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Infinera Corp. (NASDAQ:INFN)

Q2 2009 Earnings Call

July 21, 2009; 5:00 pm ET

Executives

Bob Blair - Investor Relations

Jagdeep Singh - President & Chief Executive Officer

Duston Williams - Chief Financial Officer & Principal Accounting Officer

Analysts

Simona Jankowski - Goldman Sachs

Subu Subrahmanyan - Sanders Morris

George Notter - Jefferies & Co.

Sanjiv Wadhwani - Stifel Nicolaus

Analyst for Hasan Imam - Thomas Weisel Partners

Jeff Schreiner - Capstone Investments

Mike Genovese - Soleil Securities

Blair King - Avondale Partners

Operator

Welcome to the second quarter fiscal 2009 investment community conference call of Infinera Corporation. (Operator Instructions) I would now like to turn today’s conference over to Mr. Bob Blair of Infinera Investor Relations.

Bob Blair

Good afternoon and welcome to Infinera’s Q2 2009 earnings call. Today’s call will include projections and estimates that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements address the financial condition, results of operations, business initiatives, views on our market and customers, our products and our competitors’ products and prospects of the company in Q3 2009 and beyond and are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. Please refer to the company’s current press releases and SEC filings, including the company’s annual report on Form 10-K filed on February 17, 2009, for more information on these risks and uncertainties. Today’s press releases, including Q2 2009 results and associated financial tables and investor information summary will be available today on the Investor Section of Infinera’s website at www.infinera.com. The company 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.

This afternoon’s press release and today’s conference call also include certain non-GAAP financial measures. In our earnings press release, we announced operating results for the second quarter of 2009, which exclude the impact of non-cash stock-based compensation. These non-GAAP financial measures are provided for year-over-year comparisons.

Please see the exhibit to the earnings press release for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures, and for an explanation of why these non-GAAP financial measures are useful and how they are used by the management of the company.

On this call, we will also give guidance, including guidance for the third quarter of 2009. We have excluded non-cash stock-based compensation expenses from this guidance because we cannot readily estimate the impact of our future stock price on our future stock-based compensation expenses. For the remainder of today’s call, we’ll be excluding the impact of these items as we discuss the second quarter 2009 results and cover our third quarter 2009 guidance when we refer to these results.

I will now turn the call over to Infinera President and CEO, Jagdeep Singh.

Jagdeep Singh

Good afternoon and thanks for joining us for our Q2 results conference call. With me is CFO, Duston Williams. As we announced earlier today, after nine very satisfying years at the helm of Infinera, I plan to step down as CEO in January 2010. I will be succeeded as CEO by our COO, Tom Fallon, and at that time I will assume the role of executive chairman, remaining actively involved in working with Tom and the team on product strategy and the long-term direction of the company.

As an experienced operations executive, Tom has an exceptional background for this role. He spent many years in management at Cisco, including his role as VP and GM of Cisco's optical business unit. He is one of the veterans of the Infinera management team, having joined us early in our development, and has led an increasingly broad set of functional groups at our company over the years. I'd like to congratulate Tom and I look forward to working with him on his transition into the CEO role over the next six months and to introducing him to many of you in our investment activities in the months ahead.

Turning to the second quarter and current outlook, there are several highlights worth noting. We posted revenue of $69.0 million, showing a net loss of $18.0 million and had gross margins of 31%. We saw significant quarter-over-quarter increase in booking during Q2, one of our strongest quarters ever, in fact. We derived 36% of our revenue in Q2 from Europe and Asia, a record high on both a percentage and absolute basis. These are regions where we have devoted significant focus and resources in the last two years. In fact, three of our top five Q2 customers were from these regions, one from Europe and two from Asia.

Our TAM bookings in Q2 rose above the 2,000 unit level, reversing the trend from the last two quarters and suggesting that Q1 may have been the bottom, relative to TAM demand and by extension, our business.

In addition, this increase in TAM orders is an important development from a gross margin standpoint, given the importance of TAMs to our overall business model.

And today we are providing an outlook that shows sequentially higher revenues in gross margins in the third quarter. Still on balance, although we remain cautious given the macro environment and the inherent volatility of our sector, we appear to be seeing an improving outlook.

On the customer win front in Q2 we added four new customers, to bring our total customer count to 62 and we believe that we will add at least three new customers in the third quarter. In our recent win at COLT we beat a number of other suppliers for a large deal with this $2.0 billion European-based carrier.

