Infinera Corp (INFN) 2014 Q2 法說會逐字稿

Welcome to the Second-Quarter Year 2014 Investment Community conference call of Infinera Corporation.

All lines will be in a listen-only mode until the question and answer session.

(Operator Instructions)

Today's call is being recorded.

If anyone has any objections, you may disconnect at this time.

I now would like to turn the call over to Mr. Bob Jones of Infinera Investor Relations.

Bob, you may begin.

Thank you, Sharon.

Welcome to Infinera's Second Quarter of FY14 conference call.

A copy of today's earnings is available on the Investor Relations section of Infinera's website.

Additionally, this call is being recorded and will be available for replay from the website.

Today's call will include projections and estimates that constitute forward-looking statements.

This may include statements regarding Infinera's overall businesses strategy, market conditions, market and growth opportunities, Infinera's results of operations, views on Infinera's customers and its products, as well as Infinera's financial outlook for the third quarter of FY14.

These statements are subject to risks and uncertainties that could cause Infinera's results to differ materially from management's current expectations.

Please refer to Infinera's current press releases and SEC filings, including Infinera's most recently filed quarterly report on Form 10-Q and subsequent filings for more information on these risks and uncertainties.

Please be reminded that all statements are made as of today.

And Infinera undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call.

Today's earnings release and today's conference call also include certain non-GAAP financial measures.

These non-GAAP financial measures include non-cash stock-based compensation expenses, and amortization of debt discount on our convertible senior notes.

These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons.

And further, management does not consider these items to be related to Infinera's core operating performance.

Pursuant to Regulation G, Infinera has provided a reconciliation of these non-GAAP financial measures to the most directly-comparable GAAP financial measures in its second-quarter earnings release, which has been furnished to the SEC on Form 8-K, and it's available on Infinera's website in the Investor Relations section.

I would now like to turn the call over to Chief Executive Officer Tom Fallon.

Good afternoon and thank you for joining us on our Second Quarter FY14 conference call.

With me on the call are Chief Financial Officer Brad Feller and President Dave Welch.

I will touch briefly on the financial highlights for our second quarter and then provide an update on the market, our business, and an overview of the competitive environment.

I will then turn the call over to Brad, who will provide a more detailed review of our second-quarter results and our outlook for the third quarter of FY14.

Following our solid first-quarter results, we had an extremely strong second quarter.

I am pleased to announce that we achieved record quarterly revenue, record 100zh port options, positive GAAP and non-GAAP earnings, and positive free cash flow.

We continue to be well positioned, with a balanced and growing customer base across verticals; increasing geographic diversity with a growing partner program; and shifts in network architectures that are closely aligned with the innovations in both our current and soon-to-be expanding product portfolio.

Our revenue results were slightly above the mid-point of our previous guidance at $165.4 million, representing a nearly 20% year-over-year increase and 16% growth on a sequential basis.

Gross margin came in higher than guidance, at 43.3%.

And operating expenses were $57 million as we continued to successfully execute on our plan of growing footprint, expanding our gross margin, and increasing profitability.

The combination of higher gross margin levels and lower operating expenses allowed us to drive earnings which exceeded our guidance range.

We continued to see excellent DTN-X deployment momentum across a broad base of customer verticals in our second quarter.

We added four new invoiced DTN-X customers in the second quarter, one of which was a new customer to Infinera.

This positions us with 46 DTN-X customers to continue to capitalize on the 100G technology cycle.

These new DTN-X customers included a Tier 1 carrier in Mexico; one of the largest competitive carriers in North America; a Russian cable operator; and XO Communications, a long-time DTN customer upgrading to our DTN-X platform.

Three of these new DTN-X customers are existing customers converting from DTN.

Approximately one-third of our DTN customers have now converted to the DTN-X platform.

While not all DTN customers will require the scale necessary to convert, we continue to see a promising pipeline of activity within the installed customer base.

In addition to the new DTN-X customers, we added a new DTN customer, for a total customer count of 133 invoiced customers.

We also continued to expand our international footprint.

During the quarter, we were pleased to announce SEACOM as our second customer in Africa and to have secured a multi-terabit upgrade in the Asia-Pacific region with AJC.

Further, both customers that are new to Infinera were international.

Last quarter, I was pleased to report that Infonetics had selected Infinera as the top optical vendor in the world.

This quarter we were honored to have Light Reading award Infinera Company of the Year distinction.

I believe these recognitions are a reflection of our ability to deliver superior technology, excellent customer service and, most importantly, that our solutions help create a competitive advantage for our customers through time as a weapon, lower total cost of ownership, ease of use, and unparalleled reliability.

We continue to see video, cloud, and the increasing mobile and Wireline access speeds driving continued bandwidth growth across our markets, and anticipate 100G will be the technology of choice for many years to come.

