Infinera Corp (INFN) 2020 Q2 法說會逐字稿

Good day, and welcome to the Second Quarter 2020 Infinera Corp. Earnings Conference Call. (Operator Instructions)

Please note, this event is being recorded.

I would now like to turn the conference over to Michael Bowen. Please go ahead.

Thank you, operator, and good afternoon. Welcome to Infinera's Second Quarter of Fiscal 2020 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 about our business plans, including our product roadmap, 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 third 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 Form 10-K for the year ended on December 28, 2019, as filed with the SEC on March 4, 2020. And our quarterly report on Form 10-Q for the quarter ended March 28, 2020, as filed with the SEC on May 15, 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 such circumstances that may arise after the date of the call.

Today's conference call includes certain non-GAAP financial measures. First on to Regulation G, we have provided a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures in our second quarter of fiscal year 2020 earnings release and investor slides, each of which is available on the Investor Relations section of our website.

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

Good afternoon, and thank you for joining us. Similar to last quarter, I will begin with an overall summary update and then provide an overview of our Q2 results and our outlook for Q3. Before I proceed, we extend our continued appreciation to those serving humanity around the world in the ongoing battle with COVID 19.

From a summary perspective, I'm pleased with the team's execution in the quarter from a financial, operational and technical perspective, making consistent advances on all fronts. We continue to see steady bandwidth growth globally. This is driven by the increasing adoption of bandwidth-intensive applications like 5G and the growing requirement to move massive amounts of data across long distances. We're beginning to see tangible opportunities emerge as a result of customer concern over Huawei's position in their network infrastructure and the recently increased Government pressure. We see this global trend as just beginning and believe that while small today, it represents a catalyst for a significant growth opportunity over time. The industry migration to open platforms provides us a clear insertion path for this significant opportunity. We are proactively managing the operational impacts of COVID-19, and are continuing to take the necessary measures to reduce cost and improved working capital utilization as macroeconomic uncertainty for our industry continues, and we're encouraged by the opportunity created by our ICE6 solution as the market readies for a new technology cycle, driven by ever-increasing demand for network capacity. Having clearly demonstrated performance leadership, in what is now a very narrow competitive field. We believe our 800-gig capable GX platform will position us to expand our leadership in the fast-growing disaggregated optical market. Our schedule for first customer shipment remains in place for the end of the year.

Moving to Q2. We delivered solid quarterly results that met or exceeded midpoint guidance on all GAAP and non-GAAP financial metrics. We achieved year-over-year growth of 8%, and we significantly improved our financial performance. In year-over-year comparison of quarters, our results show a 10% reduction in operating expense and an 80% improvement in operating income. While significant work remains, we believe the positive trajectory speaks to the opportunity we have as we continue to more fully leverage the assets of the company.

We are actively navigating through some business impacts from COVID-19. In regard to supply chain challenges, conditions have improved from last quarter, though we are still experiencing some delays in incremental cost as many countries continue to maintain public health restrictions that have impacted the production and delivery capabilities of our vendors. Furthermore, some customers continue to experience logistics and facility-related challenges that impact the timing of their network plans. Our bookings remained solid in the first half of 2020, an increase compared to the same period in 2019. From a regional bookings perspective, our Tier 1 and Tier 2 operator business in North America and EMEA remained strong in the quarter. Record bookings from a major APAC customer contributed to improvements in that region, as we continue to recover from bookings weakness to the early impacts from COVID-19 in Asia.

In our ICP business, orders were flat with Q1, but behind plan after significant shipments in the prior quarter. We currently anticipate bookings growth in the ICP market in the second half.

Cable bookings came in as expected in Q2, showing growth quarter-over-quarter and year-over-year, though behind our outlook at the beginning of the year.

In subsea, our current generation of ICE technology continue to drive success with new expansion opportunities in APAC and the completion of a new deployment with Orange in West Africa that we announced last week. As we forecasted in our last earnings call, we also received the first fill expansion order from the Tier 1 subsea consortium build we highlighted in last quarter, an order which will contribute to margin expansion for this project when it ships later this year.

Turning to products and technology highlights. At the edge of the network, we continue to see demand for bandwidth expansions in wireless and cable infrastructure. We continue to expand business opportunities in the Metro space with the portfolio of solutions optimized for evolving Metro trends and market drivers. During the quarter, we achieved significant year-over-year revenue growth with our XTM platform resulting from new 5G builds, while significantly ramping volumes of DRX-30 disaggregated router deployments to support 5G-driven mobile backhaul capacity needs.

In the core of the network, the drive to open compact modular platforms in the market continues to create opportunities for our group solution today, while preparing insertion opportunities for our leading 800-gig transponder tomorrow.

In Q2, group continued to perform well, evidenced by substantial year-over-year bookings and revenue growth and expanded delivery of our 600-gig offering.

In Q2, approximately half of our group bookings came from non-ICP customers, as purpose-built disaggregated platforms continue to penetrate and gain momentum in traditional carrier architectures, a trend we expect to continue.

Highlights during the quarter included the first 600-gig shipments to a major ICP for long-haul applications that will run over both our own and a competitor's line system. And a meaningful 600-gig win with one of Europe's leading research and education networks. While we're still in the early stages of ramping 600 gig, we more than doubled 600-gig port shipments in Q2, and we grew our 600-gig customer base to 16 as the market continues to take advantage of the lower dollars per bit provided by this currently available technology.

