Infinera Corp (INFN) 2020 Q3 法說會逐字稿

Greetings, and welcome to the Infinera Third Quarter Earnings Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded, Thursday, November 5, 2020.

I would now like to turn the conference over to Amitabh Passi, Head of IR.

Please go ahead.

Thank you, operator, and good afternoon.

Welcome to Infinera's Third Quarter Fiscal 2020 Conference Call.

My name is Amitabh Passi, and I'm excited to have joined Infinera recently as the Head of Investor Relations.

I look forward to working with all of you.

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 about our business plans, including our product road map, sales, growth, market opportunities, manufacturing operations, products, technology and strategy, statements regarding the impact of COVID-19 on our business plans and results of operations, as well as statements regarding future financial performance, including our financial outlook for the fourth quarter of our fiscal year 2020.

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 Forms 10-K for the year ended December 28, 2019, as filed with the SEC on March 4, 2020, and our quarterly report on Form 10-Q for the quarter ended June 27, 2020, as filed with the SEC on August 6, 2020, as well as the earnings release and investor slides furnished with our Form 8-K filed today.

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 third quarter fiscal year 2020 earnings release and investor slides, each of which is available on the Investor Relations section of our website.

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

Good afternoon, and thank you for joining us.

I will begin with a brief review of the quarter before discussing the longer-term opportunities we see ahead.

I'll then turn the call over to David and Nancy to cover the specific quarter and our outlook for Q4.

We delivered a very strong Q3 during a typically slower seasonal period for the industry.

Most notably, in Q3, we achieved non-GAAP operating profitability with non-GAAP revenue, gross margin and operating margin growing both sequentially and year-over-year.

The operational improvements we have made over the past several quarters are evidenced by our resulting margin expansion and expense reduction.

Despite the near-term macroeconomic uncertainties that the broader market and our industry are facing, I continue to be optimistic about the opportunities for the company.

Dollar per mile -- dollar per bit per mile has been and will continue to be the enabler of unbounded bandwidth growth, and innovation remains the key to helping our customers realize step function improvements in the cost of transmission.

During my tenure at the company, Infinera has played a pivotal role in identifying and advancing the core technologies that are powering high-speed connectivity services around the world.

Today, our innovation pipeline remains robust, and I am confident Infinera's thought leadership and innovative solutions are well positioned to enable cost-effective network services in the future.

Over the years, it has become increasingly clear that as networks scale to 400 gig and beyond, significant improvements in cost and optical performance will come from innovations that require deep vertical integration.

We believe we are 1 of only 2 commercially viable vendors capable of delivering 800 gig and greater solutions in the near term, a stark contrast to the numerous suppliers addressing earlier generations of optical solutions.

Concurrently, we are observing that ICP and TSP transport network architectures are transitioning to open and disaggregated models that accelerate adoption of industry innovation, break vendor lock-in and ease insertion of best-in-class solutions from any vendor.

Importantly, for customers, our open optical solutions can be deployed on the optical infrastructure that is often already in place.

Infinera pioneered this capability with our CX and XT products, and we are poised to significantly raise the bar with our ICE6-enabled Groove GX platform.

Looking further out, we believe it is inevitable that coherent optical networks, like all other communications networks, will evolve from point-to-point architectures to point-to-multipoint architectures that are enabled by subcarrier based intelligent pluggables.

After deep engagements with numerous global service providers, we are confident that operators can realize CapEx and OpEx savings of greater than 50% with XR pluggables, a potential catalyst for redefining how access and aggregation networks will be built.

The mandate for vertical integration, the market shift to open networks and the evolution to point-to-multipoint networks are starting to meaningfully alter the competitive landscape.

These shifts are laying the foundation for a healthy industry that will be led by providers of the best transponder.

Furthermore, growing concerns over infrastructure network security from solutions provider Huawei are likely to accelerate these fundamental trends.

I am confident in Infinera's position today and our opportunity tomorrow.

On our last earnings call, I announced that I will be transitioning out of my CEO role by the end of the year, and that David Heard will succeed me as CEO.

This transition is fully on track.

So this will be my final earnings call.

I would like to thank all the Infinera employees who have inspired me daily with their commitment, courage and passion.

I deeply appreciate the support of our customers, supply partners and stockholders over the years.

I will now turn the call over to David to share additional details on Q3 and our outlook for Q4.

Thanks, Tom.

Good afternoon, everyone.

I'm excited about the upcoming opportunity to lead Infinera, and I want to publicly thank Tom for his many years of service to the company and for continuing to be a great partner for me over the last 3 years.

I know he will continue to provide value, service and counsel as an active board member moving forward.

As Tom highlighted, this is an opportune time for Infinera.

The long-term growth outlook for the company is healthy, and our strategic priorities are clear.

We continue to invest in high-performance optical systems that will drive market share gains and margin expansion.

We will continue to differentiate through industry leading innovation, operational excellence, customer intimacy and diligent execution.

I look forward to sharing additional details on our open optical network strategy and market outlook at our Analyst Day, which we're planning to hold in early March of 2021.

I would now like to provide further perspective on our Q3 performance.

