Infinera Corp (INFN) 2022 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Infinera Corp. Third Quarter 2022 Earnings Call. (Operator Instructions)

Thank you. Amitabh Passi, Head of Investor Relations. You may begin your conference.

Thank you, operator, and good afternoon. Welcome to Infinera's Third Quarter Fiscal 2022 Conference Call. A copy of today's earnings and investor slides are available on the Investor Relations section of the website. Additionally, this call is being recorded and will be available for replay from our website.

Today's call will include projections and estimates that constitute forward-looking statements, including, but not limited to, statements related to our expectations regarding our business plans, model and strategy, including product roadmap and products, sales, growth, market opportunities and trends, manufacturing operations, technology, the shift to open architectures, market adoption of coherent optical engines, competition, customers, expectations regarding industry-wide supply challenges, the macroeconomic environment and ongoing COVID-19 pandemic impacts and statements regarding our future financial performance, including our financial outlook for the fourth quarter of 2022.

These statements are subject to risks and uncertainties that could cause Infinera's results to differ materially from management's current expectations. Actual results may differ materially, as a result of various risk factors, including those set forth in our annual report on Form 10-K for the year ended on December 25, 2021, as filed with the SEC on February 23, 2022, and its quarterly report on Form 10-Q for the quarter ended June 25, 2022, as filed with the SEC on July 28, 2022, as well as subsequent reports filed with or furnished to the SEC from time to time.

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 conference call includes certain non-GAAP financial measures. Pursuant to Regulation G, we've provided a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures in our earnings release and investor slides for this quarter, each of which is available on the Investor Relations section of our website.

And finally, as a reminder, we will allow for plenty of time for Q&A today, but we ask that you limit yourselves to one question and one follow-up, please.

I'll now turn the call over to our Chief Executive Officer, David Heard. David?

Thanks, Amitabh. Good afternoon, and thanks for joining us today. I'll begin with a review of our results for the quarter and then turn the call over to Nancy to cover the details of our financial performance. Given everything that's going on in the world with the markets and the economy, I'll try to be concise today. Overall, our message today is, our overall Q3 non-GAAP financial results beats consensus estimates. Our outlook for Q4 is in line with consensus expectations. We're delivering against our product strategy to drive market share gains, as evidenced by our 17% year-over-year product revenue growth, and we strengthened our balance sheet.

Financially, in Q3, we delivered revenue and non-GAAP operating margin at the high end of our outlook range, with non-GAAP gross margins near the midpoint of the range and up 170 basis points sequentially. On a year-over-year basis, we expanded operating margin by 270 basis points, grew product revenue 17%, which represented an acceleration from 11% growth that we posted last quarter, and grew total revenue by 9%. Furthermore, we generated free cash flow in the quarter, and improved our balance sheet.

Demand in the quarter remained healthy with bookings continuing at a steady pace for most of the quarter, especially in the Americas and with ICPs. In fact, 4 of our top 10 customers based on bookings were ICPs. We did have a few large orders that slipped from the last week of the third quarter, given the September 24th quarter end into the first week of our fourth quarter, resulting in a very strong start to Q4. Our backlog is healthy, setting us up well for the fourth quarter and for the full year 2023.

From a supply perspective, the environment was tougher than our expectations from 90 days ago, but our team effectively navigated the challenges in the quarter. Supply costs, including expedite fees and freight remained elevated and adversely impacted gross margins incrementally by over 100 basis points relative to our projections coming into the quarter. The total impact to gross margins for the quarter was approximately 400 basis points above normalized levels, without which our gross margins would have been above 40% in the quarter.

While we're seeing some broad-based relief in overall supply chain, we expect supply conditions to remain challenging for some critical components, through at least the first half of next year before easing in the back half of 2023.

During the quarter, we continued to ramp new products, win deals with major ICPs and Tier 1 service provider customers. Our progress in the quarter spanned our entire portfolio, reinforcing our confidence in our 8x4x1 strategy. Specifically, within our Systems business group, we had 2 key developments. First, we ramped ICE6 to over 30% of product revenue in the quarter, and secured key design wins with several large customers. including a Tier 1 global cable operator with significant operations in the U.S., a Tier 1 ICP as we expanded into their long-haul network, and a major telecommunications service provider in Asia Pacific. ICE6 remained on track to ramp to 20% to 25% of total product revenue for the full year of 2022, in line with our prior commitments.

