Infinera Corp (INFN) 2016 Q2 法說會逐字稿

Welcome to the second-quarter year 2016 investment community conference call of Infinera Corp.

(Operator Instructions)

Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Mr. Jeff Hustis of Infinera Investor Relations. Jeff, you may begin.

Thank you, operator. Welcome to Infinera's second-quarter of FY16 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.

This call will include projections and estimates that constitute forward-looking statements. These may include statements regarding Infinera's overall business strategy, market conditions, marketing growth opportunities, Infinera's results of operations, views on Infinera's customers and its products, integration of Transmode as well as Infinera's financial outlook for the third quarter of FY16. 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 conference call include certain non-GAAP financial measures. 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 is 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 2016 conference call. Joining me today are Chief Financial Officer Brad Feller and President Dave Welch. Today I'll go over financial highlights for Q2 and provide an update on our business and how current dynamics are affecting us.

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 2016. I was very pleased with our financial performance in Q2, with revenue of $259 million, Non-GAAP gross margin of 50% and non-GAAP earnings of $0.21 per diluted share. Overall the first half of 2016 has been strong with year-over-year revenue growth of 28%, 50% gross margin and 13% operating margin.

Our recent results are supported by the latest industry studies reported that Infinera posted strong market share gains in long-haul and data centers and a slight gain in Metro. Fueled in particular by our traction with ICPs and wholesale and enterprise carriers, Infinera has continued to be the long-haul leader in North America with roughly 40% market share as of the end of Q1. Our strength with ICPs is also reflected by both Ovum and Dell'Oro again ranking Infinera number one in worldwide market share in Q1 for combined ICPs and carrier-neutral providers.

In Q2 ICPs and wholesale and enterprise carriers remain strong as these customers continue to invest in DTNX for long-haul capacity, and Cloud Xpress for DCI. Cable also performed well in the quarter and delivered strong results for the first half of the year, despite a near term potential for demand and pricing pressures stemming from acquisitions in the industry. I am very pleased with our continued success in DCI, as we posted another record revenue quarter for Cloud Xpress.

This outstanding DCI result enabled us to deliver strong revenue in Q2, overcoming the early signs of a softer spending environment from our traditional telco customer base that we began to see late in the quarter. Looking more broadly at the market, there are concerning signs of slowing demand in the primary markets we serve. While the overall DWDM market is growing 6% to 8% in 2016, recent estimates from Cignal AI and to Dell'Oro suggest that roughly half of this overall growth is attributable to China.

Additionally, we're monitoring ongoing macroeconomic developments, though we cannot predict their impact on our business. In my estimation, while demand appears solid in our smaller regions like LATAM and APAC, we're seeing a softening demand environment from certain customers in North America and Europe. Now to go more in depth on our different end markets.

Our long haul demand continues to be driven by capacity adds of deployed networks. Leveraging available capacity in our 100G networks empowers customers to easily and quickly address traffic demand, either by plugging in 500G superchannel line cards, or activating instant bandwidth licenses. The products that will incorporate our new Infinite Capacity Engine remain on track and will accelerate Infinera's differentiation substantially by equipping customers with even higher capacity line cards, enhanced fiber capacity and materially lower cost of ownership.

Because current customers will be able to plug these higher capacity line cards into existing chassis, we expect to continue to see robust capacity fill activity and do not expect customers to meaningfully pause spending on existing networks in anticipation of the Infinite Capacity Engine. While opportunities to fill deployed networks remains strong, winning new long-haul opportunities has been challenging, as multiple large customers have recently completed footprint buildouts. Certain customers have held off in investing in our existing solutions with the Infinite Capacity Engine on the horizon and lighter telco-in-demand has heightened competition for limited footprint opportunities available.

Additionally, coming off a record year in 2015, our subsea business has been hurt as we managed through a technology transition period, which is limiting our success in certain submarine applications. Although we continue see a reasonable volume of new subsea opportunities over the first half of the year, our win rate was well below our historic run-rate, and below our expectations, which will meaningfully impact our subsea revenues for a period of time. I anticipate that incorporating the Infinite Capacity Engine will improve the situation and allow us to recover share in subsea, which has been a traditionally strong market for Infinera.

Avoiding this type of issue in the future is precisely the reason we had accelerated our R&D cadence to deliver next-generation optical engines more frequently in the future. In summary, for long-haul, while near-term demand trends will make it difficult for us to grow the way we have over the past several years, my belief is that our new technologies and products will result in Infinera outgrowing the long haul market for years to come.

Moving now to DCI, where we had another outstanding quarter, adding two new invoiced Cloud Xpress customers and posting another record quarter of revenue. I am very pleased that through the first half of the year, our revenue plan for Cloud Xpress is ahead of schedule. Of note in Q2, sales of 100G Cloud Xpress exceed the combined sales of 10G and 40G solutions, highlighting that ICPs are upgrading their data centers to infrastructures that necessitate higher capacity optical interfaces.

A recent report from UBS estimates that ICPs account for roughly half of all cloud computing revenues today and by the end of the decade could own more than three quarters of the market. Our DCI business today reflects these trends, with revenue heavily concentrated with ICPs and carrier-neutral providers. Recognizing that ICPs are poised to be the major players in DCI, we are striving to leverage our technology leadership and relationships to both expand our ICP market share and also achieve a more diversified business. I am proud of our Cloud Xpress results to date, and believe that the market-validated quality of our solutions and customers' recognition of our differentiated product roadmap will enable us to compete effectively over the next few quarters even as competition intensifies. Looking further out, I remain optimistic that enhancements in capacity, power, and ease-of-use with the Infinite Capacity Engine will further solidify our DCI market leadership.

