Infinera Corp (INFN) 2017 Q1 法說會逐字稿

Good day.

Welcome to the First Quarter Year 2017 Investment Community Conference Call of Infinera Corporation.

(Operator Instructions) Today's call is being recorded.

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

I would like to turn the call over to Mr. Jeff Hustis of Infinera Investor Relations.

Jeff, you may begin.

Thanks, Phil.

Welcome to Infinera's First Quarter of Fiscal Year 2017 Conference Call.

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

These may include statements regarding our overall business strategy and results of operations, market conditions, market and growth opportunities, views on our customers and products, expectations regarding the timing of new products and Infinera's financial outlook for the second quarter of fiscal 2017.

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 our most recently filed annual report on Form 10-K 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 first quarter earnings release, which has been furnished to the SEC on Form 8-K and is available on our website in the Investor Relations section.

I will now turn the call over to our Chief Executive Officer, Tom Fallon.

Good afternoon, and thank you for joining us for our first quarter 2017 conference call.

Joining me today are Chief Financial Officer, Brad Feller; and President, Dave Welch.

Today, I'll review our performance in the first quarter, market dynamics and our future opportunities.

I'll then turn the call over to Brad, who will provide a more detailed financial review of the first quarter and outlook for the second quarter of 2017.

In Q1, we generated revenue of $176 million, non-GAAP gross margin of 40% and a non-GAAP loss of $0.15 per share.

Revenue was the high-end of guidance, largely attributable to a return to sequential growth in North America, led by solid results from our wholesale and enterprise carrier vertical.

Total revenue in Q1 was slightly down sequentially, as long-haul grew while DCI and metro were each lower.

This decline, however, was muted in comparison to the 15% reduction our industry typically experiences in Q1.

DCI demand continues to be robust due to the continued rapid growth in cloud services.

We saw good performance from our Cloud Xpress products and see significant demand building for the Cloud Xpress 2. I'm also encouraged we are having success with the XT-500, with significant acceleration in bookings and 4 new XT customers in the quarter.

We anticipate this activity is a precursor to future success with the XT-3300.

Their XT products help service provider customers adopt some of the benefits of ICP architectures and extend our long-haul footprint into the metro.

We are also seeing an uptick in opportunities around open networking, not just from ICPs, but from service providers as well.

In Q1, we won open opportunity with a key service provider in Europe, that is deploying an Infinera open line system.

As open networking becomes a more pervasive deployment alternative, my expectation is that it will substantial increase our open opportunities as a broader installed base recognizes the value of Infinera's transponder differentiation.

Turning to the overall market.

We are still seeing heavy pricing pressure in our end-markets, though we expect ASP declines to not be as substantial in 2017 as we saw last year.

Shipping our new ICE4-based products and volume will help us respond to this pressure by improving our cost structure.

It should also position us to begin growing market share in the second half of 2017.

That said, there are some continuing uncertainties facing us.

Recent discussions with customers suggest they're squeezing as much out of current network as possible, even as bandwidth demand continues to grow.

We are seeing this with our telco customers, in particular, whose sequential revenues declined materially in Q1.

Additionally, customer consolidation is continuing to impact results as several of our largest customers have slowed spending to focus on integration.

Of note, our cable business was down quite a bit year-over-year on Q1, and the new management team of one of our largest customers has decided to spread their spending over the course of the full year instead of spending predominantly in the first half.

While I expect consolidation will pose challenges for us through 2017, I see this issue as transitory.

My conversations with these customers lead me to believe that as M&A activities dissipate, we are well-positioned to grow with them as they emerge as stronger and broader enterprises.

Indications are that we have maintained wallet share in our traditional markets, and are better positioned to earn opportunities in new markets within these customers.

At Insight Infinera, we announced several new products for our Intelligent Transport Network portfolio.

Our ship dates for these products remains roughly on track, though behind where I would like them, given where the market demand is.

Our current expectations are that, in Q2, Cloud Xpress 2 for DCI will be generally available.

Additionally, shipping in Q2 will be the 20-port ROADM card adding scale to our already available FlexILS open line system.

In Q3, we expect to ship several products including the XT-3300 for long-haul and metro, the XTM Series with a 400 GB module for metro and our XTS-3300 for the subsea market.

I'm pleased we have started to ship limited availability CX2s to an ICP.

These units are currently in our production network carrying live traffic and feedback to date has been positive.

As of today, our expectation is that CX2 will be generally available in the latter half of the quarter.

Given this timing, and customer-specific dynamics around testing and acceptance, there's more uncertainty than I'd like around how much revenue we'll be able to recognize in Q2.

That said, over the course of FY '17 and beyond, I expect to CX2 to significantly contribute to Infinera's growth.

Turning to long-haul.

