Infinera Corp. (INFN) Management Discusses Q2 2013 Results - Earnings Call Transcript

Jul.24.13 | About: Infinera Corporation (INFN)

Infinera Corp. (NASDAQ:INFN)

Q2 2013 Earnings Call

July 24, 2013 5:00 pm ET

Executives

Jenifer Kirtland

Thomas J. Fallon - Chief Executive Officer and Director

Ita M. Brennan - Chief Financial Officer and Principal Accounting Officer

Analysts

Kimberly A. Watkins - Morgan Stanley, Research Division

Ashwin Kesireddy - JP Morgan Chase & Co, Research Division

George C. Notter - Jefferies LLC, Research Division

Dmitry Netis - William Blair & Company L.L.C., Research Division

Michael Genovese - MKM Partners LLC, Research Division

Alexander B. Henderson - Needham & Company, LLC, Research Division

Natarajan Subrahmanyan - The Juda Group, Research Division

Operator

Welcome to the Second Quarter Year 2013 Investment Community Conference Call of Infinera Corporation. [Operator Instructions] Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Ms. Jenifer Kirtland of Infinera Investor Relations. Jenifer, you may begin.

Jenifer Kirtland

Thank you. 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 markets and customers, our products and our competitors' products, and prospects for the company in the third quarter of fiscal year 2013 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 March 5, 2013, for more information on these risks and uncertainties. Today's press releases, including results of the second quarter of fiscal year 2013, and associated financial tables and investor information summary, will be available today on the Investors section of Infinera's website at 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 release, we announced operating results for the second quarter of fiscal year 2013, which exclude noncash stock-based compensation expenses. These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons.

Please see the exhibit of the earnings press release for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and an explanation of why these non-GAAP financial measures are useful and how they are used by management, which will be available today in the Investors section of Infinera's website.

On this call, we'll also give guidance for the third quarter of fiscal year 2013. We've excluded noncash stock-based compensation expenses from this guidance because we cannot readily estimate the impact of our future stock price on future stock-based compensation expenses.

I will now turn the call over to Infinera's Chief Executive Officer, Tom Fallon.

Thomas J. Fallon

Thank you, Jenifer. Good afternoon and thank you for joining us on our second quarter 2013 conference call. Today I have Chief Financial Officer, Ita Brennan; and Vice President of Corporate Marketing, Mike Catalano, with me. Dave Welch, our recently promoted President, is traveling and unable to join us.

Today, we reported second quarter results at the upper end of our guidance. Revenues grew 48% year-over-year, to $138 million, and we achieved improved gross margins of 39%. This resulted in positive cash from operations with a slight loss. Our continued improvement in performance is a reflection of a strategic architectural decisions being made by new and existing customers to evolve to an Infinera Intelligent Transport Network, as networks begin to require converged super channel capability.

During the second quarter, we secured DTN-X purchase commitments from 7 additional customers, including initial orders from a Tier 1 win in EMEA. We've been working on many of these opportunities over the past year and we view this is an unusually strong quarter for DTN-X customer commits. Since we launched DTN-X, we have achieved orders from a total of 34 customers. Of these, 11 are new customers to Infinera, demonstrating a healthy balance between penetration of new accounts and continued business with existing customers who remain committed to scaling their Infinera experience.

From a market share perspective, we are creating significant traction. Dell'Oro reported that we were #1 in market share of 100-gig long-haul ports in both Q1 and on a cumulative basis since our market entry in Q3 2012. This is not only the result of our broader customer base, but also because our customers are building entirely new networks with Infinera as they prepare for the Terabit Era. We now have deployed DTN-X networks in 30 countries with over 500-terabits of capacity activated into production.

North America continues to deliver solid performance and represents several of the new DTN-X and DTN wins in the second quarter, along with significant DTN-X and DTN network expansions. We had a particularly strong bookings quarter with both cable and Internet content providers, 2 segments describe tremendous bandwidth growth in the market.

We also have several important wins with both the DTN-X and DTN in APAC, a region where we've historically been a minor player. We announced a significant deal in New Zealand, with competitive carrier FX Networks, that will deploy a countrywide backbone. We also had wins in Korea, Vietnam and Japan, and we are seeing strong pipeline of activity across Asia-Pacific, excluding China. Europe has continued to be a very good market for us. In fact, based on Dell'Oro data, we gained share and became the #2 provider of long-haul equipment based on revenue in Europe.

We announced a major new win with BICs, an important international Tier 1 carrier in Belgium and a customer to Infinera. Additionally, some long time Infinera DTN customers have now rolled out the DTN-X. Interoute has deployed the DTN-X in its Pan-European network. Deutsche Telekom AG has deployed the DTN-X on critical routes in Europe, where bandwidth pressure is being addressed with our 500-gig super channels. And based on their very positive experience with the DTN-X in North America, TeliaSonera International carrier is now applying the DTN-X platform on some of their busiest routes in Europe. Not only are we taking share in Europe, we are winning opportunities from incumbent vendors.

When we started this company we foresaw an unrelenting demand for bandwidth and crafted a vision that has stood the test of time, delivering an infinite pool of intelligent bandwidth. On June 12, Infinera announced our new Intelligent Transport Network architecture that will continue to deliver on this vision and prepare service providers for the evolution from the 100-gig era to the terabit era.

Service providers are facing massive traffic growth, new business dynamics, operations complexity and customer demands for instant delivery and increased visibility and control. Our architecture is designed to allow service providers to squarely address these new challenges and gain significant business value from the transport networks through massive scale, layered convergence and intelligent automation.

In addition to customers, industry analysts are validating our approach. Infonetics’ recent service provider survey shows that by 2016, 86% of respondents are planning to deploy OTN switching, and of those, 94% plan to deploy OTN switching integrated with DWDM, the platform architecture that Infinera introduced to the market with DTN and has now evolved into the industry-leading DTN-X.