Turning to Metro, we had mixed results in the quarter. While we continue to win deals and our pipeline of opportunities with large customers grow, spending from some of Transmode's traditional Metro customers remains muted. I am encouraged that mobile fronthaul and backhaul opportunities continue to increase in response to wireless carriers seeking increased efficiencies in their existing networks and planning for 5G, which will necessitate significant growth in bandwidth to and from cell towers. The revenue contributions from mobile solutions will likely not be significant for some time, they represent a sizable future opportunity for Infinera.

Beyond mobile, the Transmode teams' differentiated technology solutions and business approach have opened doors to large opportunities that customers that have historically not been receptive to Infinera. Unlike the long-haul market, there are a variety of facets to Metro. From the core to the edge there are varying capacity requirements, power thresholds, and technology intricacies. My view is that our evolving suite of purpose-built solutions that will be pick-based in the MetroCor and application optimized at the edge will prove broadly appealing to the market.

As we near the one-year anniversary of the Transmode acquisition, although I'm not satisfied with the financial results to date, I am undeterred in my believe that we have a substantial opportunity in Metro. I do expect more cross-sell wins this year, though envision that our significant cross-selling success is now more likely to materialize in 2017. Based on customer interactions with the latest analyst estimates, Metro market growth in 2016 is shaping up to be lower than predicted at the beginning of the year, an indication that the 100G Metro upgrade cycle remains in the early innings. We had the technology solutions, relationships and the drive to win, and intend to be a significant player in the Metro market for years to come.

Putting this all together, overall bandwidth demand drivers are intact, we're in excellent position for the future though facing difficult revenue environment in the near term. While time is a weapon, is the right business strategy for Infinera and our customers. Its resulting short lead times impede our visibility, a dynamic which contributed to our not identifying the affirmation softness that emerged in late Q2 and earlier. Addressing this softness is particularly challenging right now, as we simultaneously work through a technology transition to the Infinite Capacity Engine and our Metro insertion has taken longer to ramp than anticipated.

Amidst our current challenges, I remain optimistic as we believe capacity additions to existing networks will remain steady and we have not lost any customers. Our customers continue to tell us that they value our differentiated solutions and experience, and intend to continue investing with Infinera. While we are clearly in a dissatisfactory situation, the Infinera specific issues we're facing are a function of timing and are not structural. Over time, as we incorporate the Infinite Capacity Engine into our products and create traction with the opportunities we see in Metro, I am confident of ongoing success.

In closing, we're well-positioned for the long term as bandwidth demand continues to grow and we begin to introduce solutions that utilize the Infinite Capacity Engine. Addressing bandwidth demand with a world-class team and offering the most scalable solutions for the fastest-growing customers positions Infinera to deliver long-term profitable growth. Although results will be challenging in the short term, we're committed to winning in the long-term and executing on the roadmap and technologies that will deliver that success.

I continue to believe we have never been better positioned. As always, thank you to our customers and partners for their ongoing commitment to Infinera and thank you to our employees around the world. With that I'll turn the call over to Brad.

Thank you Tom, and good afternoon everyone.

As Tom mentioned we delivered strong financial results in Q2. With revenue coming in at the high end of our guidance range and Non-GAAP gross margin in EPS exceeding our guidance range.

Our success in the quarter was driven primarily by continued growth in DCI and execution on long-haul capacity-fill opportunities as we continue to deliver best in class profitability. Q2 revenue was $259 million, a 25% increase over the second quarter of last year and up 6% sequentially. Our business continues to be broad-based, with our top five customers in Q2 comprised of two tier ones, and ICP, the wholesale and enterprise carrier, and a cable operator.

Two of these customers are greater than 10% of revenue in the quarter -- the wholesale and enterprise carrier and a cable operator. Contributions from DCI fueled top-line growth in Q2 with Cloud Xpress revenue growing nearly 20% quarter over quarter. We also benefited from our sizable 100G install base in Q2 as customers across multiple verticals invested in capacity as to existing networks to address ongoing traffic demand.

Although field activity was strong in Q2, our success winning new footprint opportunities was limited. Through the halfway point of the year, revenue growth from ICPs and wholesale and enterprise carriers has been strong. And I'm particularly pleased that revenue from our cable vertical was up significantly the first half of this year as compared to last year, both from Infinera classic customers but also new customers gained through the Transmode acquisition. Revenue from our telco customers, however did not keep pace with the other verticals. Roughly flat over the first half despite the inclusion of the Transmode revenues.

In Q2 specifically, while a number of our traditional telco customers continue to buy, across the broader telco accounts demand was weaker than expected dropping off in the latter part of the quarter. Looking at our geographies, North America remained our largest region in Q2 at 65% of total revenue. Then we experienced a 4% sequential decline due to multiple large customers completing footprint buildouts.

Internationally we had a solid quarter of growth driven primarily by capacity adds to long-haul networks. In the quarter, EMEA remains steady at 25% of total revenue, while APAC and LATAM got back on track, coming at 6% and 4% of total revenue respectively.

Service revenue in Q2 was $31 million, up 10% year over year and 9% sequentially. We continue to have success delivering support services to our install base. Though we're seeing some pressure on revenue, with the less service- intensive Cloud Xpress becoming a bigger part of the mix and fewer current footprint installation opportunities.

Going forward, we believe we have substantial opportunities to grow our service revenue by both broadening our support offerings and also expanding the percentage of customers that utilize our services, including Metro customers.