The first phase of COLT's Infinera Pan European network connects major cities in eight countries in Europe, including the U.K., France, Germany, Spain, and Italy. We believe that it is significant that our speed of service and delivery advantages, part of our strategic guiding proposition, won the business at COLT. I will also note that we have already won additional business at COLT beyond the initial win.

We are also pleased to announce today that we have been selected by NTT Communications, the world's second largest service provider, to build out its new IP backbone network in the Tokyo metropolitan area. This win demonstrates our continued momentum with the world's leading tier-1 service providers and is another example of the Infinera value proposition, enabling our customers to achieve knowledge capacity and network flexibility and reduced operating expenditures.

Last quarter we spoke with you about two new tier-1 wins in Europe and subsequently we were able to announce TeliaSonera as one of those wins. TeliaSonera, the incumbent telecommunications provider in Sweden and Finland, and the largest operator in the Nordic and Baltic regions, selected Infinera to build a new nationwide network in the United States.

Our ability to win and execute new network builds with tier-1 service providers has proven to be an effective door opener strategy for us with several other carriers. To date and in the last 12 months we have won business with six tier-1 service providers including DT, OTE, TeliaSonera, NTT, and two additional operators.

It is also worth noting that during the quarter we won a competitive bid for a full overbuild at a North American telecom[?] carrier and that our recent momentum in submarine networks continues with another such win, our second in six months.

Submarine networks require greater performance as a DWDM application and typically they comprise larger size deals. Our ability to compete with these opportunities is based on the ultra long-haul system that we added to our portfolio last year.

When you look at the highly competitive environment in which we operate, it's important to consider why we have captured so many of these significant wins and demanding new pieces of business. After all, we are going up against entrenched incumbents and aggressive challenges in each and every situation, some with alternative solutions and other went deep in their pockets to form a very aggressive pricing strategy.

In this context, we are winning major pieces of business around the world with the likes of DT, NTT, TeliaSonaria, COLT, OTE, and with major customers in the Internet content provider spaces. We are winning because of our unique PIC-based value proposition and an important piece of that is the future evolution of our PIC to 40 Gig and beyond.

On that subject, I would note that we're pleased with the progress on the development of our 40 Gig product and customers have seen the technology in our labs and that we look forward to addressing the window of opportunity for 40 Gig.

I would also remind that while Infinera brought its 10 Gig solution to market seven years after the industry's first 10 Gig performance, our value propositions were so compelling that in a very short time we achieved the leading market share position.

Our strategy during the economic downturn has been to stay focused on winning new footprints with accounts such as those just named, footprints that will generate growth once the economy recovers and that will help us achieve margin improvement over time as relationships with our customers expand.

We believe that our financial results as well as our new customers wins and our history of customer activity validate the strategy as a sound one. While these new deployments have developed into some downward margin pressure in recent quarters, we believe that if these customers fill out these systems with TAMs, this margin trend should reverse itself.

Our analysis of gross margin evolution with customers over time demonstrates that our profitability of new customers is typically at its lowest in the first quarter of our business with them though over a ten quarter period of time our analysis shows that gross margins improve to a steady state level as customers populate their install within their networks with additional service in TAM.

In the last year we've been in the mode of adding lots of new customers, 18 of them in total, many of which were tier-1 providers with significant footprints. In the long term, we believe this strategy of adding to our customer base, coupled with a return to more normalized industry volumes, positions Infinera for a continued and growing leadership position in the DWDM space with our long-term targeted gross margins.

In the meantime, we will continue to focus on executing against the strategy of winning new footprints and look forward to reporting on these successes in future quarters.

I will now turn the call over to Duston who will cover our second quarter financial results and third quarter guidance.

Duston Williams

I will review our Q2 actual results and then follow that up with an outlook for Q3. The following analysis of our Q2 results is based on non-GAAP and all references exclude non-cash and stock-based compensation.

Looking at the specifics for the quarter, GAAP revenues in Q2 totaled $68.9 million compared to guidance of $70.0 million versus $66.6 million in Q1.

We had two 10% customers in Q2, represented by Level 3 and COLT. Level 3 was our largest customer and represented 20% of our GAAP revenues versus 30% in Q1.