On the new technology front, we could not be more delighted with the proven performance of our vertically-integrated ICE6 solution. In recent real-world network trials with Verizon and Windstream, ICE6 achieved transmission distances that are 3 to 4x that of competitive alternatives and greater than 2x that of competitive solutions at 600 gig. Our ICE6 performance advantage translates directly into lower cost per bit, lower power per bit and greater fiber capacity, the 3 most significant buying criteria used by network operators in vendor selection.

The Verizon trial was conducted on live fiber plant that included a challenging fiber type, reinforcing the opportunity for ICE6 to deliver massive economic impact to Metro, regional and long-haul applications. These results were -- have clearly evidenced the superior performance of ICE6. Our expectation is that network operators can achieve network live savings of up to 65% over currently deployed technologies and up 25% over competing 800-gig generation offerings with this technology.

Having made significant progress on this front. We are already seeing our ICE6 performance influencing network operator buying decisions today. We believe the combination of our leading optical performance, the very narrow field of 800-gig alternatives and the evolution to open and disaggregated architectures and carrier networks positions us well to penetrate new market opportunities and gain market share with our GX platform. This opportunity is being accelerated by the growing security and supply chain concerns many of our international customers and prospects now openly expressed about the Chinese vendor, Huawei.

Lastly, we are also continuing to invest in XR Optics, longer-term and game-changing pluggable optical technology that we believe will redefine how aggregation network architectures will be built. While early in the development cycle, we believe this innovative technology represents a meaningful opportunity for Infinera by enabling massive operational and economic benefits to our customers. As we advance the technology and deepen our engagements, customers increasingly recognize how XR Optics can reshape their future 5G and fiber deep network architecture to yield significant capital and operating cost improvements.

Collectively, ICE6, GX and XR Optics positions our company to intercept the most significant market trends in the optical networking space. Differentiated by the performance advantage created by our unique capabilities in vertical integration, we intend to lead the industry through the market transition to the next-generation of high-speed optics, compact modular platforms and networked pluggables. And we aim to deliver unprecedented customer value while creating a path to step-function improvement in the gross margins of our business.

Looking at Q3 and the rest of the year, we see continued improvement in our ability to predictably deliver goods and services to our customers, but do not expect all supply constraints to go away. For example, we are beginning to see certain COVID-19-related second order effect shortages caused by component factory closures from earlier in the year, closures that are now affecting the availability of certain assemblies. We also continue to expect inbound and outbound logistics challenges given the drastic reduction of carriage around the world. This is impacting both cost and customer satisfaction. I extend my appreciation to our customers and supply partners who are working closely with us to mitigate the impact of these challenges. Taking into account these considerations, we do expect our second half 2020 revenue to grow compared to our first half, but the evolving COVID-19 situation could cause revenue growth to be muted in comparison to our pre-COVID-19 expectations.

On our Q1 conference call, we highlighted a variety of measures we enacted to reduce expenses with an expected savings of $5 million to $7 million a quarter from our Q1 '20 OpEx level. While these savings are on track, as we head into the back half of 2020, we are continuing to drive further operational efficiencies, which should yield an incremental $3 million to $5 million in OpEx savings during the back half of the year. These additional measures are designed to enable us to enter 2021 with a lower cost structure and help accelerate our progress toward our target business model.

In summary, while our near-term view factors in expectations of ongoing challenges associated with the global pandemic, we remain extremely optimistic about the opportunity we see for Infinera. Our optimism is driven by customer response to our differentiated optical capability and confidence in our ability to deliver disruptive solutions to the fastest-growing segments in the market. In addition, we see a unique window of opportunity with the combined effect of Huawei displacement, the move to open network architectures and the dramatic narrowing of competitors in the high-performance, high-end optics market space.

I will close by thanking our customers and employees for their ongoing support. With that, I'll now turn the call over to Nancy.

Good afternoon, everyone. Today, I will begin covering our Q2 results and then provide a framework, from which to think about Q3 and the remainder of the year. As always, 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.

Despite the ongoing challenges associated with the COVID-19 pandemic, I am pleased to highlight that our results for the quarter include year-over-year growth in revenue, decreased operating expenses and strong operating margin improvement. The efforts we have undertaken to drive operating improvements and inventory reductions are showing progress as demonstrated in our results.

Q2 non-GAAP revenue was $332.6 million, above the top end of our outlook range of $310 million to $330 million and up 8% for the same period year-over-year. One customer contributed over 10% of our Q2 revenue. Our geographic mix was skewed more toward North America with 50% of revenue coming from this region, driven by ongoing strength from our Tier 1 customers and solid growth from our cable and other service providers.

Non-GAAP gross margin was 33.8%, above the midpoint of our 31% to 35% outlook range as we saw improved sales of our vertically-integrated products. The positive impact of cost reductions starting to flow through our P&L, and a return to a more normalized mix of line modules and fill. As we have shared previously, our gross margin is slightly aligned to the level of revenue from vertically-integrated products, which is why the launch and subsequent ramp of our vertically-integrated ICE6 will be so important to us as we move toward our targeted business model.