Second, we had another strong quarter for our metro platforms with revenue for the flagship GX30 product line, up in the double-digit percentage range on a year-over-year basis. Our metro footprint continues to diversify, as we expand with service provider customers, both domestically and internationally.

Within our subsystems group, there were 3 notable accomplishments for the quarter. First, our 400-gig ZR+ pluggable is industry-leading and ahead of our expectations. We are starting to vertically integrate it into our own Metro platforms, which should begin to positively impact gross margins as we exit 2023. During the quarter, we concluded a successful field trial with a large North American Tier 1 service provider, in which we demonstrated industry-leading results in reach, power and performance. All of this was accomplished in the industry's first 400-gig ZR+ software-defined pluggable.

Second, we're pleased with the progress we're making on the development of our own 100 gig point-to-multipoint coherent pluggables, based on the open multi-source specifications being developed in the Open XR forum. We believe these pluggables will revolutionize networks and open up a new multibillion-dollar addressable market for us. Membership in the Open XR forum continues to expand, and there's a growing pipeline of interested service providers and equipment manufacturers ready to sign up for the forum.

In fact, during the quarter, American Tower, Telecom Italia Mobile, joined as members of the forum, along with additional network equipment manufacturers, including DriveNets, UfiSpace and Furukawa Electric. Third and finally, the development of our next-generation 800-gig pluggables is progressing well, and we intend to lead the industry in this category as well.

I'm encouraged by our business execution across the board while being mindful of an uncertain macroeconomic environment. Our product portfolio is in great shape, and we're winning major deals and gaining market share. We are prioritizing our investments in sales and marketing and the most strategic R&D programs, to capitalize on the insertion opportunities we see globally.

In addition, as an optical semiconductor manufacturer, we have been positioning ourselves over the past couple of years with all branches of the U.S. government, including the Department of Commerce, as an intended beneficiary of the government-sponsored CHIPS And Sciences Act. Infinera is unique and our U.S.-based capability in compound semiconductors with production and packaging facilities located in the United States. We intend to use any government funding that may be made available to us to accelerate R&D leadership in this critical technology, invest in our core business capability, and potentially expand into new markets, while strengthening supply chain resiliency and national security interests.

Looking ahead into the fourth quarter, we're planning for another quarter of above-market revenue growth, while fighting the remaining acute supply chain challenges to get towards non-GAAP gross margins of 40%. We expect the fourth quarter to benefit from the continued ramp of ICE6, momentum in the metro business and additional operating leverage. Our fourth quarter outlook also implies product revenue growth of greater than 10% for the full year, and significant operating income expansion in 2022 over 2021 results. This financial performance is remarkable, especially in an environment where we expect to absorb more than $50 million in elevated supply chain costs for the year, and further demonstrates the value of our vertical integration.

As you've heard today, we're extremely focused on executing against our strategy and meeting our commitments. Our 8x4x1 strategy is working. Our products are winning in the market and supply chain disruptions are actually creating new opportunities for us and our customers, as they look to mitigate their supply chain risks. We are relentlessly driving towards our target business model and $1 per share in annual earnings power. While there are several adverse macroeconomic factors at play, the underlying demand drivers for our products and services are healthy. I continue to be impressed with the innovation, execution and resilience of our Infinera team, the high degree of engagement of our partners and suppliers, and the collaboration of our customers.

As we look forward to -- we look forward to diving deeper into our company's strategy and our product portfolio at our upcoming Investor Day that we are planning for March 7, 2023, at the OFC Industry Show in San Diego, California.

I will now turn the call over to Nancy to cover the financial details of the quarter and our outlook for the fourth quarter. Nancy?

Thanks, David. Good afternoon, everyone. I will begin by covering our Q3 results and then provide our outlook for Q4. My comments reflect non-GAAP results and outlook. For your reference on our Investor Relations website, we have posted slides with financial details, including our GAAP to non-GAAP reconciliation to assist with my commentary.

I am very pleased with our performance in Q3. The Infinera team executed well to deliver revenue and operating margin at the upper end of our outlook range and revenue in the third quarter was $390 million, up 9% on a year-over-year basis, with product revenue growth of 17%. This growth was largely due to the continued ramp of ICE6 to over 30% of product revenue in the quarter, along with the continued momentum in our Metro business.

Service revenue was stable sequentially, but still down on a year-over-year basis, as we continue to build our Professional Services backlog from the impact of delayed customer deployments earlier in the year.