As a proof point to our intelligent architecture, we added to our industry-leading demonstration of 1-terabit transmission by showing SDN and Packet Technology integrated on the DTN-X with one of our key channel partners, NISSHO, at their NETFrontier Center in Tokyo. While these were not product availability announcements, we are showing customers that our DTN-X today will continue to differentiate the technology and competitiveness tomorrow.

This quarter, DANTE, who recently deployed a Pan-European DTN-X network, demonstrated what Infinera means by time is a weapon. DANTE helped us showcase the power of our 500-gig super channels and network automation by provisioning 2 terabits of DWDM line side capacity in only 12 minutes, across their Géant production network from Amsterdam to Frankfurt.

Overall execution of our DTN-X strategy has gone well and reinforces our view that we made the right bets with our Intelligent Transport Network architecture and the DTN-X platform. Two market technology transitions, 100-gig and network convergence, have occurred simultaneously with the DTN-X launch, and the momentum created has been outstanding. We have been successful in migrating current customers to the new platform to support their increase in scale and in winning new footprint.

While analysts believe the DWDM market is growing at roughly 10%, Infinera continues to gain share and grow at a faster rate than the market. Our job is to make sure that we continue to win as many of the available new network deployments as possible and to gain market share by bringing the Infinera experience to a broader set of customers. While order flows may fluctuate from quarter to quarter based on the timing of wins and deployments, we remain focused on expanding our presence in new markets and geographies to generate sustainable revenue growth and profitability in the future.

Before I turn the call over to Ita, I would like to thank the Infinera team and our partners for their continued hard work and commitment that resulted in a very strong Q2 performance. My thanks also to our customers for their support and confidence in Infinera. Now, I'll turn the call over to Ita for a more detailed financial review of the quarter and our guidance for Q3.

Ita M. Brennan

Thanks, Tom, and good afternoon. This analysis of our Q2 results and our guidance for Q2 '13 is based on non-GAAP. All references exclude noncash stock based compensation expenses and the amortization of noncash debt discount amounts related to our recently issued convertible notes.

Total GAAP revenues in Q2 were $138 million, at the upper end of our guidance of $130 million to $140 million. We recognized DTN-X revenue from 8 additional customers this quarter, 4 of which were new invoice customers to Infinera. In addition, we also added 2 new DTN customers, taking our total invoice customer roster to 121. We had no greater than 10% customers in the quarter, the top 5 customers included a Tier 1, 2 MSOs and 2 bandwidth wholesalers.

International revenues totaled $50.1 million or 36% of total revenues for the quarter. EMEA accounted for $32 million or 23%, with APAC and the other Americas representing 10% and 3%, respectively. While we expect our geographical revenue mix to fluctuate based on the timing of deployments, overall, we are making good progress in expanding our international footprint. We had some good traction this quarter in APAC and continue to see meaningful opportunities in EMEA.

Service revenues for the quarter were $17.7 million, up from $16.3 million in Q1, reflecting higher levels of deployment activity. Services gross margin at 63% were up slightly from Q1. Overall, gross margin in Q2 was 39% at the upper end of our guidance of 37% to 39%.

Product mix for quarter remained healthy with bandwidth field sales consistent with recent periods. We continue to see a higher level of new footprint common equipment sales as we ramp the DTN-X. This is due to the large number of new deployments completed in the period and is reflective of the significant amount of 100-gig footprint that we are winning.

Our progress on yield improvements and cost reductions on the DTN-X platform remains on track. We saw some initial benefits in these improvements in the June quarter, contributing to our improved Q2 gross margin. All things being equal, we expect cost reduction activities to continue to contribute to the financials on an incremental basis through the end of the year. These improvements are a key element of achieving our gross margin target for the year of 38% to 40%.

Operating expenses for the quarter came in at $54 million, in line with the upper range of our Q2 guidance and increased, as expected, from $52 million in Q1. This increase included some acceleration of R&D prototype spending and some increases in sales expenses for the period. Looking forward to the September quarter, we expect operating expenses to be approximately $55 million, reflecting approximately $2 million of increased variable compensation costs in sales and other areas, and the continued acceleration of customer-specific R&D activities. Overall headcount for the quarter was 1,238 versus 1,219 in Q1. The increase in headcount primarily reflects additions in sales and operations to support higher revenues.

Our operating loss for the quarter was $0.4 million. Non-GAAP other income expense for the quarter was a negative $0.2 million, which included $0.3 million of interest expense associated with our newly issued convertible debt. On a go-forward basis, we expect this expense to approximate $0.8 million per quarter. This amount represents the cash interest payable on the notes and excludes the amortization of the debt discount. Net loss for the quarter was $1.2 million, resulting in a loss per diluted share of $0.01, at the better end of our guidance, which calls for an EPS range of $0.01 income to $0.04 loss per share.

Now turning to the balance sheet. As a reminder, we completed a convertible debt offering on May 30, generating approximately $145 million in net proceeds. The notes carry an annual interest rate of 1.75% and the proceeds will be used for working capital and other general corporate purposes. Cash, cash equivalents, restricted cash and investments ended the quarter at $328.9 million. Excluding the proceeds of the debt offering, cash was $184.4 million, up from $164.9 million in Q1. We generated $17.9 million of cash from operations in the June quarter, a significant improvement from using $21.3 million in Q1.

DSOs came in at 64 days, down from 82 in Q1. As expected, our billing cycle for the June quarter reflected better linearity, which contributed to improved DSO metrics. Inventory turns were 2.8x, up from 2.4x in Q1. Accounts payable days were 32 days, down from 48 days in Q1, reflecting improvement in the linearity of supply in the quarter.

Capital expenditures were $4.5 million compared to $4.9 million in, Q1 and consistent with our guidance for capital expenditures of approximately $20 million for the year. We are pleased with the incremental improvement in cash metrics in Q2 and remain committed to exiting 2013, having increased our cash balance exclusive of the debt proceeds on a year-over-year basis.