Our Q2 non-GAAP operating expenses were $118.3 million, better than our $120 million to $124 million outlook range, a demonstration of our cost saving efforts. We remain committed to maintaining appropriate investments in the key technology programs driving our innovation pipeline. At the same time, we remain acutely focused on cost discipline and actively bringing down our overall operating expenses. Our objective is to enter 2021 with an efficient fixed cost structure that will drive more operating leverage when we ramp ICE6.

In Q2, we recognized a non-GAAP operating loss of $6 million or negative 1.8%, which was within our guidance range. Our non-GAAP EPS was a loss of $0.09. We ended the quarter with $224 million in cash, down from $284 million exiting Q1.

During the quarter, operating cash flow was negative $37 million, which was improved from a $92 million usage in Q1. Within this $37 million was $25 million in onetime items, driven primarily by severance paid to employees in line with the previous outlook we had provided. We continue to see the results of the focus placed on our supply chain optimization efforts, with a $31 million reduction of inventory in Q2. We have now reduced our net inventory by more than $50 million in the first half of the year against our stated objective of $80 million for the full year.

I'd now like to share how we're thinking about Q3 and planning for the remainder of 2020. We currently anticipate Q3 non-GAAP revenue in the range of $325 million to $345 million and expect non-GAAP gross margin to be in the range of 32.5% to 35.5%. Included in this range is unexpected line system demand from Tier 1s in preparation for growth and/or insertion of new technologies in the future. We are continuing to drive the upward trajectory on gross margin through the year with healthy demand for bandwidth from customers for 600-gig and strong interest in our 800-gig solutions.

In parallel, we are facing headwinds from COVID-19 that are still impacting our supply chain efficiency and cost. As we look through the end of the year, although gross margins are expected to continue to improve through fiscal year '20, certain customer adoption processes have been protracted and have impacted the margin expansion timing we outlined pre-COVID by approximately 1 to 2 quarters.

Fundamentally, our plan to expand gross margins to our targeted mid-40% range with step function increases tied to the level of vertical integration remains sound. Our optimism about our ability to achieve this model is underpinned by documented results from our ICE6 trials, anticipated first shipment later this year and subsequent ramp in fiscal year '21.

Tom described these cost-cutting efforts we are undertaking as we drive operational improvements. Our current expectation for Q3 is for operating expenses to be between $115 million and $118 million, and we are working on an additional $3 million to $5 million of quarterly OpEx savings by the end of the year. We will continue to focus our investment in key programs designed to increase vertical integration and expand gross margins.

Finally, we expect a non-GAAP operating margin loss of 1%, plus or minus 200 basis points. Below the operating line, interest expense will be approximately $6 million in Q3.

We continue to focus and make systematic progress with our cash management efforts. Our working capital efficiency efforts discussed earlier are intended to improve our operating cash flow in 2020. In Q3, we expect that we will again utilize cash from operations and then return to generating cash from operations in Q4. Our operational improvements are taking effect with inventory reductions and focused investments on key programs. It is important to note that the previously outlined approximately $80 million in cash outflows due to onetime items carried forward from 2019 will be behind us as we exit the year. We are focused on achieving the revenue growth and margin expansion expected from the launch of ICE6 and from new and existing customers.

Additionally, we have an open window of time to take advantage of the growth being driven by changes in the competitive landscape with Huawei under pressure and a substantial customer interest resulting from our 800-gig performance. We need to balance these growth opportunities with the increased time to certify new products that we are experiencing due to COVID-19 restrictions. Taking all of this into consideration, we will be prudent when it comes to adding cash to the balance sheet, with our first priority being the ongoing work towards self-generation of cash through working capital improvement, operational efficiency and gross margin expansion.

As I reflect on nearly a year at the company, we have made positive steps forward and have significant customer and operational opportunities in front of us. Namely, we completed the Coriant acquisition on time with synergies greater than our targeted savings plans. We have now shifted those efforts toward operational efficiency, which are resulting in cost reductions through automation and process improvements. The step function working capital improvements are challenging, time-consuming and starting to bear fruit with the reduction of inventory and improved DSOs. The market demand for bandwidth continues to increase, and Infinera is positioned to grow with it. The next wave of technology with ICE6 is imminent, and I see a path to our target business model, although a quarter or two behind my original pre-COVID estimates. And finally, we are investing in the highest growth and most profitable areas of the market to drive customer and shareholder value.

In closing, I'd like to thank the Infinera team for their unwavering effort in these challenging times. I'll now turn the call back to Tom for some additional comments.

Thanks, Nancy. Before we close today's call, I'd like to announce Infinera's leadership succession plan that we'll be implementing in a seamless way in the coming months.

2020 marks my 17th year with Infinera and my 11th year as the company's CEO. When I joined Infinera in 2004, we were a true start-up. We had exciting plans and no revenue. When I took the helm as CEO in 2010, we are a one-product company, delivering 10-gig solutions for the long haul and subsea markets, primarily to wholesale customers. In the past several years, Infinera embarked on a journey to significantly expand our solutions' portfolio and deliver enhanced value to our broader customers, while redefining high-speed optical networks with technological innovation. With ICE6, we are reclaiming performance leadership and are again bringing revolutionary technology to the market as we prepare for the rollout of our next-generation GX platform. Building on this strong technology foundation and with a deep bench of expertise and talent, I believe now is the right time for Infinera to transition to a new leader.