Geographically, we derived 57% of our revenue from domestic customers, a level higher than normal due to the strength at ICPs and other service providers in the U.S. During the quarter, one customer contributed to greater than 10% of our revenue, which was an ICP customer. Gross margin of 37.8% was near the midpoint of our outlook range and up 170 basis points sequentially. We delivered this margin, while absorbing approximately 400 basis points of supply chain-related headwinds in the quarter, 100 basis points higher than our expectations, from roughly 90 days ago.

Operating profit in the quarter was $20 million, equating to an operating margin of 5.2%, which was at the high end of our outlook range. On a year-over-year basis, we more than doubled both operating profit dollars and operating margin in the third quarter. Operating expenses of $127.5 million were below our outlook range of $131 million to $135 million, as we tightly managed spending in the quarter. The resulting EPS in the quarter was $0.05 per share.

Moving on to the balance sheet and cash flow items; we ended the quarter with $210 million in cash and restricted cash, up from last quarter. Our cash balance benefited from cash flow from operations of approximately $20 million, which resulted in free cash flow of $9 million, and we reinforced our balance sheet further, as part of the refinancing of a substantial portion of our 2024 notes.

During the quarter, we paid off the $40 million outstanding on our ABL facility, ending the quarter with a 0 balance drawn. As a reminder, we will continue to utilize our ABL facility strategically for short-term working capital needs.

Despite the tough macroeconomic conditions in 2022, we continued to make meaningful progress toward our long-term target business model, while strengthening our financial position. Through the first 3 quarters of 2022 and compared to the same period in 2021, we grew company revenue by 6% and product revenue by 11%, well ahead of the 4% growth rate for the optical market, netting in an expected gain in market share. We expanded operating margin, while absorbing higher supply chain costs throughout the year, and we successfully ramped ICE6, consistent with our commitments.

Turning to the outlook for the fourth quarter, we are encouraged by the demand environment, the ramp of ICE6 and our strong backlog. At the same time, we are cognizant of the uncertain macroeconomic environment and expect supply challenges to persist, through at least the first half of 2023, albeit with some moderation. Taking these factors into account, we expect Q4 revenue to be in the range of $435 million, plus or minus $15 million, representing approximately 8% growth on a year-over-year basis at the midpoint of the range. We are planning for year-over-year product revenue growth of greater than 10% in Q4, and a sequential improvement in services revenue.

We expect gross margin to be in the range of 40%, plus or minus 150 basis points, up 220 basis points at the midpoint of the range on a quarter-over-quarter basis. The primary driver of projected sequential margin improvement, is a higher percentage of vertical integration and our mix from the ongoing ramp of ICE6. Embedded in the gross margin outlook is our assumption that we will continue to absorb approximately 300 basis points of supply chain impact from elevated costs tied to components, materials and freight.

We are forecasting Q4 operating expenses to be in the range of $140 million to $144 million, up sequentially as we pay annual commissions and continue to prioritize investments in both sales and marketing and R&D. The resulting operating margin in Q4 is expected to be 7% plus or minus 200 basis points, in line with consensus at the midpoint of the outlook range, and up 270 basis points on a year-over-year basis. Below the operating income line, we assume $7 million for net interest expense and $4 million for taxes. Finally, we are anticipating a basic share count of approximately 221 million shares for Q4 and a fully diluted share count of 260 million shares.

As I close today, I want to reiterate how proud I am of the Infinera team's accomplishments over the last couple of years, as we have ramped new products, won new customers accelerated growth and expanded margins. The team has delivered these solid operational results, while navigating through a tough external environment. We remain confident in our 8x4x1 strategy, as we drive toward our long-term business model and focus on generating $1 per share in earnings power. Finally, I'd like to extend my thanks to our partners, customers and shareholders for your continued support and cooperation.

Josh, I'd like to turn the call over for questions.

(Operator Instructions) Your first question comes from the line of Catharine Trebnick with MKM Partners.

Thank you and first time actually on the call with you guys. So my one question is you -- it looks like Europe is down 9% quarter-over-quarter. Can you talk to some of the issues going on there? Is it still pretty much -- yes, just explain what's taking place in Europe and why that's down.

Yes, it's a good question, Catharine. Good to have you online. Q3 typically, seasonally has been a bit of a down quarter in Europe, over the pandemic, not as much travel this year. I think we saw a bit more travel plus, we had quite a concentration here in the U.S. and with ICPs, and the way we count some of that revenue of global ICP, it falls in the U.S. bucket. But nothing out of the ordinary, nothing systemic, we still see strong demand and good prospects in Europe going forward.