Now turning to our outlook for the third quarter and beyond. Bookings momentum in the second quarter was particularly strong, with robust DTN-X demand from both new and existing customers. As Tom mentioned, we received DTN-X purchase commitments from 7 additional customers in the quarter, for a total of 34. Three of these additions were from customers new to Infinera, with the remaining 4 coming from existing DTN customers. In addition, we saw significant repeat purchases from customers already on our DTN-X purchase commitment list, as they continue to expand and upgrade their Infinera footprint.

This strong bookings momentum in Q2 resulted in increased backlog and unusually good visibility to revenue levels for the third quarter. As we look beyond Q3, our pipeline of RFPs and lab trials remains healthy. However, our current visibility to bookings at the back end of Q3 is less than we have experience in recent periods. This may be the impact of normal Q3 seasonality on the timing of RFP completions and order flows, but it does cause us to remain somewhat cautious when considering increases to our revenue outlook for the full year. This caution is focused more on the quarterly timing of bookings and deployments, and on the overall health of the business, as we continue to compete for and win new opportunities.

With this as background, we believe that revenues for the third quarter will range from $135 million to $145 million. The strength of this outlook for Q3 points to revenue for the year that will be at or above the higher end of our original 10% to 20% growth outlook. However, given our return to more typical bookings visibility, we will refrain from updating the upper end outlook further until we have better visibility to Q4 deployments. We expect further improvements in gross margin in Q3, as we continue to benefit from DTN-X related cost reduction activity.

Our revenue outlook for the quarter calls for a significant number of DTN-X deployment, many of which will require the installation of large amounts of lower margin common equipment. However, there are a number of significant DTN-X deployments planned, which will leverage previously installed line systems. This, combined with some initial network field sales on early DTN-X deployments, is expected to result in a more favorable revenue mix for the quarter and drive through a gross margin expansion that is somewhat ahead of our previous outlook.

On this basis, our guidance for Q3 calls for gross margins of 43% to 45%. We are pleased with the upper end of our Q3 gross margin guidance; provides a proof point for our midterm target model of 45%. This demonstrates that with a balanced mix of revenue, the business can deliver gross margins in this range. That said, we do not believe that a 45% gross margin is sustainable in this current period where our primary goal is to increase market share and expand the network footprint. We believe that, as we continue to ramp DTN-X, gross margin may be volatile on a quarter-over-quarter basis and may be constrained depending on the level and size of new deployments in a particular period. We remain on track for our 2013 gross margin outlook of 38% to 40%.

As we look at operating expenses for the year, our previous outlook calls for operating expenses in the range of $205 million to $210 million. As a result of increased confidence about our revenue and profitability outlook, we expect to incur additional variable compensation expenses of approximately $3 million for the year. As a reminder, our outlook for operating expenses for 2013 now includes approximately $6 million of incremental variable compensation related items.

With this in mind, we now believe that, depending on our final performance for the year, operating expenses could range from $210 million to $215 million. This increase will only occur if we continue to achieve on both revenue and profitability metrics. As we go forward, we intend to grow operating expenses at a lower rate than revenue in order to support ongoing profitability and achieve our midterm business model.

In summary, our guidance for Q3, which is based on non-GAAP results and excludes any noncash stock-based compensation expenses and the amortization of noncash, that discount amount, is as follows: Revenues of approximately $135 million to $145 million; gross margins of approximately 43% to 45%; operating expenses of approximately $55 million; operating income of approximately $3 million to $10 million, net income of approximately $2 million to $9 million; and based on estimated average weighted diluted shares outstanding of $125 million, this will lead to an EPS range of $0.01 to $0.07 per share. Please note that the basic share count is expected to be at $120 million for the quarter.

Now, operator, would you please open the call up for questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question today is from Kim Watkins, Morgan Stanley.

Kimberly A. Watkins - Morgan Stanley, Research Division

It's Kim Watkins in for Amy Goldblum. Just wanted to ask a little bit to better understand the comments about visibility into orders. I think you said at the end of Q3, which we're not that far away from, wanted to make sure I understand that correctly and if you could give us a little bit more insight into what you think is going on there, that would be really helpful.

Ita M. Brennan

Yes. I mean, I think what we see right now, Kim, is we have good visibility to the first kind of couple of months of Q3 bookings. September, right now, we don't have perfect visibility to that. It's not unusual that, that's the case because August tends to be kind of a quiet month from a decision perspective. But relative to what we have, what we saw in Q2, I think what we're messaging is it's a little bit -- we have a little bit less visibility than we had in Q2. It's almost back to how this business typically is and our lead times are back to what they would historically have been, right, and nothing more than that.

Kimberly A. Watkins - Morgan Stanley, Research Division

So do you think -- I mean, obviously, not increasing your guidance for the year implies a pretty sharp decline in the December quarter. Do you think we're getting at the tail end of kind of the easy pickings of DTN-X deployments at this point? I mean, it seems like you've got quite a large backlog of customers. So just trying to get a feel for what is changing in the momentum of the business.

Ita M. Brennan

Yes. I mean I think we're saying that it's the upper end of the guidance or better, we're just not ready to define how much that better would be until we have better visibility, right.

Thomas J. Fallon

Yes. We were very careful in saying that our guidance, from a floor perspective, is at the high end of our old range and we're not giving a new top end range, and that those with visibility that we have historically seen, but we've seen better visibility over the last couple of quarters. As Ita said, this is fairly typical for our company's history and it's exacerbated by our belief that time is a weapon and as we bring lead times down for our 100-gig product, to the 4- to 6-week range, we end up training our customers around having that expectation. I think that provides a competitive advantage to us and our customers in the industry. It does lead to less visibility across the horizon, but I think it's worth doing. I do see a lot of opportunities, still, around the world. There are a lot of big opportunities that we are working to achieve. So I don't see any falloff in what I consider industry demand for transport technology. I just see, as Ita said, maybe some of it's Q3, from a summer softness perspective, but mostly it's just a visibility that we have trained our customers and potential customers to have.

