to year increase was also expenses was primarily the result of increased staffing levels in attributable to fixed overhead costs being allocated over a the areas of sales, technical assistance and field support, and larger revenue base, an improvement in manufacturing efficien- increases in commissions earned, trade show participation cies, and reductions in component costs. and promotional costs. During fiscal 1998, 1997, and 1996 The Company’s gross margins may be affected by a num- selling and marketing expenses were 9.0%, 5.5%, and 6.4% ber of factors, including continued competitive market pricing, of revenue, respectively. The Company anticipates that its sell- lower manufacturing volumes and efficiencies and fluctuations in ing and marketing expenses may increase in absolute dollars component costs. During fiscal 1999, the Company expects to and perhaps as a percentage of revenue during fiscal 1999 face continued pressure on gross margins, primarily as a result as additional personnel are hired and additional offices are of substantial price discounting by competitors seeking to opened to allow the Company to pursue new customers and acquire market share. market opportunities. The Company also expects the portion of Research and Development Expenses. Research and selling and marketing expenses attributable to technical assis- development expenses were $64.5 million, $23.3 million, and tance and field support, specifically in Europe and Asia, will $8.9 million for fiscal 1998, 1997, and 1996, respectively. increase as the Company’s installed base of operational The approximate $41.2 million or 177% increase from fiscal MultiWave systems increases. 1997 to 1998 and the approximate $14.4 million or 161% General and Administrative Expenses. General and increase from fiscal 1996 to fiscal 1997 in research and administrative expenses were $17.8 million, $11.8 million, development expenses related to increased staffing levels, and $6.4 million for fiscal 1998, 1997, and 1996, respec- purchases of materials used in development of new or tively. The approximate $6.0 million or 50.8% increase from enhanced product prototypes, and outside consulting services fiscal 1997 to 1998 and the approximate $5.4 million or in support of certain developments and design efforts. During 84.1% increase from fiscal 1996 to fiscal 1997 in general and fiscal 1998, 1997, and 1996 research and development administrative expenses was primarily the result of increased expenses were 12.7%, 5.6%, and 10.1% of revenue, respec- staffing levels and outside consulting services. During fiscal tively. The Company expects that its research and development 1998, 1997 and 1996, general and administrative expenses expenditures will continue to increase moderately in absolute were 3.5%, 2.9%, and 7.3% of revenue, respectively. The dollars and perhaps as a percentage of revenue during fiscal Company believes that its general and administrative expenses 1999 to support the continued development of the various will moderately increase in absolute dollars and perhaps as DWDM products, the exploration of new or complementary a percentage of revenue during fiscal 1999 as a result of the technologies, and the pursuit of various cost reduction strate- expansion of the Company’s administrative staff required to gies. The Company has expensed research and development support its expanding operations. costs as incurred. Purchased Research and Development. Purchased research Selling and Marketing Expenses. Selling and marketing and development costs were $9.5 million for the fiscal year expenses were $45.9 million, $22.6 million, and $5.6 million 1998. These costs were for the purchase of technology and 24 CIENA Corporation related assets associated with the acquisition of Terabit during Other Income (Expense), Net. Other income (expense), the second quarter of fiscal 1998. net, consists of interest income earned on the Company’s cash, Pirelli Litigation. The Pirelli litigation costs of $30.6 million cash equivalents and marketable debt securities, net of interest in fiscal 1998 were attributable to a $30.0 million payment made expense associated with the Company’s debt obligations. to Pirelli during the third quarter of 1998 and to additional other Other income (expense), net, was $12.3 million, $7.2 million, legal and related costs incurred in connection with the settlement and $0.7 million for fiscal 1998, 1997, and 1996, respec- of this litigation. The Pirelli litigation expense in fiscal 1997 was tively. The year to year increase in other income (expense), net, primarily the result of a $7.5 million charge for actual and esti- was primarily the result of the investment of the net proceeds of mated legal and related costs associated with the litigation. the Company’s stock offerings and net earnings. Costs of Proposed Merger. The costs of the proposed Provision For Income Taxes. During fiscal 1996, the merger for fiscal 1998 were costs related to the contemplated Company received product acceptance from its initial customer merger between the Company and Tellabs. These costs include and commenced profitable operations, at which time the approximately $1.2 million in Securities and Exchange Com- Company reversed its previously established deferred tax mission filing fees and approximately $1.3 million in legal, valuation allowance. The provision for income taxes for fiscal accounting, and other related expenses. 1996 of $3.6 million is net of a tax benefit of approximately Operating Profit. The Company’s operating profit for $4.6 million related to the reversal of the deferred tax valua- fiscal 1998, 1997 and 1996 was $81.1 million or 16.0% tion allowance. The Company’s provision for income taxes of revenue, $181.5 million or 43.9% and $20.2 million or was 38.5% of pre-tax earnings, or $72.7 million for fiscal 22.8%, respectively. Excluding charges for purchased research 1997 and was 43.1% of pre-tax earnings, or $40.2 mil- and development, Pirelli litigation and costs from the proposed lion for fiscal 1998. The increase in the tax rate from fiscal Tellabs merger, fiscal 1998 operating profit was $123.8 million 1997 to fiscal 1998 was primarily the result of charges or 24.4% of revenue and excluding Pirelli litigation costs in for purchased research and development expenses recorded fiscal 1997 operating profit was $189.0 million or 45.7%. in fiscal 1998 and an adjustment to the estimated prior year The decrease in operating profit and operating margin from state income tax liability associated with Alta operations. fiscal 1997 to fiscal 1998 was due to increased competitive Purchased research and development charges are not deducti- pricing pressures causing a reduction in gross profit margin and ble for tax purposes. Exclusive of the effect of these charges, increased operating expenses from investments in operating infra- the Company’s provision for income taxes was 38.4% of structure. The year to year increases in operating profits from income before income taxes in fiscal 1998. The decrease fiscal 1996 to fiscal 1997 was primarily due to the comparable in tax rate, exclusive of the above charges, for fiscal 1998 increases in revenues and gross profits derived from the Com- compared to fiscal 1997 was the result of a lower combined pany’s MultiWave systems. If the Company is unable to convert effective state income tax expense, a larger benefit from the fiscal 1998 investments in operating infrastructure into significant Company’s Foreign Sales Corporation and an increase in revenue generating relationships, the Company’s business, finan- expected credits derived from research and development cial condition and results of operations could be materially and activities offset by an increase in non-deductible goodwill adversely affected. See “Risk Factors.” amortization expense. 25 CIENA Corporation QUARTERLY RESULTS OF OPERATIONS The tables below set forth the operating results and percentage of revenue represented by certain items in the Company’s statements of operations for each of the eight quarters in the period ended October 31, 1998. This information is unaudited, but in the opinion of the Company reflects all adjustments (consisting only of normal recurring adjustments) that the Company considers necessary for a fair presentation of such information in accordance with generally accepted accounting principles. The results for any quarter are not necessarily indicative of results for any future period. Jan. 31, 1997 April 30, 1997 Jul. 31, 1997 Oct. 31, 1997 Jan. 31, 1998 April 30, 1998 Jul. 31, 1998 Oct. 31, 1998 Revenue Cost of goods sold Gross profit Operating expenses: Research and development Selling and marketing General and administrative Purchased research & development Pirelli litigation Cost of proposed merger Total operating expenses Income (loss) from operations Other income (expense), net Income (loss) before income taxes Provision (benefit) for income taxes Net income (loss) Basic net income (loss) per common share Diluted net income (loss) per common share and dilutive potential common share Weighted average basic common share(1) Weighted average basic common and dilutive potential common share(1) Revenue Cost of goods sold Gross profit Operating expenses: Research and development Selling and marketing General and administrative Purchased research & development Pirelli litigation Cost of proposed merger Total operating expenses Income (loss) from operations Other income (expense), net Income (loss) before income taxes Provision (benefit) for income taxes Net income (loss) $63,673 $97,603 $121,845 $130,094 $145,092 $142,718 $129,116 $91,161 62,688 28,253 _______________________________ ________________________________ 28,473 35,420 _______________________________ ________________________________ 70,431 _____________________________________ 58,685 _____________________________________ 58,980 ____________________________________ 86,112 ____________________________________ 63,915 ____________________________________ 78,803 ____________________________________ 47,569 ____________________________________ 74,276 ____________________________________ 50,250 ____________________________________ 79,844 ____________________________________ 40,400 ________________________________ 57,203 ________________________________ 3,050 18,880 3,070 12,407 2,003 5,677 — — 5,000 — — 531 ________________________________ _______________________________ 13,123 37,495 ________________________________ _______________________________ 22,297 (9,022) 302 2,732 ________________________________ _______________________________ (6,290) 22,599 8,744 (2,392) _______________________________ ________________________________ $13,855 $28,480 $ 35,724 $ 37,908 $ 39,698 $ 15,305 $ 2,089 $ (3,898) _______________________________ ________________________________ _______________________________ ________________________________ 18,805 12,526 3,908 — 20,579 2,017 _____________________________________ 57,835 _____________________________________ 850 2,519 _____________________________________ 3,369 1,280 _____________________________________ _____________________________________ _____________________________________ 7,245 6,722 3,241 — — — ____________________________________ 17,208 ____________________________________ 57,068 1,426 ____________________________________ 58,494 22,770 ____________________________________ ____________________________________ ____________________________________ 16,648 11,044 4,448 9,503 10,000 — ____________________________________ 51,643 ____________________________________ 27,160 3,350 ____________________________________ 30,510 15,205 ____________________________________ ____________________________________ ____________________________________ 10,203 9,968 3,792 — — — ____________________________________ 23,963 ____________________________________ 62,149 3,691 ____________________________________ 65,840 26,142 ____________________________________ ____________________________________ ____________________________________ 8,314 7,889 3,782 — 2,500 — ____________________________________ 22,485 ____________________________________ 57,359 3,611 ____________________________________ 60,970 23,062 ____________________________________ ____________________________________ ____________________________________ 4,699 4,946 2,797 — — — ________________________________ 12,442 ________________________________ 44,761 1,846 ________________________________ 46,607 18,127 ________________________________ ________________________________ ________________________________ $ 0.97 $ 0.31 $ ________________________________ ________________________________ ________________________________ ________________________________ ____________________________________ ____________________________________ 0.36 $ ____________________________________ ____________________________________ 0.38 $ ____________________________________ ____________________________________ 0.39 $ ____________________________________ ____________________________________ 0.15 $ _____________________________________ _____________________________________ 0.02 $ (0.04) _______________________________ _______________________________ $ 0.14 $ 0.27 $ ________________________________ ________________________________ ________________________________ ________________________________ ____________________________________ ____________________________________ 0.34 $ ____________________________________ ____________________________________ 0.35 $ ____________________________________ ____________________________________ 0.37 $ ____________________________________ ____________________________________ 0.14 $ _____________________________________ _____________________________________ 0.02 $ (0.04) _______________________________ _______________________________ 14,216 ________________________________ ________________________________ 92,644 ________________________________ ________________________________ 98,021 ____________________________________ ____________________________________ 99,786 ____________________________________ ____________________________________ 100,641 ____________________________________ ____________________________________ 101,350 ____________________________________ ____________________________________ _____________________________________ _____________________________________ 102,089 102,914 _______________________________ _______________________________ 100,425 105,456 ________________________________ ________________________________ ________________________________ ________________________________ 106,296 ____________________________________ ____________________________________ 107,308 ____________________________________ ____________________________________ 107,552 ____________________________________ ____________________________________ 107,560 ____________________________________ ____________________________________ _____________________________________ _____________________________________ 108,215 102,914 _______________________________ _______________________________ Jan. 31, 1997 100.0% 44.4 _____________________ 55.6 4.8 4.8 3.1 — 7.9 — _____________________ 20.6 _____________________ 35.0 0.5 _____________________ 35.5 13.7 _____________________ 21.8% _____________________ _____________________ April 30, 1997 100.0% 41.4 ______________________ 58.6 4.8 5.1 2.9 — — — ______________________ 12.8 ______________________ 45.8 1.9 ______________________ 47.7 18.6 ______________________ 29.1% ______________________ ______________________ Jul. 31, 1997 100.0% 39.0 ______________________ 61.0 5.9 5.5 2.7 — — — ______________________ 14.1 ______________________ 46.9 1.2 ______________________ 48.1 18.7 ______________________ 29.4% ______________________ ______________________ Oct. 31, 1997 100.0% 38.6 ______________________ 61.4 6.4 6.1 2.9 — 1.9 — ______________________ 17.3 ______________________ 44.1 2.8 ______________________ 46.9 17.7 ______________________ 29.2% ______________________ ______________________ Jan. 31, 1998 100.0% 40.7 _____________________ 59.3 7.0 6.9 2.6 — — — _____________________ 16.5 _____________________ 42.8 2.6 _____________________ 45.4 18.0 _____________________ 27.4% _____________________ _____________________ April 30, 1998 100.0% 44.8 ______________________ 55.2 11.7 7.7 3.1 6.7 7.0 — ______________________ 36.2 ______________________ 19.0 2.4 ______________________ 21.4 10.7 ______________________ 10.7% ______________________ ______________________ Jul. 31, 1998 100.0% 54.5 ______________________ 45.5 14.6 9.7 3.0 — 15.9 1.6 ______________________ 44.8 ______________________ 0.7 1.9 ______________________ 2.6 1.0 ______________________ 1.6% ______________________ ______________________ Oct. 31, 1998 100.0% 68.8 ____________________ 31.2 20.7 13.6 6.2 — — 0.6 ____________________ 41.1 ____________________ (9.9) 3.0 ____________________ (6.9) (2.6) ______________________ (4.3)% ____________________ ____________________ (1) The sum of the quarterly earnings per share for fiscal 1997 does not equal the reported annual earnings per share for fiscal 1997 due to the effect of the Company’s stock issuances during the year. 26 CIENA Corporation The Company’s quarterly operating results have varied and approximately $53.1 million and $22.6 million in tax benefits are expected to vary significantly in the future. The Company’s from the exercise of stock options and certain stock warrants, detailed discussion of risk factors addresses the many factors respectively. As of October 31, 1998, the Company had that have caused such variation in the past, and may cause $227.4 million in cash and cash equivalents and $16.0 mil- similar variations in the future. See “Risk Factors.” In addition lion in corporate debt securities with contractual maturities of to those factors, in fiscal 1998, the distraction attendant to six months or less. the aborted Tellabs merger had a significant, though difficult The Company’s operating activities used cash of to quantify impact on the Company’s operations in the third $1.2 million in fiscal 1996, and provided cash of and fourth quarter. But apart from the distraction factor, the $85.0 million and $35.5 million for fiscal 1997 and 1998, Company believes the single most significant trend affecting respectively. The cash used in operations in fiscal 1996 was the Company’s financial performance is the material effect of accounted for primarily by the Company’s research and devel- very aggressive price discounting by competitors seeking to opment activities relating to its early development of the acquire market share in the increasingly important market for MultiWave system. Cash provided by operations in fiscal high-capacity solutions. The Company chose in the face of 1997 and 1998 was principally attributable to net income this pressure to continue to build market share in fiscal 1998 adjusted for the non-cash charges of depreciation, amortiza- at the cost of declining margins. The Company intends to con- tion, provisions for inventory obsolescence and warranty, tinue this strategy in order to preserve and enhance its market increases in accounts payable, accrued expenses and leadership and eventually build on its installed base with new income tax payable; offset by increases in accounts receiv- and additional products. Pursuit of this strategy, in conjunction able and inventories due to increased revenue and to the with increased investments in selling, marketing, and customer general increase in business activity. service activities, will likely limit the Company’s operating prof- Cash used in investing activities in fiscal 1996, 1997 itability over at least the first half of fiscal 1999, and may result and 1998 was $11.6 million, $66.8 million and $104.5 mil- in near term operating losses. lion, respectively. Included in investment activities were capital equipment expenditures in fiscal 1996, 1997 and 1998 of Liquidity and Capital Resources $9.9 million, $51.9 million and $75.4 million, respectively. The Company financed its operations and capital expenditures These capital equipment expenditures were primarily for test, from inception through fiscal 1996 principally through the sale manufacturing and computer equipment. The Company expects of Convertible Preferred Stock for proceeds totaling $40.6 million additional capital equipment expenditures of approximately and capital lease financing totaling $4.1 million. The Company $50.0 million to be made during fiscal 1999 to support sell- completed its initial public offering of Common Stock in ing and marketing, manufacturing and product development February 1997 and realized net proceeds of approximately activities. In addition, since its inception the Company’s invest- $121.8 million with an additional $0.6 million received from ing activities have included the use of $28.3 million for the the exercise of certain outstanding warrants. In July 1997, the construction of leasehold improvements and the Company Company completed a public offering of Common Stock and expects to use an additional $3.0 million of capital during realized net proceeds of approximately $52.2 million. During fiscal 1999 in the construction of leasehold improvements fiscal 1997 and fiscal 1998 the Company also realized for its facilities. 