Yes. And the only thing I want to press upon is, subsea has always been a strong area of upgrades for 800 gig. Can you pretty much pinpoint where you are, against some of the competitive landscape with that opportunity?

Yes, I think we're winning lots of routes. And then with -- when we look at the technology, there aren't many, with 800-gig technology out there. So that business for us has been growing year-over-year, not only in revenue bookings, but also pipeline opportunity, so it's going to be an exciting -- lots of new tables going in, to take advantage of interconnecting these data centers and handling the growth on a global basis.

Your next question comes from the line of Dave Kang with B. Riley.

My first question is, I don't know if you disclose RPO, just how much was it, and how much of that is really for immediate shipments, say, less than 3 months?

So we do disclose the RPO and the detailed schedule is in the Q that was filed today. So RPOs were up $300 million year-over-year, at $909 million. It was down $45 million versus last quarter. But I can say that in the first week of Q4, we more than offset that in some bookings that literally just pushed over into the first week of Q4.

So, is it fair to assume -- actually, that was my next question is, orders that were slipped to fourth quarter. It sounds like it's about maybe $90 million to $100 million. Is that about right?

I'm not going to give you the amount, but it's more than $45 million. I'll leave it at that.

All that came in -- our third quarter closed on September 24, just the way the days felt, sometimes getting customers and folks to realize it's not October 1st is a challenge. So yes, those orders all came in, in Q1 well over the $45 million number.

And my first question actually was about how much of that RPO is for immediate shipments?

For immediate shipments?

Like within -- yes, it's like this quarter, almost like -- how much can you ship if you have...

Yes, the remaining -- of the $909 million, the remaining to go in 2022 is $426 million.

Your next question comes from the line of Alex Henderson with Needham.

So looking at the same basic question, RPO is a little bit of an awkward term for backlog. And I guess the answer is the backlog came down by $45 million in the quarter, and that has been fully refreshed. If I were to look at that backlog, how do we think about the way it plays out into the first half of next year and specifically relative to the first quarter? Because normally, you have a seasonality in the first quarter that drops quite significantly. I know you don't want to give guidance that far out, but is there enough of that backlog -- that at this point, we would have a different than normal seasonality, and maybe a lesser decline in product sales sequentially than you've had in the past?

It's possible, but we're not going to call it yet. That RPO number and backlog number, just to remind everybody, is supply limited and has been for the last 18 months. So Alex, at this point in time, we're kind of continuing to believe we'll have the typical seasonal falloff from Q4 to Q1. Too early to call that ball, given how dynamic the supply environment is. As I mentioned earlier, while things have gotten easier for some broader parts, there's still probably an acute 8 to 12 parts in suppliers with kind of -- each a handful of parts that are really holding up the industry. Very familiar names that many CEOs like myself, have been muttering.

So if I were to look at it is, take the $45 million assuming that, that had been a normal September quarter and it sounds like you have around $900 million from RPO for the fourth quarter and into 2023. Is it reasonable to think of that as a straight backlog, and therefore, you've already got in hand, well over 50% of CY '23 product sales in hand? Or is there a large portion of that related to service?

A portion of that is related to service. I would say we feel good about our expected backlog going into '23, and that it gives us -- although we're not giving full guidance for '23 at this point, we do expect to grow ahead of the market in '23, and our backlog gives us that comfort.

All right. Thank you. I will cede the floor.

Yes. I just want to clarify for those, because I want to make sure, Alex, we get your question on the backlog and RPO piece. So again, we ended the quarter September 24. There were a couple of orders that slipped over into the following week, which ended before October 1st, that were in excess of $45 million. So the RPO number, I think, reported that Nancy just went through, was without those bookings included. So that number would have been -- the $909 million would have been up by over $45 million -- well over $45 million.

All right. So the RPO is something in excess of $910 million that you would have had -- that you had coming into the quarter, if you make that 1 week adjustment?

Correct.

Your next question comes from the line of Mike Genovese with Rosenblatt Securities.

I guess I want to understand -- I think I heard you say, Nancy, you're not giving '23 guidance right now, and I don't and you said -- does that mean we're not talking about 8 to 12 anymore for next year?

No, doesn't mean anything. It's just -- right now, we're focused on executing Q4, and we're not going to make any update to '23 at this point.

Yes. No updates to what we've said prior, Mike. So we're not backing off anything, we just want to get through this quarter and make sure we see where the stability in the market ends up.