Additionally, as Jagdeep mentioned, our international revenues represented 36% of total revenues. The revenue contribution, both in percentage and absolute numbers, were the highest in the history of the company. Revenue from Asia was 7% of revenue.

Revenue contribution from our top ten customers was 70%, the lowest historic concentrations we have experienced. Gross margins in Q2, which exceeded our guidance of 25% to 30%, were 31% versus a similar level in Q1. Although well below our longer-term target, relative to expectations, we were pleased with the gross margin performance for the quarter.

TAM billings for the quarter were a few hundred higher than our previous expectations set forth on the Q1 conference call and the TAM bookings for the quarter were in excess of the billings for the quarter.

It is also important to note that we experienced record chassis shipments in Q2, surpassing our previous high quarter by about 10%, a continued indicator of the new customer momentum we have seen.

Operating expenses for the quarter were $40.2 million versus our guidance of $40.0 million and versus $37.5 million in Q1.

The overall headcount for the quarter was 973, which reflects only 11 additions over Q1, the lowest quarterly headcount additions in the last several years. Effectively, all the additions were R&D related.

The operating loss for Q2 was $18.6 million versus an operating loss of $16.6 million in Q1. Other income expense for Q2 was a favorable $0.5 million versus an unfavorable $0.9 million in Q1.

Net loss for the quarter was $18.2 million, or a loss of $0.19 per basic share, or $0.18 per diluted share versus a loss of $17.6 million in Q1.

Turning to the balance sheet, cash, cash equivalents, restricted cash and investments ended the quarter at $287.1 million versus $306.5 million in Q1. We used $18.8 million of cash from operations in Q2 versus a use of $2.9 million in Q1.

Increases in accounts receivable in inventory formed a large page of the increase in cash usage for the quarter.

DSOs were 72 days versus 61 days. The DSO increase was primarily driven by the billing linearity during the quarter. Our accounts receivable aging has been, and continues to be, very current.

Inventory turns were 2.6 versus 2.8. The primary driver for the decrease in the turns was a $6.0 million increase in our inventory awaiting customer acceptance balance products that we have shipped and is at customer sites waiting for acceptances.

Accounts payable days came in at 51 days versus 44 days.

Capital expenditures were $2.8 million in Q2 versus $6.0 million, the lowest quarterly total since Q1 2008.

Our Q3 base operating outlook shows higher revenue and gross margins reflecting revenues from several large previously announced deals and to some degree the abatement of significant LCM charges. TAM billings should be reasonable. Operating expenses should be relatively flat quarter-over-quarter.

In addition to the base operating outlook for Q3, we will also experience restructuring charges in both Q3 and Q4 related to the upcoming restructuring of our Maryland fab. As part of this action, we will be closing our Maryland fab. We will transfer these capabilities to our existing California fab, which will have two leading photonic integration platforms in one fab enabling active PIC and passive PIC designers to work seamlessly across integration platforms for our next-gen products. This move is not expected to have any impact on our existing product offerings.

Some of the specific details around the fab closure and the restructuring are as follows: The operations will be ceased by the beginning of Q4 2009; approximately 50 positions will be eliminated, company-wide; current planning suggests an $8.0 million charge associated with the restructuring, $6.0 million recognized in Q3, $2.0 million in Q4, and approximately $3.0 million of this is cash-related. Starting Q2 2010 we should experience about a 2% quarterly gross margin improvement related to the fab consolidations.

Turning back to the outlook, the following guidance for Q3 is based on GAAP results and excludes any non-cash stock based compensation expenses and the Maryland fab-related restructuring charges.

Revenue of approximately $80.0 million to $82.0 million, gross margins of 30% to 36%, operating expenses of approximately $41.0 million, and operating and net loss of approximately $12.0 million to $13.0 million. And based on an estimated average, diluted shares outstanding of 98.0 million, this would lead to an EPS loss of $0.12 to $0.13.

As previously mentioned, in addition to the above outlook, we will expect to book approximately $6.0 million of restructuring charges in Q3. Approximately 60% of this charge will be included in cost of goods sold with the remaining 40% included in R&D expenses.

In summary, we are encouraged by the sequential revenue improvement we experienced in Q2 and with a continued further revenue and gross improvement we expect in Q3, based on our current outlook, we certainly hope that both Q1 revenue and gross margin performance were the low points and that we can continue to build off the second half of the year and into 2010.