27 CIENA Corporation The Company believes that its existing cash balance and (SFAS No. 133), “Accounting for Derivative Instruments and cash flows expected from future operations will be sufficient to Hedging Activities.” This Statement requires companies to meet the Company’s capital requirements for at least the next record derivatives on the balance sheet as assets or liabilities, 18 to 24 months. measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for Effects of Recent Accounting Pronouncements depending on the use of the derivative and whether it qualifies In June 1997, the Financial Accounting Standards Board for hedge accounting. SFAS No. 133 will be effective for issued Statement of Financial Accounting Standards No. 130 the Company’s fiscal year ending October 31, 2000. The (SFAS No. 130), “Comprehensive Income.” SFAS No. 130 Company believes the adoption of SFAS No. 133 will not becomes effective for the Company’s fiscal year 1999 and have a material effect on the consolidated financial statements. requires reclassification of earlier financial statements for com- parative purposes. SFAS No. 130 requires that changes in Year 2000 Readiness the amounts of certain items, including foreign currency transla- Many computer systems were not designed to handle any dates tion adjustments and gains and losses on certain securities be beyond the year 1999; accordingly, affected hardware and shown in the financial statements. SFAS No. 130 does not software will need to be modified prior to the year 2000 in require a specific format for the financial statement in which order to remain functional. The Company’s operations make comprehensive income is reported, but does require that an use of a variety of computer equipment and software. If the amount representing total comprehensive income be reported computer equipment and software used in the operation of the in that statement. The Company believes the adoption of Company do not correctly recognize data information when the SFAS No. 130 will not have a material effect on the consoli- year changes to 2000, there could be an adverse impact on dated financial statements. the Company’s operations. In June 1997, the Financial Accounting Standards Board The Company has taken actions to understand the nature issued Statement of Financial Accounting Standards No. 131 and extent of work required, if any, to make its systems, prod- (SFAS No. 131), “Disclosures about Segments of an Enterprise ucts and infrastructure Year 2000 compliant. Based on internal and Related Information.” This Statement will change the way testing performed to date and completed by the Company, the public companies report information about segments of their Company currently believes and warrants to its customers that its business in annual financial statements and requires them to products are Year 2000 compliant. However, since all customer report selected segment information in their quarterly reports situations cannot be anticipated, particularly those involving issued to stockholders. It also requires entity-wide disclosures about interaction of the Company’s products with third party products, the products and services an entity provides, the material countries the Company may see an increase in warranty and other in which it holds assets and reports revenues, and its major cus- claims as a result of the Year 2000 transition. The impact of tomers. The Statement is effective for the Company’s fiscal year customer claims, if broader than anticipated, could have a 1999. The Company believes the adoption of SFAS No. 131 will material adverse impact on the Company’s results of operations not have a material effect on the consolidated financial statements. or financial condition. In June 1998, the Financial Accounting Standards Board The Company is currently in the process of conducting a issued Statement of Financial Accounting Standards No. 133 comprehensive inventory and evaluation of both information 28 CIENA Corporation technology (“IT”) or software systems and non-IT systems used and validation process to assure the reliability of its risk to run its systems. Non-IT systems typically include embedded and cost estimates. technology such as microcontrollers. Examples of the Company’s The Company is also in the process of contacting its criti- Non-IT systems include certain equipment used for production, cal suppliers to determine that suppliers’ operations and the research, testing and measurement processes and calibration. products and services they provide are Year 2000 compliant. As of December 1998 the Company had assessed approxi- To date, the Company’s optical suppliers have represented mately 80% of the IT and non-IT systems used in its operations that they are year 2000 compliant or are in the process of with an insignificant amount of those systems having been iden- becoming compliant by December 31, 1999. If these suppli- tified as Year 2000 non-compliant. The Company has begun ers fail to adequately address the Year 2000 issue for the the process of upgrading or replacing those identified non- products they provide to the Company, this could have a compliant systems with completion expected during fiscal material adverse impact on the Company’s operations and 1999. For the Year 2000 non-compliance systems identified financial results. to date, the cost of remediation is not considered to be mater- Contingency plans will be developed if it appears the ial to the Company’s financial condition or operating results. Company or its key suppliers will not be Year 2000 compliant, However, if implementation of replacement systems is delayed, and such non-compliance is expected to have a material or if significant new non-compliance issues are identified, the adverse impact on the Company’s operations. Company’s results of operations or financial condition may be materially adversely affected. RISK FACTORS The Company changed its main financial, manufacturing Investors are reminded that this document contains forward- and information system to a company-wide Year 2000 compli- looking statements that should be considered in the context ant enterprise resource planning (“ERP”) computer-based system of the risks described in the Company’s Form 10-K on file with during the fourth quarter of fiscal 1998. The Company esti- the SEC as of December 10, 1998. Risk factors that may mates that it has spent approximately $4.0 million on its ERP cause the Company’s results to differ materially from those implementation and estimates that it will likely spend $50,000 discussed in forward-looking statements include, but are not to $100,000 to address identified Year 2000 issues. The limited to: intense and increasing competition, much of which Company expects that it will use cash from operations for Year comes from companies substantially larger than the Company; 2000 remediation and replacement costs. Approximately less the concentration of potential customers in the industry; the than 2% of the information technology budget is expected to impact of changing sales focus from a very small number of be used for remediation. No other information technology pro- very large opportunities to a greater number of smaller oppor- jects have been deferred due to the Year 2000 efforts. To date, tunities; new product development delays; and the relative the Company has not yet employed an independent verification newness of the products. 29 CIENA Corporation CONSOLIDATED BALANCE SHEETS (in thousands, except share data) ASSETS Current assets: Cash and cash equivalents Marketable debt securities Accounts receivable (net of allowance of $722 and $1,528) Inventories, net Deferred income taxes Prepaid income taxes Prepaid expenses and other Total current assets Equipment, furniture and fixtures, net Goodwill and other intangible assets, net Other assets Total assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable Accrued liabilities Income taxes payable Deferred revenue Other current obligations Total current liabilities Deferred income taxes Other long-term obligations Total liabilities Commitments and contingencies Stockholders’ equity: Preferred stock—par value $.01; 20,000,000 shares authorized; zero shares issued and outstanding Common stock—par value $.01; 180,000,000 shares authorized; 100,287,653 and 103,239,704 shares issued and outstanding Additional paid-in capital Notes receivable from stockholders Cumulative translation adjustment Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity The accompanying notes are an integral part of these consolidated financial statements. October 31, 1997 1998 $268,588 — 72,336 41,109 9,139 — 3,093 _______________________________________ 394,265 67,618 5 1,391 _______________________________________ $463,279 _______________________________________ _______________________________________ $ 24,760 32,022 261 2,591 1,179 _______________________________________ 60,813 28,167 1,885 _______________________________________ 90,865 — _______________________________________ $227,397 15,993 85,472 70,908 15,301 8,558 4,415 _______________________________________ 428,044 123,405 16,270 4,705 _______________________________________ $572,424 _______________________________________ _______________________________________ $ 25,686 34,328 — 1,084 838 _______________________________________ 61,936 34,125 1,414 _______________________________________ 97,475 — _______________________________________ — — 1,003 245,219 (64) (5) 126,261 _______________________________________ 372,414 _______________________________________ $463,279 _______________________________________ _______________________________________ 1,032 294,926 (357) (107) 179,455 _______________________________________ 474,949 _______________________________________ $572,424 _______________________________________ _______________________________________ 30 CIENA Corporation CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Revenue Cost of goods sold Gross profit Operating expenses: Research and development Selling and marketing General and administrative Purchased research and development Pirelli litigation Cost of proposed merger Total operating expenses Income from operations Interest and other income (expense), net Interest expense Income before income taxes Provision for income taxes Net income Basic net income per common share Diluted net income per common share and dilutive potential common share Weighted average basic common shares outstanding Weighted average basic common and dilutive potential common shares outstanding The accompanying notes are an integral part of these consolidated financial statements. Year Ended October 31, 1997 1998 1996 $88,463 47,315 ___________________________________ 41,148 ___________________________________ 8,922 5,641 6,422 — — — ___________________________________ 