In addition, we are seeing ICPs starting to build mega-data centers populated with hundreds of thousands of servers.

These servers are making the transition from 1G to 10G NIC speeds, and this combination is driving significant bandwidth demand between data centers.

With deployments in three of the top four ICPs, we have early insight into their future product requirements.

And I believe this, combined with our PIC technology, puts us in an advantaged position with both ICPs and other cloud and data center providers.

On that note, I would like to make a few comments on this rapidly-growing data center interconnect market and also the metro market.

We see the data center interconnect market segmented into long-haul and metro.

We see the very high-capacity metro portion of this data center interconnect market, which we are calling Metro Cloud, as distinctly different from a more traditional metro aggregation market, driven by telcos and cable operators.

We believe that large-scale 100G in the metro will happen first in the Metro Cloud market, starting in earnest in early 2015; and that 100G in the metro aggregation market will become interesting in late 2015 or early 2016, a view shared by many industry analysts.

We also believe application-optimized products are required for the Metro Cloud market due to the cost, size, and power requirements of these massive data centers, and that we have the right technologies, including our highly scalable PICs, to best address this emerging market.

In September, we will be hosting Insight Infinera 2014, a technology and market Summit, where we will provide a deep-dive look into this emerging opportunity and Infinera's specific plans to win in this market.

From an overall market perspective, competitors remain aggressive.

But I see a more rational pricing environment, as most real competitors are determined to create sustainable and profitable business models.

In regard to Infinera, I continue to be optimistic about our opportunities.

In the short term, I am confident, given our significant order backlog and the increased customer demand we are experiencing.

Brad will give more specifics on this during his portion of the call.

In the intermediate term, our visibility has returned to more normalized levels with significant amounts of pipeline activity, but more typical fidelity around the timing and probabilities of certain deals pertaining to Q4 of this year and Q1 of 2015.

That said, I continue to be convinced in our ability to gain share in the long-haul market on a yearly basis, as well as take meaningful market share with the new products we are going to introduce over the intermediate term.

We will discuss this further at our September Insight Infinera event.

Longer term, I am increasingly encouraged that Infinera will continue to demonstrate strong performance based on our technology and architectural leadership, and the necessity of transport playing a more strategic role in the networks of the future.

As we continue to talk to customers and industry analysts, we see several shifts occurring that are driving this conviction.

First, networks are converging, with more intelligence being driven into the optical layer.

In Dell'Oro's latest forecast, they have indicated that they are likely to collapse their core optical switching and packet transport into a single category because of the trend of convergence of WDM and digital switching.

Infinera pioneered this convergence.

And we believe that DPN-X is the innovation leader in this category, which is expected to be the fastest-growing part of the long-haul DWDM market, with a five-year compound annual growth rate of 16%.

Second, the migration of high-capacity requirements into the metro provides a new opportunity for us to use differentiated PIC technology to bring customers the experience they have grown to count on in the core.

The overall metro market is estimated to be over $7 billion by 2018, with the main growth driver being 100G, according to Dell'Oro.

This high-capacity 100G segment, which we plan on addressing, represents a significant opportunity for expansion.

Third, the emerging high-capacity metro and long-haul cloud market is an opportunity we believe will be best served with high-tech capacity PIC-based solutions.

While this category is currently tracked as part of the overall DWDM market, we believe that this market will grow extremely quickly and may add to the overall TAM of the DWDM market.

Finally, as SDN and NFV trends mature and the higher networking layers become more virtualized, we believe that the evolving transport layer will become more strategic.

A significant paradigm shift from the last decade, where the optical network was often viewed as a set of static pipes.

If architected thoughtfully, this new converged transport layer can play a key role in enabling dynamic network programmability and automation, and provide the responsiveness and adaptability demanded by our customers' evolving networks.

While networking flexibility becomes paramount, we believe optics will be the primary network scaling mechanism, requiring continued innovation at the physics level to create breakthrough capacity increases.

This intersects directly with the domain of our differentiated and highly-defensible PIC technology, where we are confident we have a multi-year lead over the competition.

As higher value is placed on the optical layer, whether in the core or metro, I believe Infinera will be one of the few companies that have the architectural and technological innovation, balance sheet strength, and demonstrated executional excellence to be successful in these growing markets.

In summary, we are pleased with the performance of the business in the second quarter and first half of the year.

We have entered the second half of 2014 with solid momentum and believe FY14 will be another strong year for Infinera.

Our focus for the remainder of FY14 remains winning new footprint, driving toward our intermediate business model financial goals, and beginning the process of expanding into and winning adjacent markets.

Finally, I would like to thank our customers, employees, and partners for their ongoing commitment to Infinera.