Just before that, if you go back to the gross margin guidance, I might have inadvertently said 30% to 36%. The gross margin guidance should be 35% to 36%. I apologize for that.

With that, we will open the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Simona Jankowski - Goldman Sachs.

Simona Jankowski - Goldman Sachs

On the sales trajectory and linearity during the quarter, it looked like you were just a little bit light relative to your guidance and Street expectations in terms of sales. Then you also made the comment that you had record chassis shipments in the quarter and it also seemed that your TAMs were actually doing pretty well and it looked like the orders and the billings accelerated particularly at the end of the quarter. So can you help us reconcile and understand how the quarter developed versus expectations and where the slight shortfall came from.

Duston Williams

As you know, we guided to 70, we came in effectively at 69 so we did have a fair amount, as I mentioned, in inventory awaiting customer acceptance and any time you try to pick that timing perfectly, you're never going to get it exact there. But we did build up that inventory that's sitting at customers waiting for acceptance. And some of those could have gotten accepted in the quarter. You never know when that's going to happen at the end of the quarter and a few of them just went into Q3.

Simona Jankowski - Goldman Sachs

And you said that was a $6.0 million amount?

Duston Williams

The increase was a $6.0 million increase quarter-over-quarter in that balance.

Simona Jankowski - Goldman Sachs

And that was the amount that kind of fell into the third quarter that you thought might have fallen into Q2?

Duston Williams

No, I'm just saying in general, it's hard to pick what's going to get accepted and what's not going to get accepted.

Simona Jankowski - Goldman Sachs

On the closing of the Maryland fab, is that primarily a cause-driven decision?

Jagdeep Singh

Yes, effectively what it is it allows us to more effectively consolidate our fabrication capabilities here in Sunnyvale where we've never seen the line capabilities we have on the [inaudible] side and it has a fila[?] fab that we believe has higher volumes and therefore better economics going forward.

Simona Jankowski - Goldman Sachs

And Jagdeep, if you can comment a bit on the CEO change and how will your role change day to day and what, if any, shift in strategy or authorizations can we expect under Toms' leadership.

Jagdeep Singh

It turns out there actually really isn't much change in terms of the overall impact on the company. If you think about it, Tom has already been taking on an increasingly greater sort of role in terms of running the company overall. He started out running operations and he has taken module and customer service and support and HR and IP and even engineering. And so effectively, there isn't that much that Tom doesn't already run and this is really just a continuation of that process.

And I will continue to be involved, focusing on the things that I have been involved in, pertaining to long-term product direction and strategy. So overall, it really doesn't represent any kind of change in the company's direction or execution strategy. It's really a continuation of both those things.

Operator

Your next question comes from Subu Subrahmanyan - Sanders Morris.

Subu Subrahmanyan - Sanders Morris

Can you repeat your EPS guidance number. I missed that.

And then I wanted to talk about the competitive environment. One of the concerns is just increased pricing pressure across the board for deals. Can you talk about just overall price pressure and deals, and then specifically on COLT you mentioned that it was a pretty competitive process. Can you talk about what you saw in terms of competition.

And if you could go, again, into kind of a longer-term business model, how and what period of time as the mix starts to stabilized between TAMs and chassis, in a typical contract, do you start seeing more normal gross margins, so to speak.

Duston Williams

Let me take the first. The EPS guidance was a $0.12 to $0.13 loss, which was an operating loss of $12.0 million to $13.0 million which equated to a same $0.12 to $0.13 EPS loss.

Jagdeep Singh

On the first question regarding competition, as we said, basically we compete with the usual suspects, the largest suppliers of telecom equipment in the world, and they all largely came to have a very similar set of offerings. The two primary things we tend to see are the guys that are trying to push the 40 Gig base solutions now and then the guys that try to—one guy in particular—tries to be very aggressive on pricing.

And what we're seeing is we're actually able to be quite effective overall against both those guys. So you asked about COLT in particular, and in COLT that was a great example where the incumbent vendor there, Vartel[?], and the challenger besides Infinera was a Chinese challenger. And as you can imagine, it's a big network with a lot of capacity on it so all the competitors were very seriously [inaudible] the business and it turns out at the end of the day Infinera won the business. And we won because of the value proposition that we offer of rapid service delivery and very high-level network flexibility.