We delivered solid quarterly results with non-GAAP revenue and gross margins at the high end of our guidance range and non-GAAP operating margin above the range.

We achieved 3% non-GAAP revenue growth quarter-over-quarter in what typically is a seasonally down quarter and grew non-GAAP revenue 4% year-over-year.

For the first 9 months of 2020, our non-GAAP revenue grew 8% year-over-year, and we gained share in a market that is forecasted to be up 2% in 2020.

Most importantly, we generated non-GAAP operating profit of $7 million in the quarter, representing year-over-year improvement of $26 million.

Overall, execution was solid across a host of operational metrics.

We continue to make progress on managing costs, expanding margin and reducing inventory, while maintaining and even growing investments in vertical integration and open optical solutions.

Nancy will provide additional details on the most notable financial dynamics in the quarter.

From a demand perspective, the quarter played out pretty well as we expected.

Our customer diversification, along with our limited exposure to recently challenged markets like India and Japan, shielded us from more significant revenue headwinds experienced by some of our peers.

On a year-over-year basis, revenue was up across our service provider customer base as operators continued to invest in networks to support traffic growth and slightly down among our ITPs and North American cable customers, primarily due to project timing and priority.

Moving on to the performance of our key platforms and technology solutions.

Our metro solutions had another good quarter.

For the first 9 months of 2020, revenue from our XTM platform was up double-digit compared to the prior year, benefiting from 5G builds and a shift in traffic patterns due to new work-from-home dynamics.

Similarly, our compact modular platform, Groove GX, critical to our open optical strategy, also performed well in the quarter.

For the first 9 months of 2020, we saw substantial revenue growth for this platform compared to the prior year.

Notable highlights for the Groove GX in Q3 were 50% of Groove GX bookings came from non ICP customers, consistent with Q2.

This ongoing traction signals the continued strong adoption of compact modular platforms among CSP customers in the industry, which represent a lion's share of the future CapEx spend in this category.

We saw continued momentum in our 600-gig solution.

During the quarter, we added 7 new customers, bringing our total customer count to 23, and doubling our port shipments quarter-over-quarter again.

Our 800-gig ICE6 platform remains on track.

We have a strong pipeline and are focused on executing our new product introduction and go-to-market resources around customer delivery of our first 800-gig products in Q4.

As we have said for the last few quarters, we expect a more meaningful positive impact to our financials from ICE6 to begin in the second half of 2021.

We continue to believe that this transition to 800-gig will be a long cycle with 2 primary suppliers with the opportunity for additional market share gains replacing Huawei.

Longer term, we see a shift to open optical networking, extending all the way to the edge of the network via pluggable technologies.

Network intelligence that fits into the palm of your hand and delivers a significant savings is a compelling value proposition for our customers.

This is what our XR optics technology is designed to deliver, and we believe it will open a new meaningful addressable market opportunity.

We are early in the development cycle, and we'll share additional details on this exciting market opportunity at our Analyst Day in March of 2021.

Looking ahead to Q4.

While the macroeconomic climate remains uncertain, and analysts have recently taken down their outlook for optical systems markets in 2020, we continue to plan for sequential improvement in Q4.

Despite analysts calling for a flat market for the full year of 2020, we expect our year-over-year revenue growth to be approximately 3%.

More importantly, we plan to deliver another quarter of non-GAAP operating profit with a focus on continued gross margin expansion and improved cash flow.

In closing, while we remain cautious about the macroeconomic environment in the coming quarters, we believe we have an opportunity to grow our market share, expand margins and drive earnings growth through innovation, operational improvements and strong execution.

We intend to lead the industry transition to a new era of open optical solutions by delivering unprecedented customer and shareholder value.

I will now turn the call over to Nancy to provide additional details on the quarter and our Q4 outlook.

Good afternoon, everyone.

Today, I will begin by covering our Q3 results and then provide our outlook for Q4.

My comments reflect our non-GAAP results.

For your reference, we have posted slides with financial details to our Investor Relations website to assist with my commentary.

I am pleased to highlight that we delivered a strong quarter with revenue, gross margin and operating margin, all up on a quarter-over-quarter and year-over-year comparative basis.

The efforts we have undertaken to drive operating improvements through focused investment priorities and cost management initiatives are showing progress, as demonstrated in our financial results, which most importantly include positive non-GAAP EPS.

Q3 non-GAAP revenue was $341 million, at the high end of our guidance range of $325 million to $345 million, and is up 4% over the same period a year ago.

One customer contributed over 10% of our Q3 revenue.

49% of our revenue came from North America.

And internationally, we saw growth in APAC, offset by a decline in EMEA.

Non-GAAP gross margin was 35.2%, near the top end of our 32.5% to 35.5% outlook range, despite what continues to be a challenging logistics environment with COVID-19.

Contributing to this margin growth was improved sales of our 600-gig product and the impact of our ongoing cost reductions across our product offering.

The business is benefiting from the integration synergies that we have discussed in previous calls as well as our ongoing operating improvements, stemming from the redesign of our supply chain and fulfillment processes and cost reduction.

These efforts will continue as we look to improve our overall efficiency and increase automation.