Now I'll turn the call over to Brad for a more detailed financial review of the quarter and our outlook for the third quarter.

Thanks, Tom.

Good afternoon, everyone.

As Tom mentioned, we reported revenue of $165.4 million for the second quarter of 2014, an increase of nearly 20% as compared to the second quarter of 2013 and just above the mid-point of our guidance range.

Our revenue increased by nearly 16% on a sequential basis, as we continue to see strong demand for our products across multiple customer verticals.

As was the case in the first quarter, our top five customers in Q2 came from a variety of customer verticals, including two Internet content providers, a cable MSO, a Tier 1, and a bandwidth wholesaler.

We had two greater-than-10% customers in the quarter, a North American Tier 1 service provider and an Internet content provider.

Demonstrating the continued strong demand for the DTN-X, we added four additional DTN-X invoice customers this quarter, including one new to Infinera and three existing DTN customers who transitioned to the DTN-X.

This brings our total DTN-X customer count to 46.

We continue to see strong RFQ activity, with customers looking to adopt the DTN-X platform, which we expect to add to our DTN-X customer count in the near future.

International revenue totaled $29 million, or 18% of total revenue.

EMEA accounted for $19 million, or 12%, with APAC and Latin America each representing 3%.

Coming off a relatively soft first half of the year, we anticipate growth within multiple international accounts in the second half of 2014.

Service revenue for the quarter was $23 million, an increase of 30% year over year, driven by both increased deployment services as we continue to win new routes and higher ongoing support revenues as we continue to grow our installed base.

Service revenues increased sequentially 24%, largely as a result of increased deployment activities.

Moving next to gross margin and operating expenses, our overall non-GAAP gross margin for the second quarter was 43.3%.

This is significantly better than the mid-point of our guidance of 40%, as increased fill activity more than offset certain new footprint deployments that shifted into Q3.

Service gross margin was 60% in the quarter, down both sequentially and from the year-ago period, as a result of the increased mix of deployment services.

We are excited about the higher overall gross margin levels but are cautious that as we continue to grow footprint in the second half of the year, our ability to maintain these levels will be highly dependent upon the continued trend of customers adding significant new capacity to their networks.

Our non-GAAP operating expenses came in at $57 million, which is below our guidance of approximately $59 million, as certain R&D spending pushed into the second half of the year.

Our SG&A expenses were relatively in line with our expectations.

Taken all together, we achieved a non-GAAP operating margin of 9% for the quarter, demonstrating the leverage in our financial model, as we continue to grow revenue.

This is a significant improvement versus 4% in Q1 2014, and an operating loss in the year-ago period.

In Q2, our interest and other expense was $700,000; and tax expense was $600,000.

The shares used to compute diluted non-GAAP EPS during the second quarter were $127 million, up from $125 million in the prior quarter as result of stock issuances.

In total, this resulted in non-GAAP net income for the second quarter of $13 million, or $0.11 per diluted share.

This is $0.07 higher than the mid-point of our guidance, driven by higher gross margin levels and lower operating expenses.

We are very proud of the financial results we were able to deliver in the second quarter, and believe that these solid results represent yet another proof point of our ability to deliver strong financial results over time.

Now summarizing Q2 results on a GAAP basis.

We had net income of nearly $5 million, or $0.04 per diluted share, a significant improvement as compared to a net loss of $10 million, or $0.09 per diluted share, in the year-ago period.

On a sequential basis, we turned a $0.04 loss in the prior quarter into $0.04 of income in Q2.

The difference between our GAAP and non-GAAP results during the second quarter was due to stock-based compensation expense of $7 million and $2 million of amortization of debt discount.

Now turning to the balance sheet, cash, cash equivalent, and investments.

As of the end of the second quarter, were $355.5 million, an increase of over $6 million from the previous quarter, largely driven by the strong overall profit levels of the business.

We generated cash from operations of $10 million in Q2.

This compared to using $15 million in operations in Q1, a net improvement of $25 million quarter over quarter.

As we have stated in the past, cash generation is one of our top priorities.

And we remain confident in our ability to generate cash over the course of the full year.

Moving next to our outlook for the third quarter of FY14, we currently project revenue to be in the range of $165 million to $175 million.

The mid-point of this range represents year-over-year growth of nearly 20%.

As mentioned on our Q1 earnings call, we expected to see elevated revenue levels in both Q2 and Q3.

This is playing out in our results and our outlook, as we continue to see strong demand across our customer base at new customers, as well as growth with existing customers.

Although we remain very optimistic about our core business, as Tom mentioned, our intermediate visibility has returned to more normal levels, causing us to be cautious about our ability to maintain revenue at these levels as we exit the year.

We currently project non-GAAP gross margin to be in the low 40%.

