Infinera Corp (INFN) 2020 Q1 法說會逐字稿

Good afternoon. And welcome to the Infinera Q1 2020 Earnings Conference Call. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Michael Bowen. Managing Director, ICR. Please go ahead.

Thank you, operator. And good afternoon. Welcome to Infinera's first 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 road map, sales, our 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 of our second quarter of fiscal 2020 outlook. 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 as included in our most recently filed annual report on Form 10-K as well as the earnings release and investor slides furnished with our 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. 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 first quarter of fiscal 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. While I would typically start by reviewing financial highlights from the quarter, I wanted to begin today's call by talking about the impact of COVID-19, and how we are responding to this unprecedented challenge. First, on behalf of everyone from Infinera, I would like to extend our sincere appreciation for those around the globe who are working tirelessly to protect all of us and care for those in need despite the obvious health risk they take upon themselves. This selflessness represents the very best of humanity and brings hope during a time of fear and uncertainty. Thank you.

From an Infinera perspective, at a high level, our employees remain safe, our customers are being serviced, and our ability to deliver remains in place. We are taking active measures to reduce costs and improve working capital efficiency during an uncertain time. And the first of our new ICE6 800-gig products is on pace for delivery later this year, with performance that we expect will set the benchmark for optical reach and costs. For context, I will give an update on our operations before reviewing the quarter.

While our production facilities operated below capacity during the second half of the quarter due to COVID-19 related constraints, the vast majority of our development teams and support functions work from home with modest impact to productivity. For a significant portion of the quarter, we experienced supply chain disruptions as many countries imposed public health restrictions that impacted the production and delivery capabilities of our vendors around the world. This disruption had a negative impact on our ability to fulfill certain customer requests during the quarter. For Q1, while our final non-GAAP revenue achievement of $331 million was within our guidance range, the customer mix varied significantly from our original expectations, and our corporate non-GAAP gross margin was 28% for the quarter. This margin was approximately 500 basis points below our expectation and that's the result of 2 separate events.

The first was recognition of revenue of a major 19 country Tier 1 subsea consortium build that was accepted by the customer a quarter earlier than anticipated. The initial rollout of this project was comprised primarily of common equipment, which contributed a negative gross margin impact of 300 basis points. On the positive side, the common's deployment is now completed, and this project is expected to produce high-margin revenue as the consortium members begin to add capacity in the near term. Margin was also compressed because of the significant shipments of our 200-gig Groove solution that is based on merchant optical engines. These shipments were driven particularly by a major North America ICP. While this had been anticipated for the quarter, our constrained shipments of higher-margin product limited our ability to offset this compression as planned.

Moving forward, as more of our customer base qualifies our 600 gig and eventually 800 gig solutions, we will be able to improve the margin of our offering with vertically integrated technology. On the bookings front, customer demand in the first half is relatively in line with our view from the beginning of the year and ahead of where we were last year at this time. We've seen increased demand from some customers as they have reacted to new network requirements brought on by the pandemic. As we look to the second half, however, we are seeing less clarity on demand as our customers assess the economic impacts on their respective businesses and the customers they support. From a regional perspective, strength continued from Tier 1 and Tier 2 operators in North America and EMEA. We saw Q1 bookings weakness in Asia due to the early impact from COVID-19 in that region, but we see demand from Asia recovering in Q2. IPP demand continued to be lumpy with Q1 bookings behind plan after significant shipments in the first quarter. Cable was weaker than expected in Q1, but we also see some recovery in this segment in Q2.

Turning to product and technology highlights. We saw record bookings in Q1 for our XTM metro platform, driven by wins in the past year and expanding opportunities with existing customers. Groove continued to perform well with substantial year-over-year bookings growth and delivery of 600 gig product to 11 customers in the quarter. From an opportunity win perspective, we continued our 2019 momentum with several significant awards in Q1. Further, we are very pleased with the progress we are making on our ICE6 800-gig product, which remains on track for delivery during the second half of this year. During the quarter, we demonstrated technical performance leadership in 800-gig transmissions in a major North America operators live production network, conducted with our new ICE6 powered Groove GX Series platform, which we announced in the first quarter, we successfully carried an 800-gig, single wave length signal over 950 kilometers in the trial.

While others in the industry are taking the position that 800-gig technology will mostly be about 400-gig and 600-gig deployments, our demonstrated performance highlights the ability of our ICE6 technology to address approximately 40% of North America backbone network links with 800-gig transmission speeds and over 75% of links with 600-gig. With our ICE6 solution, network operators will be able to maintain 800-gig signals rates long after alternative solutions need to be dialed back to lower speeds. The net result is a highly differentiated 800-gig solution that provides savings of greater than 25% in cost per bit, power per bit, and capacity for fiber. The 3 most significant buying criteria for network operators versus other fifth generation coherent solutions at a network level.