Our Q3 non-GAAP operating expenses were $113 million, below the low end of our $115 million to $118 million outlook range.

While our cost-saving effort drove meaningful reduction, especially on a year-over-year basis, the timing of certain operating items resulted in lower-than-expected expenses during the quarter.

Approximately $2 million to $3 million of operating costs originally expected in Q3 will now be recognized in Q4, with the second half expenses being in line with our previous outlook.

We remain committed to maintaining appropriate R&D investments in the key technology programs driving our innovation pipeline, specifically ICE6, Groove GX and XR optics, while continuing to focus on our total operating expense level.

In Q3, we recognized a non-GAAP operating profit of $7 million or positive 2% operating margin, which was above our guidance range.

Compared to the year ago quarter, our operating profit improved by $26 million.

Our non-GAAP EPS in Q3 was a profit of $0.02.

Moving on to balance sheet and cash flow items.

We ended the quarter with $216 million in cash and cash equivalents, down $8 million from $224 million exiting Q2.

Our focus on working capital continued with a $12 million reduction in inventory this quarter, having now achieved $65 million of the $80 million inventory reduction target for the year.

Accounts receivable were flat and we reduced payables while we continue to move to a more variable model, leveraging our strategic contract manufacturers.

Importantly, we have taken care of the previously discussed $80 million in onetime cash integration costs a quarter early.

All total, during the quarter, we utilized $36 million in operating cash flow, flat with Q2.

We exited the quarter with $77 million drawn on our $150 million ABL and raised $31 million through our existing ATM offering.

Regarding our capital structure.

Our primary area of focus remains the achievement of sustained cash flow generation through operational profitability, while maintaining ample liquidity and optionality to execute on customer opportunities in this unique time.

As we look at Q4, our outlook is as expected when we shared that revenue in the second half of 2020 would exceed the first half.

In Q4, we expect sequential growth in our business with Q4 non-GAAP revenue in the range of $340 million to $370 million.

This would represent approximately 4% quarter-over-quarter growth, at the midpoint of the range.

We expect non-GAAP gross margin to continue to improve and be in the range of 34% to 37%.

The slightly wider guidance range is meant to balance the opportunity in front of us this quarter, with any macroeconomic risks that may occur with COVID-19.

At the midpoint, this would represent modest sequential improvement in gross margin.

As we have shared on prior calls, we believe our plan to expand our gross margins to our targeted mid-40% range in 2022 remains sound and will come with step function improvements tied to increasing our level of vertical integration.

Our projected gross margin growth in the near-term will be achieved through cost improvements and product mix.

We expect the next step function improvement to come with the revenue ramp of ICE6 in the second half of 2021.

Our current expectation for Q4 operating expenses is to be between $115 million and $117 million, which includes $2 million to $3 million of expenses that shifted from Q3 into Q4.

We expect a non-GAAP operating margin of 3%, plus or minus 200 basis points.

Below the line operating -- below the operating income line, interest expense will be approximately $6 million in Q4, and taxes are estimated at $2 million to $3 million.

Finally, in Q4, we expect to generate modest cash from operations as our revenue and gross margin expansion are complemented by our continued efforts to improve working capital.

Our Q3 results demonstrate that the work we have done to improve operating efficiency, margin expansion and working capital optimization are starting to take hold.

Our approach is purposeful as we position ourselves to succeed in what is a unique period of time.

We must be prepared for the potential global macroeconomic impacts of the ongoing COVID-19 pandemic.

Our industry is moving to open optical architectures and creating new insertion opportunities.

The competitive environment is evolving as one of the largest market shareholders is increasingly being restricted for participating in certain markets.

We are poised to deliver our margin expanding vertically integrated ICE6 and continue investments in our technology-leading innovation pipeline.

And finally, the operational improvements undertaken over the last couple of years are taking effect as demonstrated in our financial results.

I remain confident that the changes we have driven through the company are the right ones to position us for long-term success and shareholder value creation.

In closing, I'd like to thank the Infinera team for their amazing effort in these challenging times.

Tina, I'd now like to open the call for questions.

(Operator Instructions) Our first question comes from the line of Alex Henderson with Needham.

So I think you've talked a little bit about the GA availability of the ICE6 platform.

And I think in the press release, you said you expected first shipments in the fourth quarter.

So it sounds like you have some orders.

Can you talk a little bit about what the pipeline of activity is?

And to what extent people have been testing the product?

I mean, it's clearly, in my opinion, the most important element of the current outlook, or for that matter, the next several years.

So we'd love to have some more granularity on what's going on there.

No.

Thanks, Alex.

It's -- and you're right, super important part along with our other technology rollouts, super important to our growth for the future.

So in terms of ICE6 and the GX platform, you did get it right.

We continue to remain on track this quarter for shipment to customers.

We continue to have a large pipeline of customers, lots of demand out there in a market too for 800-gig.

We have received purchase orders.

We do have for deployment in the first half of next year.

And we remain consistent that we think that, that will materially come into any kind of revenue start in the back half of next year, just given the typical cycle.

So that demand in the pipeline is pretty well across the board with ICPs as well as CSPs as we go to ramp the technology.