Where we end up will depend largely on whether we continue to see increased fill activity across our customer base, or whether there will be a pause as customers digest the capacity they purchased in Q2.

We have consistently stated that this year is about footprint win in the growing 100G market.

The ultimate gross margin result will depend on the mix of footprint and fill.

We currently anticipate non-GAAP operating expenses to be $61 million, plus or minus $1 million.

Our year-to-date R&D expenses are quite a bit lower than planned, and we will need to ramp the levels of spend a bit over the remainder of the year to ensure we can deliver on our planned road map.

Although there may be minor fluctuations in our operating expense levels from quarter to quarter, we remain committed to our target of R&D expense at approximately 20% of revenue on an annual basis.

Maintaining this level of R&D expense is important to allow us to continue to develop additional features for our long-haul offerings, but also allowing us to expand into adjacent markets.

With regard to our SG&A expense, although we will need to increase spend over time to support growth, we anticipate this to be slower than revenue growth, driving additional financial leverage.

At the mid-point of our projected guidance, this should translate to a non-GAAP operating margin of 6%, plus or minus 100 basis points, largely dependent on the gross margin results.

The combination of interest and other expense is expected to net out to approximately $500,000, and tax expense should be approximately $600,000.

We currently expect the diluted share count to be approximately 128 million shares, and project non-GAAP EPS to be $0.07 per diluted share, plus or minus a couple of pennies.

We currently expect GAAP EPS to be lower than non-GAAP EPS by about $0.07 per share, primarily related to stock-based compensation expense.

On the balance sheet, we currently expect to generate positive free cash flow in the third quarter.

The first six months of the year represented strong execution in the business, reinforcing our view that the 100G market is growing and our belief that we will be able to grow our business faster than the market during 2014.

We are excited about the opportunities we continue to see with both new and existing customers.

We are also excited about the additional technologies we are developing for both the long haul and adjacent markets.

Additionally, after delivering the strong financial performance in Q2, we are increasingly excited about our ability to deliver solid financial results over the course of 2014.

With that, I'd like to turn the call over to the operator to begin the Q&A portion of the call.

(Operator Instructions)

George Notter, Jefferies.

Hi there.

Thanks very much guys.

Can you hear me?

Yes.

Great, thanks.

I wanted to touch on your commentary about intermediate visibility, I guess, returning back to normal levels.

What precisely are you talking about there?

Are looking at Q4 being below seasonal norms?

Is it a byproduct of bookings or backlog?

Is it just simply that this large customer you've got here in Q2 and now also in Q3 just rolls over and finishes up their network build?

Can you give us more flavor for what's going on there?

Thanks.

Sure, George.

What we have said historically is kind of normal visibility is we have a really good feeling for the first quarter, and not much data yet supporting a definitive answer for the quarter after that.

The last couple of quarters we've been pretty clear that visibility was higher than usual.

We had pretty much -- a pretty good two-quarter look.

I think we're back to the normal -- the current quarter we understand pretty well.

Next quarter we have a lot of indications that there's a lot of pipeline activity.

We see lots of RFQ's.

There's lots of potential new customers, but there's just less fidelity around the specifics of those on either timing or if we will win.

I think one of the reasons is we've been carrying bigger backlog than we desire.

I've been pretty crystal clear for years now about time as a weapon.

We can only do that obviously if when customers order they get that product pretty quickly.

We've been running a couple weeks longer in lead time than I desire from a customer support perspective as we've ramped up.

We're going to bring that back down to what I consider normal levels, where we represent another unique value proposition to our customers.

We have longer lead time and more backlog, as it takes longer for people to get their gear, they also then have to digest that gear.

I think that in conjunction with visibility being more normal, we also have a little bit of higher backlog that causes other people's plans, our customers' plans, to be less clear.

There's nothing in my mind alarming about this view.

It's just going back to normal.

Got it.

Okay, fair enough.

I also wanted to ask about the gross margins, obviously real strong here in Q2.

You talked about 2014 being a year of footprint grab.

Can we think a little bit about 2015?

I think in the past you guys have talked about the market potentially going back to a more normal mix of line cards versus chassis.

How do you see that playing out, and what gives you the confidence that we return to that more normal mix?

What does that therefore translate into in terms of what gross margins could look like out into next year?

Thanks.

Sure.

As we've talked about in the past, on a normal basis between 18 months and two years after initial deployment, customers will come back for that next layer of fill.

Obviously we saw some strong fill activity in Q2, which is why you saw the stronger gross margin results.

We still expect in 2015 to continue to grow footprint.

But that level of fill we expect to continue to ramp up and become stronger and stronger throughout 2015, to where you start to get to on a more steady-state basis a more normalized mix.

As a result, you start to see margins more like our mid-point model of 45 points.