Compared to the current third-generation 400-gig solutions, we believe ICE6 will enable savings of more than 65% in the same typical North America backbone network. As a consequence of this superior performance, our competitors have taken to publishing white papers that challenge our results as violating the laws of physics.

I candidly can't think of a higher compliment and look forward to competing in the field. As highlighted before, ICE6 is targeted at the high-performance 400-gig and above optical transport market, where we see a narrowing set of viable competitors, with only 2 non-Chinese suppliers having in-house products. This is one of the fastest-growing segments of the overall optical networking market with a forecasted compound annual growth rate of 35%, and excluding China, is expected to reach over $4 billion by 2023. We are also continuing to invest in longer-term disruptive technologies that open up new accretive markets, with XR pluggable optics progressing at a rapid pace, built on our leadership in DSP technology independent on our subcarrier advances, XR optics fundamentally redefines how aggregation network architectures can be built. Purpose built for the evolution of wireless access and backhaul, cable and metro core networks, XR optics is gaining increasing interest and support from Tier 1 providers around the globe.

This quarter, we conducted several technology demonstrations for customers and industry analysts that showcase the powerful capabilities of the technology, a transformative impact on the cost structure of the networks and its operations, with the potential to drive down costs by as much as 70%. XR Optics leverages our proven leadership and expertise in VSP technology along with critical pick integration capabilities that deliver lower power and cost. With ICE6, GX and XR, we are positioning our company to intercept the biggest market trends and lead in 3 of the fastest-growing segments of optical networking: high-speed optics, compact modular platforms and network pluggables. Enabled by our unique approach to vertical integration, these also create a path for product-driven step function improvement in gross margin to our business beginning in 2021.

As we look to Q2, we see continued improvement in our factory utilization and signs of increased stabilization from manufacturing partners around the world, but we do not expect all constraints to go away. Further, we anticipate ongoing access restrictions at certain customer sites that could delay our ability to deploy certain networks in Q2. As a response to these constraints, we have extended lead time expectations to our customers. They are responding favorably with this change by accelerating orders. For the second half of the year, we expect that macroeconomic uncertainty felt by customers could more than offset the continued expansion of bandwidth demand that is projected to remain intact. To address this uncertainty, we are taking proactive measures to reduce operating expenses and improve gross margin. These measures include both the temporary reduction of salaries for senior management and the Board of Directors and staffing reductions, largely in the area of contract positions with limited impact to our regular global workers.

These actions are expected to yield a savings of approximately $5 million to $7 million a quarter from our Q1 OpEx level and are being accompanied by an intense and ongoing drive to optimize our supply chain and improving our working capital efficiency, a process which has been in key focus areas since the beginning of the year. The impact on our cash position of these decisions, considering the cash conversion cycle, is expected to be meaningful in the second half of the year. While our near-term view is clouded by the impact of COVID-19, we remain extremely optimistic about the opportunity we see for Infinera in the medium and long term, driven by our focus on delivering differentiated solutions for the fastest-growing segments in the market. This differentiation is enabled by our long held, vertically integrated approach to DSP and Photonic Integrated Circuit intellectual property development and manufacturing, which we view as mandatory capability to compete successfully in the markets we serve.

In summary, we are pragmatic about the near-term macroeconomic challenges we face and are intensely focused on cost discipline and improving our cash conversion cycle. As an organization, we are motivated by the opportunity to serve our customers who are bringing people, communities and business together at a critical time of physical separation and remote connectivity. We are also excited about the opportunity to prove that, while pushing the boundaries of physics, our optical networking innovations will bring significantly improved economics to the market while structurally improving our gross margin and operating profit. As bandwidth continues to grow and the economic environment improves, we'll be ready to deliver on that opportunity.

With that, I'll turn the call over to Nancy.

Good afternoon, everyone. Today, I will begin by covering our Q1 results and then provide a framework from which to think about Q2 and the remainder of the year. As a reminder, my comments today will be directed to 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 challenges associated with the COVID-19 pandemic, our results for the quarter included year-over-year growth in revenue, decreasing operating expenses and modest operating margin improvement. Q1 non-GAAP revenue was $331 million, above the midpoint of our $315 million to $335 million guidance range and up 12% year-over-year.

As Tom mentioned, revenue and margin were impacted by a large-scale subsea consortium deal completed in Q1, a quarter earlier than we had anticipated. This was coupled with the impact of COVID-19 on our ability to fulfill certain customer demand, which ultimately impacted the overall revenue mix. We had one 10% customer in the quarter and continued to see strength from a leading cloud provider whose business once again came in just under 10%. Our geographic mix continued to be skewed more towards North America, driven by strength from our Tier 1 customers with 52% of revenue coming from that region.