Many of you have come to know, our Chief Operating Officer, David Heard, on these calls. When David joined Infinera 3 years ago, one of our objectives was to bring a COO on board that could be groomed to seamlessly take over as CEO at the right time. David's contribution since joining the company have been substantial, scaling our market position as he led us through a major acquisition, successfully driving an aggressive synergy plan through operational improvements and aligning our product and service portfolio through focused investment on the highest areas of value for our customers and shareholders.

Today, I'm pleased to announce that Dave will be assuming the role of CEO by the end of the year. I couldn't be more pleased with the Board's selection of David as Infinera's next CEO. I have the utmost confidence in David's ability to successfully lead the company in the next phase of growth.

Despite these changes, my commitment to Infinera and believe in its growth potential remains unwavering, and I'm pleased to continue participation in the company as a Board member. In this capacity, I will assist David in the CEO transition, and continue working closely with the company's extended leadership team and employees. I will also continue to nurture the many customer relationships we have developed over the years. In conjunction with this transition, we are also announcing that Kambiz Hooshmand will be stepping down as Chairman of the Board simultaneous with the CEO transition. Kambiz has served as Chairman since October 2010, and I, together with the whole board, thank him sincerely for his long-standing and dedicated commitment to Infinera. George Riedel will be elevated to serve as Chairman of the Board when Kambiz steps down from that role. We are very fortunate to have someone with George's industry experience, knowledge and strategic leadership ability to step into the Chairman's role and partner with David as he assumes the CEO mantle, later this year. These succession changes have been thoughtfully planned, and we anticipate a smooth transition. I am deeply appreciative of the opportunity to serve as CEO over the past decade, and I look forward to helping Infinera in the next phase of our journey as a member of the Board.

With that, we'll turn it over to questions.

(Operator Instructions) Our first question today will come from Alex Henderson with Needham.

Thank you very much for the opportunity to ask a question, but also for the strong print. I was hoping you can talk a little bit about the 800-gig blades or line cards, to what extent they can fit in existing chassis that are in the field that have already been deployed, both on in terms of your legacy footprint Infinera systems as well as on the Coriant side?

For instance, just as an example, is it possible that somebody like a Centurylink could then go back and upgrade their long-standing backbone with you guys with an 800-gig by just simply changing out the line cards? And similarly, can they do that on existing footprint in the DCI space?

Yes. Thanks, Alex. So look, from an 800-gig standpoint, we will have a portfolio approach out to the customers. The first area where we see the most demand is actually in the highest growth sector, which is in the compact modular portion of the business. And so the compact modular portion of the business will have a series of form factors available for sizes and shapes for ICPs and CSPs, and that will be a continuation of the group platform. And then obviously, as we go out to the rest of the world, we'll look at the various cards that we want to make available for our customers. But most of them are demanding that in the compact modular format on our flex line systems as we go out. And more importantly, on open line systems, which we've seen a huge uptick over the last 3 to 4 quarters in the insertion opportunity for.

And if I could ask a second question. There was a talk about a qualification process on the 600-gig product going into the DCI space with a Tier 1 player. I haven't heard an update on that. I was wondering if you could give us an update on whether they've qualified that. And are therefore, positioned to start to take delivery in 2H.

Yes. So on the last call, I said specifically that there were 2 Tier 1 scale ICPs that were in a qualification planning. And I said on the call, one of them, we began shipping to in Q2 for long-haul applications. It was an initial long-haul rollout with this ICP. So one of the 2 certified the product. One of the 2 has actually begun deployment in Q2 and we'll continue deployments in other markets in Q3. That's for long-haul applications. And as David pointed out, this is important, the first application goes over some of our line systems and also some of our competitors' line systems. And this whole move to open, I think, speaks very well to our road map of, quite frankly, our mission, build the world's best lowest cost transponder. The second ICP that I referenced was, they had to delay the certification process. Their lab was shut down for the quarter of Q2. We are now in that lab. The process is just starting. So I would qualify my view as the plan is the same. My expectation is the same. We don't control the answer, but it will probably be a one quarter delay from what we had anticipated on the last earnings call. So one of 2 done, second one to go. And that was for a data center interconnect application, which quite frankly, drives more volume.

So just to be clear, if it goes -- if it's in the lab now, generally, the time line to get that qualification is less than a quarter. Would that be then something that would start to ship in 4Q? Or would that be more into the first half of next year?

We are driving as hard as we possibly can to have it be a Q4 shipment, Alex.

All right. I get it. And then just one last question on the modeling side of the equation. You obviously have a pretty large fourth quarter historically. Do you expect that typical seasonal pattern to persist? Or given the constraints that you've been seeing, maybe more of a flattish sequential from the September quarter into the December quarter. How are you thinking about that in this environment?

Yes. So traditionally, Q3 is seasonally down. You've seen that our guide is, I'll say, flat to slightly up just based on what we're seeing today. Q4, although visibility isn't perfect at this point. I would expect to see that continue to trend up. I'm going to have to reserve how much at this point, but certainly, we see the uptrend going through the year.