Okay. And then I'm looking at the presentation, it said bookings continued at a steady pace. I think in prior quarters this year, they were up, I think, double digits year-over-year. Is that -- does that continue in the third quarter, or does steady means sort of flat year-over-year?

Yes. So I think what we're seeing is the forecast that we had for the back half of the year is holding strong with steady growth. The timing of that week of ending the 24th to October 1 was the only change that we saw, Mike. So we still see that kind of growth rate, as we look at the back half of the year and positive book-to-bill. Our book-to-bill, just to be clear, was just under 1. And if you take that week into -- was definitely over 1 and consistent with what our thoughts were, as we entered the back half of the year.

Okay. So a couple of more questions, if you don't mind. First of all, on the ICPs, really good quarter for ICPs, it sounds like you had 1 10% customer. But were there strengths from other customers in that as well, or was it primarily driven by one?

No. As I mentioned in the last call, where we used to only engage one ICP or two at a time, we're now kind of positioned with the top 7 going forward, and some of those are ramping. You heard in my comments where we're ramping different applications with each of those ICPs. So while there was one 10% ICT, there were a couple of very large contributors to the quarter as well.

Great. And then I'm going to ask just 2 at once, and that will be it for me. The supply -- supply chain, I think like a lot of people have said is, still bad and even a little worse than we thought. But you still managed to come in with what I call in-line gross margins, in-line gross margin guide. Does that mean that the mix shift to ICE6 is even more powerful than you thought? And then secondly, unrelated, what's the driver of the share count dropping in 4Q from 3Q?

Yes. So first question, yes, look, 400 basis points was not what we expected on the supply chain drag. That is going to eclipse a $50 million extra cost for us this year. The positive piece of our margin performances, as we said in the script was, ICE6 was over 30% of product revenue for the quarter. So that powerful mix and margin of that product line and vertical integration did help us mitigate some of that supply chain costs and will continue to in Q4 and into 2023. And that same vertical integration in our pluggables as we move into the Metro, with our own pluggables will help us in the future.

Yes. And on the share count, it's somewhat of an unusual quarter, because of the new 28 converts, which are an instrument fee, meaning we intend to pay those back in cash, so they are not included in the fully diluted share count. We actually have a bridge for you in the material that's on the website that walks you through the share count calculation. But I can go into more detail later if you want, but that bridge is actually out there. But it's one of the attributes of an instrument fee, you would not include those shares in the fully diluted count.

Your next question comes from the line of Simon Leopold of Raymond James.

So David, I feel like I heard you say something or suggest something, and I want to just make sure this isn't my imagination running away from, but it sounds like you suggested that you're taking some extra share, and doing a little bit better in part because competitors are having issues, perhaps with supply chain and -- so part of your ability to grow fast in the market is coming from your supply chain execution, relative to others. If you could maybe elaborate on what you were talking about?

No, you actually -- I wasn't intimating or -- that is a fact. So, you got that right. That was a good translation. We are seeing in a number of markets where maybe people have been waiting or had orders placed and they're hitting traffic limits, where they need to bring in an alternative with open line systems and open transponders or lead times on those transponders, given we had planned for a big ramp and wanted to have extra ability to take share, #1. And #2, the vertical integration puts more of that supply chain in our own hands. And so that has provided us in many cases, where we can deliver transponders in 12 weeks or 16 weeks, compared to somebody else that might have been waiting for a couple of quarters or a year.

And I guess the follow-on to that is, how sticky is that? Does that reverse at some point when supply chain eases for everybody, or does it give you some advantage?

Well, the way I think about it is, when I talk to our customers, anytime you experience a shock like this, whether it's Y2K or any of the initiatives that have gone across corporations and into boardrooms, supply chain has been a huge discussion in everybody's boardroom. And so I think people have just looked at the concentration on where they have their spend in each category including optical. And as somebody who is a share taker, it provides us for more opportunity, where maybe some of the customers have been more concentrated, not just temporarily but permanently.

And then just a quick clarification. I think in the past you've given us the target for ICE6 to be 20% to 25% of revenue, I believe, for the full year and given the 30% you achieved in this quarter, and your outlook for the fourth quarter, do you have a revision to the full-year target? Was it still that 20% to 25%?