Non-GAAP gross margin was 28.3%, below our 31% to 34% guidance range due primarily to the following 3 drivers: first, the timing of the initial deployment of our previously mentioned large-scale subsea network implementation, which represented approximately a 300 basis point decrement to Q1 margins. Now that the initial installation is complete, it is anticipated that this consortium deal will favorably impact gross margin in the second half of the year. Second, the impact on product and margin mix from the expected ICP deployment that represented approximately a 200 basis point impact in Q1, which we were unable to entirely offset in the quarter as planned. This skewed our mix significantly to merchant optics.

And third, COVID-19 related market dynamics resulted in us absorbing higher freight and logistics premiums, which represented approximately 35 basis points. We have included these types of premiums in our estimates for Q2 guidance. All told, these 3 drivers negatively impacted our Q1 gross margin by approximately 535 basis points. We also note that our Q1 non-GAAP gross margin excludes onetime impact of $2.9 million in other COVID-related onetime expenses. These expenses consist of higher replacement costs associated with certain warranty parts customers were unable to return for repair due to logistics issues and public health mandates. We were also impacted by the necessity to source key components from an alternate supplier at substantially higher cost in order for Infinera to fulfill delivery commitments in the normal course. In both cases, we only excluded the incremental cost.

Our Q1 non-GAAP operating expenses were $124.9 million, better than our $128 million to $132 million guidance range. As discussed in our call -- Q4 call, we are committed to maintaining appropriate investments in key technologies -- technology programs driving our innovation pipeline. At the same time, we are very focused on cost discipline and actively bringing down our overall operating expenses in anticipation of a possible protracted market downturn, and while still positioning the company to effectively scale with the launch of new products later this year. In Q1, we recognized a $31 million non-GAAP operating loss or a loss of 9.4%, which was within our guidance range. Below the line, interest expense was $3.6 million, which reflected a few weeks of interest from our new 2027 convertible notes and also an interest -- a credit interest from a supplier.

In Q1, we recognized $12.9 million in a foreign exchange loss, heavily impacted by the approximate 20% devaluation of currencies in the Latin America region in countries where we have a presence. Our non-GAAP EPS was a loss of $0.27, but if the impact of foreign currency had been excluded, non-GAAP EPS would have been a loss of $0.20, which would have been at the low end of our guidance range. Historically, our guidance did not incorporate any projected foreign exchange gain or loss, hence beginning with this new fiscal year, we will provide guidance down to the operating margin to remove the risk of currency fluctuations that are beyond our operating control. We ended the quarter with $284 million in cash, up from $133 million exiting Q4. In March, we raised $195 million in the quarter through a convertible offering in the last days prior to the COVID-19 market decline. During the quarter, we drew an additional $55 million on the ABL for a total of $85 million drawn on the $150 million facility.

As I mentioned in our previous call, we remain focused on cash generation and driving working capital efficiency. And early results include a reduction in DSOs from 83 days in the December quarter to 75 days in Q1. A portion of the cash generated from receivables was utilized to reduce our payables. In parallel, we began the implementation of the supply chain optimization efforts I highlighted in our last call, focused on planning, logistics and inventory efficiencies. And in the quarter, we reduced inventory by $20 million. This work requires time and dedicated focus to generate optimal benefits, and we are in the early stages of realizing these benefits as we enter Q2.

As a reminder, we have approximately $80 million in onetime cash outflows this year, resulting primarily from actions taken in 2019. During Q1, these onetime items totaled $30 million. Excluding these onetime items, our cash utilization from operations was $62 million. Importantly, as we drive improvements in our working capital efficiency, we are also driving to margin improvement and consistent cash generation. Overall, despite the impact of COVID-19 on our customer and revenue mix, we maintained revenue results within our guidance range. While this mix resulted in our gross margin being below our expectations, we are encouraged by the initial results of our operating expense efficiency efforts and the early signs of working capital improvement, each of which will continue to drive throughout this fiscal year. We do not currently foresee a similar magnitude of customer mix and its resulting gross margin impact occurring during the remaining quarters of 2020.

I'd now like to share how we're thinking about Q2 and planning for the remainder of the year. Certain customers appear to be focused on keeping their supply chain optimized and accordingly, are placing orders in line with our revised expected lead time. We currently anticipate Q2 non-GAAP revenue to be up year-over-year in the range of $310 million to $330 million and expect non-GAAP gross margin to be in the range of 31% to 35%. In both cases, we project minimal COVID related supply chain impact and more normalized customer mix. Tom described the cost-cutting efforts we are undertaking to position ourselves to endure a protracted macroeconomic downturn. Our current expectation is for Q2 operating expenses to be between $120 million and $124 million.