Moving now to gross margin. Non-GAAP gross margin for Q2 remained very strong at 50.4%. Gross margin continues to be driven by differentiated cost structures enabled by our vertically integrated business model, a higher portion of long-haul capacity fill and capabilities such as instant bandwidth. Additionally, service gross margin contributed to the overall gross margin strength coming in at 60% in line with recent results. Despite achieving 50% margins for two quarters in a row, we're not at a point where we can generate margins at this level consistently.

For a period of time we expect some pressure on gross margin related to competitive pricing pressures and investments we are making with certain key customers to maximize footprint growth in anticipation of Infinite Capacity Engine-based solutions coming to market. While we still firmly believe in our 50% gross margin target in the not-too-distant future, it is important that we balance expansion in margin with key investments which will allow us to achieve this goal on a consistent basis in the future.

Now moving to OpEx. Non-GAAP operating expenses were $96 million in the quarter, growing sequentially in line with revenue and within our guidance range. In Q2 we continued to heavily invest in R&D to support the timely delivery of new products that incorporate technologies from the Infinite Capacity Engine. SG&A expenses in Q2 were essentially flat as we continued to balance strategic investments with active cost management.

Putting this all together, we coupled solid revenue growth with strong profitability in Q2, delivering Non-GAAP operating margin above our guidance range at 13.2%, net income of $31 million and EPS of $0.21 per diluted share. On a GAAP basis in the quarter net income was $11 million or $0.08 per diluted share. The difference between our GAAP and non-GAAP results was attributable to approximately $11 million in stock based compensation, $6 million of intangible amortization and other acquisition related costs, and $2 million in amortization of debt discount.

Now turning to the balance sheet. We had another solid quarter of cash generation, increasing our total cash, cash equivalents, and investments as of the end of the second quarter by $15 million to $376 million. We generated cash from operations of $28 million in Q2, spent CapEx of $12 million and were negatively impacted by foreign exchange of $1 million.

Now for our outlook for the third quarter of FY16. As Tom discussed, we're facing several near-term headwinds, multiple large customers recently completing network buildouts and challenges in our subsea business, lead us to expect that winning new long-haul footprint will be challenging for a period of time. Additionally, although we continue to make solid progress, we are not yet realizing significant financial benefits from cross-selling Metro solutions to Infinera's existing customer base or from sales of recently introduced products. These factors, along with the demand weakness Tom discussed are resulting in our third-quarter revenue outlook shaping up to be extremely challenging.

To add a bit of color to the situation we are experiencing, our bookings in Q1 exceeded our internal plan and bookings for Q2 into early June were in line with the plan as well. Unfortunately however, in the last weeks of Q2 our bookings declined dramatically and thus far in Q3 the situation has not improved.

While visibility is often challenging given our short lead times, we're very surprised by the speed and extent of this recent deceleration of bookings. As such, for the third quarter we currently project revenue to be $185 million, plus or minus $5 million. The midpoint of this range represents a year-over-year decrease of about 20%.

Our revenue expectation reflects our ongoing challenge with visibility, which is limited even for opportunities we are confident in closing. Obviously we're very disappointed with this outlook and are taking steps to improve the situation. While it is difficult to predict how long this challenging period will last, with the Infinite Capacity Engine on the horizon and a strong presence and reputation with the fastest-growing customers in the market, I am confident that we will restore strong revenue growth in the future.

As for the rest of our Q3 guidance, we currently anticipate non-GAAP gross margin to be 47%, plus or minus 200 basis points. The absorption of fixed cost across a smaller revenue base and the early impacts of the aforementioned strategic investments are driving this margin outlook in Q3. Please keep in mind that even during an investment period, we will have the ability to deliver gross margin results amongst the highest in the industry.

Looking ahead, in the near term there could be more variability and pressure on gross margins as we work to accelerate revenue growth and opportunistically invest to capture footprint opportunities. Over this period I want to emphasize that we will still continue to benefit from our vertically integrated model, capacity as to long-haul networks, instant bandwidth and purpose-built products.

In light of our revenue outlook, we're taking steps to curb the growth of operating expenses. We currently anticipate non-GAAP operating expenses to decline to $87 million, plus or minus $2 million. We have enacted an aggressive plan to control spend across the board having instituted a hiring freeze and incorporated multiple expense controls to prioritize our most essential activities. In addition, we have adjusted down our estimates in relation to sales commissions and incentive compensation as a result of the current financial outlook.

While we are mindful of the importance of controlling OpEx spend, our plan is to continue to invest in the R&D required for the timely delivery of Infinite Capacity Engine-based solutions as this is a key component of our future success. You should expect our R&D as a percentage of revenue to run above our 20% of revenue target for a period of time. As for other operating expenses, we find a reduced SG&A expenses in Q3, balancing the need for growth with focus on critical spend areas.

We continue to invest in the integration of the Transmode business as well as key new end markets which will maximize our revenue opportunity moving forward. We're committed to managing expenses tightly as we work through these near-term periods of reduced demand. Putting this all together, the midpoint of our projected guidance translates to a non-GAAP operating margin of roughly breakeven, plus or minus 200 basis points.

EPS is expected to be breakeven as well, plus or minus a couple of pennies. As for GAAP EPS we project it to be lower than Non-GAAP EPS by about $0.13 per share, primarily related to stock-based compensation expense and amortization of intangibles.

Wrapping up, while we had a solid financial performance in the first half, we face significant challenges in the second half of the year stemming from both softer demand in the markets we serve and also certain issues that are specific to Infinera and our customer base. Like other companies, our business has a variety of moving parts and challenges that can emerge from time to time, including large customers slowing spend. While we can typically manage through a quarter in which one or two customers slows spend without significant impact to the overall results, in a period where multiple customers across multiple verticals slow spend, it is not something we can absorb.