So I think all in all our basic competitive strategy is to compete on the value proposition of our offering, not to try to get into a price war. We believe from what customers are telling us that they see enough value in our overall offering that we do not need to be the lowest bidder and if for some reason a competitor wants to sort of buy the business, if you will, at a given account, we're not going to play that game. We're going to focus on building a viable business model going forward.

Subu Subrahmanyan - Sanders Morris

Just to that point, at what stage of a contract, given you mix of the way [inaudible] ship and the way TAMS ship and timing, do you get to more kind of normalized margins. The reason I ask is if several deals in a very early stage, with large carriers announced over the last quarters and I'm trying to get a sense of when it starts to normalize out a little bit.

Jagdeep Singh

I think what we've said about that is that the first quarter of the business typically is the absolute lowest the margin will be. And the reason for that is that is when you have primarily common equipment heavy deployments with some small number of TAMs. Over those time, those TAM slots get filled and as they get filled, the quarterly margin clearly goes up. In fact the cumulative margin of the deal goes up as well.

The data that we've analyzed suggests that that general upward trend continues for many quarters into the future. Where it specifically ends up is obviously a function of the specific customer network consideration and their network capacity growth rate and so on. So I can't answer specifically.

But the general point is that the margin for any given account is typically as low as it will ever be up front and then from there it goes up relatively smoothly over the next many quarters.

Subu Subrahmanyan - Sanders Morris

You mentioned 40 Gig in trials, or your customers are seeing it in the labs. Can you give us more color on when it would trial and you can have revenues from 40 Gig platform and how the timing is compared to where you initially thought it would be, where you would be in the process with your 40 Gig platform.

Jagdeep Singh

Yes, as you know, we don't comment on unannounced products before they're announced. I can't provide any more context on the timing of the product, but what I can say is that we, as I mentioned on the call earlier, we obviously are very pleased with the progress we are making on the 40 Gig. We demonstrated PICs, as you all know, at the LC show earlier this year, the results within those PICs. And for the customers coming here get to see our labs with our 40 Gig technology there.

So I think overall I would say progress continues well. We're happy where we are and we fully expect to be a factor in the industry with our 40 Gig solution.

Operator

Your next question comes from George Notter - Jefferies & Co.

George Notter - Jefferies & Co.

I just wanted to ask about gross margins. The gross margin performance in the quarter was good, better than expected. Obviously there are a number of moving parts there. You said that the TAM modules were better than you thought, but I know there are also some other factors in there, lower of cost to market write-downs I think are a factor here. Mixture of existing and new customers. Any other kind of components to the gross margin out-performance that you can walk us through? And how big was the LCM piece in the quarter?

Duston Williams

Most all of the, or the vast majority of the margin greater than the guidance number was TAM-related. We talked about a specific customer's discount that we thought was going to be exhausted in Q2. We talked about that on the Q1 call. Most of that did but there is a little bit remaining so that might have helped margins by a percent or so. But most all the other stuff was TAM related, which is obviously good news from our perspective.

George Notter - Jefferies & Co.

And what was the LCM write-down in the quarter?

Duston Williams

I don't have that right in front of me. I'll have to get back to you on that.

George Notter - Jefferies & Co.

I guess I'm just trying to drive towards a margin number that is more normalized, that we can get a sense for what your margins would look like without those LCM write-downs and normal kinds of mixtures of chassis versus modules, normal situations in terms of discounts with customers. What can you point us to to give us a sense for what the norm is for you?

Duston Williams

The norm is, if you look at historical averages, we've been anywhere in the 30%s to 47%. In any given quarter. Right, you're going to have more things going on with LCMs and customer mix and new customers and as the big new customers stop in any given quarter, we're going to have a pop in margins at some point, when the TAMs return.

So, again, it's hard to give you a normalized, if you will, because there are so many factors in this current quarter. But the trend is in the right direction. With TAM so far, what we've seen from a TAM volume perspective, it looks pretty good. So hopefully we will get back to where we've been in the 40% range plus over the next several quarters.

George Notter - Jefferies & Co.

The gross margin, the guidance for Q3, what is your expectation on the LCM write-down there?

Duston Williams

It will be within normal historical levels. Except, obviously, we had the big one in Q4 and Q1, but take those out of the equation with the big customers adds, there shouldn't be anything unusual that we know about from LCM in Q3.

Operator

Your next question comes from Sanjiv Wadhwani - Stifel Nicolaus.