20,985 ___________________________________ 20,163 1,096 (443) ___________________________________ 20,816 3,553 ___________________________________ $17,263 ___________________________________ ___________________________________ $ 1.25 ___________________________________ ___________________________________ $ 0.19 ___________________________________ ___________________________________ 13,817 ___________________________________ ___________________________________ $413,215 166,472 ________________________________________ 246,743 ________________________________________ 23,308 22,627 11,823 — 7,500 — ________________________________________ 65,258 ________________________________________ 181,485 7,593 (408) ________________________________________ 188,670 72,703 ________________________________________ $115,967 ________________________________________ ________________________________________ 1.53 $ ________________________________________ ________________________________________ $ 1.11 ________________________________________ ________________________________________ 75,802 ________________________________________ ________________________________________ $508,087 256,014 ________________________________________ 252,073 ________________________________________ 64,536 45,945 17,825 9,503 30,579 2,548 ________________________________________ 170,936 ________________________________________ 81,137 12,551 (259) ________________________________________ 93,429 40,235 ________________________________________ $ 53,194 ________________________________________ ________________________________________ 0.52 $ ________________________________________ ________________________________________ $ 0.49 ________________________________________ ________________________________________ 101,751 ________________________________________ ________________________________________ 92,407 ___________________________________ ___________________________________ 104,664 ________________________________________ ________________________________________ 107,895 ________________________________________ ________________________________________ 31 CIENA Corporation CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) Common Stock Shares Amount Additional Paid-in- Capital Receivable Cumulative Translation Stockholders Adjustment From Retained Earnings (Deficit) Notes Total Stockholders’ Equity (Deficit) (dollars in thousands) Balance at October 31, 1995 Exercise of warrants Exercise of stock options Compensation cost of stock options Issuance of warrant for settlement of certain equity rights Net income Balance of October 31, 1996 Issuance of common stock, net of issuance costs Conversion of Preferred Stock Exercise of warrants Exercise of stock options Tax benefit from the exercise of stock options Repayment of receivables from stockholders Translation adjustment Compensation cost of stock options Net income Balance at October 31, 1997 Purchase acquisitions, net of transaction costs Exercise of stock options Tax benefit from the exercise of stock options Repayment of receivables from stockholders Translation adjustment Compensation cost of stock options Net income Balance at October 31, 1998 $ 12,935,415 676,425 579,745 — $ 129 7 6 — 178 — 71 2 $ — $ — $ (6,969) $ (6,662) 7 17 2 — (60) — — — — — — — — — ____________________________________________________ 14,191,585 — — _____________________________ 142 156 — _______________________________________ 407 — — ______________________ (60) — — ______________________ — — 17,263 ______________________________________ 10,294 156 17,263 ______________________________________ 10,783 7,002,060 74,815,740 666,086 3,612,182 70 748 7 36 173,947 40,256 — 859 — — — (73) — — 29,709 — — — — — — — — — — — 174,017 41,004 7 822 29,709 — — — — ____________________________________________________ 100,287,653 — — — — _____________________________ 1,003 — — 41 — _______________________________________ 245,219 69 — — — ______________________ (64) — (5) — — ______________________ (5) — — — 115,967 ______________________________________ 126,261 69 (5) 41 115,967 ______________________________________ 372,414 304,144 2,647,907 — 3 26 — 20,817 6,215 — (392) 22,634 — — — — — — — 20,820 5,849 22,634 — — — — ____________________________________________________ 103,239,704 ____________________________________________________ ____________________________________________________ — — — — _____________________________ $1,032 _____________________________ _____________________________ — — 41 — _______________________________________ $294,926 _______________________________________ _______________________________________ 99 — — — ______________________ $(357) ______________________ ______________________ — (102) — — ______________________ $(107) ______________________ ______________________ — — — 53,194 ______________________________________ $179,455 ______________________________________ ______________________________________ 99 (102) 41 53,194 ______________________________________ $474,949 ______________________________________ ______________________________________ The accompanying notes are an integral part of these consolidated financial statements. 32 CIENA Corporation CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash (used in) provided by operating activities: Non-cash charges from equity transactions Amortization of premiums on marketable debt securities Effect of translation adjustment Purchased research and development Write down of leasehold improvements and equipment Depreciation and amortization Provision for doubtful accounts Provision for inventory excess and obsolescence Provision for warranty and other contractual obligations Changes in assets and liabilities: Increase in accounts receivable Increase in inventories Increase in deferred income tax assets Increase in prepaid income taxes Increase in prepaid expenses and other assets Increase (decrease) in accounts payable and accrued expenses accruals Increase (decrease) in income taxes payable Increase in deferred income tax liabilities Increase (decrease) in deferred revenue and other obligations Net cash (used in) provided by operating activities Cash flows from investing activities: Additions to equipment, furniture and fixtures Purchase of marketable debt securities Maturities of marketable debt securities Net cash paid for business combinations Net cash used in investing activities Cash flows from financing activities: Net proceeds from (repayment of) other obligations Net proceeds from issuance of or subscription to mandatorily redeemable preferred stock Net proceeds from issuance of common stock Tax benefit related to exercise of stock options and warrants Repayment of notes receivable from stockholders Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental disclosure of cash flow information: Cash paid during the period for: Interest Income taxes 1996 Year Ended October 31, 1997 1998 $ 17,263 $115,967 $ 53,194 158 — — — 883 1,082 76 1,937 1,584 (20,601) (15,165) (1,834) — (1,009) 7,259 3,801 — 3,386 ___________________________________ (1,180) ___________________________________ (11,558) — — — ___________________________________ (11,558) ___________________________________ 41 — (5) — 923 10,251 489 7,585 11,866 (46,309) (35,466) (7,305) — (2,403) 30,311 (3,701) 4,793 (2,007) ____________________________________ 85,030 ____________________________________ (66,820) — — — ____________________________________ (66,820) ____________________________________ 41 464 (102) 9,503 1,605 33,266 806 9,617 10,523 (13,707) (39,416) (6,162) (8,558) (11,456) (8,307) (261) 5,958 (1,507) _______________________________________ 35,501 _______________________________________ (86,399) (93,869) 77,876 (2,070) _______________________________________ (104,462) _______________________________________ 2,543 (2,260) (812) 25,950 24 — — ___________________________________ 28,517 ___________________________________ 15,779 8,261 ___________________________________ $ 24,040 ___________________________________ ___________________________________ $ 419 ___________________________________ ___________________________________ $ 1,830 ___________________________________ ___________________________________ — 175,446 53,083 69 ____________________________________ 226,338 ____________________________________ 244,548 24,040 ____________________________________ $268,588 ____________________________________ ____________________________________ — 5,849 22,634 99 _______________________________________ 27,770 _______________________________________ (41,191) 268,588 _______________________________________ $ 227,397 _______________________________________ _______________________________________ $ 405 ____________________________________ ____________________________________ $ 26,999 ____________________________________ ____________________________________ $ 249 _______________________________________ _______________________________________ $ 30,203 _______________________________________ _______________________________________ Supplemental disclosure of non-cash financing activities: Issuance of common stock for notes receivable from stockholders $ 60 ___________________________________ ___________________________________ $ 73 ____________________________________ ____________________________________ 392 _______________________________________ _______________________________________ The accompanying notes are an integral part of these consolidated financial statements. 33 CIENA Corporation NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) THE COMPANY AND SIGNIFICANT amounts of assets, liabilities, revenue and expenses, together ACCOUNTING POLICIES with amounts disclosed in the related notes to the financial state- Description of Business ments. Actual results could differ from the recorded estimates. CIENA Corporation (the “Company” or “CIENA”) designs, manu- factures and sells open architecture, dense wavelength division multiplexing (“DWDM”) systems for fiberoptic communications networks, including long-distance and local exchange carriers. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. CIENA also provides a range of engineering, furnishing and Marketable Debt Securities installation services for telecommunications service providers. The Company has classified its investments in marketable debt Principles of Consolidation The Company has ten wholly owned U.S. and international subsidiaries which have been consolidated in the accompanying financial statements. During the fiscal year ended October 31, 1998, the Company completed a merger with ATI Telecom Inter- national Ltd., (“Alta”). The merger constituted a tax-free reorgani- zation and has been accounted for as a pooling of interests securities as held-to-maturity securities as defined by Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Such investments are recorded at their amortized cost in the accompanying con- solidated balance sheets. All of the marketable debt securities are corporate debt securities with contractual maturities of six months or less and have $60,000 and $9,000 of unrealized gain and unrealized loss, respectively, as of October 31, 1998. under Accounting Principles Board Opinion No. 16. Accordingly, all prior period consolidated financial statements presented have Inventories been restated to include the combined results of operations, financial position and cash flows of Alta as though it had been a part of CIENA. The accompanying consolidated financial Inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out basis. The Company records a provision for excess and obsolete inventory whenever such statements include the accounts of the Company and its wholly an impairment has been identified. owned subsidiaries. All material intercompany accounts and Equipment, Furniture and Fixtures transactions have been eliminated in consolidation. See Note 2. Equipment, furniture and fixtures are recorded at cost. Depre- Fiscal Year The Company has a 52 or 53 week fiscal year which ends on the Saturday nearest to the last day of October in each year ciation and amortization are computed using the straight-line method over useful lives of 2-5 years for equipment, furniture and fixtures and of 6-10 years for leasehold improvements. (October 31, 1998; November 1, 1997; and November 2, Goodwill 1996). For purposes of financial statement presentation, each The Company has recorded goodwill from two purchase trans- fiscal year is described as having ended on October 31. Fiscal actions. See Note 2. It is the Company’s policy to continually 1998 and 1997 comprised 52 weeks and fiscal 1996 com- assess the carrying amount of its goodwill to determine if there prised 53 weeks. Use of Estimates has been an impairment to its carrying value. The Company would record any such impairment when identified. The preparation of financial statements in conformity with generally Concentrations accepted accounting principles requires the Company to make Substantially all of the Company’s cash and cash equivalents are estimates, judgements and assumptions that affect the reported custodied at four major U.S. financial institutions. The majority 34 CIENA Corporation of the Company’s cash equivalents include U.S. Government until the terms of acceptance are satisfied. Revenue for installa- Federal Agency Securities, short term marketable securities, and tion services is recognized as the services are performed unless overnight repurchase agreements. Deposits held with banks may the terms of the supply contract combine product acceptance exceed the amount of insurance provided on such deposits. with installation, in which case revenues for installation services Generally these deposits may be redeemed upon demand and, are recognized when the terms of acceptance are satisfied and therefore, bear minimal risk. installation is completed. Revenues from installation service fixed Historically, the Company has relied on a limited number of price contracts are recognized on the percentage of costs customers for a substantial portion of its revenue. In terms of total incurred to date compared to estimated total costs for each revenue, the Company’s largest two customers have been Sprint contract. Amounts received in excess of revenue recognized are and MCI WorldCom. While there were no revenues derived recorded as deferred revenue. For distributor sales where risks from MCI WorldCom in fiscal 1996, Sprint accounted for 62% of ownership have not transferred, the Company recognizes of the Company’s fiscal 1996 revenues and both Sprint and revenue when the product is shipped through to the end user. MCI WorldCom combined accounted for greater than 88% of the Company’s 1997 fiscal revenues. MCI WorldCom accounted for less than 10% and Sprint accounted for approximately 53% of the Company’s fiscal 1998 revenues. The Company expects that a significant portion of its future revenue will continue to be generated by a limited number of customers. The loss of any one of these customers or any substantial reduction in orders by any one of these customers could materially adversely affect the Com- pany’s financial condition or operating results. Additionally, the Revenue-Related Accruals The Company provides for the estimated costs to fulfill customer war- ranty and other contractual obligations upon the recognition of the related revenue. Such reserves are determined based upon actual warranty cost experience, estimates of component failure rates, and management’s industry experience. The Company’s contractual sales arrangements generally do not permit the right of return of product by the customer after the product has been accepted. Company’s access to certain raw materials is dependent upon Research and Development single and sole source suppliers. The inability of any supplier to The Company charges all research and development costs to fulfill supply requirements of the Company could impact future results. expense as incurred. The Company performs ongoing credit evaluations of its cus- tomers and generally does not require collateral from its customers. The Company maintains an allowance for potential losses when identified and has not incurred any significant losses to date. As of October 31, 1997, Sprint and MCI WorldCom accounted for 84% of the trade accounts receivable. Sprint and three other customers comprise 10%, 11%, 25% and 26% of the trade accounts receivable respectively as of October 31, 1998. Income Taxes The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (SFAS No. 109), “Accounting for Income Taxes”. SFAS No. 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the carrying amounts of assets and liabilities for financial reporting purposes Revenue Recognition and their respective tax bases, and for operating loss and tax The Company recognizes product revenue in accordance with credit carryforwards. In estimating future tax consequences, the shipping terms specified. For transactions where the Com- SFAS No. 109 generally considers all expected future events pany has yet to obtain customer acceptance, revenue is deferred other than the enactment of changes in tax laws or rates. Tax 35 CIENA Corporation savings resulting from deductions associated with stock options Marketed,” requires the capitalization of certain software devel- and certain stock warrants are credited directly to additional opment costs incurred subsequent to the date technological paid-in capital when realization of such benefit is fully assured feasibility is established and prior to the date the product is and to deferred tax liabilities prior to such point. See Note 8. generally available for sale. The capitalized cost is then amor- Foreign Currency Translation The majority of the Company’s foreign branches and subsidiaries use the U.S. dollar as their functional currency as the U.S. parent exclusively funds the branches and subsidiaries’ operations with U.S. dollars. For those subsidiaries using the local currency as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date. Resulting tized over the estimated product life. The Company defines technological feasibility as being attained at the time a working model is completed. To date, the period between achieving technological feasibility and the general availability of such soft- ware has been short and software development costs qualifying for capitalization have been insignificant. Accordingly, the Com- pany has not capitalized any software development costs. translation adjustments are recorded directly to a separate Accounting for Stock Options component of shareholders’ equity. Where the U.S. dollar is the functional currency, translation adjustments are recorded in other income. The net gain (loss) on foreign currency remeasurement and exchange rate changes for fiscal 1996, 1997, and 1998 was immaterial for separate financial statement presentation. Computation of Basic Net Income per Common Share and Diluted Net Income per Common and Dilutive Potential Common Share In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, “Earnings per Share” (SFAS No. 128). SFAS No. 128 simpli- fies the earnings per share (EPS) computation and replaces the presentation of primary EPS with a presentation of basic EPS. This statement also requires dual presentation of basic and diluted EPS on the face of the income statement for entities with a complex capital structure and requires a reconciliation of the numerator and denominator used for the basic and diluted EPS computations. The Company has implemented SFAS No. 128 in fiscal 1998, as required. Accordingly, all prior period EPS data has been restated. See Note 6. In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (SFAS No. 123), “Accounting for Stock-Based Compensation,” which is effective for the Company’s consolidated financial state- ments for fiscal years 1996, 1997, and 1998. SFAS No. 123 allows companies to either account for stock-based compensation under the new provisions of SFAS No. 123 or using the intrinsic value method provided by Accounting Principles Board Opinion No. 25 (APB No. 25), “Accounting for Stock Issued to Employees,” but requires pro forma disclosure in the footnotes to the financial statements as if the measurement provisions of SFAS No. 123 had been adopted. The Company has elected to continue to account for its stock based compensation in accordance with the provisions of APB No. 25 and present the pro forma disclosures required by SFAS No. 123. See Note 7. Newly Issued Accounting Standards In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130 (SFAS No. 130), “Comprehensive Income.” SFAS No. 130 becomes effective for the Company’s fiscal year 1999 and requires Software Development Costs reclassification of earlier financial statements for comparative Statement of Financial Accounting Standards No. 86, “Accounting purposes. SFAS No. 130 requires that changes in the amounts for the Costs of Computer Software to be Sold, Leased or Otherwise of certain items, including foreign currency translation adjustments 36 CIENA Corporation and gains and losses on certain securities be shown in the (2) BUSINESS COMBINATIONS financial statements. SFAS No. 130 does not require a specific Astracom format for the financial statement in which comprehensive income During December 1997 the Company completed an Agreement is reported, but does require that an amount representing total and Plan