Kimberly A. Watkins - Morgan Stanley, Research Division

Okay, that's really helpful. And then how does the guidance for gross margins fit into that? Because I think we've been trained to think about it as once you deploy the common equipment which typically has lower margins and you start to sell the chassis, you end up a little bit higher margin business, but that also leads me to think that the chassis deployments are slowing down. So what's the context there of higher gross margin in the quarter?

Ita M. Brennan

Yes, I mean and certainly, if you look at the revenue guidance for Q3, nothing is slowing down in that guidance, right. So I think what we're seeing is we have some customers who had deployed DTN in their networks and the line system that goes with the DTN, which is what we call common equipment for this purpose is leverageable to DTN-X, if they want to put DTN-X and upgrade to DTN-X on the fiber, right. so we are seeing, this quarter, a number of larger networks where we're actually going to leverage the line system for the DTN-X deployment, and that's helping us with the product mix perspective. I mean, I look at it as it just shows what the model can do when there will be a more balanced mix, but this mix change is really a positive thing, it's customers leveraging what they already have.

Thomas J. Fallon

I also think it's very important not to draw a conclusion that DTN-X wins are slowing down. As I stated, we had 7 in 1 quarter and we think that that's a very strong and healthy number. And some of those, as Ita said, are going to take advantage of an optical infrastructure they've already deployed. It's customers who like the DTN experience and want to have the DTN-X experience, and are using that optical infrastructure. Some are new customers that will have new line systems, et cetera. I think the real resonance should be 45 points. We've gotten some concerns from people, is 45 points of margin really an intermediate-term target. This is a great proof point, that when you have a nice mix of new wins and customers upgrading old networks, 45 points is a very realistic number, even when you're picking up market share.

Kimberly A. Watkins - Morgan Stanley, Research Division

Absolutely. One other quick question about the competitive landscape. I mean, certainly, this isn't showing up in your P&L, but just out of curiosity, have you seen any changes in Alcatel-Lucent now that they're a little bit healthier from at least a balance sheet perspective and a competitive standpoint?

Thomas J. Fallon

Well, I'm not sure borrowing money makes them more healthy from a balance sheet perspective, but that's a different discussion for a different time. I think it's too early to state whether the new CEO is going to insist on new business practices. I think that they have a significant challenge ahead of them. I still interface with customers who are concerned about increasing their dependence on any supplier that is fiscally uncertain. So I think that the proof will still be in the pudding.

Operator

Rod Hall, JPMC.

Ashwin Kesireddy - JP Morgan Chase & Co, Research Division

This is Ashwin in behalf or Rod. I think my first question is on revenue guidance. You already commented on visibility. Now, what do you think can happen during the quarter, which can probably push the numbers above your guided range? In other terms, what other surprises are sort of [indiscernible] from this guidance?

Ita M. Brennan

Yes. I mean, clearly, the guidance we provided for Q3 is based on our best visibility that we have now, and that's our view of how the quarter is going to turn out. If there are surprises, there'll be surprises, right. I mean it's not that we see other things that we haven't incorporated in here. I think that's our best view of the quarter as we sit here today.

Ashwin Kesireddy - JP Morgan Chase & Co, Research Division

All right. I just got another sort of housekeeping question. I think last quarter you mentioned that you had like 26% market share in total 100-gig port shipments. Is there any update to that number?

Thomas J. Fallon

Those market share update numbers that we reference are from public firms, Infonetics and Dell'Oro typically. And those numbers won't be updated, typically, until the middle of August.

Operator

George Notter, Jefferies.

George C. Notter - Jefferies LLC, Research Division

I wanted to ask about your experience with the trade-off between the DTN and the DTN-X. And you've got a year I guess, now, of experience with the DTN-X and can you just talk about anything you can say quantitatively or even qualitatively about how customers view the DTN versus the DTN-X? Are you seeing a lot of cannibalization on the DTN? What's the experience like?

Thomas J. Fallon

Well, I think that our customers that have upgraded into the DTN-X, are reflecting that they expect and are seeing the same ease-of-use, the same quality, the same rapid fulfillment, the same fundamental experience that they fell in love with at the DTN. They're expecting that with the DTN-X and they're getting that with the DTN-X. I think that for new customers, clearly, what they're intrigued by is our reputation around quality and customer service, but also our cutting edge and leading technology. Nobody else can provide 500-gig super channel on a single card, point-and-click provision 2-terabit capacity in 12 minutes. It doesn't exist on the planet except with us. So we're creating a new terabit-age-ready platform available to the market today. Customers get it. Is it cannibalizing the DTN? It's kind of a funny way to look at it, George. We're clearly selling the DTN-X today where the DTN would've sold before. But the DTN caps out at 400 gigs of capacity. The DTN-X, once we put a terabit line card in there, caps out at 10 terabits of capacity. You're not going to use that product for that solution if you're only going to carry 200 gigs. There's a big market, still, for the DTN. We continue to win new DTN customers, but it's for applications where bandwidth requirements aren't going to the multiple terabit range. The DTN-X adds a new tool to our toolbox, allowing us to sell a product in the core, allowing us to sell product in regions and in metros. So I think that cannibalization is probably the wrong way to look at it. Somebody has a very high capacity network, they would have bought something other than the DTN. Blessedly, they're buying the DTN-X.

George C. Notter - Jefferies LLC, Research Division

Got it. Yes. I guess just to clarify the question, I don't think there's any debate here about the fact that your market opportunity is much, much bigger now with the DTN-X in the mix. I guess I was just curious about where the ultimate revenue stream for the company can go. Obviously, there's kind of 2 parts of that: How much success you have with the DTN-X and what component of that revenue stream then kind of goes away with the heritage DTN shrinking to some extent. That was kind of the gist of the question and so I was kind of wondering if you could say anything qualitatively or quantitatively in terms of what percentage of the customers do you think will ultimately go for the DTN-X, what percentage of the revenue stream might that be. I mean, any clarification there I think would be kind of helpful to understand the upside case of Infinera.