While the overall spending environment remains challenging, we are making progress winning new business with our XT-500, with meaningful deployments in Q1 with several large customers, including a cable operator, a wholesale and enterprise carrier and an ICP.

I'm cautiously optimistic that our long-haul business will return to growth in the second half of 2017, as we build on current traction with the XT-500 and address opportunities with our new XT products.

Our expectation for improvement aligns with the most recent Dell'Oro forecast which projects the [B2B] long-haul market outside of China will resume growth in the second half of the year.

Regarding DCI, we had a good Q1 with solid spend from our largest CX customers, while adding 3 new customers.

The robust feature set we have developed to address customer needs as the first vendor in the purpose-built DCI market continues to compel customers to choose Infinera.

While viable competition has emerged, I'm pleased that we have maintained market leadership with Cignal AI estimating our market share in purpose-built DCI was 52% in the second half of 2016.

Analysts continued to project this market will grow significantly in the coming years, exceeding $1 billion annually by the end of the decade.

With the impending availability of CX2 and our ramped up technology cadence driving future products to market more quickly, my expectation is we will continue to grow our DCI business as the worldwide market leader.

Now on to metro.

Though Q1 was seasonally weaker, we continue to have success winning opportunities with our XTM Series packet optical portfolio.

The strength of XTM is at the edge where customers appreciate our low-power, low latency solutions and the ability to provide Layer 2 aggregation, while fulfilling multiple access applications.

We believe our new 400-GB module which will yield an 8x density increase and a 3.5x power reduction per GB will prove to be very competitive in numerous metro applications.

There's also growing interest in the XT-3300 for metro.

While ICPs are generally interested in XT-3300 for long-haul, service providers are looking at it for both long-haul and metro transport applications, taking advantage of its ease-of-use, compact form factor and sliceability.

My view is that the timing of these new products, both for metro edge and metro transport, aligns well with impending inflections around next gen access architectures, such as Remote PHY and multiple cable operators in 5G and mobile operators.

We believe these architectural inflections will dramatically increase access bandwidth and drive fiber deeper into the metro, increasing demand across our portfolio.

One emerging opportunity I would like to touch on is enterprise.

We are seeing early success from our investments in products across the XTM Series and Cloud Xpress.

Of note, we recently deployed a large intercampus network with a health care company that is a global leader in robotic-assisted surgeries, which selected the XTM Series based on its low latency.

Additionally in Q1, we deployed DCI networks for a large sports apparel company and also a well-known chip manufacturer.

Our expanding portfolio of purpose-built solutions, complemented with investments in sales, channel and marketing infrastructure should drive increasing contributions from areas like enterprise, government and Tier 3 over time.

On the technology front, at OFC, we announced Instant Network, the next evolution of our highly successful Instant Bandwidth capability, which we believe is the industry's only software-defined capacity offering.

Instant Network is a unique capability made possible by our PIC technology and Xceed Software Suite.

Our customers can now create revenue-generating infrastructure, by aligning network capacity with services demand, including moving bandwidth from route-to-route as opportunities arise.

This is not just a pricing strategy, but a combination of leading hardware and automation software that is delivering a new level of user experience to our customers.

One of our key customers, Telstra, leverages Instant Network to deliver on its always-on service guarantee, which assures network availability to its customers across key subsea cable routes.

Customers appreciate the value Instant Network brings in terms of network optimization and automation, and are excited about their new ability to create service differentiation.

I believe we will see more customers embrace Instant Network as a valuable element of their network and go-to-market strategy.

In terms of our optical engines we continue to make progress on ICE5, and remain committed to a cadence of delivering new optical engines every 2 years.

This strategy should minimize the likelihood of future technology gaps, and is already bringing us increased credibility with customers as we collaborate around creating and fulfilling long-term network strategies and visions.

In closing, with a stream of new products coming of the next few quarters and a ramped up technology cadence, we are well positioned to gradually improve our financial results.

Pent-up customer demand suggests that our new products are well suited to address evolving architectures that require the most scalable and cost-efficient networks.

I look forward to delivering our new products to the market, continuing to provide the best customer experience in the industry and ultimately capitalizing on the substantial growth opportunity we have ahead of us.

As always, I would like to thank our customers, partners, shareholders and employees, and you for your support for Infinera.

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

Thanks, Tom, and good afternoon, everyone.

We executed well in Q1, delivering financial results at the high end of our guidance ranges.

Q1 revenue was $176 million, down 3% sequentially.

Given the large cable customer Tom mentioned, now spreading its spend across the full year and the broader challenges we are working through, I'm pleased with our Q1 revenue result.

In the quarter, revenue grew sequentially in all of our customer verticals, with the exception of Tier 1, which continues to be challenged.

Our top 5 customers in Q1 consist of 2 wholesale and enterprise carriers, one ICP, one cable operator and one international Tier 1. One customer accounted for greater than 10% of revenue in the quarter, a wholesale and enterprise carrier.