So as I think about the process, are you going to be able to give us some sense of announcements or contract wins or any other along the road signs of direction of demand that we can use to triangulate on how this is going?

Or is it just simply a production problem that you're sold out for an extended period of time, you have limited production initially?

Yes.

So we're in the NPI phase of the technology.

Certainly, it's reasonable for you to ask about the milestones, the design wins, POs.

And as we come out for our Analyst Day in March of 2021, we'll be able to kind of give you color on that as well as our other new product introduction milestones moving forward.

Completely reasonable.

Our next question comes from the line of Rod Hall with Goldman Sachs.

This is RK on behalf of Rod.

It's been great working with you, Tom, best wishes.

Thank you.

To start with, I wanted to ask about visibility.

Some of your peers have made more cautious comments, but you guys seem to be a bit more shielded.

So could you comment on the demand environment you're seeing by geography?

And I have a follow-up.

Yes.

Maybe I can remind you that when we -- first half of the year, when we talked about COVID and its kind of macroeconomic impact, we kind of adjusted our back half expectations.

And I believe we adjusted yours at that time.

We took additional operational action to ensure that during these times, we could drive quicker profitability to the company in those times.

So as we've entered the back half of the year, the demand in Q3 was about what we expected.

And the demand that we see for Q4 is about what we expected.

There have been others in the industry, certainly, that have more concentration at certain Tier 1s, maybe in markets like India, and within the ICP sector that when they went through their spending kind of freezes and cut down in the back half of the year given their CapEx intensity in the front half of the year, had a bit more exposure than we do.

As Nancy noted in the quarter, we only had 1 customer that was a 10% customer.

We certainly are aspiring to have more customer concentration.

But at this time, it proves to be a little bit of a softener for us from a demand profile.

Did you have a follow-on?

Great.

A quick one for -- I do.

2 quick ones for Nancy, if I may.

On services, revenue was up significantly sequentially.

What drove that?

And is it sustainable?

And on cash flow, could you give us a number for what it was x the onetime integration cost and whether is it going to be cash flow positive even past fiscal Q4?

Or is that just what you are looking for?

So on the services side, we were pleased to see the growth.

It has been driven by the breadth again of product and customer -- sorry, the breadth of customers that we have in the marketplace.

And we're continuing to get good traction and see that business perform well for us.

On cash flow, we had approximately $8 million in onetime items that occurred in Q3.

As I mentioned in my comments, we have put behind us that $80 million in onetime items.

We've taken care of that and are pleased to be moving forward in Q4, generating cash flow from operations.

Our objective going forward would be to continue that, but it's going to be driven by sustained profitability.

Our next question comes from the line of John Marchetti with Stifel.

Given that a big part of the margin story going forward is going to be this more favorable mix as you move to the 600 and then ICE6 over time, just curious if you can characterize where we are now relative to sort of the first half of the year where we saw some delays of new products and things like that, and you saw more of the older or lower speed demand, which was really weighing down margins, how do we think about that mix as we're looking out here, not just in Q4 but into the -- maybe the first half of next year?

Yes.

I think you have to be careful in the compare for the first half of the year.

Q1 had a -- as we talked about, a very large subsea deployment that we're laying out the razors for the growth of the razor blade or the transponders.

All the line systems were out there for us to grow.

And that has really come back to the second half and proven our thesis there.

So I think our mix is normal.

And as we go ahead to scale, you saw the growth, the doubling of ship portments on ICE -- on 600-gig.

I think that is mildly adding to our margin accretion.

It's still a small portion of our weighted average revenue.

The operational work that we've done over the last couple of years and invested in and, as Nancy said, retired the investment of the cash we paid to be able to get our supply chain in shape, is beginning to pay benefit.

So we believe that, together with the 600-gig is the key to the first half of next year in terms of its margin accretion and strength versus prior periods.

And that as we go to scale in the second half and as revenues begin in the second half with ICE6, you will see the next step function begin for, as Nancy basically talked about in her prepared results, would get us into that 40-point range in 2022.

Did that answer your question?

It does.

And when I think a little bit more about some of the comments around Huawei.

Last quarter, you had mentioned that you're actually seeing the benefits there.

In some of Tom's opening remarks, he talked about that still happening.

Just curious how much of that is either you're qualified in through either existing relationships or things like that and they're reverting to vendors that have already qualified, but don't want to go back to Huawei, versus some traction with some of the newer products as we look out maybe a little bit longer term?

It's an excellent question.

I think last quarter, we talked about the fact that we were just beginning to see opportunities.

We were seeing countries continue to make decisions.

We were seeing particular time frames be put in place for swap outs that were as long as 2 to 3 years out.

We continue to see that same dynamic.

We are now seeing more RFPs and RFQs along that line, which allows us to be able to bid in this new open optical environment where open line systems, where I can put our transponder on to a Huawei line system.

It makes it more economical and faster, as Tom said in his prepared remarks, to be able to insert into that market space.

And so we see it in the network.

The good news is for 800-gig, there's only 2 competitors that should be able to compete for that business.

It is sizable.