At these levels, we will continue to focus our investment in key programs that drive vertical integration and gross margin expansion. Finally, we expect a non-GAAP operating margin of a loss of 4%, plus or minus 3%. Below the operating line, interest expense will be approximately $6 million in Q2. We will no longer be guiding on EPS. Cash management, although always important, becomes even more so in these times. Our working capital efficiency efforts discussed earlier are intended to improve our operating cash flow in 2020. In Q2, we expect that we will continue to utilize cash from operations, although less than in Q1.

Taking into consideration both the timeline to improve supply chain efficiencies progressively during the year and onetime cash outflows, which will again be approximately $30 million in Q2. The substantial majority of our projected $80 million in onetime cash outflows will be completed in the first half of the year. In Q2, we reduced our inventory by $20 million, and our plan is to further reduce inventory by $60 million over the balance of the year.

Through the implementation of this plan, we should continue to see improvement in our working capital utilization in the second half of 2020.

In closing, last quarter we shared our long-term business model with an outline for margin expansion driven by vertical integration and a plan to be cash flow from operations positive, excluding onetime cash outflows. Fundamentally, this long-term model remains intact, and the drivers to achieve it are sound. However, given current market conditions, at this time we are refraining from providing an outlook for the remainder of the year. In closing, I'd like to echo Tom's acknowledgment of those working tirelessly to keep us safe and thank our Infinera team for their steadfast commitment and tremendous effort working over the past several weeks in this new and challenging environment. Operator, I'll turn it over for questions now.

(Operator Instructions) First question will come from Alex Henderson with Needham and Co.

Great. You've talked a lot about COVID impact in the quarter, and you've detailed it relative to your gross margins, but was there also an impact on your ability to deliver revenues and to what extent did your orders exceed your reported revenues in the quarter? And then second question I have for you is, you obviously have a lot to show these service providers with this 800-gig product. How have you found the reception? To what extent have you been able to demonstrate it despite the fact that there's obviously huge constraints around that? And how do you see that impacting the time to realize orders for that product once it's GA?

Yes. So first, in regard to revenue impact. When we went into and guided for Q1, we had talked about contemplating $15 million of supply-constrained impact, and that impact did occur. The thing we did not take into consideration was customers around the globe who actually shut down their ability to receive product or shut down their ability to implement networks, which turned out to be about another $15 million, which we had not contemplated. So we see disruption in the Q1 timeframe in the neighborhood of total between supply and the ability to receive product of about $30 million. So there was a fairly significant impact because of COVID, not only supply, but logistics. Moving forward into Q2, as we talked about, we see it easing somewhat, but not going away. We are not specifically identifying COVID-related impacts, but you could assume in our guidance, we have incorporated both expected supply disruptions and deployment disruptions so that gets us to the $310 million to $330 million range.

Without that, we would see the opportunity to do more than that. Customers would've liked us to do more than that. From a bookings perspective, as you know, Alex, we don't typically talk book-to-bill, but bookings were just slightly under. Q1 is a typically slower quarter in our industry, but Q1 bookings for us were actually pretty strong in comparison to outlook at the beginning of the year. In regard to trials for 800-gig, one of the disappointments we're certainly having with COVID is we have a series of trials lined up with a number of customers that continues to be delayed based upon their ability to open up a network to us, trying to make sure they keep their employees safe, which we certainly appreciate and understand.

We are doing a lot of reviews with analysts and customers over the internet, showing the performance of the

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demonstrate our technology, both at 800-gig, 600-gig and 400-gig. And so far, those are being very well received, and it's actually increasing desire by customers to actually test it on their fiber in their factories or in their plants. We have a number of them lined up for as soon as COVID restrictions are released, and we will -- with these customers, we are lining up making sure that they're interested in doing PR so that we can actually talk with more detail around the results. Hopefully, that answered your questions.

Our next question will come from Meta Marshall with Morgan Stanley.

Great. I just wanted to dive into -- you mentioned kind of ISPs and cable customers coming in slightly short of expectations and -- or at least bookings kind of coming in slightly short of expectations. I wanted to get a sense of, is that purely a matter of access and that they just are -- facilities aren't open, and they can't get to them? Or do you -- have you seen kind of a change in plans for the year or kind of end demand?

Yes, for ICP and cable. For ICP, I think that our very significant deployments in Q1, there's a digesting period, and that business is invariably fairly lumpy. We see good opportunity this year with ICPs. So I would consider that more reflection of digestion of a significant Q1 and lumpiness that their plans change and don't always (inaudible) early. In cable, cable is usually stronger in the first half, particularly Q2. We're seeing that come back. I don't think it was related to COVID in Q1. I think it was just planning when we started at the beginning of the year. We had more linear view of quarter-on-quarter for the year, and we're seeing more in Q2, less in Q1. We did see strong European access demand from a cable provider with our XTM platform, which had record bookings for access, both in cable and in other areas.