As the year progresses, the combination of pent-up demand for our new solutions across all of our end-markets and the possibility that long-haul will return to growth in the second half, gives me confidence we can gradually grow revenue sequentially over the course of this year.

Geographically, North America returned to growth in Q1, up 3% sequentially and accounting for 57% of total revenue.

Our progress in North America was attributable to a strong contribution from wholesale and enterprise, and solid results from cable, including early growth from the new metro customer, we announced last quarter.

Our international results in Q1 were mixed, as EMEA accounted for 33% of total revenue and experienced a sequential decline of 15%, in line with typical seasonality in the region.

The sequential decline in EMEA was led by telco customers, and partially offset by an increase in wholesale and enterprise.

APAC demonstrated both sequential and year-over-year growth in Q1, accounting for 7% of total revenue.

We are making good strides expanding our customer base in this region, with increasing contributions from ICPs and enterprise customers in particular.

Finally in Q1, LatAm was a small contributor, sequentially down and accounting for 3% of revenue.

While I continue to believe our long-term prospects in LatAm are bright, certain customer specific project delays continue to hinder our business in the region.

Now turning to margins.

Non-GAAP gross margin in Q1 was 40.3%, due to ongoing pricing conditions including investing to preserve existing business ahead of delivery of our new products.

In addition, we continue to be negatively impacted by the reduced volumes within our manufacturing infrastructure.

As I have said previously, our gross margins are likely to remain at similar levels until we see the impacts of new products ramping.

We continue to evaluate deals focusing on the long-term, which may continue to put pressure on margins in the short-term.

Regarding OpEx, non-GAAP operating expenses were $91 million in Q1, in line with guidance.

We continue to balance the spending required to deliver ICE4 products to market and support our faster technology cadence, with ongoing expense management in light of our current revenues.

Over the course of FY '17, we continue to expect R&D expense to be in the mid- to high-20s as a percentage of revenue.

To ensure we deliver the new suite of products to market and also make the required investments to ensure a robust pipeline of future solutions.

We anticipate SG&A expenses will also increase to support the adoption of the new products, although, at a slower rate than R&D.

Putting everything together in Q1, we incurred a non-GAAP operating loss of 11.4% and a bottom line net loss of $0.15 per share.

While these bottom line results exceeded our expectations going into the quarter, operating the business at a loss is certainly not a long-term strategy of ours.

Our expectation is that the investments that we are making today will maximize our future opportunities and enable us to restore our profitability over time.

On a GAAP basis, we incurred a net loss of $40 million or $0.28 per share.

The difference between our GAAP and non-GAAP results was attributable to approximately $11 million in stock-based compensation, $5 million of acquisition related costs and $3 million in amortization of debt discount.

Turning to the balance sheet.

Total cash and investments at the end of Q1 was $359 million, down $1 million from the end of Q4.

Cash flow from operations was $3 million as positive working capital changes offset our operating loss in the quarter.

In Q1, we continued the process of rebalancing our inventory mix, keeping the overall inventory levels steady as we ramped the levels of ICE4 inventory and sold existing products.

The other significant drivers of cash in Q1 were CapEx of $15 million and proceeds from equity issuances of $10 million.

I'm pleased we were able to keep our cash level steady in an otherwise challenging quarter.

Now for our outlook for the second quarter of fiscal 2017.

We currently project revenue of $180 million, plus or minus $5 million.

The midpoint of this range represents sequential growth of 3%.

Our expectation is that sequential growth in Q2 will be driven by our cable and ICP verticals.

Tempering growth is the possibility that the impacts of preclosure planning from 2 of our larger customers merging, could cause further softness on their CapEx spend.

Additionally, with CX2 not being generally available until the latter half of the quarter, we are only expecting a low to mid-single digit revenue contribution from CX2 in Q2, as customers must complete their qualifications for us to recognize revenue.

Pent-up demand for CX2 remains strong, so it's largely a timing concern at this point.

Regarding margins and expenses.

We currently anticipate non-GAAP gross margin in Q2 to be 40%, plus or minus 200 basis points.

As we have previously discussed, we won't start to see margin recovery until our new products gain traction in the market which should enable us to realize cost structure benefits and to reestablish fixed cost leverage from our vertical integration model.

As for OpEx, we currently anticipate non-GAAP operating expenses will be $95 million, plus or minus $2 million.

Sequential OpEx growth in Q2 stems predominantly from R&D as we prioritize delivering new products to market and invest in future technologies that will drive long-term differentiation.

Also, we intend to fund customer trials to support qualification and adoption of new products.

Below the line, the combination of interest and other expense in Q2 is expected to net out to approximately $500,000 and tax expense should be approximately $1 million.