In my script, Alex -- I picked these words carefully. We see second half revenue being greater than first half revenue. And I wouldn't have said that if it was very narrowly above. There has to be some level of comfort. There's no guarantees in life. But our view is, obviously, Q4 will be relatively healthy in comparison to Q3.

Super. Thank you for the question, and I'm sorry to see you retiring, but I guess it's a good thing for you. I'll look forward to talking to Dave on...

We'll chat offline, Alex. Thanks for your years of being a great analyst for us.

And the next question will come from Meta Marshall with Morgan Stanley.

(technical difficulty)

We're getting nothing, but static.

Meta, if you could please dial back in and see if you can get a better connection. In the meantime, the next question will come from Rod Hall with Goldman Sachs.

This is Bala Reddy on for Rod. And congrats on a good quarter. Tom, my best wishes to you on your transition. To kick it off, I want to start with Huawei. So you mentioned opportunities from Huawei backlash, I guess, that we are seeing in the U.K. and probably some other parts in the Europe as well. Maybe some thoughts around how you're thinking about the time line of this opportunity? Is this more next year or even more longer term? Any thoughts around that? And I got a follow-up.

Yes. I think interestingly enough, we watched the Huawei kind of geopolitical pressures for a period of time right now. And there was always a question whether it was real or part of a larger political game. And I'm completely changed my opinion that it's very real, and people are -- customers are under the absolute necessity of evaluating and making change. We've seen the first part of that. We saw some in Q2, small amount of revenue, but a decision that went our way. We also saw another small one in Q3, and it's really not the beginning of the process, and we're replacing Huawei, we're in a competitive bid it's us at Huawei, and now it's falling to us. We've also seen our first RFQ for a very, very large opportunity, where it is specifically around displacement of Huawei network. I think those large opportunities will take while to transpire. So my guess is, in the short term, when you're in a bake-off and we Huawei is participating, they're really not participating. They might still be used to drive down price but they're not really participating. In the medium term, I think there's going to be significant opportunity for true replacement of Huawei networks. This is not being viewed as a game. It is real, and customers are fairly -- obviously concerned, but starting to execute already on this new model. I think it's, quite frankly, for a non-Huawei person, it's a once in a lifetime opportunity.

That's one is brilliant. Connects on that. And I want to touch upon the 800-gig trials with Verizon and for their customers. So could you maybe give us some color on the early feedback that you got for the product, the reception of the customers? And in general, like how are you thinking about the time line for qualification at the customer and maybe actual deployments? Any color on that?

Yes. So the trial response has been overwhelming. There -- it's really fascinating to watch before we did these trials and even when we just did the first trial, there were a lot of pundits in the industry that talk about what we were doing was physically impossible that we were playing engineering games, that were using special fiber and as we did the Verizon announcement, and we're very specific that it's a live network with live traffic on standard fiber that's been in the ground for a long time. The results were overwhelmingly positive. It quite frankly, shocked the Verizon folks. And it's a small world. The ripple effect or the butterfly-wing effect of that has gone around the world. We are seeing an incredible increase in request for trials, more than we can actually, in the current environment, deal with. But before we talk about deployments, I want to make sure everybody knows. It's our job to deliver this product this year. And that's where we have to focus our attention. I believe that the customer demand is significant. We've had customers already commit that they want to roll this out. But I don't want our company to be detracted by that. What we need to do is bring this product out with exceptionally high quality. The performance is clear. And I think there's going to be abundance of market opportunity, both because of our -- and quite frankly, stand-alone performance from an optical capability. It translates directly to cost. It allows customers to build with 800-gig networks that they thought had a constraint of about 400-gig. It's a really big deal. Our job is to deliver this product. And we have a customer that has signed up for delivery in Q4. Our job is to satisfy them.

I think the economic results from these trials, I think, were pretty profound. So I think what we saw is that by being able to carry traffic 3 to 4x in the network, that when we look at kind of competing technologies. There's a huge ability to reach Metro areas that couldn't have been reached before as people contemplated 800-gig, and that resulted again in what Tom talked about as a 4x for each advantage at 800-gig and a 25% reduction in overall cost to the service provider. That's 800-gig to 800-gig and a significant cost from generation to generation. So again, to Tom's point, as we go to ramp that product, this isn't our first vertically-integrated product as a company. First, rolling out on that compact modular platform and getting out into the network. We get certifications, we go through trials. We go through initial implementations and then it scales. And I think we've been relatively consistent that we've talked about that scaling really as we get into the back half of the year, contributing significantly to a step function increase in margins. In the second half of next year, step function increase in margins.

And the next question will come from Meta Marshall with Morgan Stanley.

All right. Can you guys hear me this time?

Much better.

That sounds great.

All right, beautiful. Who said, work from home as seamless. All right. So on -- just a quick question on -- I know it's impossible to necessarily quantify, but just kind of what you think the supply chain overhang is right now? And is it more concentrated on one particular product? Or just any quantification or narrowing of the supply chain overhang? And then you're cutting OpEx quite severely. Clearly, managing a lot of expectations. But how do you balance some of the cuts in sales and marketing with what seems to be a more open landscape in Europe with Huawei displacement opportunities?