Our next question will come from Rod Hall with Goldman Sachs.

I -- well, first of all, I wanted to say our thoughts are with you guys. It's tough to operate a business in this environment. So let me start, Tom, you've been through this before. You've been around in the industry a long time. I wonder if you could characterize what you're hearing back both from the hyperscale providers and the carriers, MSOs that you talk to in terms of how they see spending through this recession? Do you think it's likely to be as disruptive as it was in '09? Or were all the credit market functioning problems back then kind of an esoteric thing and here it will be maybe less liquid goal? So that's kind of a big picture question given all your experience in the industry?

And then the second question I have is on subsea. I wonder if you guys could, in any way, quantify how much revenue pull forward that was, and I was kind of -- I know that normally chassis deployments are low margin, but subsea tends to be higher. So I wonder, could you dig into those margin impacts a little bit? And just kind of help us understand why that drug margin so much in the quarter?

First, I'll answer the first question. And Nancy will answer the second one, but in regard to demand, we're creating our impression around 2 things. And clearly, we see a second half that has risk around macroeconomics because we were taking fairly significant actions at the company both at a personal, but also within the company's perspective. So we're taking it very seriously. We get our position from 2 things: one, as I -- we all read the analyst reports, talking about people pulling in network builds into the first half, and the probabilities from an analyst perspective, that it's actually going to be a pull-in. It's not going to be something that builds upon. Whether that's right or wrong, I don't know, but that's part of what we think about. The second thing comes from talking to a number of customers. And the number of customers I talk to it ranges.

Some are going to be, business as usual. Some are going to be, we are pulling in because we see demand needs right now, and we don't think it will affect our capital plans for the second half of the year, and others are more cautious saying, we're definitely pulling in because we see bandwidth today, but we are not planning on replenishing that capital in the second half of the year. That's more correspondent to what I read in the analyst reports. I think that in comparison to the last big transition, I don't see the same type of impact. I think bandwidth demands have fundamentally changed. How the way we work has fundamentally changed. I think the internet has done a remarkable job of keeping up with the capacity, but I don't think anybody believes they're sufficient today for this new model of how we live, work and play. I do think that there is not a liquidity issue out in the market. There are capital expenditure plans.

I've read some of the reports that the customers are saying, we've spent 70% of our CapEx budget for the year. And I think that they're going to be evaluating just like we are, what does that mean for the next half of next year? So I think there's a reasonable number of customers who are approaching this cautiously, and clearly, we are seeing customers, as we've extended lead time, give us orders in Q2. Is there a chance that they continue to do that Q3 and Q4? Absolutely. Is there a chance that there's going to be a pause? We are preparing for that and hoping that, that does not occur. Nancy, on subsea?

Sure. So the subsea deal that we spoke about had a 300 basis points impact on the margin. So you can ascertain that it was a reasonable size relative to the total revenue, although we're not going to disclose the total amount, but that deal was implementing the common aspect of the installation. And as we move forward, and we're already starting to see small orders. As we move through the remainder of the year, the gross margin impact from those additional orders that come in through that consortium will be significantly higher gross margin. And as I mentioned, will positively impact our margin in the second half of the year. So the fact that this occurred earlier than we expected coming in, in Q1 versus Q2, coupled with the ICP deployment that we talked about in Q1 really was much more of a significant impact than we would have anticipated starting in the year, but we're very glad to have the consortium installation complete. It's allowing us now to move forward with them and to see the benefits of that deal in the back half of the year.

Yes. In addition, this was our historically lowest or highest consumption of merchant optics. So for those of you who follow players like Acacia and others who may supply to us, it was our highest consumption given that ICP deployment. And that had, again, a 200 basis point impact in quarter. Year-over-year, when you do the comparison of quarter-to-quarter, it was significant impact in how much merchant integration we had in this first quarter this year versus last year.

Our next question will come from George Notter with Jefferies.

I guess I wanted to go back to the gross margin question. I think there were some positives also that, I guess, we had talked about in the past from a gross margin perspective. Certainly, you guys were getting past the manufacturing transition. I think there was a view that, that was going to help margins. There's a new ERP, I think you guys had just instituted. And also, I guess I would have imagined there would've been some instant bandwidth sales in the quarter, given the growth in work-from-home traffic, but were there some positive aspects to the quarter from a margin perspective also that are part of the narrative here?