Note, that despite our current loss position, we still are required to pay tax in jurisdictions where we have cost-plus entities.

Hence, under our current tax structure, we will incur a tax expense in most quarters.

Putting this all together for Q2, the midpoint of our projected guidance translates to a non-GAAP operating loss of 13%.

Non-GAAP EPS is expected to be a loss of $0.17 per share, plus or minus a couple of pennies.

As for GAAP EPS, we project it to be lower than non-GAAP EPS by about $0.14 per share, primarily related to stock-based compensation expense.

In closing, with CX2 nearing general availability, success to date and potential acceleration from our XT portfolio and signals that the long-haul market could resume growth in the second half, we continue to believe that our results will improve over the course of the year.

Note that as we deliver new products to the market, financial improvements will be gradual.

For example, on the margin front, cost structure reductions from new products will be a multi-quarter process, that will not all occur day 1. Additionally, I anticipate having to continue investing to preserve existing business for the next few quarters in areas where we haven't yet delivered new products.

Once we get multiple new products or market, however, we should be well positioned to resume revenue growth and margin acceleration.

In the near term, we will continue to manage expenses prudently, while investing to realize our significant future opportunities.

Ultimately, I'm confident that our differentiated solutions and operating structure will enable us to grow our top and bottom lines over time.

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

(Operator Instructions) Our first question comes from Doug Clark of Goldman Sachs.

My first one's on Cloud Xpress.

I'm not sure if I caught it in the prepared remarks, is the CX2 slightly later than your original anticipation?

Or is this timing for kind of later part of second quarter the expectation going in?

We were hoping to get it out earlier in the quarter.

So it's slid into the second half.

We have started shipping as I said to one customer.

We consider it -- it's pre-GA.

We have certain customers who like to take products that we believe are robust, but we haven't finished our testing yet.

That's been running in their network now for 2 weeks and we've gotten good feedback.

But we're not -- we are not done with all of our testing so that the product will not ship until the second half, which is probably a month later than I had expected.

Okay.

I mean, can you talk a little bit about what caused those slight delays?

And then more broadly outside of this one customer, what type of interest you're seeing from customers in general for it?

Yes.

The CX2, we have a tendency as a company, obviously, to push a lot of technology, both our own and market technologies.

We incorporated a couple of cutting edge pieces of technology into the CX2, that accommodate what I think are important features -- what we think are important features for our customers.

These new technologies and our own both had some learnings that we had to do, meaning we had to go and discover bugs and get them fixed either by us or some of our technology providers.

And that just slowed things down a little bit.

I'm feeling very comfortable that we understand all the issues.

They're being fixed and we're just in a testing phase.

The disappointing part, Doug, quite frankly is that the demand, you asked about demand, is quite frankly extraordinarily large from both our current customers and new customers.

And the opportunity is as big or bigger than I had anticipated.

The challenge is making sure we get it out to the market, and get into our customer's testing cycle so that we have the opportunity to monetize it as soon as possible.

So I think that the product is in -- I consider it in good shape today, based on our customer feedback.

It's one of our large CX customers.

They've been running it for 2 weeks, without problem.

So I'm comfortable that we're progressing, but I want to make sure that we go to mass market where we've dotted all the Is and crossed all the Ts.

And that's good to be a few weeks later than we had hoped or expected actually.

All right, got it.

And my other question is on the 2 customers that are merging and perhaps deflating a little bit of the second quarter expectations.

Is it possible that, that takes a further step down later on in the year?

Or do you think second quarter will be the low watermark?

Candidly, I'll never say never.

But the numbers that we're seeing for Q2 have been cut so much.

I can't fathom that they could possibly go lower than they are.

It's literally, I think, impossible.

Our next question comes from Patrick Newton with Stifel.

I guess, just the dovetailing off the last response, Tom.

You have new products kind of slipping slightly.

You commented on aggressive pricing, you talked about some merger headwinds and then you mentioned a challenged environment multiple times in your prepared remarks.

So I'm curious if your second half expectations have been somewhat tempered relative to a quarter ago when you spoke to an expectation of stronger growth?

Or should we think about more pent-up demand and an even better second half from where you were sitting a quarter go?

I don't -- my second half view has not gotten more negative than it was the last time we talked.

I continue to be optimistic about the second half.

A lot of the optimism is based upon the real demand we we're seeing for the CX2, the real demand we're seeing for the XT-3300.

I hope people caught the importance of the commentary on winning with XT-500.

That's nice wins for us.

But we brought the XT-500 out about a year ago, and it's taken about a year for us to get the architectural buy-off from customers to go with the XT-500, and we are seeing really good success in Q1 with that.

I am expecting that, that architectural sale has now been accomplished.

So that we bring out the XT-3300, we're able to ramp that up and put it into real applications versus convince people about the architectural direction.