The combination of major long-haul footprint builds ending for customers, weakness in subsea, a delay in expected Metro cross-sell success and lower telco growth in North America and Europe will have a pronounced financial impact on Q3. As we manage through this period we're committed to prudently managing expenses though not hinder activities focused on delivering our next generation solutions and market expansion opportunities. Given our belief in our tremendous long-term opportunity, we will have the courage to make key investments to further set us up for long-term profitable revenue growth.

Despite our disappointing outlook, I'm steadfast in my belief that our strategy is sound, we remain well positioned to address the opportunities ahead and deliver strong financial results over time. Growing market share in each market and consistently delivering 50% gross margin and 15 points of operating margin continue to be our objectives.

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

(Operator Instructions)

Rod Hall, JPMorgan.

I guess the first thing on our minds is to what extent this reads across to other companies that are exposed to the carrier world and the cable world, and the data center world that you guys are? So I'm hoping you can help us with a little bit more color on how much of this is company specific? How much of it is customers of yours that are not spending, or maybe you have lost competitive bids or something like that?

And how much of it do you think is related to wider market dynamics that is just rapidly changed here at the end of Q2? And maybe Tom, if you can couch your statements regionally so we get some feeling for whether there is a difference between Europe and the US?

You are asking, first off, is this Infinera-specific or is it broader in the industry, that is one question -- I will give you an answer which might be a little helpful, might not. I think there is both dynamics at play. I think that we are seeing some of our specific customers that have been either acquired or being acquired and were probably overly exposed in that area.

Current customers that have been acquired, TWC and Cablevision, customers being acquired, XO, any time that happens in the short term, we historically have seen either pressure from availability of new POs or pricing. I think a couple of our customers, particularly in North America, we have found put themselves in an inventory position that is bigger than they want. I think there was a phase they all went through where they were trying very desperately to acquire sufficient capacity for the explosion of demand that they were seeing. And a couple of them are in a position where they have more inventory than they want, that will bleed off. We are not aware of any customers that we are, certainly not losing or losing market share in.

In North America, across the entire long-haul space, we have seen in Q2, a significant falloff in RFQs. Now, one of two dynamics is in play. Either RFQs for long-haul are happening and we're not being invited all of a sudden, which I think is not probable, or there has been a slow down in some long-haul builds for a period of time. And that is my estimation, particularly in the telco space which we commented to.

I believe that has to be a temporary dynamic because none of the demand drivers that are in place, whether it is the move to cloud, whether it is more video, whether it is increased bandwidth requirements in general, are going away. But I do think there is a -- in North America a little stall, and I think there is a perspective that is moving some to IP investment and some to Metro investment. Whether that hurts other people or not I cannot answer.

I did listen to part of Juniper's call, and they reflected a softening in some telco and they also talked about significant pricing pressure in Europe. We're absolutely seeing significant pricing pressure in Europe, more than typical, particularly in Metro. We're also seeing, in the wholesale space, in Europe, an incredibly demanding and challenging environment for -- we have been very successful historically in that space.

Some of our customers there I think are trying to figure out what their business is going to be moving forward and I think they will figure that out. Right now I think there is a slight demand pause from them. We are seeing strength in general in LATAM, and while APAC is not a large portion of our business, we are seeing wins in APAC, a lot around Metro but also some around long-haul.

Long story short, I think we are seeing, in parts of the market a demand slowdown that is potentially industrywide, for long-haul. We're seeing pricing compression particularly in Europe that I do believe is industrywide. We're seeing submarine for us being industry-specific. Our gen 4 technology is critical for us to retake competitive leadership. That is an Infinera-specific issue, and that will cost us some amount of money, certainly in the second half of this year until we get the gen 4 out. I think we also have the complicating factor of -- we are relatively new to the Metro and we are in the middle of a technology transition to gen 4 or the Infinite Capacity Engine.

We are extraordinarily bullish on what that will do for the company and I believe that at the end of the day, this is in my mind -- a bump in the road toward us achieving our objectives. And I am still extraordinarily bullish about the opportunity of our company.

That is a very lengthy response and thank you, Tom, for all that detail.

You asked a complicated question, Rod.

Vijay Bhagavath, Deutsche Bank.

I just want to build upon the prior question here, more in terms of use cases and where the buildouts were? You could walk us through saying -- fine, you saw some demand slowdown towards the end of June? Were there any specific use case or architecture related -- like, for example were the carriers or the customers of yours look to do something else architecturally, is that an architectural reason motivating the slowdown or is it just a demand for spending pause?

It is definitely not any kind of use case application that we're seeing. In fact, the use case of cloud continues to drive -- we have been very strong in Internet content. We continue to see lots and lots of demand there.

We continue to see long-haul demand interconnecting data centers. We have had strength in a number of classic of our customers. What we are seeing, like I said, is a couple of customers as we have gotten over inventoried, were also seeing the telcos as I specifically mentioned, as being relatively soft.

Submarine for us moving forward is relatively soft and we are winning in the Metro. There are lots of opportunities in the Metro but we are disappointed and surprised a little bit by how long it is taking to turn success in labs into success in field trials into success in creating a substantive revenue. I feel comfortable that we're making great progress, but it is taking a lot longer than we had anticipated, and I am disappointed in the results but it is not a use case issue. There are lots of use cases out there that are going to require more capacity.

A quick follow on would be -- thank you Tom, that's very helpful. How long do you anticipate this funk to last? Do you have visibility saying, for example, will this last through year end? Or ideally lead on into early next year or is this short-term?

That is a good question and I wish I had a good answer for you. For the same reason we do not give yearly guidance is because we have a hard time seeing very far ahead and this falloff happened extraordinarily fast. My anticipation -- I look at it this way.