Sanjiv Wadhwani - Stifel Nicolaus

Just a question for Jagdeep, for looking at Q3 your guidance called for about 15% sequential growth, which is obviously a big ramp up. Can you just talk about visibility, where is it coming from. Is it COLT, is it NTT?

Jagdeep Singh

Obviously we can't talk about any specific accounts, but I think, as you know, our basic process is that we go with our customers across the board on their network plans and they deployment objectives for the upcoming quarter and based on that we have a sense for what their needs are going to be.

We also have what we refer to as inventory awaiting customer acceptance, or IACA, which of course is equipment that's been shipped to customers and in some cases been turned up but has not officially been accepted yet so there is not revenue recognized on that until it's accepted.

So between all the different parts of our process, we roll that up to come up with what we believe the most likely outcome is for the quarter. And that's what gives us comfort relative to our guidance.

Duston Williams

I think from a visibility perspective, again, we've always said and this quarter is really no different, the current quarter that we're in, we've got reasonable visibility outwards. It gets a little bit less visible there. I will tell you probably, as Jagdeep mentioned, the inventory awaiting customer acceptance, I think between what we know we have there and in backlog, it's quite honestly probably a little bit stronger going into this quarter than it has been. So that gives us a little added confidence, also.

Sanjiv Wadhwani - Stifel Nicolaus

The $6.0 million incremental inventory awaiting customer acceptance, is that with one customer or with multiple customers?

And as far as mix between domestic and international, obviously skewed towards international in Q2 in terms of growth, should we expect that momentum to continue into Q3 or how does that mix fall out in Q3?

Duston Williams

The $6.0 million is the total bucket so it could have numerous customers in there. So it's just the aggregate increase quarter-over-quarter and that, as I say, has numerous customers.

Jagdeep Singh

Also significant is it's the increase not the total value of the account.

Duston Williams

And the second part?

Sanjiv Wadhwani - Stifel Nicolaus

Just in the international versus domestic in the mix for Q3.

Duston Williams

That's going to bounce around a lot. It will probably most likely because it was so high in Q2, it's probably going to come down in Q3, most likely.

Jagdeep Singh

In general, our mix within any given quarter is going to vary from quarter to quarter whether it's mix by international versus domestic customers or mix by customer segment. Those individual mixes will obviously vary on a quarter-to-quarter basis. One of the benefits of having more diversification in our business is that we're less exposed to any one sector or geography.

Operator

Your next question comes from Analyst for Hasan Imam - Thomas Weisel Partners.

Analyst for Hasan Imam - Thomas Weisel Partners

Just wanted to go through the 2% incremental increase in gross margins from Q2 of 2010. Could you give more color on is this all going to hit on Q2 2010 and kind of be at the same steady level going forward, or should we expect further increases and benefits of that restructuring going through the year?

Duston Williams

As we see it now, we believe almost all or all of it will be realized in Q2. And that balance most likely continues at a fairly steady level going forward.

Analyst for Hasan Imam - Thomas Weisel Partners

And restructuring expenses that you mentioned of $6.0 million and $2.0 million, that's also one-time offset, you're not factoring that in when you're taking the non-GAAP opex, or are you?

Duston Williams

Correct. It's excluded from our guidance.

Operator

Your next question comes from Jeff Schreiner - Capstone Investments.

Jeff Schreiner - Capstone Investments

Wondering if we could talk a little about in the service margins. There is obviously some type of growth there over what they've been kind of running. Is that implied to continue somewhat as we move into the third quarter?

Duston Williams

Again, it depends on what we're deploying and who we're deploying with and other stuff there, so again, that's probably going to bounce around a little bit, also.

Jeff Schreiner - Capstone Investments

And would you be able to give us any color in terms of the distribution of TAM order whether from newer customers or just trying to bucket customers or maybe new customers versus what we call legacy customers.

Duston Williams

I think it was pretty well spread around actually. We had several larger deals we've deployed and there were a fair amount of TAMs associated with that. And our existing customer base, although not back to the levels that we think it should be, not too bad there. So some reasonable signs. We'll have to see how we progress here into Q3.

Jeff Schreiner - Capstone Investments

How are we going to get to a point where we can kind of reconcile the strong new customer growth, which obviously is needed for the longer term success of the model, and when maybe the current customers or some of the newer customers have come up here recently in the last few quarters, when kind of, let's call them the legacy business, is going to be able to offset the impact of adding new customers into the model. I mean, where do you see the model at now and how long before maybe we could get to something like that?