of Merger with Astracom, Inc. (“Astracom”), an early comprehensive income be reported in that statement. The Com- stage telecommunications company located in Atlanta, Georgia. pany believes the adoption of SFAS No. 130 will not have a The purchase price was approximately $13.1 million and con- material effect on the consolidated financial statements. sisted of the issuance of 169,754 shares of CIENA common Also in June 1997, the Financial Accounting Standards Board stock, the payment of $2.4 million in cash, and the assumption issued Statement of Financial Accounting Standards No. 131 of certain stock options. The transaction was recorded using the (SFAS No. 131), “Disclosures about Segments of an Enterprise purchase accounting method with the purchase price represent- and Related Information.” This Statement will change the way ing approximately $11.4 million in goodwill and other intangibles, public companies report information about segments of their and approximately $1.7 million in net assets assumed. The amor- business in annual financial statements and requires them to tization period for the intangibles, based on management’s esti- report selected segment information in their quarterly reports mate of the useful life of the acquired technology, is five years. issued to stockholders. It also requires entity-wide disclosures The operations of Astracom are not material to the consolidated about the products and services an entity provides, the material financial statements of the Company and, accordingly, separate countries in which it holds assets and reports revenues, and its pro forma financial information has not been presented. major customers. The Statement is effective for the Company’s fiscal year 1999. The Company believes the adoption of SFAS No. 131 will not have a material effect on the consolidated financial statements. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 (SFAS No. 133), “Accounting for Derivative Instruments and Hedging Activities.” This Statement requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting. SFAS No. 133 will be effective for the Company’s fiscal year ending October 31, 2000. The Company believes the adoption of SFAS No. 133 will not have a material effect on the consolidated financial statements. Alta On February 19, 1998 the Company completed a merger with ATI Telecom International Ltd., (“Alta”), a Canadian corporation headquartered near Atlanta, Georgia, in a transaction valued at approximately $52.5 million. Alta provides a range of engi- neering, furnishing and installation services for telecommunica- tions service providers in the areas of transport, switching and wireless communications. Under the terms of the agreement the Company exchanged 1,000,000 shares of its common stock for all the common stock of Alta. The merger constituted a tax- free reorganization and has been accounted for as a pooling of interests under Accounting Principles Board Opinion No. 16. Accordingly, all prior period consolidated financial statements presented have been restated to include the combined results of operations, financial position and cash flows of Alta as though it had been a part of CIENA. Reclassification Prior to the merger, Alta’s year ended on December 31. In Certain prior year amounts have been reclassified to conform to recording the business combination, Alta’s prior period financial state- current year consolidated financial statement presentation. ments have been restated to conform to CIENA’s fiscal year end. 37 CIENA Corporation All intercompany transactions between CIENA and Alta In connection with the Terabit acquisition, the Company have been eliminated in consolidation. Certain reclassifications recorded a $9.5 million charge in the year ended October 31, were made to Alta financial statements to conform to CIENA’s 1998 for purchased research and development. This generally presentation. No material adjustments were made to conform to represents the estimated value of purchased in-process technol- CIENA’s accounting policies. ogy related to Terabit’s avalanche photodiodes (APD) that have The following table shows the separate historical results of not yet reached technological feasibility and have no alterna- CIENA and Alta for the periods prior to the consummation of tive future use. the merger of the two entities: (in thousands) Revenues: CIENA Alta Intercompany eliminations Consolidated revenues Net Income (loss): CIENA Alta Consolidated net income Terabit Year Ended October 31, 1997 1996 $54,838 33,625 — ________________________________ $88,463 ________________________________ ________________________________ $14,718 2,545 ________________________________ $17,263 ________________________________ ________________________________ $373,827 39,531 (143) _____________________________________ $413,215 _____________________________________ _____________________________________ $112,945 3,022 _____________________________________ $115,967 _____________________________________ _____________________________________ During April 1998 the Company completed an Agreement and Plan of Reorganization with Terabit Technology, Inc. (“Terabit”), a developer of optical components known as photodetectors or optical receivers. Terabit is located in Santa Barbara, California. The purchase price was approximately $11.5 million and con- sisted of the issuance of 134,390 shares of CIENA common stock, the payment of $1.1 million in cash, and the assumption of certain stock options. The transaction was recorded using the purchase accounting method with the purchase price represent- ing approximately $9.5 million in purchased research and development, $1.8 million in goodwill and other intangibles, and approximately $0.2 million in net assets assumed. The The amount of purchase price allocated to in-process research and development was determined using the discounted cash flow method. This method consisted of estimating future net cash flows attributable in-process APD technology for a discrete projection period and discounting the net cash flows back to their present value. The discount rate includes a factor that takes into account the uncertainty surrounding the successful develop- ment of the purchased in-process technology. The estimated revenue associated with the APD technology future net cash flows assumed a five year compound annual growth rate of between 5% to 43%. The revenue growth rates were developed considering, among other things, the current and expected industry trends and acceptance of the technologies in historical growth rates for similar industry products. Management’s esti- mates or projections were based upon an estimated period of ten years with revenues reaching a peak in 2002 and declining through 2008. The estimated net cash flows were discounted to present value at a rate of return which considers the relative risk of achieving the net cash flows and the time value of money. A 30% rate was used to effect the risk associ- ated with Terabit’s APD technology. This rate is higher than the Company’s normal discount rate due to inherent uncertainties surrounding the successful development of purchase in-process technology, the useful life of the technology, and the profitability amortization period for the intangibles, based on management’s levels of such technology. estimate of the useful life of the acquired technology, is five The resulting net cash flows from the APD project was years. The operations of Terabit are not material to the consoli- based on management’s estimates of revenues, cost of sales, dated financial statements of the Company and, accordingly, research and development costs, selling, general and adminis- separate pro forma financial information has not been presented. trative costs, and income taxes associated with the project. 38 CIENA Corporation (3) INVENTORIES (6) EARNINGS PER SHARE CALCULATION Inventories are comprised of the following (in thousands): The following is a reconciliation of the numerators and denom- October 31, inators of the basic net income per common share (“basic Raw materials Work-in-process Finished goods Reserve for excess and obsolescence 1997 1998 $27,716 5,679 15,180 ________________________________ 48,575 (7,466) ________________________________ $41,109 ________________________________ ________________________________ $ 43,268 8,592 30,202 _________________________________ 82,062 $(11,154) _________________________________ $ 70,908 _________________________________ _________________________________ The following is a table depicting the activity in the Com- pany’s reserve for excess and obsolescence (in thousands): EPS”) and diluted net income per common and dilutive poten- tial common share (“diluted EPS”). 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 and shares issued upon conversion of all outstanding shares of Manda- torily Redeemable Preferred Stock (in thousands except per Beginning balance Provision charged to operations Amounts written off to reserve Ending balance October 31, 1997 $ 1,937 7,585 (2,056) _____________________________ $ 7,466 _____________________________ _____________________________ 1998 $ 7,466 9,617 (5,929) _______________________________ $11,154 _______________________________ _______________________________ (4) EQUIPMENT, FURNITURE AND FIXTURES Equipment, furniture and fixtures are comprised of the following (in thousands): Equipment, furniture and fixtures Leasehold improvements Accumulated depreciation and amortization Construction-in-progress October 31, 1997 1998 $ 65,444 13,953 ___________________________________ 79,397 ___________________________________ ___________________________________ (12,279) 500 ___________________________________ $ 67,618 ___________________________________ ___________________________________ $139,142 24,055 _____________________________________ 163,197 _____________________________________ _____________________________________ (41,144) 1,352 _____________________________________ $123,405 _____________________________________ _____________________________________ (5) ACCRUED LIABILITIES Accrued liabilities are comprised of the following (in thousands): Warranty and other contractual obligations Accrued compensation Legal and related costs Consulting and outside services Unbilled construction-in-process and leasehold improvements Other October 31, 1997 1998 $12,205 8,284 4,577 3,219 1,427 2,310 _______________________________ $32,022 _______________________________ _______________________________ $17,256 9,128 534 2,837 — 4,573 ________________________________ $34,328 ________________________________ ________________________________ share amounts). Net Income Weighted average shares—basic