Ita M. Brennan

Yes. I mean I think the way to look at it, George, is still to come back to, we have DTN customers who are moving to DTN-X and they're spending the same amount of money or more, because we're expanding inside those accounts, on the DTN-X and with Infinera, right. So metrics that I think help see where the expansion is going to be is looking at -- out of the 34 new purchase commitments that we have, new customers buying the DTN-X, 1/3 of those are new customers, right. So that's obviously completely incremental revenue to the company, right. You also saw this quarter that had -- we saw a lot of customers, who are on that list, now buying more DTN-X, right. So I think we have to look at it from, are we expanding geographically. We're seeing traction in APAC, and we've talked about that. That was an insignificant market for us before, right. And then we're seeing these new customers being added to that list and that's what's going to drive the growth.

Thomas J. Fallon

And it's important to realize, too, George, that if somebody is a DTN customer and they start buying the DTN-X, they're not throwing away the DTNs typically. They are continuing to fill, they're continuing to add capacity, too, and in some cases, continuing to extend applications into other parts of their network. So most of the time, it's not replacement revenue, it's incremental revenue.

George C. Notter - Jefferies LLC, Research Division

Got it. Okay, great. And then one last question, just on gross margin. I was just sort of thinking about the move from 36% last quarter to 39% now this quarter. And Ita, you've talked about the different pieces of gross margin improvement. Obviously, you get a yield improvement on the PIC chip fab. You get just volume improvements, leverage on manufacturing. Can you parse out, for the Q2, the components of the margin expansion? Was it mostly from the yield improvements? Was it mostly from cost down? Anything you can give us there would be helpful.

Ita M. Brennan

Yes. I mean, I think from Q1 to Q2, it's moved along pretty much in line with what we expected, and the majority of it is coming from cost, right, and from cost improvements both on the PIC and on the other elements of the DTN-X platform, right. We're still -- in Q2 for sure, we had a heavy mix of common equipment, et cetera, so we're not really getting that much from mix in Q2. Our outlook for Q3 definitely incorporates some benefits from being able to leverage some existing common equipment in networks, et cetera, but we're also getting incremental cost reductions into Q3 as well, right. So we're continuing to execute to that roadmap that we had laid out, which has the margin expanding through the end of the year, on the back of the cost reductions, and then some of the upside that we're seeing is coming from customer mix or from product mix in that time period.

Operator

Dmitry Netis, William Blair.

Dmitry Netis - William Blair & Company L.L.C., Research Division

Got a couple of quick questions here. On the acceleration of OpEx, you're guiding it up a little. I'm just trying to parse this a bit and if you could comment -- and also your guidance as far as the timing, and maybe less of a visibility towards the back end of the Q3, Q4. Does this have anything to do with your ability to expedite orders? The fact that you're raising your R&D investments up a little here, you're trying to get the product out in time for customers, what's driving the OpEx up? Trying to parse this thing, if you could help, that'd be great.

Ita M. Brennan

Yes. I think the biggest driver for the OpEx growth is all around variable comp, both sales and other variable comp. I mean, if you look at the 215 is the upper end of the range, and there's about $6 million of increased variable comp in that number, which puts you back at a 209 type number, which is really not up significantly from last year, right. So the vast majority of the growth is coming from those drivers. We do have some incremental R&D spend where we're just moving and accelerating some R&D activities as we see that as being important versus our future growth. But I wouldn't link that, in any way, to the fact that this is Q3 and we are not seeing the same strength or visibility in Q3 as we saw in Q2.

Dmitry Netis - William Blair & Company L.L.C., Research Division

Okay. So you're able to ship product. This is not a product constrained environment you're in right now?

Ita M. Brennan

Yes. I mean, at $135 million to $145 million, we're shipping more revenue and more products than we have historically and we can ship a lot more.

Thomas J. Fallon

And our lead times are at target. So roughly 4 to 5 weeks after an order, we're able to fulfill that order. So we are not experiencing the constraints and we've prided ourselves that we think time is a weapon and I think, like I said, part of the reason that some of the visibility is down is because we are training customers as we've trained them on the DTN. We are going to be there when you need it.

Dmitry Netis - William Blair & Company L.L.C., Research Division

Okay, great. And then on the customer side, did you have any 10% customers this quarter? I apologize, I joined a little bit late.

Ita M. Brennan

Yes. So we had no 10% customers. We had a couple that were just under the 10%, and then we said the top 5 customers, we had 2 MSOs, 2 bandwidth wholesalers and 1 Tier 1 in the top 5.

Dmitry Netis - William Blair & Company L.L.C., Research Division

Okay. And then for the new guys that are following the stock now, would you give us a bit of a view on those top 5 customers and how much they might represent as a percentage of revenue? Is it less than 50% or is it more than...

Ita M. Brennan

Yes, it would be less than 50%. I mean, yes, we don't have the same customer concentration as you might have seen historically. Yes, those 5 customers are significant in the quarter and then they rotate in and out with a fair amount of variability and who's in that top 5 customer list every quarter.

Dmitry Netis - William Blair & Company L.L.C., Research Division

Okay, great. That's helpful. And then the last question, kind of the metro opportunity and how positioned are you in terms of your product base. Right now, I'm not sure, I think in the past you've played in the metro. It was a combo solution where you had the ATN plus the DTN. Are you doing similar thing right now with the DTN-X, where you're basically linking the ATN with the DTN-X? Have you had that kind of deployment or -- that's sort of the one question. And then the second, if you could update us on sort of the new product that potentially could fit that market segment. And specifically, I know you play in the core, but maybe more toward the access side of the network or the edge side of the network.