As we've mentioned that we've been behind a little bit in subsea, I'm a very -- high expectations of recovering in that with our XTS-3300.

So I'm still optimistic, very optimistic on the second half.

The challenges -- the headwinds that we faced that are more specific to us.

The integration of these acquisitions.

We have been -- 40% of our revenue quite frankly has gone through an acquisition.

We're getting through a lot of those, but the 2 biggest ones are still ahead of us.

And I think that we've paid the fiddler completely for those.

I said in the last comment, I don't think we can go lower from a revenue perspective.

But nothing's done until it's done.

And once acquisitions are done, there's always a process of the companies integrating before they start rebuilding.

So that's a headwind that's ours specifically.

I do think that the telecom pressure is not ours specifically and it's real.

And these guys are really trying to squeeze assets and it's not just the guys that are being acquired.

I do think that, that runs a course that has to stop.

Because bandwidth -- everybody agrees, bandwidth in their networks continues to grow.

In some of the markets, the pricing pressure continues to be real.

Last year, ASPs in our industry went down, industries say about 29% per 100-GB port.

That's fairly unparalleled except when you do a technology transition.

Last year was not a technology transition-led event.

I do see distinct pricing pressure still, but I don't think it's as bad as last year.

Part of it is the wholesale space, both in North America and in Europe, are under brutal attack between each other.

The cost of capacity, the wave in Europe has absolutely cascaded.

That brings incremental pressure on CapEx.

The good news is, I believe, particularly with ICE4, we bring a solution that has more CapEx efficiency than anybody else.

So I think that's transitory, I think the second half, I'm optimistic about.

I'm focused quite frankly, right now, on just getting these product out.

And the demand is real for them.

I appreciate the detailed response.

You did just -- but you did just touch a little bit on subsea as being an opportunity in the second half.

Can you elaborate a little bit more there and perhaps balance commentary on the opportunity in LatAm and APAC against you being in the process of field trials with your ICE4 that's required in certain deployments?

And I guess specifically, I'd like to understand when subsea could rebound back to kind of a typical 5% to 10% of total sales?

Sure, I'll try and add commentary.

This is Dave Welch.

We're actually seeing pretty good order rate for our subsea business right now.

Understand that these -- the subsea business has the longest time from order to shipment and revenue from that.

We'll be getting out some of our first product out to the field in this quarter.

And we expect to see that continue to grow.

So as Gen 4 gets out to the field, into our customers' hands, I expect that to continue to become a growing [competitor].

I feel from a competitive position, we are actually in a pretty good spot from here going forward with Gen 4 and then with Gen 5 not too -- not in the too distant future.

The next question comes from Jeff Kvaal from Nomura Securities.

I was wondering if you wouldn't mind touching on the competitive landscape in DCI?

There have been a few more introductions, and certainly some of the existing products have had a little bit more time to gain some traction.

And then Brad, I wanted to, just as a clarification, follow up on your prior -- your last quarter's comment on breakeven and what it would take to get there and when that might be.

Yes.

So with regard to DCI.

We still have a significant portion of the market.

But candidly, we are under pressure from a couple of people who have introduced viable products and in the second half of last year started shipping them in reasonable volume.

Quite frankly, it makes me mad, it's our fault for having our product come out later than we should have.

But I do believe with our Gen 4 based product, we have the industry's leading capability.

I am -- my goal is to make sure we stay above 50% market share in this market even as it grows to hopefully multiple billions of dollars.

I think with our technology, we have the ability to do that.

Clearly, we have a first mover advantage of ease of use and the software features that people want.

And I think our customers want us to be in their network.

But in the ICP space in particular, there's not loyalty like there is in a lot of other market.

There are really loyal to a dollar per bit and they're loyal to watt per bit.

I think with our approach on technology, we can and should the lead market.

And with our increased cadence of technology, I am very comfortable that we're going to.

We just got to get the Gen 4 out and we'll be in fine shape there.

But we do have a couple of competitors there.

Any market's going to attract a couple of -- there's going to be more than one person.

And there's 2 people who are there right now that, quite frankly, are viable competitors.

And Jeff, just to take the second part of your question on the breakeven.

I think it's still possible by the end of the year.

Obviously, with our guide for Q2, it's going to take a decent ramp in the second half.

But as Tom mentioned, I think there's a lot of great opportunities when the new products get out to market.

So it'll take some acceleration of revenue, good success with the Gen 4 products which will drive both the top line and drive some acceleration from a margin perspective.

So it's a little more challenging than it was when we last talked, but I still think it's possible.

Our next question comes from George Notter from Jefferies.

I guess I wanted to kind of expand the discussion on product availability.

I think understand what you said, certainly, on Cloud Xpress 2. But Tom, the monologue had a lot of content in here.