Effect of dilutive securities: Employee stock October 31, 1997 1998 1996 $17,263 $115,967 $ 53,194 ___________________________________ _____________________________________ ______________________________ ___________________________________ _____________________________________ ______________________________ 13,817 ______________________________ 75,802 _____________________________________ 101,751 ___________________________________ options and warrants 8,533 8,774 6,144 Conversion of preferred stock Weighted average shares—diluted Basic EPS Diluted EPS 70,057 ______________________________ 20,088 _____________________________________ — ___________________________________ 92,407 ______________________________ ______________________________ $ 1.25 $ ______________________________ ______________________________ $ 0.19 $ ______________________________ ______________________________ 104,664 _____________________________________ _____________________________________ _____________________________________ _____________________________________ 1.53 $ _____________________________________ _____________________________________ 1.11 $ 107,895 ___________________________________ ___________________________________ 0.52 ___________________________________ ___________________________________ 0.49 ___________________________________ ___________________________________ (7) STOCKHOLDERS’ EQUITY Stockholder Rights Plan In December 1997, the Company’s Board of Directors adopted a Stockholder Rights Plan. This plan is designed to deter any potential coercive or unfair takeover tactics in the event of an unsolicited takeover attempt. It is not intended to prevent a takeover of the Company on terms that are favorable and fair to all shareholders and will not interfere with a merger approved by the Board of Directors. Each right entitles shareholders to buy a “unit” equal to one one-thousandth of a share of Preferred Stock of the Company. The rights will be exercisable only if a person or a group acquires or announces a tender or exchange offer to acquire 15% or more of the Company’s common stock or if the Company enters into certain other 39 CIENA Corporation business combination transactions not approved by the (the “1996 Plan”). Under the 1996 Plan, 750,000 shares Board of Directors. of the Company’s authorized but unissued Common Stock In the event the rights become exercisable, the rights plan are reserved for options issuable to outside members of the allows for CIENA shareholders to acquire stock of the surviving Company’s Board of Directors. These options vest to the director corporation, whether or not CIENA is the surviving corporation, over periods from one to three years, depending on the type having a value twice that of the exercise price of the Rights. of option granted, and are exercisable once vested. Under The Rights were distributed to shareholders of record in January the 1994 Plan and the 1996 Plan, options may be incentive 1998. The Rights will expire December 2007 and are redeem- stock options or non-qualified options, and the exercise price able for $.001 per right at the approval of the Company’s for each option shall be established by the Board of Directors Board of Directors. Public Offerings In February 1997, the Company successfully completed its initial public offering of Common Stock. The Company sold 5,750,000 shares, inclusive of 750,000 shares from the exer- cise of the underwriters over-allotment option, at a price of provided, however, that the exercise price per share shall not be not less than the fair market value for incentive stock options and not less than 85% of fair market value for non-qualified stock options. Following is a summary of the Company’s stock option activity: $23 per share. Net proceeds from the offering were approxi- (in thousands) mately $121,800,000 with an additional $600,000 received Balance at October 31, 1995 from the exercise of 300,000 shares of outstanding Convertible Preferred Stock warrants. In July 1997 the Company completed a public offering of 10,477,216 shares of Common Stock of which 1,252,060 shares were sold by the Company inclusive of 252,060 shares from the exercise of the underwriters over-allotment option, at a price of $44 per share. Net proceeds to the Company from the public offering were approximately $52,200,000. Stock Incentive Plans Granted Exercised Canceled Balance at October 31, 1996 Granted Exercised Canceled Balance at October 31, 1997 Granted Exercised Canceled Balance at October 31, 1998 Shares Weighted Average Exercise Price 6,941 5,901 (579) (1,180) ____________________________ 11,083 1,737 (3,612) (98) ____________________________ 9,110 4,654 (2,648) (3,280) ____________________________ 7,836 ____________________________ ____________________________ $ 0.03 1.85 0.14 0.18 0.97 32.81 0.27 0.52 7.33 26.12 2.40 40.85 5.83 The Company has an Amended and Restated 1994 Stock Option During September 1998, the Company cancelled and re- Plan (the “1994 Plan”). Under the 1994 Plan, 20,050,000 shares issued outstanding employee stock options with exercise prices of the Company’s authorized but unissued Common Stock are in excess of the fair market value, except those options held reserved for options issuable to employees. Certain of these by outside directors and officers of the Company. A total of options are immediately exercisable upon grant, and both the 2,905,116 options with an average exercise price of $42.87 options and the shares issuable upon exercise of the options were cancelled and reissued at $12.38 per share. At October 31, generally vest to the employee over a four year period. The 1998 approximately 292,000 shares of Common Stock Company has the right to repurchase any exercised and non- subject to repurchase by the Company had been issued upon vested shares at the original purchase price from the employees the exercise of options and approximately 2.2 million of the upon termination of employment. In June 1996 the Company total outstanding options were vested and not subject to repur- approved the 1996 Outside Directors Stock Option Plan chase by the Company upon exercise. 40 CIENA Corporation The following table summarizes information with respect to stock options outstanding at October 31, 1998: Options Outstanding Options Not Subject to Repurchase Upon Exercise Range of Exercise Price $0.02-$0.03 $0.06-$1.66 $2.25-$4.34 $4.40-$11.56 $12.38-$12.38 $12.56-$43.25 $0.02-$43.25 Weighted Average Remaining Contractual Life (Years) 6.23 7.41 7.66 8.56 8.93 9.57 7.92 Weighted Average Exercise Price $ 0.03 $ 0.80 $ 2.48 $ 6.55 $12.38 $32.40 $ 5.83 Number Outstanding at Oct. 31, 1998 1,048,678 1,102,096 2,648,482 189,216 2,761,977 85,675 ________________________________________ 7,836,124 ________________________________________ ________________________________________ Number at Oct. 31, 1998 Weighted Average Exercise Price 878,524 363,080 450,455 47,818 419,150 $ 0.03 $ 0.80 $ 2.54 $ 6.15 $12.38 — $ — _______________________________________ 2,159,027 _______________________________________ _______________________________________ $ 3.21 Pro Forma Stock-Based Compensation The aggregate fair value and weighted average fair value The Company has elected to continue to follow the provisions of each option granted in fiscal years 1996, 1997 and 1998 of APB No. 25 for financial reporting purposes and has were approximately $6.7 million, $33.6 million, $73.0 million adopted the disclosure-only provisions of SFAS No. 123. Had and $1.14, $19.33, and $20.90 respectively. The fair value compensation cost for the Company’s stock option plans been of each option grant is estimated on the date of grant using the determined based on the fair value at the grant date for awards Black-Scholes Option Pricing Model with the following weighted in fiscal years 1996, 1997, and 1998 consistent with the average assumptions for fiscal years 1996, 1997, and 1998: provisions of SFAS No. 123, the Company’s net income and net income per share for fiscal years 1996, 1997, and 1998 would have been decreased to the pro forma amounts indi- cated below (in thousands, except per share amounts): 1996 October 31, 1997 1998 1996 60% 6.1% 3 yrs 0% October 31, 1997 60% 5.8% 3 yrs 0% 1998 109% 4.4% 3 yrs. 0% Expected volatility Risk-free interest rate Expected life Expected dividend yield (8) INCOME TAXES Net income applicable to common stockholders— as reported Net income applicable to common stockholders— pro forma Basic net income per share— as reported Basic net income per share— pro forma Diluted net income per share— as reported Diluted net income per share— pro forma $17,263 $115,967 $53,194 ________________________________ ____________________________________ ________________________________ ________________________________ ____________________________________ ________________________________ Income before income taxes and the provision for income taxes consists of the following (in thousands): $16,770 $110,404 $28,327 ________________________________ ____________________________________ ________________________________ ________________________________ ____________________________________ ________________________________ 1996 October 31, 1997 1998 Income before income taxes $20,816 $188,670 $93,429 ________________________________ _____________________________________ _______________________________ ________________________________ _____________________________________ _______________________________ $ 1.25 $ ________________________________ ________________________________ ____________________________________ ____________________________________ 1.53 $ 0.52 ________________________________ ________________________________ $ 1.21 $ ________________________________ ________________________________ ____________________________________ ____________________________________ 1.46 $ 0.28 ________________________________ ________________________________ $ 0.19 $ ________________________________ ________________________________ ____________________________________ ____________________________________ 1.11 $ 0.49 ________________________________ ________________________________ $ 0.18 $ ________________________________ ________________________________ ____________________________________ ____________________________________ 1.05 $ 0.26 ________________________________ ________________________________ Provision for income taxes: Current: Federal State Foreign Total current Deferred: Federal State Foreign Total deferred $ 4,483 $ 67,744 7,373 98 _____________________________________ 75,215 _____________________________________ 694 210 _______________________________ 5,387 _______________________________ 39,780 4,444 40 ________________________________ 