I am going to assume it takes a while, because I want to make sure we approach this conservatively. But at the same time, I am not going to believe this is a winter storm that is going to last for a whole season. We're going to continue to invest steadily in R&D, because I believe that getting gen 4 to market is imperative.

There are a lot of other things we are bringing to market that I think are imperative and I fundamentally believe in the demand drivers that are going to drive us opportunistically over the next several years. Do I think it is a long recovery? I don't. Can I tell you it is a one quarter phenomenon? I cannot, and we're going to approach it conservatively.

I will add one comment on there. What we find is a lot of our customers, larger customers are engaged in is the transport of data center interconnectivity over the long haul. These customers carried a large portion of the data in that application set.

The predictability of the base traffic demand in that market sector is sporadic. It is a less predictable demand cycle than the one that is generated from aggregation networks. This transition here, not transition, this bump in the road, as Tom puts it, is the alignment of that lack of visibility into exactly what those demand cycles are and driving it.

The presence, the architectures that you were asking about, architectures is still solid and still the same and are positioned within this customer as still solid and still the same.

George Notter, Jefferies.

I guess I was curious, you said a lot here, it is a big reduction in expectation, certainly for the September quarter. I guess I'm wondering if you can put some of these explanations in a box, in terms of how impactful they are? You talked about subsea, you talked about completion of network builds, inventory, price pressure in Europe, lack of cross-selling, is there a way to parse out the step down in expectations according to each of these factors? Or is it mostly one or another?

And then I guess related, how many customers are we really talking about? Is it 3 customers, 5, 10, how broad-based is this?

George I will take a cut at it and let Dave and Tom add some color. The reality is, we're not going to exactly size each of the different things. The Metro situation is really just a lack of growth that we had anticipated.

The base business is relatively flat, we're just not seeing the growth we anticipated both from the traditional Transmode business or the XTC II platforms. The large customer spend, we have several different customers who have spent a lot of money over the last several years, that some are shifting demand to Metro and IP. Some guys just haven't laid out their plans for their next build, so that is a relatively large piece of the challenge.

Subsea, we have had our fair amount of success over the past several years. We continue to see a lot of opportunities. We're just not winning at the rate we did before. Subsea is not a huge market, but it is a big challenge for us as we don't continue to win the follow-ons.

Then, just in general, telco demand, given the size of some of our customers, some of our tier 1 customers, when those guys pause spend, it does put a hurt on this.

Again are we talking about 5, 10, 3 customers, what is the magnitude of this?

We've said in the past, if one or two guys pauses, someone can backfill it. This is multiple customers and multiple verticals so it is unfortunately the bad alignment of several customers.

Across different verticals, George.

Alex Henderson, Needham.

A couple of related questions. Obviously some of this is a function of you shifting to Metro and still having to fight your way into that marketplace as the long-haul slows. Do you think the shift in spending priorities may have caused some hesitancy in the long-haul as they shift their spending priority into the Metro?

Or do you think this is more a function of M&A activity? How would you weight those two factors, and how big a factor is the transition and technology if you were to wait that, if you were to take those three pieces, how would you parse the pressure here?

It is hard to be for sure Alex, but I think certainly the transition in technologies, I think is mostly constrained to the subsea area today. That is where fiber capacity is highly prized and there is no trade-off for it and I think that is certainly an Infinera-specific issue. I think across the larger customers that have slowed some spend, some of it is absolutely moving to Metro builds. Not all of them, but some of them. And there has been clarity in the industry that over the last few years the long-haul market has grown faster than most people anticipated and Metro has grown slower than most people anticipated and I think there is some shift to that right now.

There has been a relatively hefty upgrade cycle to 100G in the long-haul, there's been a relatively hefty investment in capacity expansion in preparation for needing to bring more capacity into the Metros. I think some of that spend is now happening in the Metros. That does not say that capacity in long haul is sufficient today, as new architectures within cloud, as 5G starts to be prepared for, long-haul capacity -- I just saw a report that says bandwidth in the long-haul is supposed to grow somewhere in the 30% to 40% per year for the next five years. I believe that at least. So I think there's going to be significant bandwidth growth continuing to long-haul but in any one quarter or short period of time there will be priorities of Metro over long-haul and probably balancing out what would be historically an over investment in long-haul, historically.

I do see some potential for the acquisitions to be causing some slow down, but like I said that is temporary in nature and I do think the competitive environment for Metro is truly unbelievable. It is extremely competitive and I think that is partly a dynamic that the Metro market continues to be over served. And I think that is going to continue to fix itself over the next couple of years and there is going to end up being fewer competitors in Metro and we are going to be one of them. I think gen 4 will help us in the Metro bring a significantly differentiated platform to the market. And in the meantime we're going to have to go fight it out and probably adjust our margin expectations of what we can earn in the Metro.

When you look at some of our competitors in the Metro space they are growing relatively quickly but they're doing it at the expense of margin. Margins have been crushed and it is almost inverse economies of scale. The more I sell, the less I make and that is a hard concept for me and us to wrap our heads around but we are going to have to go look at that until we can get our gen 4 platform out.

Just to be clear, you have got a number of M&A events happening to your customer base? What portion of your customer shortfall was related to customers that were within that set?

It is not huge, Alex, but if you think about it, some is pricing pressure, so when a customer doubles in size or roughly doubles in size, they're going to come back and try to pay for part of that acquisition through getting price reductions. That impacts us. The other piece is just uncertainty. We have got customers that are being acquired, that have to go check with the head office before they can spend. It is not huge, but it is meaningful.

(Multiple speakers) 25% of the gap in the third quarter number? Or less than that?