Looking at some of these other products, the 3300, the 3600.

Is the timing on the rest of the portfolio the same as you were outlining last quarter and at the Analyst Day?

I just want to be sure that nothing has changed there.

For the 3300, it's roughly on the same time schedule we said last time, that we weren't sure if we get revenue in Q2.

But probably in Q3, I would say we're probably going to be in Q3 and I think will achieve a reasonable amount of revenue from the 3300 in Q3.

On the 3600 and the DTN-X, we didn't comment today.

We have so much that's focused my mind on the CX and the XT.

But we are on track for doing those this year, probably in Q4.

And metro as well.

And then metro, the TM upgrade to 16QAM is on track, we said, also in Q3 and it's basically the same schedule we talked about.

Got it.

Okay, and then the TM portfolio, I guess, the 16QAM upgrade, I guess I was also wondering if there's anything new to talk to there in terms of PIC integration.

Is that still the Gen 5 threshold where you bring that into the portfolio or do we have that in there earlier?

Yes, George I'll try to comment on that.

The -- we are actually doing very well from 100-GB wave perspective and the cumulative metro market inclusive of metro data center business.

The -- and so the vast majority of our 100-GB waves in the metro space are PICs.

We will continue to complement that with wavelengths on the XPM and the aggregation markets.

And then as we move towards our next generation platform, that will create a common operating system across our metro long-haul activities.

We'll start bringing in unified optical engines across our portfolio.

The next question comes from Meta Marshall from Morgan Stanley.

Great.

I wanted to dig in just a little bit more if you could talk about the customer who's utilizing the open line system?

And just whether they were using that for kind of new applications?

Or hoping to kind of change a bit of their architecture?

And then, second question is just on flexible bandwidth, if kind of rolling out customers on that has any material impact on gross margins as well?

Or is it just kind of price -- aggressive pricing leading to margin pressure?

Sure I'll try to address it.

On the open line system, we've had a number of interactions.

We've specifically identified 8. One of the customers that have rolled this out, that has converted from utilizing our competitor's product to our product, built it off of an open line system as well as built it off our waves on that line system.

Frankly, that business is going well.

We are happy with -- they're happy with the product, we are happy with the growth that they're demonstrating in those networks.

And there will be a class of customers that are comfortable with buying their line system independently from the transponders and then there's going to be a lot of service provider-centric customers that prefer to have one integrated network.

And we are happy with our technologies to address both of these markets.

On the flex bandwidth, I think you're referring to our Instant Bandwidth or our Instant Network offerings that we brought out, I'd say, we've been offering Instant Bandwidth since the fall of 2012.

And that has been overall an enhancer to our margin offering.

And I think that continues to be.

As we get into ICE4, I expect a greater percentage of our customers to be an Instant Bandwidth customer.

So I'd say maybe for a brief period of time, a slight added margin pressure.

But overall, I think it'll add -- it'll increase the margin capability, the product line.

In Q1 we had a reasonable amount of business for line systems and footprint in our model.

That bears obviously lower margins.

That's coming to bear a bit in Q2.

The good news about that is when we have low margin because of footprint adds, we have an ability to monetize that expand margin for a long period of time.

So for Q2, that's a good reason that margins are under pressure.

Getting ICE4 out is part of that solution and obviously that being a bit of later than we thought is not a good reason margins are compressed in Q2.

Yes.

So Meta, the biggest thing is really the bridge investments to the new products.

So obviously, we're making the right investments so that when Gen 4 gets out, those grow at very nice margins.

Obviously, some customers have contractual price compression that hits in Q1 as well.

So it's more of those things than the Instant Bandwidth piece.

Our next question comes from Alex Henderson from Needham and Co.

I wanted to look a little bit more tightly at the gross margin guidance.

Seasonally, 1Q is usually the weakest quarter.

Then you've also got some products coming out in 2Q.

I'm a little surprised to see the idea that you might be 100 to 200 basis points below what you did in 1Q and 2Q, given the plus or minus 2 points on a 40% guide.

What might cause that to slide sequentially like that, given the guidance?

Yes, so as we mentioned on the prepared remarks, Alex, the impact for Gen 4 that we're planning and the numbers we guided to is relatively small.

And the first units that go out because they don't have optimal yields and that kind of stuff yet, actually can be a drag on margins.

So that's a small impact.

And in fact, a negative impact as we bleed through some of those early units.

So that's the incremental negative.

The overall piece is just really making sure that we're are not afraid to make the investments to bridge customers for the new technologies.

Because any amount of delay cause customers to be concerned about other offerings and they start to look at other offerings.

And we've been fairly aggressive in making sure that we keep those customers in our portfolio, so that they're ready when the products start to get out to market.

Is it reasonable to think that if you were to go to the lower portion of the gross margins that would also entail possibly going to the higher end of the revenue range?