No. It's -- those are great questions. I think, first, from an overall perspective on the supply chain side. Look, we saw some hoarding happen in -- as we exited Q1 and into Q2 of certain pluggables in the industry. There's a hangover impact. When you're looking to ship and the order complete, and it needs every pluggable, every power supply, every element. We've just seen a portion of those hang up from quarter-to-quarter. And as you get to the end of the quarter, our industry, unfortunately, is shaped a bit like a hockey stick as you exit the quarter. And so the kind of freight and facilities that allow you to ship out in the last week or 2 of the quarter aren't as open as they used to be. And so it is -- we talked about that contemplated range in our guidance in Q1. We've just baked it into the range into Q3, and we baked it into the range into Q2 as well. So we're keeping a watchful eye. We're being cautious in terms of the margin outlook for the business contemplated. Because we just think there are those potential still to be able to hit us as we look at the numbers on a worldwide basis, and we talk to our client base.

From a cost basis, look, we are flipping our investments very, very high on the fastest growth markets that we see happening in this new open optical world. We're very encouraged by the adoption of open line systems. And as Tom said, the best transponder wins when you look at the bill of material for our customers and the price performance that that provides them in their network with bandwidth growing at a dramatic pace. So our R&D investments continue, nailed up on compact modular on ICE6. I'm putting in the next phases beyond that for what our next optical engines are, on intelligent pluggables as we go forward. So we're keeping R&D very focused on where we think the market is going. Where we're able to get some of our sales or our SG&A numbers down is as we went through the integration, we installed systems and processes that we had to put in place as we went through the integration. Now we're able to transform them and get better operating cost effectiveness throughout not only our sales and marketing force using salesforce.com, but as well in our supply chain, in our finance team, in our IT team and across the company. So that's where we're really, really pinching down. And obviously, given we're in COVID times, there are some innate savings that we're getting in terms of travel and other costs that we're benefiting from in this period.

Yes. I don't want you to walk away thinking that we're going to go start a customer base while we're bringing out these great technologies. That is not the plan at all. As David articulated, we bought Coriant 2 years ago, we deployed an ERP system 1 year ago. Once you get the ERP system running, there's massive amounts of automation that you have to do to basically affect all of the manual work that goes along. Those are starting to come into being as we speak. Also we've now owned Coriant long enough. We understand -- we had a very broad footprint of sales people around the world. We understand where the opportunities are. We also understand where the opportunities aren't. And we are refocusing more toward where the opportunities are versus chasing ghost. We're not going to do that.

And I think one of the things on the supply chain stuff, I think I agree with everything David said, people are underestimating the impact of the logistics stuff right now. That makes volatility at revenue recognition time, much more difficult at the end of the quarter. It used to be if you ship something on a Tuesday, you knew it would be somewhere by Friday for revenue recognition. Now if you ship something, it might take 14 or 15 days. So don't underestimate the lack of precision around that part of the equation. That's for incoming material and outgoing material.

As well as the cost premiums can be 30% to 50% and sometimes 70% in that.

And the next question will come from George Notter with Jefferies.

Tom, we're going to going to miss you. Guys, can you hear me?

Yes.

Yes, loud and clear. George.

Great. Tom, we're going to miss you in these earnings calls and intra-quarter conversations. But welcome, David, certainly. I guess I wanted to just kind of ask you, like, why did you feel now is the right time to transition out of the CEO role. I mean, it seems like the company is really turning a corner here and getting new products out and certainly on top of what should be some more success in the marketplace. Why is the timing, what it is?

Yes, George, good question. It's something I've thought about for a while and contemplated for a while. And I'll just give you a few things. I do believe, philosophically, that a CEO has a natural tenure of how long they should be in a role. I think that there's a need for everybody to recognize that they have -- it's a job that you have to earn every day. And people who stay in a role too long, become a figure instead of earning that job. And I'm -- I always said to myself, I would not allow that to happen. And I watch it with CEOs, I watch it with coaches, I watch it with Board members. And I do believe a transition should happen candidly, when things do look like they're in a better position. I am very proud. We're not done yet, getting our 800-gig to market. I would have felt if a technology wasn't robust and differentiated. That it would be a difficult time to transition. I also think over the last 3 years, since David had been on Board, we really rebuilt the entire leadership team fundamentally for the next challenge, next growth phase. And that's been in place now for a couple of years. So I think from my perspective, I want to be careful of making sure when I leave, I still have -- felt like I needed to earn the job. Two, David is ready. Three, more importantly, the team is ready. And I do think that there is an opportunity with our technology position and our product position to hopefully have an opportunity to hand it over where they can drive it to where we think it can go versus in a negative spot.

Super.

George, one other thing too. This is important. I'm not leaving the company. I'm going to a Board member, I'm going to continue to be a Board member. And David has asked me to be an active Board member, both to help him in the transition, but also, I love the company. I love the people. And I'm a big believer in it. And I'm going to help David, to the best of my abilities, to continue on the traditions that have been important to me.

The next question will come from Jim Suva with Citi.

Tom, congratulations, and it will be difficult to see you retire, but hats off to you for a nice -- really long duration there. My question is...

That's certainly a long duration. That's right.

Some great times and some challenges. That's for sure.