No, it's still 20% to 25%, and then somebody had the question of full year guidance. That's why on this call we also mentioned we're having our Investor Day, March 7th at OFC. So we'll try to give you all those metrics like we did. I think for this year, we did a nice job saying hey, here's what we're going to ramp ICE6 to, here's what's going to happen with pluggables, here's what's going to happen with operating margins, here is what we believe the supply chain drag will be. We will give the same kind of detail on March 7th in San Diego.

Your next question comes from the line of Meta Marshall with Morgan Stanley.

Maybe just bearing in on the supply chain bit for a minute. Just what form did kind of a more complicated supply chain take this quarter, just trying to get a sense of where the products that became -- were there different products that became unavailable during the quarter, were there just higher broker fees than expected? Just a little bit of context about kind of what happened versus what you were expecting.

And then second, the international business was obviously a little bit weaker. I understand that there is lumpiness and project-based stuff there. But you did mention [macro] in your script. And so just wondering, if kind of the strengthening dollar had any impact with kind of your European customer base? That's it from me.

No. Both excellent questions to go through. I think on the macro basis, back to demand, so far we haven't seen anything significant. We're service providers in general. Maybe I'll make a comment about spend. I think ICPs are continuing to grow in their datacenter. I think you saw what Meta's CapEx numbers are. We expect datacenter growth to continue and the subsea cables to continue. We have very good insight into that, as we've been partnering with our client base, because those are long projects when you're planting cables under the sea, we get to see those. So that gives us a little bit more confidence that our CapEx will be prioritized.

When you think of the CSPs, in prepared remarks from the largest CSPs, most of them have said look they are going to continue to spend CapEx primarily focused on fiber, on the implementation of fiber and 5G. 5G tends to be a very radio heavy first implementation, and so that means the intensity of the spend we're seeing is really on that fiber implementation. If you've seen Corning announce too -- they're a very conservative company. They announced 2 factories, 1 in Arizona, 1 in Warsaw, to actually make fiber, which means this is going to be a continued trend, be a little bumpy with the economy, but the investment thesis is strong there.

From a supply chain perspective, I'll tell you this; supply chain costs went up in terms of expedite fees and transportation fees, big time broker fees. Obviously, we grew product revenue 17% year-over-year. So in order to do that, we had to make our supply available. The good news was, it was also a large portion of our ICE6, which is a lot more under our own vertical integration, so a little bit of our own control. We continue to see again, this 8 to 12 parts -- or 8 to 12 vendors that are still ramping up their fab capacities in older geometries and analog technologies. Those still are biting on the industry and we expect those to ease in the back half of next year.

Yeah. And on the FX impact, on both a quarter-over-quarter and a year-over-year, I would say modest on the revenue. Certainly quarter over quarter, call it $5 million-ish, but we have a natural hedge in terms of our expenses there, so net-net, it was almost neutral to $1 million impact, so not anything that would have (inaudible) change.

Your next question comes from the line of Fahad Najam with Loop Capital.

A clarification first. David, if you guys are taking share then why are you still maintaining your ICE6 revenue contribution to be 20% to 25%. Is it that the most of the shares are not in ICE6, they're more in legacy products?

No. I mean, I think if you do the weighted average math, I mean again you follow this stuff probably even closer, that when I look at the competition, most of the competition on a year-over-year basis is down in terms of revenue and significantly down in terms of their gross profit percentages. So all I know is, we're up in revenue by 9%, up in product by 17% and I don't believe the competition is there. So when the -- [Vias] and others report their market share gains, if the major competitors are down and we're up, I think we'll be gaining share and that's, by the way, both on our long-haul ICE6, as well as in the Metro, and we haven't even unleashed our own pluggables yet.

Got it. If I take a step back to the real question, if I look at your R&D spending, you managed to bring in down sequentially, even in the face of worsening inflation and you mentioned that you plan on taking a leadership role in 800 gig VR developments. You've got a number of -- ahead of you, yet your R&D spend is coming down in the face of an adverse inflationary environment. How are you managing to sustain this R&D and still think that you're going to keep ahead of competition?

Yeah, we're vertically integrated. We develop our own photonically integrated circuits. Those same integrated circuits can do big transponders like ICE6 800 gig or 1.6 terabit, 2/800 gig which is what our product is. As well as that's how we build the Transmit Received Optical Assembly or the TROSA, which is the largest portion of a pluggable. So that kind of platform development allows us to be efficient in our development.