That you may be choosing to use that pricing to pull some revenues in?

Probably not, I mean, it's just there's a lot of variables right now, Alex, and a couple of larger opportunities, whether they get fulfilled this quarter or not will move us from one part of the range to the other.

And going back to the R&D line, if I could.

Just could you give us a little bit more clarity on the slope of that over the course of the year?

Is that spiking up here in the June quarter?

Is that going to come back in as we go forward or flatten out a little bit?

Or is that due to the new product launch timing?

Yes.

It's just getting the new products out and make sure we have the right investments.

It will still grow from a dollars perspective, but relatively small over the course of the year.

It'll go down, though, as a percentage of revenues.

Alex, to be clear, I know you're worried about the 40 points plus or minus 2. Our intention is to be at 40 points.

There's more variability based upon how much of the new product we're going to ship or not.

But we try very hard to at least meet our guidance and I would consider the guidance to be flat but there's more uncertainty, because of the new product launch.

As Brad talked about, there is a large number of opportunities that could certainly move the revenue distinctly.

That would be a good opportunity, but I just don't feel like we can commit it, knowing the uncertainty at this point.

So I continue to be optimistic on where we sit.

But considering that the new products are a little bit later than I had hoped, that uncertainty is seen in our guidance.

The next question comes from Dmitry Netis from William Blair.

So just kind of taking a step back here and looking at the funnel in general and maybe some of the new products that are coming up here in the back half of Q2 and then Q3, specifically CX2, 3300.

As you look at the funnel of the opportunities, has your funnel of the opportunities of those product grown from 3 months ago, has it stayed about the same?

Just comment generally on what you're seeing?

And maybe on the DTN-X, the current product you're shipping.

Is it still seeing more opportunities coming your way on either the new or the old product?

So I'd say on the CX, the funnel's about the same.

It's always been pretty big, we see a lot of opportunity.

I wouldn't say it's grown since we saw -- talked to you guys last.

On the 3300, I think the funnel is increasing.

We're seeing new applications.

We talked about a little bit on the -- in the access space, the Remote PHY types of opportunities.

We see substantive amount of potential opportunity in that area.

That includes the 3300, but we're also seeing as the XT-500 sells well, we're seeing more opportunities from the 3300 in general.

The DTN-X, demand, it's driven a lot by companies that are under acquisition and in the telco space where there's pressure.

The RFQ activity in general for the company is much higher than it's been for a long time.

We bottomed out, I think Q2 of last year on RFQs.

And I made a comment on that, at the time, when our business fell precipitously.

The RFQ activity has been growing steadily and in Q1, I believe it was either a record amount of RFQs across our portfolio or close to a record of RFQs.

So I'm seeing in the market more opportunities than we saw certainly 6 months ago.

And even 3 months ago.

So the pipeline of activity in general is much better.

Excellent.

And my follow-up is, I guess twofold.

One is, you mentioned the long-haul part of the market grew, I didn't capture whether that was year-over-year or sequentially?

And is that a blip?

Or do you actually see maybe several quarters of kind of a long-haul business sort of coming back to life here despite the consolidation and M&A that we've seen at your customer base?

And then, on the CX side, is that still (inaudible) 10% of revenue?

And is CX basically filling the void while you are getting CX2 ready to go out in the market?

Or is CX seeing an air pocket as well?

So just if you could address those 2 things.

I think we said the long-haul market was up sequentially.

And Q4 was pretty weak quarter for long-haul, quite frankly.

I do think that the long-haul business we do see -- start to see recovery.

Some of it's being replaced with XT type of opportunities versus DTN-X, that obviously has a significantly lower selling price.

But the magnitude of the opportunities are also bigger volume.

I do think that as we said on my prepared statements, we see an opportunity to grow market share in the second half of the year.

And I believe that is the case.

I do think a number of the customers that are -- have tamped down their spending are going to get to the point in that time frame when they have to start spending money to grow their network.

It's not like they're not growing their network, but what they're doing is, they're trying to optimize assets in their warehouse and they're bringing down to a level that, quite frankly, is going to start bringing them concern.

We egged that on a little bit by having very, very fast lead time.

And we shipped typically 2 to 3 weeks.

So there's more and more I would say financial scrutiny -- if Infinera ship in 2 to 3 weeks, why are having a couple of months of inventory on our shelves?

They are as intense on asset utilization as I have ever experienced them.

So it's real, but it's going to run its course.

So I'm more optimistic about our long-haul space than I was over the last couple of quarters.

In regard to the cloud business being 10%.

Personally, I believe it has to be greater than 10% of our business.

It has the opportunity to.

If we had the CX2 out fully in volume right now, it would be substantially bigger than 10% of our company.

And I think there's a huge opportunity.

We made the mistake of delivering ICE4 later than we should.