Duston Williams

Again, in any given quarter, if we sign up three big customers, we're always going to have impact to margins, because again, the common equipment which you put in, lower common to begin with and then get filled over time. Jagdeep mentioned a little bit on the history, how a customer regresses the first quarter, obviously very low, and then increasing every quarter after that. I'm not sure how to give you a whole lot of color.

Jagdeep Singh

Also to some extent what we're seeing right now is the fact, exactly that effect. Obviously one of the reasons why Q1 margins were lower than normal was because of the one-time deployment that we had made, the big ones we had. And one of the reasons why the Q3 margins appear to be recovering, to some extent is because the TAM ratios are starting to go up.

So I think that's sort of happening in the current set of quarters that we see here and over time we expect that as we sell more TAMs those margins continue to trend upwards.

Operator

Your next question comes from Mike Genovese - Soleil Securities.

Mike Genovese - Soleil Securities

Asking the same question, just a slightly different way. Given where we are in terms of pricing and expected new customer deployments, do you expect that if you, if the next say two to three quarters, build about 2,100 TAMs in a quarter, would you expect your gross margins to be in the mid-40s based on those TAM shipments and billings?

Duston Williams

We're obviously not going to give gross margin guidance for several quarters here. Again, we're only going to tell you it's the TAM levels in a given quarter have a significant impact on the margins but there are a lot of other variables that can happen. You've got customer mix, who we ship to, how much common, etc. So the biggest thing and the best thing we can do for the business is increase TAM shipments and we had a good quarter in Q2. Q3 looks pretty good and as long as that continues we feel pretty good about margins going forward.

Mike Genovese - Soleil Securities

Switching gears here, the win with NTT for the Tokyo area looks like a metro deployment. Is that something that you—is this similar to previous deployments or is this something new? Is this signaling a newer capability of cost-effective use of the platform, or is this deal similar to other deals you've won and networks you've filled?

Jagdeep Singh

The win with NTT is for their IP WDM in the Tokyo area. Tokyo is obviously the biggest metro area in Japan and to say that the deal is about to deploy more capacity, it's obviously a tradition WDM type deal but what's interesting about it is that they had a layer two network that they were using to test more drive traffic and they're moving that to a next-gen IP WDM network and it's one that is very flexible and sort of IP-friendly WDM platform and that's why they chose Infinera.

So I guess the real significance for us is that we have a really good [inaudible] at NTT now from which we can launch further attacks into the account.

Mike Genovese - Soleil Securities

Do you think being executive chairman will be a full-time job or do you expect to get involved in something entrepreneurial again?

Jagdeep Singh

I think I'm pretty energized about the change. I remain very committed to the company. I think that we have some really great opportunities ahead here. I think , in fact, this new role is going to help me spend more of my time focused on the long-term strategy and direction of the company, allowing Tom to pick up some of the more day-to-day responsibilities. So from my standpoint I think it's—as always, I'm adding value and the company sees value in it, my intention is to stick around.

Operator

Your next question is a follow-up from Subu Subrahmanyan - Sanders Morris.

Subu Subrahmanyan - Sanders Morris

I had a follow-up on gross margins and TAMs. If I remember right, you had said there would be about a 700 basis point negative impact of that one-time discount, or fixed discounted customer this quarter and then there was some LTM impacts. At least that discount impact was expect to go away. And then we have some growth in TAMs. So I'm wondering what the offsetting factors are which are on gross margins since the guidance for gross margins is up more like 4% at the midpoint of the range.

And on TAMs, the guidance for this quarter was about a 25% decline of that 2,100 number, which is more the 1,500 to 1,600 range. Can you tell us where you fell versus that guidance.

Duston Williams

Sure. We actually mentioned that in my script, that we billed a few hundred more than what we had expected, that we outlined in the Q1 call. So your math is approximately correct and we did a few hundred better than that in Q2.

Subu Subrahmanyan - Sanders Morris

But it was still below the 2,000 level.

Duston Williams

Yes, the billings were still a significant chunk below the historical 2,100 level that we had with a lot fewer customers. Correct.