Now on the other side of that, we have had some relief, because we do some of our development for some of our system software and others in FX positive jurisdictions, but not a tremendous amount. Next year, again, we've said we will continue to invest in R&D in those critical areas and we've taken our product portfolio in a much more simplified set, as well as we're going to expand our go-to-market investments. Why? Again, if you're going to gain share, it's not just about having the product, but it's about being there to be able to have the relationships and sales channel with the customer.

I realize you're going to give your full-year outlook for '23 at the OFC, but that does lead to the question, do you think that the intensity of your spending on R&D and sales and marketing is likely to increase, as you look at all these projects and your ambition on sustaining leadership role?

Yes. I think, overall, you're going to see an increase -- by the way, there's some inflation going on, too, as well. So, yeah, both in terms of where we invest, as well as the inflationary impact, good news being operating leverage, good news being Nancy mentioned earlier, that we intend to grow faster than the market, good news is you'll probably see margin accretion on the gross level and the bottom line level and that's what we've been doing for the last 3 years and that's what we intend to do. We're just not ready in this market to nail down the specific numbers, but we feel good about our position growing faster than the market.

Your next question comes from the line of Jim Suva with Citigroup.

In your prepared comments, you talked about supply chain. Have they actually gotten worse then or better and I'm just trying to get a better understand -- or is it just like different things that -- final parts?

Yeah. Both. The cost went up in Q3 more than we expected by 100 basis points and that was just in order to, again, late breakers that we needed to expedite, pay expedite fees to get through, to make sure we meet the big demand of that 17% product revenue growth. We did see some lightening of the overall supply chain environment, like general components are beginning to free up, as the consumer demand lightens, and as people work through what was the backlogs with a more robust economy. We still see where there was expansionary requirements again, and a very focused number, an acute number of components for line systems and other things, with older geometries that are in the process of building out that capacity, and we expect that capacity to be in place, and effective for us so that -- call it, 3 quarters from now in the back half of next year, we don't see the same dynamic.

Okay. Then my follow-up is on -- more for Nancy probably, interest expense going forward, is this current run rate that you had this quarter a good number, or the Fed of course increased rates by 75 basis points should we be modeling interest expense upward as we continue on?

No. In fact we're really glad we got the refinance done at the 24 converts when we did, so those interest rates you should keep as they are. The only ebb and flow would be there, is if we utilize the ABL, but that would be on a temporary basis for working capital needs. But as of today and as of the end of the quarter, we don't have anything drawn on that ABL.

Your next question comes from the line of George Notter with Jefferies.

Hi. I wanted to ask about the mix of vertically integrated products. I think you said the ICE6 was greater than 30%, but do you have an overall number for the mix of vertically integrated products?

Yeah. It was close to 50%.

Okay. Great. And then also I wanted to ask also about you guys kept referencing the September 24th quarter end, are you suggesting it was a 12-week quarter or was it was indeed a 13-week quarter -- or what's unique about that?

It was just the timing. It was a 13-week quarter. We are going into a 14-week this quarter. So this quarter will end December 31st.

Your next question comes from the line of Samik Chatterjee with JP Morgan.

Hi. This is Angela Jin on for Samik Chatterjee. I just had one question, so just thinking ahead to 4Q in 2023, could you maybe rank order how you expect revenue growth to trend for your customer verticals?

That one is going to be probably pretty tough to do. I will tell you ICPs are going to continue to be very strong for us. I do believe that you'll continue to see, not just in Q4, but next year, Tier 1 service provider U.S. beginning to scale up, as we have a number of certifications underway. But nothing out of the ordinary for Q4, Q1. A lot of that has to do with revenue recognition, when projects get complete and we've contemplated that kind of normalized mix into Nancy's guidance for the quarter.

(Operator Instructions) Your next question comes from the line of Alex Henderson with Needham.

Great. So I wanted to go back to the comment about $50 million worth of absorbed supply chain cost increases over normal. Certainly, I get that that's the math for this year, but I also understand that prices are going up. So as you look out into the next 3, 4, 5 quarters, will we see when the supply chain improves, that that 400 basis points falls through to the gross margins, or are there price increases that you're anticipating that would cause the effective normalized costs to go up and offset some of that benefit?

Yes, it's a good question. When that happens, our job is to offset it. And our plans -- I think we've mentioned this in prior calls, we've added in $30 million of contemplated excess supply chain costs for next year. So remember we said we thought it would be go from $50 million to $55 million this year to $30 million-ish next year.