We're not going to size it exactly, Alex but it is an impact. It is not the biggest impact, though.

I think it is important Alex, Brad mentioned four or five different things that are confluencing together. It is a combination of all of them that makes this such a big drop and quite frankly, happening so quickly.

Michael Genovese, MKM Partners.

I heard basically from you here that long-haul is slowing down, that Metro is taking time competitively, specifically for you guys and that Cloud Xpress is doing very well, and I'm not surprised by any of those things although I am surprised by the magnitude of the guide. I think the most important thing to get to here is, for the Metro -- I know you have been asked this two or three times already but further clarification is great.

On the Metro, how much of it is actually delayed spending versus these long sales cycles, your product upgrades, you coming to the market later than some of the other competitors versus -- again how much of it is company specific and how much do you actually believe the Metro market is slowing and what would be the reasons you could figure out for why the Metro market would be slowing if it is?

I will try to answer that. Overall the Metro market isn't slowing. The introduce of new product into the Metro platform, and the number of the key areas that we are seeing strengthen is out in the access end of the spectrum.

They don't go and massively deploy access in all of their Metros simultaneously. They go do it out and they step function, they prove it out within a particular size network, and once they prove it out, up they make it available to all of their additional Metros. And it takes a period of time, so an actual ramp up in the access network may take a couple of years. The value of it is substantial.

Our visibility and opportunity for Metro deals coming in Q2 was substantially higher than Q1. So we're seeing a lot more opportunities, and we were advancing those opportunities at a very good clip. But the timing it takes for that to realize into real revenue, especially on the access side of the network, takes time.

There is nothing you can do for this because it is too many sites. A number of locations on how these things get deployed is much greater than in a long-haul network. That is the nature of an access site.

On the core side of the Metro application which is an extension off of our long-haul system, that is a higher dollar per site opportunity than an access portion of the network. And those things are starting to convert and those are mostly Infinera classic customers adding on our Metro portfolio onto their networks. Those are going well, the opportunities are going, pricing pressure is definitely a reality in the Metro especially as 16QAM type technologies impact the Metro which is not a dynamic in the long-haul.

This transition, those wins are coming. We talked about [Thelia] I think we've made announcements, we've a couple of other wins in that category. But it takes time for them to prove it out and test it in the lab and turn it into revenue.

Just for my follow up, maybe for Brad, if we get a 300 or 350 basis point sequential decline in gross margin, is the biggest factor there volume? Or is it mix, competitive pricing, what are the other two biggest features there?

The biggest one, Mike, is volume driven, because it is the absorption of fixed cost. So we've got an infrastructure, whether it is in sales, support, new process introduction, this kind of stuff, it is fairly steady and built based on a much higher revenue base. So because we believe in the opportunity, in the longer-term opportunity, we're not going to cut that back in one quarter so it has more of a drag on the margin, so that is the biggest thing. There is some amount on pricing pressure in some of the investments but the fixed cost absorption is a bigger piece.

Dmitry Netis, William Blair.

I'm going to probably ask seventh question on the call about this but again, as you look at the softness, pockets of weakness in telco submarine, Metro, some of the standout performers are clearly DCI and ICP. Can we, what are you guys baking into Q3 and maybe Q4, as you look into the second half of the year for those two verticals? I know Dave said there is sporadic demand from those two, but you have enough in the pipeline to continue to see that perform to your expectations? And can you describe maybe competitively, what are you seeing out there from the competitors that are coming in with the new products out there as well?

Obviously we're baking into our guide what we seek happening and we see still healthy opportunities for data center capacity in general, and the wholesalers that carry that traffic. But we are seeing increased competition for the first time, really in this quarter, both from the [Infinera] solution as has been talked about is a little bit. But we think that is fairly contained.

We're also seeing entrance into the market that we're now competing with for purpose-built solutions that are more in the model of the CX. We still think we have a substantive lead from an experience set. We've been now selling to and listening to customers and putting in features that they value.

We believe without question with our gen 4 roadmap, that it continues to remain the technology leader as other people are just now entering the market, but we do see entrants into the market that appear real for the first time. We still have healthy CX expectations for the quarter, though we are not anticipating the growth like we have had over the last couple of quarters. The last couple of quarters have been quite outstanding.

Part of it is new competition, part of it is spend cycles from certain of our customers that are in an off spend cycle because of either fiscal years budgets or project planning. We do anticipate certainly healthy demand, very healthy demand over the long term and even in the short term continued expansion into that market space. Not only with our traditional customers but we're also continuing to win new customers with the CX platform.

As a follow-up, can I ask a two-part question? Number one is, it follows up to the previous question on DCI opportunity and this Infinite Capacity Engine. Is there any timing to when the platform will be available? Was it something you're going to disclose at the Analyst day or Investor Day you are planning at the end of August? Give us a sense when that will be ready to go and commercially available?

The second part to the question is, as you go into Europe, I want to zoom in a little bit on Europe? And then maybe ask you to describe what you are seeing out there as far as the competitors driving this pricing pressure? Is it the -- the Alcatel-Lucent's now being part of Nokia, that have been really aggressive? Is it the US competitor group, guys like Cisco maybe? Is it the Chinese potentially that are playing there that is driving the price down? Any color on that front would be really helpful.

I will answer that one first. Our view in Europe is -- pricing is being probably driven down by Orient and Alcatel -- and we're also seeing, in certain applications, Huawei, their new DCI space be even more competitive than I am used to seeing as they enter into a new market. Virtually or literally giving applications away, particularly around the DCI space. But I do think it is a couple of people leading and a lot of people following along because the market price is being set quite frankly very competitively by a couple of price leaders.