Yes. I think -- great question. Thank you. I think we are absolutely seeing the benefits of the transition to the outsourced manufacturing model. We are also seeing operational efficiencies with the new ERP system and are in the early stages of the supply chain transition that we're going through, where we're optimizing our efforts around logistics and planning and inventory management. So we are starting to see the early benefits of those. We wanted to detail out the bridge really explicitly between where we landed on margin, and where we would have been had these 3 items not occurred, really the 2 largest that we've been spending time on, but the other aspect that we're very focused on in the supply chain world, and we mentioned it in the prepared comments, is the optimization on the inventory management side.

And we are, in Q1, brought inventory down $20 million with the expectation of bringing that down in our plan, another $60 million during the year. All of these efforts that we are undertaking in the early part of the year, and we'll move on through the year, will benefit us in the back half. So absolutely, there are positive things happening. We had very heavy overshadowing this quarter with the impact of COVID, the earlier consortium deal 1 quarter than expected and then the implementation of the ICP. So a lot happening in Q1, a balance between positive and some that impacted our margin a little bit more negatively.

George, on high bandwidth, you asked the question, did we see a surge? Interestingly enough, we had not. We had kind of anticipated at one because when we guided, we just the beginning of COVID. So I had anticipated like you did that there would be a surge of high bandwidth. There really was not. I think a lot of the congestion today you're seeing in the Internet is in excess. I don't think -- I think as that continues to be built out, that bleeds over to regional and core. But today, we have not seen a surprising uptick in instant bandwidth. The other thing we laid out last time, which is beginning to take hold is 600-gig. They're transitioning from 200-gig to 600-gig. We see about 1,000 basis point improvement as that migration happens.

It's certainly taking longer than most of the industry would have anticipated. That's one of the reasons I specifically said we shipped to 11 customers in Q1. The real opportunity comes when any significant ICP start buying it as a replacement for 200-gig. We talked about that being a second half event. We still feel we are on track for that occurring, but it is taking longer than we had anticipated. And then the real opportunity, obviously, is when we go to 800-gig.

Our next question will come from Jim Suva with Citi.

Thank you very much, and I am very impressed with how detailed you've given out the gross margin challenges and associated with the subsea. So that's very good. So I just have one question, and it's pretty simple. If subsea got pulled in about 60 days, and the reason why I mentioned 60 days is by the time you gave guidance, 1 month was already gone for the quarter. So subsea came in by no more than 60 days. Why wouldn't you have come in materially above your guidance for the quarter?

Yes. So good question. And we try to lay it out, but there's a lot of puts and takes on that. It was actually less than 60 days. We had been tracking to a Q2 acceptance. Our customer had a significant fiber cut that they were dealing with. So we did not anticipate that they would get that fiber cut resolved all of our gear and links tested and accepted. They actually truncated a little bit of the testing cycle because they wanted the capacity. That was their decision, and the agreement was when they started carrying live customer carrying revenue, that would transition with their agreement to being (inaudible) for revenue for us.

So that was a -- fairly late in the quarter, less than 60 days and certainly after the earnings call. And the question of why wasn't revenue more? As I talked about, we had contemplated $15 million of COVID impact from a supply perspective. That came real. We also -- did not contemplate about $15 million of shipping delays because customers basically closed their receiving dock. So that customer accelerating their acceptance, actually bridged off that, yes, bridged that $15 million that we had not contemplated.

That's very clear. Thank you so much. I appreciate your additional commentary.

Our next question will come from Michael Genovese with MKM Partners.

Thanks for the questions. When we think about the second half visibility and sort of the change that we've seen since COVID started, I'm wondering about the hyperscale market versus the telco market. Has the visibility changed more in one than the other? You said 600 G is taking longer in the hyperscale market. Is that worse or better than what you're seeing in the telco market generally?

The ICPs have always been lumpy. And as Tom said, in Q1, we had a very large deployment demand, which impacted revenues and margins as a result of that vertical integration, as we talked about. As they start to onboard 600-gig, that again gets accretive by kind of in that 1,000 basis points range. Obviously, that takes more time in this environment. So we think demand will continue to be lumpy from their perspective. This is -- we do see growth in data center to data center. We do see surge capacity even in Q2 demand coming in on that front. I think from the service provider's perspective, it's a mixed bag depending on their service mix of consumer to small business.

I think for those that are serving the consumer, I think people understand that, that demand is relatively sound, kind of Maslow's hierarchy of needs. The last thing people give up even when they're unemployed, is their cell phone, the Internet and Netflix. From a business standpoint, I think there's just a little trepidation thinking about the back half of the year to say, small businesses and other impacts on carrier-to-carrier traffic, what will happen given they've fueled up the bandwidth in the first half of the year. So that's why I think we're just maintaining caution.