Thomas J. Fallon

Yes. So, today, we are using the ATN as an aggregation and feeder into both DTN and DTN-X. We have had customers that are buying that configuration, and having 2 of them together has been very useful. In the core metros, we do sell quite a bit of DTN. We sell a reasonable amount of DTN-X. Some of the new customers we've won actually have been core metro applications, and we have articulated an expectation that we are developing a metro platform, a new metro platform to complement the DTN and the ATN. We have not released a timeline on that, but we did say that it was going to be PIC-based. That PIC is in development and we anticipate having working PIC modules this calendar year, as kind of a milestone that you can measure success against. Beyond that, you're going to have to wait for product updates when we officially feel comfortable talking about products.

Operator

Mike Genovese, MKM Partners.

Michael Genovese - MKM Partners LLC, Research Division

Given that you have no 10% customers in the quarter, given your market share, it seems like your comments about what you're saying, about an order void in August is a comment about the industry, more than specific to you guys. But also isn't that normal? I mean, wouldn't you normally expect that? And I guess the question that I'm trying to drive at is the question of should we think about 4Q '13 being a – or 4Q, just in general, being a seasonally strong quarter? I mean it used to be years ago. Hasn't proven to be the last couple of years, and I'm talking more for the industry than you guys. But in this part of the market, you guys are becoming the industry. So what's your view on seasonality of the fourth quarter? And are you just using this order void to stay conservative on both the full year revenue guide and the gross margins? Both seem like they should go up. Are you just using this to stay conservative here or is this something you're really worried about?

Thomas J. Fallon

Well, first of all, you used the word void a couple of times and that's not a word we used. So I caution that we don't see an order void. That's a very fundamentally different type of worry that I would have if we saw an order void. What we're seeing is more typical industry demand and profiles of demand that, one, is a little bit typical of Q3 and is also reflective of our lead times being back at what we consider to be good lead times for our customers. We still see, as I mentioned, a number of big and good opportunities across the world and in all of our vertical markets where we are seeing, not a void, but right now, lack of clarity on when those people are going to make their final decisions. I continue to believe that the market for transport is growing, at probably what the industry says is 10% or so. And we continue to pick up market share; actually we've been picking up, I would guess market share, at an accelerating rate. That rate can't continue at the pace it's been at, but I do continue to believe we are going to pick up market share in a growing market. I do think that there is some lack of visibility, though not a void of opportunities where we're seeing, late in this quarter, which is like I said, more typical, and Ita said, more typical of the business that we're used to for the last several years. In regard to margin, we're not trying to explain away something that you might think is going to be up higher later. It's very important to understand that our margins in Q3, as we try to very aggressively win footprint, are being very favorably impacted by the fact that some of the footprint we are winning in Q3 is going on top of line systems that we sold over the last several years. That is, to me, a very good metric that we have satisfied those customers. They want to continue to have the Infinera experience. They're leveraging the investment they made historically. But typically, when we win new customers, that is not going to be how they roll out product. Typically, they're building a new network, even if it is a current customer. And I think that we guided at the beginning of the year, 38% to 48% margin. We are still very resolute that we are reaffirming that 38% to 40% margin. Clearly, Q3 is ahead of our margin guidance for this year, but it reflects what we've said is our intermediate goal and I think it's, as Ita said, a great proof point, that when you have a nice mix of fill and new wins, it's a very achievable model.

Michael Genovese - MKM Partners LLC, Research Division

Could you comment on the seasonality question? I mean, like I said, the last couple years the fourth quarter for the industry hasn't been that great. Do you think that that's kind of the new way of things? It used to always be a big double-digit up company for carrier selling things like you -- I mean, for vendors selling things like you sell. Do you think that that's changed? And then also, finally, on the gross margins, just a hypothetical question, which is that if you did have a 20% customer, if you were to win a 20% customer, say, that was building a nationwide network with you guys, how would that affect the gross margin trajectory that you're on? I'm not talking about the third quarter gross margins, but just general, the gross margin improvement, knowing that the cost of the PICs are coming down. Do you think a large deployment, if someone were to become a sustainable 20% customer, would that affect your gross margins over a short period of time?

Ita M. Brennan

Yes. I mean, I think, Mike, the way to think about gross margins is we had laid out a roadmap that, ahead of exiting the year, above 40% gross margin. In the low 40s in Q4. And we're not changing that and we haven't moved away from that in anything that we've said today. What we've tried to do is to caution against taking the Q3 margin and expanding that up from 45%. So that's kind of our intention around the gross margin trajectory, just to be clear. Your question about would a 20% customer change that margin and what would that look like. We're carrying a lot of common equipment right now, in the revenue model and in the gross margin model. So if somebody came and dumped an entire Pan-Americas network into a single quarter, that will drive the margin down, but if we see normal rollouts with these guys, we'd like to believe that doesn't fall below 45% in that scenario. So I think, is there a case, a hypothetical case, where it could? Yes, but it would be coming with some fairly significant, and not typical roll out of a large network.

Thomas J. Fallon

I don't think that you should expect a customer to take 20% of our output, in a given quarter, and roll it out and recognize revenue in that quarter. It's too much network to deploy that quickly. It'll be much more metered out. Second of all, your question in regard to Q4 seasonality, my personal view is that, in the industry, there will be some Q4 upside in end-of-year money. I think that industry, in general, is growing. I think that there are opportunities that are occurring. And around the world, I see companies getting more comfortable with the economic outlook, and I think that, that will allow people to have some end-of-year money to spend. How big it'll be, I don't know. How much of it will it get to Infinera, I don't know. But I do believe there will be some Q4 opportunities that we don't see yet.

Ita M. Brennan

And again, just to reiterate, I mean, we're saying we'll be at the upper end or above. But we're reluctant to try to quantify that above right now, and that's the extent of the caution that we're putting there.

Operator

Alex Henderson, Needham & Company.