The longer it takes us to get there, George, quite frankly the better off we are in long-term shareholders.

But I agree with Brad.

We anticipate that starting to balance out next year.

Okay.

Thanks very much, guys.

Simona Jankowski, Goldman Sachs.

Hi.

I did have one follow-up on the gross margin question.

I think you discussed the interplay of the mix there between fill and footprint, but can you also give us an update on where you are in terms of both utilization and yield in the fab?

I recognize you don't disclose the precise numbers, but if you can just give us a sense for how much head room there is there, as well?

Yes, Simona, I can give you some directionality, but you're right, we don't break out that level of detail.

You can believe that the team continues to drive up the yields of the product in the fab.

As we continue to grow the overall revenue numbers, we are increasing the level of capacity that we are absorbing in the fab.

There is still some room to grow there, though.

I will give slightly more color.

I would say our yields overall are at or slightly above planned, so we are executing to what we think.

We actually have a lot of experience in this now.

We are being a little bit favorable on the current yield we are experiencing.

On a capacity perspective, we do marginally increment capacity periodically with CapEx, but we still have a reasonable amount of head room to afford ourselves a lot of growth with the current infrastructure.

As we think about you guys expanding into adjacencies as you started to detail in terms of the metro opportunity, roughly how many years should we think about you having of head room ahead of you in terms of capacity?

And how many points of growth margin upside do you think there is to grow into as you expand your revenue base?

Simona, it really depends on how much success we get in these adjacent markets.

As Tom mentioned there is a reasonable amount of head room there.

We like the new products we're coming out, and our hope is that we run out of capacity quicker than longer.

That's the dynamic I would look at in terms of that component.

Then last question on the --

Real quickly, this is Tom.

Some of our CapEx in the fab has a fairly long lead time cycle of both buying it and then deploying it, somewhere in the 18 months to three-year time frame.

Don't anticipate us making any of those purchases this year, but as we start making those kind of decisions, we would certainly make that available to the shareholder community, because it's a long-term investment.

Sure.

Appreciate that.

One last question on the timing of the metro opportunity, which I think before you had talked about the real volume in the industry, which is typically what you look to intercept, happening more toward the end of 2015.

But now you broke that opportunity up into two parts, the aggregation piece and the cloud piece.

It sounds like the cloud piece you think will be taking off in early 2015.

Is that a little bit of a change in the timing of when you think you'll be intercepting that opportunity?

We're going to try to always intercept opportunities as the opportunity becomes interesting, which is with volume.

You can anticipate we're going to go hard after both the cloud interconnect market, and the more long-haul market or aggregation market.

Simona, I'm going to hold off on giving any more details, because I'm excited about people coming to visit us in September to get a deep dive on what we are doing.

Okay, sounds good.

I'm planning on it.

Thank you.

Sanjiv Wadhwani, Stifel.

Thank you.

Tom, I wanted to ask about some of the M&A that's taking place in the industry, specifically with their customers.

You guys have some decent exposure on the cable side.

Would love to get any details on if you're seeing any lumpiness in spending because of M&A, and then thoughts on spending in that vertical going forward?

Thanks.

So far we have not.

We've come into this before seeing any disruption of spend.

I anticipate that through this year there won't be a positive or negative impact.

I think as that specific deal I think you're referencing comes closer to fruition we will have a better insight into it for next year.

I think it is too early to call what it means for next year.

For this year, I think it doesn't have any impact, at least to us.

I can't speak for everybody in the industry, but not to us.

Got it, okay.

Brad, I think for next year you were commenting about gross margins, and as you see more fills, et cetera, it will help gross margins.

You commented about 45%, which is more normalized mid-point.

Are you guiding to 45% gross margin for 2015, or any color over there?

Thanks.

Yes, Sanjiv, we don't guide over more than a one-quarter period.

I'm trying to give you a feel for the fact that they should be in those types of levels over the course of the year.

Obviously that can change from quarter to quarter, but you should see a step function up in 2015.

And then 2016 and then longer term we think there's even more head room from there as we -- to Simona's point, continue to fill up the fab and grow in these adjacent markets.

Got it, that's helpful.

Thank you.

Alex Henderson, Needham.

Yes, let me start off with the most mundane.

There was a little crackling on the line when you gave the EPS number.

I was wondering if you can just repeat it?

It $0.07, plus or minus $0.02.

Plus or minus, thank you.

The question I wanted to ask is you made a tantalizing comment about soon-to-be announced new products.

Obviously you're not announcing them here, but can you give us some sense of when we might be anticipating those product announcements?

Any granularity on that?

I like that you used the word tantalizing.

That gives me great expectations that will be great interest.

We have a history of not bringing things to market or launching things or really expressing them until they're pretty close to being ready to go to customers.