I'll also say that from my perspective, the Tier 1s and Tier 2s have been quicker to respond to short-term changes in lead time and capacity demands than the Internet content providers. We have, I would say, a more open relationship with mostly the Tier 1s and the Tier 2s, where we do more network planning with them. We have less engagement, I would say, as a typical practice with the ICPs. They just do not share and perhaps don't have as clear of plans as we're seeing with the Tier 1s and 2s. So I don't think that's different. It's just normal.

We've also seen, obviously, with the Tier 1s, there's a bit of a push in capacity on the access network. So that's fundamental to the portfolio that we serve. We've seen a bit more push there in terms of creating capacity at the edge.

That's helpful. I'm very interested though in the 600 G and when we're going to start to see the 1,000 basis points because it sounds like the certainty that it would be in second half '20 is clearly not what it was. And so again, focusing on that change that's happened recently, do you think it's 100% due to COVID? And the other questions that COVID has raised? Or was it -- was the visibility getting -- slipping away because they weren't telling you what was going on or when orders might come in or and -- and also, do you think there's any other potential competitive issues? Or do you think they might skip 600 together and just go to 800? Sorry to ask so many questions at once, but those are the last question.

I think for the ones that we lay out that we saw opportunity for 600-gig for, those opportunities are still progressing, and COVID is not speeding anything up. That's for sure, but I do believe that there's opportunity for us to have meaningful shipments in the second half to ICPs on 600-gig. As I said last time, not all ICPs are going to 600-gig. So it is not a universal decision either to go forward or not go forward, but I do believe that the cost reduction that they get by incremental capacity and lower dollar per bit is substantive enough that there is a real intent to move to some portion being 600-gig. I also see 200-gig technology remaining in their network and continuing to buy for a long period of time just like in the carrier world.

A 100-gig is still a very, very significant trend, but I do think that 600-gig will be -- has a reasonable chance of being meaningful for us in the second half of the year, and I do believe that the vast majority will move to 800-gig, but not necessarily 800-gig exclusively. 800-gig, whether it's from us or other people, I think, is making great progress in the industry. I think that the demonstrable savings are going to be substantive enough that they are going to be impossible to ignore. Having said that, 600-gig was introduced over a year ago, and the adoption cycle takes a while. I think 800-gig is still not only not to market so I think that there's a period of time that people will be utilizing the best economics that's available today.

Makes sense. Great. It sounds like they need some more edge bandwidth in (inaudible) or wherever you are Tom so you should sell them some.

I need some more edge bandwidth. There's no question.

(Operator Instructions) Our next question will come from Simon Leopold with Raymond James.

Great. A couple of things I want to check on. One, in terms of the 600-gig progress, I presume a lot of the trials have been deployed pre-COVID and have been going through sort of a classic soak phase. So when you talk about the second half of the year, 600-gig revenue rec, is it safe to assume that some portion of it has been deployed in the field, and it's just a matter of needing a soak period to get revenue recognition, and therefore, that's part of the higher confidence?

Yes.

Yes.

Yes. So as I think was in the script, we shipped 11 customers of 600-gig out that are out. Today, we had a number that were qualifying and also needed some surge capacity that they filled at 200-gig because they needed it like yesterday before the qualification was over, but maintain their current course and speed to 600-gig in the second half. So again, I think we feel good about that continuing to grow in the second half, albeit we're watching very carefully that growth in bandwidth across all sectors.

And then in terms of generating the cash from working capital, my rough guesstimate to get $60 million of cash from inventory would need the turns -- the inventory turns to get up to maybe 3.5, 3.6. And you definitely have had an improving trend, but it was below 3x most of last year. Just wondering if there are any specific hurdles we should be aware of for you to achieve increasing your inventory turns?

So I think there's a couple of things that we're doing internally. One is, as we talked about at the end of last year and then again this quarter, last year was the year of integration, right? 2019 was all about integrating Coriant. As we move into 2020, we are driving operational efficiencies. And one of the key areas is around our supply chain, whether that's the logistics or inventory management. In Q1, we reduced inventory by $20 million, and we have a plan, which would drive an additional $60 million in the next 3 quarters.

We feel very good about that plan with actions laid out to complete. And that, you're correct, right, by liberating that much inventory, our turns would be, I'll say, in approximately that same region. And you also know that driving an improvement in inventory terms is a challenging process and takes time, but we have begun the execution and the implementation of this plan and feel very good about our ability to achieve it through the year.

So I'm asking you a question. Does 3.6 turns sound like a really well-run operational organization?

It's an improvement over where it was.

Yes.