Relative to Q3 margins again, if we get lucky and the TAM orders hold to be pretty good and we ship more TAMs and everything else being equal, we should do better. But right now we're comfortable with the 35% to 36% numbers there. But again, TAMs have a big swing in the equation. We'll have to see how that goes.

We're encouraged with what we're seeing so far. Hopefully those trends will continue.

Subu Subrahmanyan - Sanders Morris

And the fixed discount impact, can you tell us what it ended up being for the quarter?

Duston Williams

Yes, you're right. We basically said 7% last time. It was probably 5.5% maybe, somewhere around there, impact instead of the 7%. Some of that is going to roll. We thought it would all be exhausted in Q2. Actually a piece of that is going to roll into Q3.

Operator

Your next question comes from Blair King - Avondale Partners.

Blair King - Avondale Partners

In the first quarter you mentioned that you would ship products to your two new European PPTs which you announced and that would account for tens of millions of dollars this quarter and then tens of millions of dollars again, I think, in Q3. And I'm just curious if that came to fruition and then again, you plan to continue to ship product from that second carrier into Q3?

Duston Williams

On the call last quarter, I believe we said it would be about $10.0 million or so for one of those European customers. And that basically happened in Q2 and we also mentioned that we expect more similar levels in Q3 for those customers, and we expect that to happen in Q3.

Blair King - Avondale Partners

If you could, you see the outlook improving and without getting into specific customer detail, is there a geographic region that's improving more than others or is it wide-spread improvement?

Duston Williams

Europe has been pretty strong and we continue to see a lot of things happening there. Whether we win them or don't win them, the existing customer base, we see some new orders coming in from the existing base.

Jagdeep Singh

I think that generally, once we establish a certain presence in the geography, then of course it's just a function of the normal bandwidth demand growth in that geography in our [inaudible] different account, so I would think in North America and Europe we are at this point. I think we are quite well established and we continue to work on establishing our footprint in Asia. So over time we might expect to see some movement there over the long run. But otherwise, I think it's really more a function of individual customer activity than any macro geography type activity.

Blair King - Avondale Partners

You had mentioned in your remarks, 10% customers, Level 3 being 20%. Did you mention how much COLT was in the quarter?

Duston Williams

We did not. Typically if they're an announced customer, we'll give the percentage for the number one customer but not anybody under that.

Operator

Your next question is a follow-up from Analyst for Hasan Imam - Thomas Weisel Partners.

Analyst for Hasan Imam - Thomas Weisel Partners

I just had a couple of questions on the other income expense line item in your balance sheet. I was looking at your cash and cash equivalent in Q2 2008 versus Q2 2009. It's around the same, it's about $211.0 million to $212.0 million but your interest income is ¼ the size. Could you comment on what's going on there?

And also the other temporary impairment losses. Any further details on what the $2.7 million of impairment losses is?

Duston Williams

I think the cash balances you were referring to were not all inclusive of total cash and long-term investments and all that. So I think you're off a little bit on the cash balances. It should have been at that $300.0 million, I don't have the exact Q2 2008 number in front of me, but it was $300-and-something million, all in there. So your $200.0 million is probably just cash and cash equivalents, probably.

Analyst for Hasan Imam - Thomas Weisel Partners

It's actually $284.0 million in 2008 versus $360.0 million in 2009 but still, that's four times more of interest income versus—

Duston Williams

Well, rates had come down over that time frame and we're mostly invested in some pretty boring very low yielding securities at this point. So to get any reasonable yields out of a portfolio without taking extended risks is kind of hard to do.

Analyst for Hasan Imam - Thomas Weisel Partners

And the second part about the other temporary impairment losses.

Duston Williams

For this quarter?

Analyst for Hasan Imam - Thomas Weisel Partners

Correct.

Duston Williams

We had a couple of things moving around there. I don't have a full break out.

[inaudible] the margin rate securities that you've got in two different buckets there that pretty much offset each other. And I'll have to get you the exact break out of that. There are two separate transactions there that go in the opposite direction, which kind of, there's another line there on the P&L but we'll get back to you on the full detail there.

Jagdeep Singh

In closing, let me just thank everyone for joining us. I also want to just thank all the members who worked on our team, and our customers, for their contributions to our results. And we look forward to keeping you abreast on our efforts going forward.

Operator

This concludes today’s conference call.

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Source: Infinera Corp. Q2 2009 Earnings Call Transcript
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