I'm not -- never been an advocate of doing product launches way ahead of time, so you should anticipate that it's in the relatively near term.

Super.

I look forward to hearing about those at the Analyst Day, I guess.

On the --

(multiple speakers) It's in the quiet period, so we have to be very careful of not talking at all about finances.

Well, there you go.

Yes, so we're just going to inundate you with tantalizing products and technology.

Can you go a little bit into a little bit more granularity in the European theater, on whether the situation in the Ukraine-Russian markets are having any impact on you guys in any form, fashion, or other variable?

Yes, I think Brad commented that the first half of year was a little slower in Europe.

I think part of it is North America has been remarkably strong.

But we don't see any fundamental problem in the bulk of the European business, and we anticipate as he had commented that in the second half of year we see some reasonably good opportunities.

I anticipate as a percentage of business it will increase.

In regard to Russia specifically, we've commented before that we are continuing to sell in Russia.

On the last call we made the comment that we are staying mindful of the uncertainty.

If anything, in the last quarter that uncertainty in my mind has grown quite substantially.

We continue to sell in Russia.

We continue to see opportunities in Russia.

I continue to be growing more cautious on baking that into our forecast in the near term.

Okay, so is there any financial risk as a result of those transactions in terms of exchange-rate swings or cost elements that we should be thinking about?

No.

Tom's commentary -- the current business, we don't expect to see any impact.

It's just -- it may impact the timing and size of future deals.

Going back to the metro side of it for a second.

Sienna made the comment that 20% of their sales of Coherent went into the metro last quarter.

Would you characterize the market currently as straight cloud interconnect within that context of the granularity that you gave earlier?

It seems like the coherent market is seeing some move into metro, but it's not clear from what's been said whether you would -- which category that would fit into?

Yes, this is Dave Welch -- as we stated before, we do supply some of our products in the high-capacity metro, or even metro regional markets.

The application of that is high-capacity aggregation rings, or and/or high-capacity data center connections to that.

That is, if you look at the historical numbers of the growth rate and the total unit volume that we expect out of the metro market is insignificant to the opportunity that's out there.

Currently we supply, with the exclusion of China, we supply the -- are the largest supplier of 100-gig technologies out there.

We expect the metro market to turn on, as Tom indicated, from a volume perspective from the data center connections, start turning on more so in 2015, and the aggregation rings late 2015, beginning of 2016.

You will see applications within that, or prior to those dates, but from a volume perspective I don't think they will really be that accelerating until those time frames.

One of the things I'm asking you to think about, Alex.

We certainly understand that today there are some 100-gig coherent being deployed in the metro.

I picked the word interesting for the volume of it carefully.

If you look back on the long-haul market, the initial 100-gig coherent entered the market in 2010.

The market became interesting 2012, 2013 time frame.

That's when the bulk of the decisions were made.

That's when the bulk of the dollars started to ramp.

It's when market share was earned.

It's the path we followed with the DTN-X, and I think that has served us quite well.

When we say that 100 gig in the metro becomes interesting in lat 2015, 2016, you should map into that kind of model.

One last question, then I will cede the floor.

In looking at companies like Google pushing out 500,000 server data centers -- these hectare-scale plants, and then connecting them with DWDM systems, will there be a difference in the scale of the initial deployments when they do at data center to data center build, in terms of the capacity necessities that that implies, than your typical build on a long-haul backbone or a metro backbone?

I would assume that they would have much larger initial point-to-point capacity needs, and therefore the utilization of the box would be higher initially than the traditional loadings.

Is that correct?

The right way to think about in the scale these 100-acre types of data center scenarios is 0.5 million servers, you've got a 70/30, 80/20 type of internal traffic to external traffic So yes, the scale of the connections and the extra traffic from these large data centers can be large.

It is unclear of how many of these huge data centers will be built, but it is certainly a great opportunity to see the bandwidth grow associated with that.

If you want to do your math and you think about the type of traffic, then really a 70/30, 80/20 is not a bad ratio for the traffic that stays in the building versus the traffic that goes outside the building.

The loadings are going to be comparable, smaller, bigger?

Can you give us some sense of what the initial builds look like?

I think if you could take your number of 500,000 servers and they're operating at various stages of 10-gigabit or 40-gigabit types of capabilities, you can add up bandwidth pretty quickly on what that looks like.

I get it.

Thanks.

We historically see pretty high fill rates within the internet content provider space, in comparison to more traditional markets.

Thank you, that's very helpful.

Rod Hall, JPMorgan.

Hi, thanks for taking my question.

This is Ashwin on behalf of Rod.

I was hoping you could clarify one of the comments you made around sustainability of momentum being dependent on capacity expansions.