And it will be a multiyear cycle that we'll be able to go through.

I think that, again, based on the fact that we're bidding on opportunities now and it's increasing in its pace, we would see that as we exit next year in terms of its impact on the income statement and cash flow.

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

This is Mauricio in for Simon.

Can you guys please give us an update with the traction with your 600-gig platform?

I think last quarter, you mentioned you started to ship to a major ICP customer.

But there was a segment that wasn't in the qualification process.

So if we can get an update on that.

And then how should we think about the lifespan of the 600-gig once you start shipping 800-gig in volume?

Yes.

No, it's a good question.

Again, we did add 7 new customers, bringing our total up to 23.

And we did double our ship -- our port shipments this quarter, and we also mentioned we doubled them last quarter.

So it is beginning to grow, albeit 2 quarters ago on a lower base.

It's beginning to gain momentum.

That 1 ICP that we discussed is still not qualified.

As you know, in these times, qualification modes can get extended.

We do expect 600-gig to continue in the cycle.

We continue to sell 100-gig and 200-gig solutions today.

600-gig will maintain the cycle of a couple of years, albeit not at the amplitude and the length that we expect 800-gig to be.

So our customers are using it to drive the lowest cost per bit in their network solutions.

And given our platforms, allow for multi optical insertion.

We're finding that to be a real advantage for us in the market.

I'll say one thing to add on the second ICP.

They are a customer that is currently buying other products for us.

So we're doing business [with them].

Yes.

They are, of course, is in your 200-gig, right?

If I'm correct?

Correct.

Our next question comes from the line of Jim Suva with Citi Group.

I know an important part of your strategy is the efforts into going more vertical.

Can you give us whether it be milestones or how we should think about that vertical shift?

I know it's a very long-term in nature and gradual, and it's not like a light switch on and off.

Can you talk to us about maybe it's your RFPs, or design wins or status of going, whether it be percent of your portfolio or kind of chapter one?

Or how should we think about it as we go forward strategically?

Yes.

No, it's an excellent question.

When the company was founded and one of the attractors I had coming to the company was that the company was founded on vertical integration.

Meaning it does its own photonically integrated circuit (sic) [Photonic Integrated Circuit] and its own DSP and is able to package that.

And the number of suppliers who have been able to do that when we were at 100-gig and 200-gig went from 8, to now we're at 800-gig and 2.

We see in the marketplace that technology for us -- that's what the company was built on, and we're very excited about the 800-gig, which will increase the number of products that we have with vertically integrated technology.

On the metro side of things, we've been using, as a result of the Coriant acquisition, merchant third-party optics in some of those commodity markets.

And we've been buying from players like Acacia and others, which you can see from their results.

That is non vertically integrated.

We do have strategies to continue to use.

Things like VR, ZR Plus, which will be cost reductions for us as a company and allow us to leverage a bit more on margin expansion, but we also see an opportunity to take our vertical integration that we've always used for the leading high capacity network optics and be able to drive those down into network pluggables that are managed on the edge of the network.

And so you're absolutely right, Jim.

We look at it as to the coverage of our total products by vertical integration.

Today, that is under 50%.

Our goal is ultimately, we'd like to see 70% plus of our portfolio covered.

When we do that, there is a step function increase in our gross margins going forward.

I think recently, we've seen the demand for optics, DSPs have a, let's say, scarcity and a very, very high multiple in terms of the demand, as you've seen by the purchase of Acacia and the recent purchase from Marvell or intent to purchase Inphi.

And so we think it's a very, very good place to be.

It's good for our business model, good for the customers.

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

You may have addressed this last quarter, but I just wanted to check on the temporary reduction in management salaries that you guys have announced in Q1.

Have those all rolled back in at this point?

Or just kind of any update on some of the kind of immediate cost actions that were taken with COVID?

And then maybe second.

Just as Europe kind of heads into a second lockdown, just any changes you're expecting with customers or any changes you've seen with customers on just ability to ship or ability to receive product?

Sure.

So the management reductions in salaries that we took are still in effect.

As we go into next year, we would intend to see those come back to their full salary and bonuses as well.

So we did not pay bonuses this year, but plan to accrue for those fully next year.

The other, though, as we look at the cost reductions that we've taken, those are sustained and will continue through.

And that is a much larger driver in the deltas that you're seeing today in terms of cost reductions on the operating expense line as well as on the margin line.

As it relates to COVID, we are still experiencing challenges in logistics in terms of increased freight cost and timing of deliveries.

I would say, we've not seen a substantial impact from the recent shutdowns in Europe.

But part of the reason I've given a little bit wider guidance range this quarter in terms of revenue is just to make sure that we're prepared for that, should it happen.

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

I guess I'm curious about the gross margin improvement.

Quite good here in the September quarter.

It was also quite good looking back to June.

And I guess I'm assuming that the work-from-home environment is helping to some degree.

I assume that you're seeing a higher mix of line card sales as opposed to chassis and amplifiers, which would be lower margin.

I mean, does that make sense?

And is that a big driver of the performance right now?

And if you could quantify that somehow, that would be great.

Yes.