In regard to when we will talk about our products based on the Infinite Capacity Engine, our anticipation that at Inside Infinera, we will tell people what our specific plans are for introduction of that technology into platforms.

Tim Savageaux, Northland Capital Markets.

I want to follow briefly on some of the vertical questions. If I heard you right the cloud business may not grow at the same rate in the second half and may see some declines? But that has been a bright spot and I imagine, given the pricing commentary in Metro, seeing what we had was a customer issue with Transmode last quarter that has been may be added to some degree by market issues.

Confirm if that is the right way to look at it, even with some more conservative assumptions there, let's just assuming you are able to stay flat in Q4, you are looking at something on the order of a 15% or so decline in long-haul for the year, trying to reconcile that relative to your overall market growth rate commentary. I know I think it was 6% to 8%, and maybe half of that is China. I don't know if that's half the growth rate or how you meant that, but are we looking at a situation where we are under growing the market by that wide of a margin? Understanding some of that is maybe subsea and temporary, but if you can comment on that direction of thinking and where that growth rate or rate of decline for long-haul is?

I will start by answering some of your cloud commentary, and I think what you've articulated is how we view Q3 in regard to cloud. In regard to the commentary on Metro with a historic Transmode customer last quarter is actually a Q1 dynamic. And the good news quite frankly, is as Brad had said earlier, the Metro, our Metro business has not actually declined, not only flat but a little up.

We've been able to backfill that business successfully. The challenge is growing it substantively with new wins that rollout for revenue. As Dave said, there's a fairly long gestation cycle between a win and a materially impacting revenue. That gestation cycle is longer than I had anticipated. We are creating wins and as Dave said, looking at our RFQ from Q2, I believe it was a record for us on the number of Metro RFQs that we received.

So there is lots of activity, we're making lots of progress, the gestation cycle is just significantly longer than we thought, and it is compounded by prices compressing extraordinarily fast. We've been playing, unfortunately, a little catch a falling knife game, and it has not been as successful as -- in hindsight we should have been more aggressive sooner.

In regard to long-haul market share, in Q1 the industry analysts said we gained market share in Q1. It is hard to understand right now what is happening in the dynamics of the long-haul space. As we've said in Q2, there were very few RFQs is that we received.

If we're not receiving or anticipating, other people are not receiving them also. We do believe the long-haul is all real-time numbers. The long-haul space outside of China will probably grow 2% to 3% this year.

Are we going to grow market share or lose market share? Too early to call. But I think there is a reasonable chance we will grow market share in long-haul this year, it just won't be 3X the market growth we have shown the last couple of years.

We have grown market share, we've grown three times the growth in long-haul over the last three years. We knew that at some point that would meter out. It has metered out a lot faster than we had thought and I believe we will stay neutral to grow market share because I don't know of long-haul deals we are losing, we are not seeing that. That is my read of the situation, Tim.

As a quick follow-up, is there any indication of maybe some legacy technologies falling off? To the extent 10G is still any type of meaningful part of the equation here?

From a technology cycle point of view, the only place which we talked about earlier was in subsea and we will be out of that one pretty shortly. I don't see any issues around any other technology cycles.

10 gig business in long-haul cycle is very small, so that's not the issue.

Meta Marshall, Morgan Stanley.

A couple of questions, you mentioned making some investments in customers as reason for the gross margin pressure? I just wanted to get a sense of whether those were existing customers that are expansion projects? Or were those new customers that you were looking to get into? And just a sense of the categories they fall into.

The second question was, Transmode customer issues seem to be related to a particular customer waiting to see whether they were going to win additional -- a bid to provide capacity for ICPs and I just wanted to get a sense of whether that decision had been made away from them, and that was part of the reason for the pause or unrelated?

Meta, in terms of the investments we're making, its a combination of both new and existing customers, so we have some existing customers that we are growing share with that are great longer-term customers that when the Infinite Capacity Engine comes out, we want to make sure we have more and more of their footprint. It will take some investment up front to go expand that business. It is something we have done in the past and has been very successful for us.

We also have some newer customers that we are getting opportunities with, that are going to take us some investment to get in the door with. These are all opportunities that are great longer-term margin profile. They are potentially very large opportunities. We're not going and taking dumb deals that will never be profitable. It is just a matter of making that investment up front, making sure we are in with that customer and we can maximize the benefits of the Infinite Capacity Engine when it comes out.

This plays out one of our strengths as a leader in gross margin in the industry, and to be able to make those investments and sustain a guide of 47 plus or minus percent, that is an incredible position to be in to be able to make those investments for upside.

Meta, to address your Transmode question -- we had highlighted a customer last quarter. Although the customer is still there the volume hasn't increased with that customer.

(Operator Instructions)

Stanley Kovler, Citi Research.

I just wanted to ask if we can get back to looking at specifically the long-haul? And if I back out, I guess what I think would be index quarters service revenue, and if we back out some Metro, is it fair to say that your long-haul business is back to 2013 levels on a quarterly basis? And we can plot a path back over time?

Is that the trajectory we should be thinking about? The other side of the question would be specific to Metro, perhaps even on subsea, can you help us understand the features, or the feature sets that are maybe stalling the opportunities for you here especially in Metro? What are some of the things you need to get from a product standpoint besides Infinite Capacity Engine to get the 100Gig.

I will address the first part of let Dave address the Metro question. From a long-haul perspective, we're definitely not down to the 2013 levels. We've grown that business very significantly with our DTN-X technology over the last several years.

To Tom's point it is just not growing at the 20%, 25% we did over the last years. So there is some challenges with that business but we're still a significantly bigger business than we were back then in long-haul. And we have a tremendous opportunity with the Infinite Capacity Engine to get that on another significant growth trajectory.