Which many can't say. That's for sure. You've been through cycles. That being said, you mentioned, I believe, on your prepared comments that your margin goals may be pushed out a couple of quarters. Can you remind us of the time line? I think it was gained long-term margins. And now when we're talking about a quarter or 2, it seems like you've got more visibility into a time line of those? Or how should we be thinking of that statement and time line as such?

Yes, sure. So at the beginning of the year, when we came out of Q4, before COVID, we laid out a plan at that call, which looked out into 2022 and looked at step function improvements in gross margin of 200 to 400 basis points a year. Going through those 3 years to bring us into that mid-40% range. What I'm commenting on now is, now that we're in the time of COVID, we're probably going to be delayed by 1 to 2 quarters there. But the fundamental achievement of mid-40s is absolutely within our grasp, and it's all about the level of vertical integration. And as the percent of vertically-integrated products are sold and generated in our revenue, that's when you'll start to see the real step functions up, the largest of which in the near-term is the 800-gig.

And the next question will come from Michael Genovese with MKM Partners.

My first question is, are you guys seeing any other 800-G products that come into the market or that will come to the market in 2021 besides the one from Ciena that we all know about in yours?

While we're seeing Huawei do a demonstration. It was very, very limited reach, I think, 80 or 100 kilometers. And we've had a hard time getting any real G-2 on it. But considering the markets we now serve and the markets that Huawei is going to serve, we don't see any other 800-gig technology coming to the market next year. I've seen one competitor announced that they plan on bringing something to market next April, but they're not a vertically-integrated manufacturer. So I'm not sure how they're going to pull that off. So I don't think that next year, at least from anything that we see, there will be other 800-gig alternatives. So you mean its 2 magnificent new things. Huawei being pinched out and competitive market narrowing to 2. It's really significant.

Great. And then as we read these trial announcements on 800-G, which look impressive. And as we look at your data sheets for your new products, what should we focus on, as we compare the product versus the competitors? What metrics should we be comparing it as we try to decide who's is "better"? And then along those lines, given that last trial announcement was with Verizon, I don't think they're a big optical customer of yours. Do we take anything away from announcements of live networks traffic trials with customers that are not historically meaningful optical customers for you guys?

Well, I'll start with that one. They're a very, very good customer to us, and we sell optical to them. If you remember, they bought the assets and footprint of the XO network, which was an Infinera footprint. And I think I've described this, this is a long time ago, though. Originally, they told us -- tell us the warehouse, you want to go put this stuffing because we're going to rip it out. And then they said, well, you know what, it runs pretty well, we're just going to cap it and leave it alone. And they said, well, we're going to expand capacity on it because we really like how it performs. So they're a reasonable optical customer for us today. This trial, I think, is a continued indication that they are interested in continuing to utilize where they see us delivering differentiated value propositions. And I think that it's certainly not a decision to buy. But it's certainly a decision that they're going to invest their own time and effort into looking at a technology to see if it brings appropriate economic value. Their response has been -- you saw the press release exceptionally well received in how they think that this type of technology can impact their network. We still have to go earn that business, but I think that it's certainly cannot be viewed as anything but positive.

In regard to performance, reach is very, very important. It's simply, if you have a 800-kilometer link, do you want to send 800-gig down that link? Or do you want to send 600-gig down that link? Because that's the economic difference. Our 800 -- our ICE6 will go approximately 3 to 4x further than anybody else's. In 600-gig mode, it goes 2.5x more than what we've seen from a deployable network spec. It allows customers to utilize fiber, which is scarce and expensive to transmit more data. So reach is a very, very important attribute. It translates directly to dollar per bit and watts per bit and spectral efficiency. So I think that's probably the most important thing. And then availability, obviously, we need to bring it to market and be available.

Yes. I think the good news when we compare to prior generations is when you look at 100-gig or 200-gig, and you had anywhere from 12 players down to 8 players. Now we believe that the lowest cost per bit and performance, we feel good about what we've seen in live networks, not hero experiments. There aren't 8 in the field. There aren't 12 in the field. Right now, we see visibly 2 in the field. And more importantly, as the challenger to gaining share, we have open line systems that are now mature enough. And this has happened in other industries and access and switching in QAMs, in radio, you see with ORAM. The best transponder will win, and that's what we're going to keep focused on. But we also know that it takes a while to certify and to roll out initial applications with customers that then go into scale mode. And that fits nicely with what Nancy talked about in terms of the business model and gross margin expansion, having that step function as we get into the back half of 2021.

And Tom, I'll congratulate you on the future call. I'm sure it sounds like you'll be around on at least a couple more, which I'm glad about.

Thank you.

And the next question will come from John Marchetti with Stifel.

Tom, last call that you had with us, you talked about your visibility into the second half having weakened a little bit. I just wanted to come back to that comment now that we're sort of a quarter further and then get your pulse or take your pulse on how that visibility looks now? And obviously, you made some comments feeling good about the sequential increase 4Q from 3Q. But just maybe if you could talk maybe about some of the different segments and what you're seeing there as you're looking out on the second half? That would be helpful.