George, I recognize that historically, when we set the higher margin based on mix, you'll notice Nancy did not say favorable mix in her script.

We actually sold more line cards -- I'm sorry, line systems in Q3 than we did in Q2 and also up from last year.

So the cost reductions that have been effected by Nancy and David over the last year are actually impacting overall cost structure of the company.

That's part of the outsourcing strategy.

It's getting our alignment with 1 manufacturing ERP.

So I think that the gross margin is less mix oriented.

If anything, we sold more footprint than we had, implying both cost structure of the company's down, product margins across the board are roughly up, and we are still winning footprint for future deployment.

Got it.

Okay.

That's great.

And then just as a follow-up, I think you guys mentioned ZR and ZR Plus as being potential pluggables that you guys will use with cost reductions.

And is that -- I seem to remember at one point you guys talked about not pursuing the ZR pluggables market, given the number of competitors there.

Can you -- am I remembering that correctly?

And can you just kind of talk through what's changed now?

Yes.

You're remembering it entirely correctly.

So when we say we buy a CSP2 plus for 200-gig from someone like an Acacia today to put into our XTM platform, we will have the option to be able to put ZR Plus in that same form factor to be able to use it as a cost reduction, just now with more competitors.

So George, we will entirely leverage that.

We are not planning to build our own DSP for ZR Plus because we believe that, that commoditization would occur.

So we do see a trend towards pluggable for adding network intelligence to the edge.

And so we've put our investments in DSPs around a category called XR optics.

So we absolutely are going to leverage ZR and ZR Plus.

However, we are not building our own DSP there.

We don't think that's a good investor return.

Our next question comes from the line of Ryan Koontz with Rosenblatt Securities.

I was wondering if you see the rural broadband opportunity as anything that could provide a little tailwind for you guys.

Obviously, getting fiber connectivity out to Middle America seems to be escalating priority, and then the timing of that.

And secondarily, as it relates to product mix, we've talked a lot about the mix of different coherent optical speeds at 200, 400, 600.

I wondered if you could help us with maybe ranking those in terms of revenue, where you're seeing the most volume, most revenue still among the -- I assume the 200 and 400 are still a pretty strong mix.

No, it's excellent.

No, we're not seeing -- I wouldn't say anything material from the Tier 2 broadband build yet.

Although we are seeing, on the access and aggregation portion of the metro network, as we said in our prepared comments, demand across the board there from the new work-at-home environment and our XTM platform and metro platforms across the company are doing quite well.

And so that's great for us as we go.

As we mentioned, we are still selling 100-gig and 200-gig in the company across the board.

Predominance in the long cycle of 200-gig does continue.

Obviously, the industry continues to buy 400-gig and be very, very hungry for higher bandwidth services, as Tom mentioned, getting to lower cost per bit over distance.

600-gig, again, is beginning to roll for us.

Again, on a weighted average basis, it's not a huge portion of our revenue at this point in time.

But it will continue to crawl up quarter-over-quarter, and next year will be a bit more profound and its impact on our network financials.

And as we get into the back half of the year, you'll start to see the impact of 800-gig go.

We do believe that 800-gig, some of these cycles are a bit shorter, and some of these cycles are a bit longer.

We do see from our customer demand, from our pipeline, from our design wins, from the POs that we're getting on 800-gig, we do believe that is going to be a very long cycle.

And again, I must remind everyone, it is a market of 2.

(Operator Instructions) Our next question comes from the line of Samik Chatterjee with JPMorgan.

I just wanted to have a couple of questions.

I just wanted to start with ICE6 and just going back to the pipeline that you have.

I mean, usually, when we see a successful launch of product that's kind of, one, like you are going to be in a duopoly in that sense with that product.

It should come with strong market share gains.

So how should I think about when I look at your customer verticals, like Tier 1, other service providers and ICPs, how should we track the market share gains and which verticals to be -- should we be expecting that strongest share gains to be coming from with that product?

Yes, very similar to our prior generations of technology.

Typically, these technologies tend to roll out first in the ICPs.

They are rolling out in compact modular platforms, which is great.

And open line system configurations allow us to insert those technologies, for example, onto Huawei networks or onto other competitor networks and Tier 1s much faster than it used to be historically in any technology.

You're seeing a lot of the same in OpenRAN and a lot of the hype on OpenRAN.

It's the same in our industry.

The world is looking for the best transponder to drive that cost per bit, the largest portion of the bill of material in an optical network.

And so first, you'll see it in the ICPs.

And then you'll see it insert into the Tier 1s across the globe.

We -- our current funnel is [centered] both U.S., Europe, Asia, it's quite global.

As well as it's across our product category of subsea ICP as well as the CSP players that are out there.

Got it.

And if I can just follow-up.

I mean, you discussed kind of the customer move or the industry move towards open solutions.

And maybe you mentioned this already, what portion of your revenue today is -- or in the quarter was optical -- open optical solutions, what kind of growth are you seeing there?

And just a clarification, any wins on the XR optics?

Yes.

So yes, let me clarify a couple of things.

So I think March of 2021, I think we're going to give you a pretty good view as to what our definition of open optical is.