Is that more related to revenue momentum, or gross margins up side?

My second question really is on, Tom, you talked about having the technology and capability to support data center interconnects.

Now what additional features do you think you need to have in order to develop for traditional metro product?

Finally, I was hoping you could comment on the concerns around CapEx related to tier ones here in the US, and probably juxtapose that with your moderated view on medium term.

Is there any underlying softness in the market?

Does it make sense that there's concerns around CapEx?

Will it have any impact on the optical market, generally?

I will take the first part of the question and let Tom address the second part.

The first part of your question related to gross margin, so we were talking about where in the low 40s margin will end will depend highly on that mix of footprint and fill.

I want to make sure we didn't confuse you talking about capital expansion internally in short-term driving margin issues.

There's no substantive CapEx expenditures planned internally right now.

I don't want you walking away saying, or thinking we have to go and put a lot of CapEx into expanding the fab.

We have good yield profile.

We have good availability to expand our output based upon our current CapEx infrastructure with normal spend of what, 5% of revenue on that.

You shouldn't assume any kind of change in model of that.

Does that answer the question?

Yes, thanks.

In regard to tier one CapEx, and I'm going to give -- Dave talked about technology for ICP tier one CapEx, I'll make a couple comments.

We're up to now 16 tier ones.

We had a tier one that was a top-five customer.

Our business with tier ones continues to be robust.

Is the tier one market afford us a lot of opportunity to grow with that?

It does.

But we are not seeing any kind of specific challenges.

I know I've made this comment before.

Typically, when people ask about tier ones, they're specifically asking about AT&T and Verizon CapEx.

We don't have real exposure to that, so I don't really have any insight for you, other than to comment I continue to believe that -- those two players in that market continue to get undue type of view for how much of the market they are.

They're important, but I think that other spaces -- internet content, cable, wholesale are driving a huge amount of the CapEx expansion.

For transport, the discussion around the tier ones defining the market I really think is not a good service to the view.

In regard to the technology for the internet content space in addition to PICs, I don't know, Dave, if you want to make any comments?

The Internet content space, along with frankly a good chunk of the restaurant market, their number one need is scalable technology, the ability to deliver high bandwidth and the growth of bandwidth for that.

If you look -- here you are in a transition from 10 gigabit to 100 gigabit, 40 gigabit being a very short-lived opportunity, it's a huge -- it's a result of a shift of high-capacity demands still growing.

The technologies are very similar.

This is where our original focus, which was on developing photonic integrated circuits, in order to manage high-capacity opportunities, and developing intelligent transport networks for the convergence of digital and optical technologies on a common platform.

It has served us well, and will continue to serve us very well.

Being optimized -- optimize offerings for high-capacity at-scale deployments is directly -- is a target of our technology choices.

Okay, thank you.

Michael Genovese, MKM Partners.

Great, thanks a lot.

Listening to your commentary, it sounds to me the Level 3 100-G footprint build may have slipped into the third quarter from the second quarter.

Can you comment on that?

Yes.

Mike, we can't comment on a specific -- what mobile will do in the third quarter, this kind of stuff.

What I will say about Level 3 is we mentioned that they were going to come on as a 100-gig customer this year.

They have.

They have ramped -- probably a little bit slower than we expected, but for the year we think they will do a nice piece of business with us, and will be a great customer and 100-gig for a long time.

Okay.

For the record ports in Q2, can you just generally talk about in general terms the percentage that's tied to new footprint build in that quarter?

And then the percentage that's channel fill related to networks that were built in previous quarters?

Can you give us a sense of that?

Maybe I can make a comment.

We don't break it out between how much was of our build from new build or fill.

The vast majority of our networks to date are lightly filled that we have deployed, so there is still a tremendous amount of growth to be had in that.

We continue to put on significant amount of new footprint every quarter, and we expect that trend to continue.

Okay, then last one for me.

Just a comment about the fourth quarter that you made.

I think Tom you said something about a flat to down quarter, which makes sense.

But I just wanted to clarify whether you are using 3Q or 2Q as the base which we might be flat to down from in 4Q?

Most importantly, I did not comment that it would be flat or down or up.

We've said that we've gone to more normal visibility.

I think Brad commented that based on that visibility it brings us more uncertainty of whether we will be able to maintain the revenue of Q3.

Please don't read anything more into that than what was said.

Okay.

Great, well congratulations on the great results and guidance

Thank you very much.

(Operator Instructions)

Dmitry Netis, William Blair.

Two quick ones for me.

Nice win there with XO, obviously existing customers.

In the past, I think Tom it hovered around 10% of revenue, somewhere in that ball park.

Is it reasonable to expect that during this DTNX cycle this customer can achieve the same revenue breakdown?