Sure. I would say, in general, I have a better view and a more positive view on visibility than a quarter ago. There are still conversations that are occurring in regard to, worried about macroeconomics, but bandwidth continues to be under demand for growth. And so far, we are seeing our customers stay relatively steady on their bandwidth growth plans. There are some certainly that have retracted. And I think you read about them in the paper as they've made CapEx cuts, but others are making CapEx expansions. I have seen a couple of projects that got delayed when Q2 -- when everybody was shut down physically, and there were some network builds that were planned in Q2. They didn't get canceled, but they got pushed out. That pushouts, you never go back and recapture the growth that would come off of that. So part of my concern was the impact of those pushouts and to the push-outs continue to get pushed out or canceled. They're actually happening, but they've been delayed. So some of our plans that were built on the back half of those pushouts will also be delayed. But I would say, overall we see more confidence in our ICP business. We see more confidence in our general Tier 1 business around the world. Subsea continues to be reasonably strong. Our cable for us are less certain. But I think that in a macro, I'm more confident than I was a quarter ago. And hopefully, that came across in the script as we talked about the expanding bookings from some of these markets and the iteration of our revenue, my belief, our belief that revenue will grow second half over first half. A quarter ago, I would not have said that.

And the next question will come from Simon Leopold with Raymond James.

Great. Hopefully, you can hear me okay.

Yes.

You're going to be missed, but I think if you're looking for somebody with the energy that could rival you, David Heard's probably the guy, so I'm looking forward to that. So I wanted to look at what's going on in the ICP vertical. Just looking at your first half year-over-year, it looks like it was down meaningfully in the second quarter versus the first quarter, roughly 30% sequential decline. Assuming that math is correct, was this more about the related to the delays of that customer? Or what played into that sequential drop in the second quarter from ICPs?

Yes. We had very significant rollouts in Q1 of revenue that it takes a period of digestion to deploy all of that. And that's what we experienced in Q2. As I commented on the call, bookings in Q2 were roughly flat in the ICP space with Q1. So we don't see this as fundamentally disrupting our ICP progress. We do have, as I mentioned -- I said, we see ICP strengthening in the second half. Part of that is driven by the fact that that inventory will have been deployed. Part of that is driven by the opportunity that we are executing to with some of the 600-gig for long haul. And then we are still hopeful that we'll be certified for data center interconnect in the ICP space with -- as I talked about earlier, hopefully, by Q4. But we do see -- we have committed plans from customers that the ICP in the second half will be stronger than the first half. They just have to execute on what they said they're going to do.

And as part of that assumption, reflecting 600-gig basically replacing 200-gig in the second half of the year in the ICP vertical?

It's not really replacing. I would say it's complementing. There's going to be some applications where 200-gig is what they want. But we need to start selling them the 600-gig. It's a new opportunity for us. They get a better dollar per bit. We get enhanced margin because it's partially vertically-integrated. Performance for them is a lot better, but not all applications require 600-gig technology.

And just one last one on gross margin. You talked about the supply chain issues, the shipping issues, which we've heard about from others. I'm just trying to get a sense of how to maybe bridge the COVID effects. Is it roughly 50 basis points of headwind on the higher product cost, higher shipping costs? Is that about the level of impact?

Yes, I would say between 50 and 100 basis points depending, right. Depending upon the severity and the specific product, right? As Tom mentioned earlier, things are just taking longer, right? We think we're going to have a delivery in a period of days, and it turns into weeks. And costs are being driven up by expediting and others. So it ranges.

The next question will come from Samik Chatterjee with JPMorgan.

This is actually Joe Cardoso on for Samik Chatterjee. Just one question from me and just feeding off of the customer vertical questions, specifically around service providers. If I look at your disclosures, it looks like Tier 1 slowed down in revenue growth in 2Q, but it would appear your other category actually saw an acceleration. Just wanted to get a little color on the variance there and how that's feeding into your 3Q. And then more specifically on APAC. In your prepared remarks, you spoke about a specific recovery with a Tier 1 there. However, if we kind of exclude them from the region, how did you see the rest of the region recover in 2Q?

I think -- as Tom mentioned, APAC has been slower to recover, just given the impact earlier in this year. So we are pleased to start to see that recovery happening. We're watching that carefully, but seeing good traction and seeing a lot of interest across the board there. As far as the Tier 1s and the strength we're seeing in that area. We have, as I mentioned in my comments, seen some unexpected demand coming through recently, which we believe is either being used to position for future technology adoption or just additional growth. So both in the Tier 1s and the Tier 2s, I think that bandwidth demand is still there. And we're really pleased to be able to execute on it.

Yes. I would also say on the Tier 1s, as we got -- as we were in the height of COVID and as we kind of exited Q1, there was some Metro build out that was significant. So this is also the digestion period between bookings and revenue that we didn't see an uneven pace when we look at the Tier 1s on a bookings basis. It's just when these projects were available to complete. And Tom mentioned there's a couple of these projects that became more difficult to get service folks in to get acceptances done given the COVID restrictions.

We certainly have not seen a drop-off of bookings demand from Tier 1s there. The volatility is more like what David talked about.

Congratulations, Tom.

This will conclude today's question-and-answer session. I would now like to turn the conference back over to Tom Fallon for any closing remarks.

I appreciate your time. And I very much appreciate the support you've shown over the years. So I look forward to chatting with you again next quarter. Have a great day.

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