And again, you'll see similarities with technologies and access routing, mobile and why we're so convinced that this is a great time for our company going forward.

We do not break out today our technologies as to which are in that category, but we will be -- give you a lot more detail in March.

What I will tell you is that 50% of the compact modular platforms that we sold today, which is one of the elements of open optical, went to CSPs not just ICPs, again, for the second quarter in a row.

And that's kind of a nice tipping point because that says they're adopting these open and disaggregated architectures that Tom mentioned in his prepared comments.

The second piece to that is of the compact modular platforms that we sold, 50% of those went over open line systems.

And that says that there's an opportunity for us to be able to take share in the markets moving forward, online systems of our competitors at a much faster pace than historically.

Got it.

And sorry, any wins on the XR optics?

Oh, yes, sorry.

And as I mentioned in my prepared remarks, we're early innings in the investment of the category of XR optics, which we do believe will be a category in the industry of point-to-multipoint optics.

And again, we'll get more into how we see that evolving into a addressable market opportunity that we believe is accretive and healthy for the company going forward in our March Analyst Day.

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

I'm sneaking in for a second one.

Great.

I was hoping we could talk a little bit about the competitive position between you and your other duopoly partner.

Any more clarity on the differential in performance or reach or power characteristics or any of the other metrics around that from field trials that you've done with customers that might have given you some insight into those deltas?

Yes.

No, it's a good question, Alex.

And kind of the era of the trialing and people building different situations to be able to highlight different reaches and performance.

The way we look at it is we trialed with a Tier 1 ICP and with 2 major carriers that are quite public that trial their technology in real-life situations against competitor A and competitor B, meaning 2 of us.

And we are still very comfortable about our performance of the technology, on where it is today and where we expect it to be as it's being deployed in the market.

We think that the right thing for us to concentrate on now isn't that argument because we have our facts and data.

It's really our own, Alex, for us to execute and ramp the technology and get it into the income statement and cash flow as we've indicated for the second half of the year.

If I could follow-up on that latter point.

Do you expect to initially have a very slow ramp?

And I would assume initial production volumes are going to be fairly low margins.

So is there a little bit of a margin pressure as you ramp in very small amounts of volumes initially and then once you get to scale, obviously, the margins stabilize and improve?

Can you talk a little bit about that -- those dynamics in terms of availability, timing and the initial cost element?

Yes.

So certainly, at any NPI, but in particular, in optical NPI, right, you don't come out of the floodgates, drop in huge volumes in the first quarter then you go out.

So we do have a very large demand curve to go service.

That's the good news.

And we're going to go execute against that.

We do expect that ramp to be -- with ICPs, they go through a little bit quicker of a testing cycle.

With CSPs, it takes a bit longer.

And so we expect that to play out where the first half of the year is with kind of mostly the ICP world.

And where in the back half of the year, you're seeing more and more on the CSP side of things.

In regards to your margin comment.

It's not as profound as it has been in the past in terms of the periods of entitlement for what we do in terms of how the DSP interacts with the photonically integrated circuit (sic) [Photonic Integrated Circuit] in its bill of material.

However, there is a scaling impact.

We don't see it as dilutive in the early periods.

But certainly, the accretion does move even better as you move out over time, which is why Nancy has given her comments that, look, we'll start to scale that margin, you'll start to see an impact in the back half of the year, but the real step function improvement we expect to be in 2022.

If I could last...

Did that help answer it?

It's exactly what I was looking for.

If I could fit one last one in.

Relative to the normal seasonal patterns, you obviously had a large 1Q last year associated with the subsea build.

But sequentially from the fourth quarter to the first quarter, is there any reason that, that would be better than seasonal, worse than seasonal or any other elements that we should be thinking about for that Q-to-Q transition?

Well, I think it's a little early to be looking at '21.

But we would not disagree with the fact that Q1 is likely going to be somewhat seasonal, and we'll be providing more commentary as we announce our Q4.

Our next question comes from the line of Jeff Kvaal with Wolfe Research.

I think one of the themes that have come up in the optical space about the second half slowdown has been an inability not to shift to existing customers but to shift to new wins.

And so I guess, to what extent are you all thinking about that as a headwind either first, for the second half revenues?

Or should the pandemic persist, is this something that we should worry about weighing on the trajectory of 800-gig?

So again, I think we kind of -- we did lay out early in the year what we thought the second half would be and a more muted impact to the second half.

We took our action, and we, for the most part, seen that play out in Q3 and Q4, still with growth, second half over first half, as we promised.

As we look at new technology introduction, I think we're -- we baked that into our second half of this year.

I think as we come out in March, we'll give you the appropriate milestones to be able to see where we see any impact at that time with COVID.

Right now, look, everybody takes longer in this period of time to go through new product introduction technology.

However, with compact modular platforms and open line systems, so far, even for new deployments and you'll recall, we did a -- I think it was a 22-country subsea deployment in this environment.

We have some real heroes of our employees out on the front lines making this happen.

And I think our industry is doing a nice job.

Our customers, our competitors are putting the right protocols in place to keep things going.

So we will certainly keep that in mind as we get into next year and as we give an outlook for next year.