But, Alex, you're absolutely right, some suppliers are going to go ahead and up the chip price here or there. Our job is to continue to drive that down. We do have annual cost reduction initiatives with our suppliers that I do expect as the supply chain begins to turn, we can go get those back. We've also made commercial arrangements, i.e., pricing adjustments and things like that in the marketplace. So we're not going to go into -- in detail on this call, that should be able to mitigate. And we'll contemplate all of that into our guidance for next year, when we go through it, March 7th.

Okay. So, conceptually if -- hypothetically we were to see the majority of that 400 basis point hit to gross margins in 3Q, fall out, say, 3 quarters -- as it fall out in the 3rd quarter of next year, would the expected strategy be to take that to the bottom line, or would you take some of that and reinvest it into R&D sales and marketing and other expenses?

Yeah, it's a good question that we'll go through, I mean, yeah, conceptually, what we said is...

I am not looking for a forecast.

No, no. It's okay. Conceptually, what we said is we are increasing our R&D because we've got this vertically integrated U.S. based, again, asset that we view this vertical integration for 800 gig pluggables, 100 gig pluggables and 400 gig pluggables are going to be pretty powerful. So you will see us continue to invest there, as well as transponders for subsea in long haul, as well as you're going to see a step-up in sales and marketing. And we've never had the confidence to go do that, because honestly the product line has never been a better shape and the industry dynamics have opened and the need for supply chain diversity has never been there.

So our contemplation is that, yeah we'll continue to grow sales and marketing and R&D while we do that, and we have to continue year after year to expand margin while we do it. And some of that will come from operating leverage, but some of that's going to come from more products vertically integrated. And then in 2024, so, see that I won't give any '23 but I will talk about '24. As the pluggables become more of our Metro platform of our own system products, you're going to see the next kick point of margin there as well, as well as continued operating leverage, but we do have to continue that investment in sales and marketing, as well as R&D. I'd say, sales and marketing with more intensity than R&D though.

Okay. Just one clarification on the R&D comment from earlier. While I guess it's down sequentially and actually down year-over-year, I know you have a lot of prototype costs and things of that sort that caused big pops and big declines when they fall out. As I look at the December quarter, it looks like the spend will go up quite a bit sequentially and I assume that a good chunk of that's in R&D, which would put you at a meaningful increase in R&D for the year. Is that the right way to think about the R&D here for the fourth quarter?

It is. It generally trends as you get -- we said we were splitting samples out in the back half of the year and beginning to go through certification. So you nailed it on the head. That happens in Q4. It's not a stark of a increase, as everybody probably expected. Again, we got a little bit of a benefit from FX, but it will continue to increase, as we get into next year, albeit still while we increase our operating income and increase our gross margins for next year.

In Q4 also with commissions with the planned bookings for Q4, you'll also see that step up as well.

So commissions during the sales and marketing are [in line though], right?

They are.

Correct. But we are talking about OpEx in total.

Yeah. Okay. Perfect. I understand. Thanks.

There are no further questions. I'd like to turn the call back to CEO, David Heard, for closing remarks.

No, I appreciate it. Really good solid questions. I know it's a difficult market out there. A lot going on. So we're trying to keep things relatively concise. Overall, we had a quarter that beat expectations and delivered 17% product revenue growth, which is tremendous given the supply chain environment, and our Q4 guidance met the midpoint of prior expectations.

So our heads down and get ready to execute to that. We delivered 3 strong quarters for the first 3 quarters of the year and a tough macro backdrop. Total revenue growth while the services drag was there, was 6% still in that environment with total product revenue growing at 11%. We've expanded our operating margins like you saw this last quarter, over double year-over-year while we do that. So we're really trying to drive that efficiency while we do that and drive things to the bottom line.

So look, our strategy is working. We are laser focused, no pun intended, on driving towards that dollar per share of earnings power and that makes lots of things go well, and I really want to thank the Infinera team for their dedication. I mean, we've gone through pandemics. We've gone through wars. We've gone through -- we are now in a recession that we're going through. But the great news is there's demand for what we do. The CapEx seems to be very focused on fiber and fiber build outs. That's our specialty.

We have vertical integration that matters there, and we've got an environment where Huawei is stepping away. There is an open architecture for us to insert to. So you're going to see our heads down -- call it helmets on, mouth pieces in and heads down to execute. And look, we look forward to dive in deeper into the strategy and answering all the detailed questions you're going to have in our Investor Day on March 7. So we hope to see you there at OFC in San Diego.

Thanks. Take care of yourselves and your families. We appreciate your support.

This concludes today's conference call. You may now disconnect.