We are not going to make that mistake again.

ICE5 is actually on track or ahead of track on all technical performance and schedule.

We need to go and make sure we have a cadence of delivery that never puts us here again.

I believe the GEN 4, the CX2 will put us in a good position of growing market share again.

We just got to get the thing out.

Our next question comes from Vijay Bhagavath from Deutsche Bank.

My question is on the data center optical opportunities.

So it'll be truly helpful to get your color on what competitive pricing dynamics you're seeing in the DCI market?

And where I'm coming from is, who do you run into mostly in terms of the vendor portfolios, the vendors, the suppliers out there in sales deals?

And then Tom, how do you see the DCI opportunity playing out this year versus last year in terms of growth rate, the number of customers you have now versus prior years?

And then also the price declines you're seeing on the year-on-year?

Any and all color on the DCI market very helpful.

Yes.

Sure.

So the DCI market continues to grow robustly.

The biggest volumes are being driven by a few guys.

But as we talked on the call, we continue to add new customers every quarter.

And this is going to be an important part of this long-term move to cloud.

It's not done, and it's not just 5 guys that have this business.

So we are working very hard to address enterprise customers.

We are working very hard to get into new markets, where they have important DCI applications.

And we're achieving relative success.

But the biggest volumes are coming from the top ICP guys.

We continue to be well-positioned where we've historically been.

One of the ICPs as I mentioned has already deployed the CX2.

And they like it, and quite frankly, the mixed blessing of them doing early deployments is that they like it.

So they're quite frankly putting enormous pressure on us to start shipping them to in volume.

It's a good problem, but it's a problem.

So we need to go and execute on that.

There has been a couple of entrants into the market.

But it started basically Q4 of last year.

We saw a couple of significant -- we saw lots of people deliver products.

I consider we had 2 viable real competitors.

And I think that, quite frankly, both of their products are good.

I do believe that our CX2 is better, the market will decide.

And we just have to make sure it's in labs, competing with these guys.

And that's -- quite frankly the biggest challenge right now is making sure we're not missing lab qualification cycles for buy cycles.

These guys in the ICP space move fairly quick.

So we need to get product to them and not miss qualification cycles.

Right now, we don't believe we are of qualification cycles, but if we delay much longer, we run that risk.

I think that the long term, we have a huge opportunity.

And I said -- I tell my team internally all the time.

We must maintain at least 50% market share in this DCI space.

Anything less, we have quite frankly failed.

Okay.

Perfect.

And then, quickly Tom.

In terms of line rates coming from one data center to another.

Are they mostly 10 and 40 GB, Tom?

Or are you seeing like native like 100 GB traffic going from one data center to another?

It's all 100 GB.

Actually Dave said I'm too binary.

It's [vastly] 100 GB.

Our next question comes from Rod Hall of JPMorgan.

Just wanted to come back to the product development time line I guess.

It's always been a pretty challenging time line.

And you guys are calling out this slight delay now on CX2.

I just wanted to understand whether -- how that knocks on and impacts the rest of the time line?

Are you -- is this the same group of people, I think I remember that it is, but can you just remind us, is it the same group of people that have to get through all these ICE4 product developments?

Or do you have teams running in parallel so that the CX2 doesn't affect so much what happens with the other products?

And then, I guess as an add-on to that.

Tom, do you think that your development resources, are you adequately resourced?

I mean, is this kind of one-off because the ICE4 was delayed?

Or do you feel like you need to add some resource there?

Yes, so Bob (sic) [Rod], we have multiple teams developing these platforms.

So it's not as simple as this one moves a week, so the next 3 move a week also.

Obviously, the CX and XT are very similar platforms.

So while one impacts the other more, in regard to the 3600 and DT-X, there's separate hardware teams that are working on that.

The challenge with our ICE product is that the first one we bring to market is where do that the debug of the optical engine for all of them.

So there's not repeat learning around the optical engine.

There's certainly new learning that has to occur around the system because each system has their own requirements.

But the optical engine is, quite frankly, the heart of our IP.

And that's where we can take extra learning on the first one.

And one of the challenges moving forward is how do we make sure that we can step and repeat these across multiple platforms simultaneously.

We will -- we're making progress in that arena, but that's a challenge.

So long story short, some delay.

You shouldn't map it one-for-one.

There could be some delays that are correspondent, but you shouldn't map it one-for-one.

And I'm comfortable with our overall engineering resourcing.

I do think that we have some certain skill sets that we need to continue to add.

But overall, general engineering resourcing, I'm comfortable with.

This concludes our question-and-answer session.

I'd like to turn the conference back over to CEO, Tom Fallon for any closing remarks.

Well thank you, guys, for joining us today.

I appreciate your questions.

I look forward to updating you on our continued progress.

Have a great day.

The conference has now concluded.

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