It's a bit early for that.

And we're being very mindful, as Nancy said, in our guidance for Q4 of any second wave impacts that we could see around the world.

It is -- it's certainly a bit of a tough time.

Indeed, indeed.

And then secondly, would you mind adding whatever color you can to the opportunities for you in web scale?

I think, obviously, that's a fast-growing markets.

We've got different reports on how good visibility is into that market, frankly, but there's that.

And then obviously, Infinera was a pioneer in small form factor in that particular market a number of years ago.

How much share -- where are you with your share now?

And where do you think the opportunity lies for you all?

Yes.

It's a good question.

When we look at the ICP market space of compact modular, I believe we've been growing share in that space, which is great.

Again, that is an area we pioneered.

So we do believe, especially with 800-gig rollout and 600-gig and a great agile platform of the GX Groove, that we've got an opportunity in front of us with the ICP.

So us being in the top 2 in that space, we're number -- I think we're #2 now.

And there's nothing ahead of us that doesn't say we can't continue to monetize that.

The more important part is that same architecture that the company pioneered and that the ICPs adopted is now being adopted, as I mentioned, by the CSPs, which is a lion's share of the CapEx spend.

And again, I mentioned that for the last 2 quarters, 50% of our Groove GX sales have been to that CSP segment.

And that's probably more exciting from an investor perspective.

Those customers also tend to be a bit more predictable.

And as you've seen from prior periods of lumpiness on behalf of the ICPs, a bit more predictable in terms of their demand.

(inaudible) guys made company (inaudible).

What's that?

But -- sorry, I'm just saying, other vendors since have mixed experience without it.

But I guess the other question I want to ask there is, is that -- are those new wins for you?

Or is that, like, we're placing an existing metro solution, and therefore, there's a little bit of price cannibalization associated to that?

No.

It depends, obviously.

It might be a cap and growth scenario or it might be we have lots of new customer wins on the Groove GX platform.

But as we said, those platforms tend to be more capital-efficient for us from a margin perspective as well.

We're margin efficient going forward.

And so that is where it really tells you, it's all about leveraging either commodity optics to get a better margin stack or being vertically integrated.

Our next question comes from the line of Fahad Najam with MKM.

And I apologize if you've addressed this earlier, but I want to kind of dive a little bit deeper into your ICP revenue trends.

If my math is right, it's 2 consecutive quarters of steep declines.

One would expect ICP to be actually spending more given the pandemic and all the enterprise workloads moving to the card.

So can you help us understand a little bit about what's happening in the ICP space.

Is this softness just before you guys have introduced your latest 800-gig product.

So there's kind of a pause before the new product gets accepted?

Just help us understand what's really driving the ICP business here.

Yes.

Well, it tends to be lumpy, and we were down a bit this quarter softly in terms of the ingestion of the ICPs.

We haven't had a trend of a couple of periods of down.

And we're seeing reasonable strength as we exit the year in that ICP category.

And so they just tend to be lumping.

When they want it, they want it now, and they want it yesterday.

So no, we don't see a huge downward trend on the ICPs.

And again, looking forward in our current demand profile for the quarter and contemplated in our guidance, we see reasonable demand from the ICP segment.

If I may push back on that explanation that ICPs tend to be lumpy.

I mean, if I look at Oracle, which is one of your large ICP customers, they have the fortune of having Zoom as a customer.

And Zoom traffic has been going crazy, growing crazy.

Microsoft, which is another large ICP customer, is going through an upgrade cycle itself.

So one would wonder why is it that your revenue is still negatively impacted.

And then there is talk about Amazon developing its own white box solution, Project TiGRIS.

And so I think you want meaningful players in Amazon to begin with.

But nonetheless, is there something else going on, maybe a trend of maybe share shift or maybe a, like, with the Amazon, you shift to white box solution, maybe any insights you can share there?

So I guess, I mean, I'll just start with -- actually, our revenue from ICPs this quarter was up quarter-on-quarter.

So in the supplemental material, you'll see the split by customer vertical.

And so I'm a little bit confused where you're seeing the 2 quarters of...

(inaudible) year-over-year growth.

Year-over-year.

Year-over-year.

Yes, and as it pertains to lumpiness, look.

Well, let's say, Teams and Zoom and lots of these platforms are growing.

The way they buy and provision for the bandwidth is in huge globs in optical.

Maybe different in servers.

But when you look at our competitive base, I think everybody has always experienced that if that happens, it happens to be more lumpy as they onboard additional capacity, ingest, draw down the inventory and the bandwidth that they bought and then buy the next slug for deployment.

It just tends to be the way they buy.

It's been the way they've bought since we invented the compact modular space for the ICP market that's now bled over into the bigger market of CSPs.

Okay.

I think I think we're out of time (inaudible).

Yes.

Thank you, guys, very much for your time today.

I appreciate the support over the years.

And David looks -- and David and Nancy, look forward to chatting with you next quarter.

Stay safe.

Tom Fallon.

Bye-bye.

Thank you.

Bye-bye.

That does conclude the conference call for today.

We thank you for your participation and ask that you please disconnect your lines.