44,264 ________________________________ (3,376) (2,015) (1,690) (653) (497) (144) — — — ________________________________ _____________________________________ _______________________________ (4,029) (2,512) (1,834) ________________________________ _____________________________________ _______________________________ $ 3,553 $ 72,703 $40,235 ________________________________ _____________________________________ _______________________________ ________________________________ _____________________________________ _______________________________ The above pro forma disclosures are not necessarily represen- tative of the effects on reported net income or loss for future years. Provision for income taxes 41 CIENA Corporation The tax provision reconciles to the amount computed by (9) EMPLOYEE BENEFIT PLANS multiplying income before income taxes by the U.S. federal Employee 401(k) Plan statutory rate of 35% as follows: Provision at statutory rate Reversal of valuation allowance Non-deductible purchased research and development State taxes, net of federal benefit Research and development credit Other October 31, 1997 35.0% — — 2.6 — 0.9 _________________ 38.5% _________________ _________________ 1996 35.0% (20.0) — 2.7 — (0.6) _______________________ 17.1% _______________________ _______________________ 1998 35.0% — 3.8 3.8 (3.6) 4.1 __________________ 43.1% __________________ __________________ In January 1995, the Company adopted a 401(k) defined contribution profit sharing plan. The plan covers all full- time employees who are at least 21 years of age, have completed three months of service and are not covered by a collective bargaining agreement where retirement benefits are subject to good faith bargaining. Participants may contribute up to 15% of pre-tax compensation, subject to certain limitations. The Company may make discretionary annual profit sharing contributions of up to the lesser of The significant components of deferred tax assets and $30,000 or 25% of each participant’s compensation. In liabilities were as follows (in thousands): fiscal 1997 the Company revised the plan to include an October 31, employer matching contribution equal to 100% of the first 1997 1998 3% of participating employee contributions, with a five Deferred tax assets: Reserves and accrued liabilities Other Net operating loss and credit carryforward Gross deferred tax assets Valuation allowance Net current deferred tax asset Deferred tax liabilities: Equipment leases Services Depreciation and other Deferred long term tax liabilities $ 9,281 — 1,555 ________________________________ 10,836 (1,697) ________________________________ $ 9,139 ________________________________ ________________________________ $ 3,985 19,389 4,793 ________________________________ $28,167 ________________________________ ________________________________ $14,611 690 1,562 _______________________________ 16,863 (1,562) _______________________________ $15,301 _______________________________ _______________________________ $ 7,978 21,594 4,553 _______________________________ $34,125 _______________________________ _______________________________ As of October 31, 1997 the Company assumed net operating loss carryforwards of approximately $4.5 million through its acquisition of Alta. The net operating loss carryfor- wards begin expiring in fiscal 2002. The income tax provisions do not reflect the tax savings resulting from deductions associated with the Company’s stock year vesting plan applicable to the Company’s contribution. The Company has made no profit sharing contributions to date. During fiscal 1997 and 1998 the Company made matching contributions of approximately $0.3 million and $1.1 million, respectively. Employee Stock Purchase Plan In March 1998, the shareholders approved the Corporation’s 1998 Stock Purchase Plan (“the Purchase Plan”) under which 2.5 million shares of common stock have been reserved for issuance. Eligible employees may purchase a limited number of shares of the Company’s stock at 85% of the market value at certain plan-defined dates, the first of which occurs in March 1999. As of October 31, 1998 no shares had been issued from the Purchase Plan. option plans or the exercise of certain stock warrants. Tax bene- (10) COMMITMENTS AND CONTINGENCIES fits of approximately $29.7 million and $23.4 million in fiscal Operating Lease Commitments 1997, and $22.6 million and $3.6 million in fiscal 1998, The Company has certain minimum obligations under from exercises of stock options and certain stock warrants were noncancelable operating leases expiring on various credited directly to additional paid-in-capital and to long-term dates through 2006 for equipment and facilities. Future deferred income taxes, respectively. annual minimum rental commitments under noncancelable 42 CIENA Corporation operating leases at October 31, 1998 are as follows Kimberlin Litigation. On September 9, 1998 the U.S. (in thousands): Fiscal year ending October 31, 1999 2000 2001 2002 2003 Thereafter $ 5,729 5,510 5,070 4,282 3,050 10,358 _______________________________ $33,999 _______________________________ _______________________________ Rental expense for fiscal 1996, 1997 and 1998 was approximately $717,000, $2,652,000 and $5,616,000, respectively. District Court for the Southern District of New York granted summary judgment with respect to federal securities law claims brought against the Company and certain of its individual direc- tors by investor Kevin Kimberlin and related parties, finding “no violations” of federal securities laws in the Company’s or direc- tors’ conduct. The Court also dismissed all related state law claims without prejudice, declining to exercise jurisdiction over these claims. The remaining state law claims, as well as the Company’s counterclaim against the Kimberlin-related parties, were fully and finally resolved in October 1998 by agreement of the parties. Litigation Pirelli Litigation. On June 1, 1998 the Company resolved Class Action Litigation. A class action complaint was filed the long-standing litigation with Pirelli S.p.A. The terms of the settle- on August 26, 1998 in U.S. District Court for the District of ment involve dismissal of Pirelli’s three lawsuits against CIENA Maryland entitled Witkin et.al v. CIENA Corporation et. al previously pending in Delaware, dismissal of CIENA’s legal (Case No. Y-98-2946). Several other complaints, substantially proceedings against Pirelli in the United States International Trade similar in content, have been filed. These cases were consoli- Commission, a worldwide, non-exclusive cross-license to each dated by court order on November 30, 1998. The complaint party’s patent portfolios, a five-year moratorium on future litigation alleges that CIENA and certain officers and directors violated between the parties. As a result of the settlement, CIENA recorded a certain provisions of the federal securities laws, including charge for the fiscal year ended October 31, 1998 of $30.6 mil- Section 10(b) and Rule 10b-5 under the Securities Exchange lion relating to the Pirelli settlement and associated legal fees. Act of 1934, by making false statements, failing to disclose material information and taking other actions intending to artificially (11) FOREIGN SALES inflate and maintain the market price of CIENA’s common stock The Company has sales and marketing operations outside during the Class Period of May 21, 1998 to September 14, 1998, the United States in Canada, The United Kingdom, Belgium, inclusive. The plaintiffs seek designation of the suit as a class action France, Japan, China and the Philippines. The Company has on behalf of all persons who purchased shares of CIENA’s common distributor or marketing representative arrangements covering stock during the Class Period and the awarding of compensatory Austria, Germany, Italy and Switzerland in Europe, and the damages in an amount to be determined at trial and attorneys’ Republic of Korea and Japan in Asia. The Company also fees. The proceedings are at an early stage. No discovery has has representatives in Mexico and Brazil. Included in been taken, and no prediction can be made as to its outcome. revenues are export sales of approximately $3.5 million, The Company believes the suit is without merit and intends to $11.7 million, and $117.1 million in fiscal years 1996, defend itself vigorously. 1997 and 1998, respectively. 43 CIENA Corporation REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of CIENA Corporation In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of changes in stockholders’ equity (deficit) present fairly, in all material respects, the financial position of CIENA Corporation and subsidiaries at October 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1998, in conformity with generally accepted accounting principles. These financial state- ments are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the finan- cial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP McLean, VA November 25, 1998 44 CIENA Corporation HISTORIC STOCK PERFORMANCE Market for Registrant’s Common Stock and Related The market price of the Company’s Common Stock has Stockholder Matters: fluctuated significantly and may be subject to significant fluctua- The Company’s Common Stock has been traded on the tion in the future. Much of the fluctuation during the third and Nasdaq National Market since the Company’s initial public fourth quarters of fiscal 1998 was related to the Company’s offering on February 7, 1997 under the Nasdaq symbol CIEN. planned and then terminated merger with Tellabs, Inc. The following table sets forth for the fiscal periods indicated the As of October 31, 1998, there were approximately high and low sales prices of the Common Stock, as reported on 784 holders of record of the Company’s Common Stock and the Nasdaq National Market. 103,239,704 shares of Common Stock outstanding. Price Range of Common Stock High Low stock. The Company currently intends to retain earnings for use Fiscal Year 1997 in its business and does not anticipate paying any cash divi- Period of February 7, 1997 to dends in the foreseeable future. The Company has never paid cash dividends on its capital April 30, 1997 $44.00 $22.25 Third Quarter ended July 31, 1997 $57.25 $28.50 Fourth Quarter ended October 31, 1997 $63.62 $43.00 Fiscal Year 1998 First Quarter ended January 31, 1998 $63.56 $47.44 Second Quarter ended April 30, 1998 $58.25 $37.25 Third Quarter ended July 31, 1998 $92.38 $46.88 Fourth Quarter ended October 31, 1998 $75.88 $ 8.13 The closing sale price for the Common Stock on October 30, 1998 was $17.56. CIENA CORPORATION 1201 Winterson Road, Linthicum, Maryland 21090 410.865.8500 800.921.1144