One of the things that I would encourage you to not go back to 2013, when we were rolling out a brand-new platform in the DTN-X. The difference this time is that if it is just a technology issue which I don't think it is, our customers can go now, with our Infinite Capacity Engine in the chassis they already have. The chassis they already deployed, and with an in-service upgrade, an upgrade to this line card that carries more than twice the capacity.

It's a much easier upgrade cycle. We've already won that customer. They already have the Infinera infrastructure ready to be upgraded versus putting in a whole new infrastructure.

I think it is a substantively more straightforward decision for them to make and a substantively easier win for us to have. I still go back in for most of the long-haul state I do not believe most of our challenge today is a technology transition. It is the fact that we are not seeing quotes for long-haul, and I don't think that is Infinera-specific issue.

Let me try and address your feature question. To be clear, our Metro trying to create -- exceeding the momentum in the Metro is not a feature problem. What we have tried to explain is that in the nature of an access oriented Metro product line, which is where we are differentiated the most, it takes time to be able to deploy those out because of the number of access nodes that you have to have in order to generate the same amount of revenue for that, the overall opportunities are big and great but it is, takes more time for investment. There's no future shortage, in fact most things like mobile fronthaul we're feature preferred in these technologies. No shortcoming in Metro features as far as slowing us down.

On the subsea, the features that we do refer to there is which is the only place they see any type of feature shortness and is a short term issue and that is all about fiber capacity. If I'm deploying new capacity on a fiber over the next quarter, Infinera's product line is slightly less capacity than the alternatives out there. That is solved by our gen 4 engine, and it actually becomes an advantage, slight incremental advantage to us when we get our gen 4 engine out. We will be through that transition here pretty quickly, from that.

If I can add on a couple of statements on the long-haul trajectory, to Tom's point this is not a product transition issue. This is, our customers carry a large portion of the long-haul data center interconnect. Their growth averaged over the course of the year is very high.

We continue to be the supplier for those customers, no loss of market share, however their deployment of that bandwidth has taken a pause in their spending style. Then those pauses between various customers unfortunately happened to lineup this quarter. No loss of market share, no loss in -- our customers are still deploying substantial amounts of capacity for that application and hence why we believe this is a pause and not a reset to our business.

Jeff Kvaal, Nomura.

I guess I have two questions, and one is -- when you were talking to your customers about them ramping up their footprint plans, what were they telling you about what they would be buying after they finished a given product or project? I'm a little surprised that they would yank the rug out from under you so quickly, given they were finishing a project that might have been something you could have had a conversation about?

Jeff, the reality is -- even though we're close with our customers, a lot of our customers aren't very forthcoming with exactly what they are planning to do and especially in some of our bigger verticals it is even more challenging. They do not tell anyone anything about their business. That is the challenge we have is they do not always lay out exactly what they are planning to do and in certain cases they have talked about it but timing is not certain on what they are going to do that.

It varies by customer. Some of our customers were very clear to us that when they were done with this long-haul build, they were going to move some of their spend to the Metro. Other customers have implied or talked about that when they finished this build that will start planning on an overbuild, a next generation new one. A lot of those have now moved out in time to a degree from a couple to several quarters. That is the surprising part to me.

Usually when we see our customers finishing builds there is a number of customers who start new builds at the same time. The fact that some of our customers were telling us that they were finishing their builds and we knew they were finishing their builds -- the surprising part has been the lack of new builds that are filling that hole. That is a unique situation over the last several years that we are not familiar with. So, as Brad said, some people won't talk about it, some people did give us plans that are moving, some people did what they said which was moving spend priority over to the Metro. It is a whole combination.

In the old history of telecom where the aggregation networks, the data for the aggregation networks are driven by human to human interactions. You're able to spread that over out over a sea of large numbers. Now a lot of the bandwidth is consumed by machine to machine communications.

And that environment build infrastructure, absorb it, build infrastructure, absorb it, is much of a stronger tendency. Plus the people that are doing that and trying to come up with projections of bandwidth -- they do not have 1,000 people working in there to go do their planning. They have a handful of people to go do their planning, and that makes for a different dynamic than the way the telecom business was a decade ago.

My second question then comes to OpEx. And that is, to what extent would you consider further squeezing your operating expenses if revenues don't come back over one, two or three quarters?

Jeff, we will continue to watch that quarter to quarter. What we don't want to do is cut our spend that cuts our opportunity in the future. We will be very mindful of what we do spend. As I think you have seen we have taken significant actions already, but we will play it as we go but we will continue to invest in the future. Because that is what is the opportunity we believe in.

Let me be a little more emphatic. We have been, I think, very prudent in how we have adjusted our expenditures. We stopped hiring, we're addressing any type of discretionary spending.

But I mean it, I have never been more compelled that we have a huge opportunity in front of us. I think gen 4 is a monumental capability that the industry will absorb and we're going to continue on track of bringing gen 4 to market across various platforms as soon as we possibly can. We're also going to continue to invest in next generation technologies like gen 5, so that we never end up with a technology gap again. Because it is too difficult to gain market share and then lose your position because of a six-month or one year gap. We're going to bring our cadence, bring the technology to market and continue to improve it to being less than it is today.

Having said that, we're being prudent on what are the new things we're starting. We're not going to start some things that we would like to start but we recognize that we are in a fiscally challenged position, and I prize very much creation of cash and not losing money so we're going to try to balance that. I do not believe this is a long-term protracted downturn. If it turns out to be such we will react in a different fashion but that is not what I plan at this point.

As always thank you to our customers and partners for their ongoing limited thanks to our employees around the world. With that, we will talk to you next quarter.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.