Alexander B. Henderson - Needham & Company, LLC, Research Division

I got a couple of questions for you. The first one, I just wanted to delve into the third quarter guide a little bit. So it sounded like, from the answers in the last question set, that there's a fair amount of what I would describe as legacy 10-gig networks being deployed on the DTN, as opposed to DTN-X sales that are in that quarter. Is that what's driving that increase in comm equipment?

Ita M. Brennan

No. I think the way to look at it is, we're seeing very healthy DTN-X deployments, but some of those DTN-X deployments are not requiring us to ship new line systems comm equipment. So the DTN business is actually holding up very well and it's very consistent to what we'd originally planned. We're seeing ongoing fill into those networks and we're also seeing some new deployments for DTN.

Alexander B. Henderson - Needham & Company, LLC, Research Division

So does that mean that the DTNs that were placed in the prior 2 or 3 quarters, are now pulling new blade sales to go in them?

Thomas J. Fallon

No.

Ita M. Brennan

Well, so DTN networks that are deployed, that customers are going to leave in place, are going to continue to be filled with additional capacity. We have some customers where they've maxed out fiber and now they're placing the DTN with DTN-X, and they're leveraging all of the common equipment that's already in place. We've got both of those dynamics happening in that revenue guidance.

Alexander B. Henderson - Needham & Company, LLC, Research Division

Okay. So it's a replacement of a DTN with a DTN-X and sharing the comm equipment that's already in place for it that's driving that. Okay. That helps a lot. So as you look forward into the activity rates that you're looking at, the number of deals that you're chasing, the size of the deals that you're chasing, getting away from the seasonality of whether people order in the middle of August or whether they take vacations, do you think that the order activity, the number of deals you're chasing, the size of the deals you're chasing, are larger than prior periods? Are they accelerating? Is your order book increasing sequentially? Can you characterize that a little bit for us?

Thomas J. Fallon

I would say it is a healthy opportunity pipeline of both requests for information, requests for proposals and trials. The Q2 activity I had commented on was that we had not seen Q2 activity at that level, probably in the history of our company. Q2 was a particularly robust quarter from an activities and pipeline. I would say the environment we're seeing today is a good environment, but it is more spaced over time. There are a lot of big opportunities around the world, but I would say it's more of a good environment versus the [indiscernible] we've seen.

Alexander B. Henderson - Needham & Company, LLC, Research Division

Okay. And then can you talk little bit about the problems that Huawei is having competing and how -- whether that's impacting your share position and your opportunities and getting into some of the installed base that they've got out there, potentially even replacing them in places?

Thomas J. Fallon

Well, clearly, in North America, they publicly have stated they're no longer interested in doing business in North America and that makes the competitive environment against them fairly benign. In Europe, there are starting to be hackles raised around is there a risk or not here. So I think the European community is some period of time behind North America in regard to, is there concern over network security. Whether it's going to impact short-term decision-making or not, I think it's too early to tell. I think that we're going to have to asses, over time, whether that takes on tangible meaning in Europe or not. I think that it already is impacting, certainly when we're dealing with international wholesalers who are exchanging capacity and doing data exchanges with North America wholesalers and independents, there is a concern of their ability to win business if they are using an infrastructure from China. That is certainly helping us to either win business or keep the Chinese suppliers having a more difficult time winning the business. But I think it's too early to understand what the impact might be in Europe. Clearly, in North America, the impact has been fundamental.

Alexander B. Henderson - Needham & Company, LLC, Research Division

One last question and this one's a little bit longer term in nature. You're obviously very well positioned in regional and long-haul applications. As you get into the metro, there's a lot more legacy, SONET, SDH and all kinds of other nonsense to integrate with. But I've been out with several industry execs that have talked about the metro market being potentially 10x the size of the long-haul backbone when that conversion finally starts in size, which some people think that we'll see the toes of that S curve in the middle of next year and then really ramp it into '15, '16 and beyond. How would you describe your view of your competitive position in the metro market given the advantages around the OEO conversion and the switching functionality versus your -- on a magnitude basis, the advantages that you have in the long haul piece? Is it larger advantage in metro market when you get into that more complex switching environment?

Thomas J. Fallon

I think that, historically, people have divided long-haul for metro based mostly on the attribute of reach. And I think with current technologies, that is probably the wrong metric to look at. We really think about capacity and services. In long haul, it requires huge amounts of capacity, large switching capability and long reach. In the metro regionals, it requires the same type of thing, but less reach. But the technology makes that irrelevant. So we now, really, more think about it as high capacity requirements and lower capacity requirements. For higher-capacity markets, in areas like metro regional and core, I think the advantages of our PIC and our ability to very effectively have the ability to integrate switching and GMPLS control have the same fundamental advantages they do in the core but probably at a bigger scale, because you're doing more traffic management. As you get closer to the edge, services become more important and that's where our ATN has played a role, historically, of taking and aggregating those services into our DTN or DTN-X. I think the opportunity for us, for our new metro portfolio, is to take the value proposition of the PIC, the value proposition of our integrated switching, whether it's an OTN or MPLS, the opportunity of having a GMPLS network control across the entire network is a huge advantage. But right now, we don't have that platform. So at the services edge, I would say that we have some catching up to do. I do not believe the numbers that the metro opportunity is 10x that of the core. The core is probably a $4 billion market plus, growing to $6 billion or so. It's implausible, in my mind, that the metro market is going to grow from a $5 billion market to a $50 billion or $60 billion around services. I just don't see that as being viable at all.

Operator

[Operator Instructions] The next question is from Subu Subrahmanyan, Juda Group.

Natarajan Subrahmanyan - The Juda Group, Research Division

Tom, if you don't mind, I want to address the guidance question again. If revenue for September is at the midpoint and full year guidance, just the high-end of the range, and I know you said high end or higher, it would imply December down double-digit in a typically seasonally strong quarter. And I know you're not guiding to that, but I'm trying to understand, given that the business tends to be lumpy, if there some large deals which are kind of tailing off out of the September quarter, which makes you think that December could be down or is it just, at this point, you don't have the visibility? I'm wondering if there are specific deals then you have visibility of where that starts to tail off.