I'm not going to comment on what percentage they might have been in the past.

It varies so much quarter-to-quarter and year-to-year.

Obviously they are very large customer.

We have a great relationship with them.

They have the potential of buying a lot of gear, but we are not sole source there.

There's another person that's also qualified in, that we've now earned a second spot.

I think we're going to have a lot of good opportunity with them.

But I'd be cautious of baking in any kind of percentage of our corporate revenue based on them.

Okay.

Are they deploying as we speak, or is this a time line issue?

They're deploying as we speak and I anticipate they're going to deploy for a long, long time.

Great.

Okay, good.

The second question on the R&D, that 20% of revenue, is that an annual number?

I think that's what you said.

If that's the case, are you basically guiding that both 2015 and 2016 should be modeled at that 20% on the annual basis?

Yes, that's the target.

It'll have some small fluctuations from quarter-to-quarter, but 20% of revenues is what we're targeting.

Obviously we've alluded to several times in both Tom's and I's prepared remarks about going after adjacent markets.

We do think 20% of revenue is a good level for us in balancing both our future road map, but also looking at the profitability of the business.

I will comment, just to clear down what Brad said.

I think for 2015 certainly 20% is a reasonable number to model.

I think over time what we have said that as we achieve certain scales, we believe that we should be able to bring that down as a percentage.

We'll always be a technology Company.

We'll always be a deep R&D Company.

Beyond 2015, quite frankly, I don't know enough yet to say what the number will be.

So 20% is a max, but at some point you should think about it's not a permanent 20%.

I don't know what the scaled number is, but it's not a permanent 20%.

Right, that helps.

The reason I ask this question is because you obviously have this spur of activity with regards to metro launch and product development.

Coming in 2016 I get there's different items on the road map, but whether they take as much of R&D as metro is what I was trying to ascertain here.

Thank you very much.

That's helpful.

You bet.

Brian Coyne, National Alliance.

Hi, guys.

Thanks for taking my call.

Two quick ones.

First, help me understand just maybe a little bit of your commentary around the more normalized outlook.

If you go back to the end of the last quarter, would the improvement in the outlook that you had into 2Q and 3Q -- is that really given by that one large North American order that's being deployed?

Or was it more broad-based?

I guess I'm just trying to understand when you're thinking about a little farther out into Q3 and Q4, is it just because that one order -- that sled moves through the business and then everything else really didn't change?

Or was more the visibility also impacted by any changes in any other customers?

If you look at our results over the last couple of quarters, we've been pretty consistent that we've had a pretty mixed bag of customers as top five -- cable guys, internet content guys, wholesalers, tier ones.

What I would say is that we are in a very fortunate position of having a lot of opportunities spread a lot across a lot of vertical places, and we had this incremental order that was substantive on top of that.

That created one, bigger backlog then we feel comfortable maintaining while promising time as a weapon.

But it created hugely beneficial visibility, because the combination of both those things or all those things hitting simultaneously.

It was a much broader base than one big order from one guy.

Got it, that's helpful.

Secondly, your comment on the more rational pricing environment.

Does that imply -- is it just simply the fact that some of the legacy guys aren't showing it maybe quite as consistently, or is there something else perhaps that's driving the rationality that you're seeing?

The follow-on to that is, does that condition in the pricing environment give you any additional head room to maybe price a bit more aggressively as you look to gain [to prentis] over the next year, year and a half?

No, I'm not going to advocate that we price more aggressively.

I think we're pricing fairly and we're competitive.

I think our customers appreciate the value proposition.

I think that part of it is the winners being defined in the 100-gig market are becoming pretty declared.

I've actually had some customers on deals we've won tell me the competition was so low, and these are with some people that were I'd say financially not necessarily as solid as others, that it causes them alarm.

That if they're pricing that way, it makes them concerned for the competitors', our competitors', long-term viability.

That's a nice place to be, for a change, when low price actually can cause a customer to be concerned about long-term viability.

I think, as I said, there's going to be new winners and new users as we move to this 100-gig coherent, this super-channel market.

I firmly believe we're a new winner.

I think that the market continues to be over-served, and it's going to be rationalized over the next many years, both in the long haul -- that's already started -- and in the metro.

We're going to try to accelerate that by going hard into that space.

For the most part it's still very competitive.

It's still over-served, but I'm seeing -- this might change quarter-to-quarter, I'm seeing currently fairly rational behavior.

That's great, Tom.

Thanks a lot, and nice job on the quarter.

Thank you.

I am showing no further questions at this time.

I'll turn the call back over to Mr. Fallon.

Thank you guys very much for joining us this afternoon for your questions.

We look forward to updating you on our continued progress, and hope to see you in September.

This concludes today's conference.

Thank you for your participation.

You may now disconnect.