So that's my point. This is not saying we're going to take $60 million out and go from 6 turns to 8. This is a -- I'm not trivializing the task. It's a big task. And as Nancy said, getting our manufacturing strategy aligned last year, getting an ERP system that goes across our product aligned last year, puts us in a place where we have the tools to do it. We also have a significant necessity to go do this. We understand that. We have taken very significant actions in regard to how we're managing the MRP, extending lead times, quite frankly, supports that initiative. So now we can actually be buying what people want versus what we think they want. That's a non-trivial impact. So I appreciate the candor, but I will tell you, 3.6 turns to me is a very, very first step goal.

Hence the question. And then just one last one. As you think about your positioning in 800-gig, and we start to think about the setup into 2021, we haven't seen a lot of the detail yet, but my impression is that your expectation is on a competitive basis, you'll have certain advantages. How do you sort of see that market shaping up? I think in the past, you've talked about kind of being happy with the duopoly. Could you maybe talk a little bit about what your expectations are once that market is really shipping?

Yes. I think that -- I think the 800-gig fifth generation DSP, let's not call it 800-gig. It's fifth generation DSP technology will allow customers to create significantly lower dollar per bit and utilizing their scarce fiber assets much more productively. I think that the step up in cost savings is very, very significant, and there is significant desire within the market for this to come out sooner rather than later. I believe that the market is anxious, as I've talked to customers, are to have more than one supplier. This is going to be a main technology, and I think that having the ability to have supply continuity and also competitive pricing between at least one other participant is highly desired. Our 800-gig, as we've demonstrated will go to 950 kilometers. So some people are positioning 800-gig as really being designed for short reach type of applications.

Our performance is such that we believe we can get over any type of fiber, 600 to 800 kilometers at 800-gig that covers 40% of backbone links in North America and at 600-gig, up to 75% of the links. So we're calling it 800 gig for everybody, right? Because we can cover a significant portion of backbone network build with this technology. I think that the real test right now needs to be getting into market this year. We have a customer who's ready to take it into their labs and deploy it as soon as we're ready. And I think that this will spur a lot of activity by other customers also. So it's up to us to go and do what we say we're going to do.

Our next question will come from Jeff Kvaal with Nomura Instinet.

Yes, that was it. I have 2 questions. I guess one for you, Nancy. If the gross margin trajectory from the first quarter gross margin headwinds kind of abate for the second one, which is what it sounds like. And 600 is plus or minus, on track. How much of that initial gross margin goodness for the year might we still anticipate by the end of the fiscal year?

Yes. I think what we laid out fundamentally last quarter before COVID is foundationally sound, right? The benefits that we will start to see in gross margin with 600-gig and then really importantly, with 800-gig as we exit this year and move into '21 are exceptionally meaningful. You could see that even in our commentary on the ICP deployment this quarter, where we were more heavily skewed toward merchant optics, and you see the impact to our overall gross margin. So as the 600-gig deploys and becomes a larger part of our revenue base in the next quarter and then into the second half, that's really where you'll see that expansion starting to occur, but really, the fundamental step up will occur with 800-gig.

Okay. All right. So the 200 to 400 is more or less intact. It just might have shifted out by a quarter or so?

I think that's fair.

Yes. Okay. And then I guess, maybe, Tom, for you. With -- is the 800-gig sort of your next inflection point for market share? Is that what I'm understanding you're saying? Or do you think that you'll be able to reel some market share in -- with the 600-gig ramp?

Our group platform today is picking up significant market share. We have significant customer growth last year. And again, in Q1, we had shipment growth again in Q1 -- bookings growth in Q1. It's been a very, very well received platform. And what I talked about in my script, was 3 fundamental significant growth market drivers in optical. One is the disaggregated type of platform, which is the group leadership platform today that for us, and it's winning customers and growing market share. Putting the 600-gig and 800-gig in that, we believe, will continue the trajectory it's already on. Another major growth area is high capacity optics, defined as 400-gig and above. Today, that's an underserved market.

It's a very fast-growing market. I think in my prepared remarks, I said it's targeted outside of China to be a $4 billion market by 2023, and it's growing about 35% a year. The beautiful thing about the GX platform is it takes (inaudible) and optics, and pairs it with the platforms that are both growing the most. We think it's a significant opportunity for earning a leadership position in that space. We also are continuing, we believe, certainly in Q1, picking up some market share with our XTM platform as it's targeted at access space, both for carriers and cable providers.

This will conclude our question-and-answer session. I would like to turn it back to Tom Fallon, CEO, for any closing remarks.

I want to thank all of you for your time today. I also want to extend my appreciation to our employees who are focused on our customer success by supporting them when and where they are needed. To the rest of the employees, I also want to thank you for your spirits up and heads down as we attack the rest of this year. Thank you very much.

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