Thomas J. Fallon

Well, Subu, just to reiterate the guidance, we took the new guidance to the bottom being the former high-end of our previous guidance and we gave no upper limit to that. What we're trying to articulate as clearly as we can, we're confident in our business. The current results are outstanding, Q3 looks like an outstanding quarter for results, but as our visibility gets less certain, we are going to become -- pass that uncertainty on and say this is what we see. We have no reason not to believe that our business is in a good position, but our visibility is less and I think that we've tried to be clear that, historically, both Ita and I have said, we're going to guide to what we can see. We got a little bit, I think -- I don't know, out of sync a little bit with some of the analysts when we gave a 1-year outlook last year because we thought that, with the DTN-X introduction, what we could see was not reflective of the opportunity that we knew was there. As we go back to more typical business process, we're going to go move to just quarterly announcements or quarterly guidance, and this is directionally in that tone. There's nothing that I am concerned with, about the DTN-X losing viability and leadership in the market. But with less visibility of our sales guys being to look me in the eye and tell me we're going to win this deal at this time frame, we're going to pass on that level of lack of clarity to you.

Ita M. Brennan

Yes. And I think, Subu, you're right, that will be $120 million quarter or so in Q4, which clearly would be a different trajectory. We're not saying that's what's going to happen. What we're saying is it's difficult because the timing in that last quarter, to basically size any upside to the original 20%. And it's -- we have a lot of deals in the pipeline but the timing of when they actually get executed on and how much of that will fall into Q4 as revenue is something that we're just going to have to see how it plays out. But again the momentum is there. This is more a timing of what will show up in revenue in Q4.

Natarajan Subrahmanyan - The Juda Group, Research Division

Understood. I guess my question was, are there existing large deals that are playing out in 2Q and 3Q, which may be tapering off into Q which needs to be filled by some new deals? Is there that kind of a dynamic?

Ita M. Brennan

I mean our model is that you're always going to have to have a number of large deployments in every quarter, to make our revenue numbers where we typically see them. So it's not a question of that top 5 customer list rotates every quarter. So there will be and will need to be key wins, either with new or existing customers, in each quarter. And that's what we've been seeing and we would expect to continue to see that. But you need -- to call those for Q4 from now, that's -- we just don't have the visibility to call those yet. They're definitely there, to be won. But which ones hit and when? We're just not willing to kind of go and increase that 20% growth rate just yet.

Natarajan Subrahmanyan - The Juda Group, Research Division

Understood. And Tom, generally, lumpiness in the market, how are you thinking about lumpiness in the market? We've seen, obviously, a good phase of growth as 100-Gs on an early part of the trajectory for growth. But optical traditionally has been a lumpy business and over the next few quarters, how do you think about that?

Thomas J. Fallon

Well, I like to think about it, first, over the next few years. Over the next few years, I see huge opportunity. I see that there's a fundamental requirement for more transmission. I see that in all the same trajectories, video, wireless, cloud, all those are continuing to be extraordinarily robust. I see an absolute shift in the market to 100-gig, to 500-gig, to terabit and I see an absolute shift to the market to convergence. I don't know of anybody better positioned to take advantage and accelerate those convergence or those trajectories than we are. So I feel very fortunate with where we are across the next several years. Now if you bring that timeframe down to a shorter period of time, across quarters, I think, in our industry, Q1 is always a soft quarter. It's always going to be a soft quarter. So I think there's going to be continued lumpiness and there's always going to be certain big deals that drive big opportunities. That's not going to change. So I think volatility, quarter-to-quarter, should be somewhat expected, with a general trajectory of up and to the right.

Natarajan Subrahmanyan - The Juda Group, Research Division

And final question, you talked about gross margin exiting the year at a 40%-plus kind of rate, which you've talked about. I just wanted to understand, was that a specific reference to the December quarter that would -- you connected at 40% or higher? And another bigger picture question is it seems like we can either have big footprint growth which drives revenue or good margins with line card mix. When can we hit that kind of steady-state where we can have both at a mid-40% gross margin?

Ita M. Brennan

You're going to move to it over time. First of all, the commentary on the Q4 is just referencing back to our guidance of 38% to 40% and the fact that, to achieve that, we would expect it to be exiting the low 40s, and we're holding to that commitment that we would exit in the low 40s. I think from a, when do we see this margins get to this 45% on a steady-state ongoing basis, it's as the mix of what we revenue becomes more balanced between fill and common equipment. And we are starting to see some DTN-X fill go into the networks that we deployed a year ago. So we definitely see the fill levels starting to come. But again, we would hope that next year we're going to be deploying a ton of common equipment for new customers and we're going to want to do that, and that's going to kind of constrain the margin for a while.

Thomas J. Fallon

And is the line card fill this quarter DTN or DTN-X or both?

Ita M. Brennan

Both. So we expected to see the DTN hold and it's holding, and we're starting to see probably DTN-X fill a little more accelerated than what we would've thought in Q3.

Thomas J. Fallon

Yes, if anything, we're pleasantly surprised by customers who deployed DTN-X in the last year, mostly in of the last half of year, starting to come back and needing to expand the fundamental capacity ahead of what they thought. So to me, it goes back to my comment a minute ago, the horizon looks pretty strong from an opportunity of continuing to support incremental bandwidth needs.

Thomas J. Fallon

Thank you for joining us this afternoon for your questions. We look forward to staying in touch in the months and quarters ahead, with your report on our continued progress. Thanks very much.

Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time.

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Infinera (INFN): Q2 EPS of -$0.01 beats by $0.01. Revenue of $138.4M beats by $5.1M. Shares +3.5% AH. (PR)