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Infinera Corp. (NASDAQ:INFN)

Q3 2009 Earnings Call

October 20, 2009 5:00 pm ET

Executives

Bob Blair – Investor Relations

Jagdeeb Singh – Executive Chairman of the Board

Thomas J. Fallon – Chief Executive Officer, President, Chief Operating Officer & Director

Duston M. Williams – Chief Financial Officer

Analysts

[Michael Genevieve] – Soleil Securities

Simona Jankowski – Goldman Sachs

Brent Bracelin – Pacific Crest Securities

George Notter – Jefferies & Co.

Analyst for Sanjiv Wadhwani – Stifel Nicolaus

Alex Henderson – Miller Tabak & Co.

Analyst for Mark Sue – RBC Capital Markets

Blair King – Avondale Partners

Operator

Welcome to the third quarter fiscal 2009 investment community conference for the Infinera Corporation. All lines will be in a listen only mode until the question and answer session. (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 Mr. Bob Blair of Infinera Investor Relations.

Bob Blair

Welcome to Infinera’s Q3 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 the prospects of the company in Q4 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 10K filed on February 17, 2009 for more information on these risks and uncertainties. Today’s press releases including Q3 2009 results and associated financial tables and investment information summary will be available today on the investor’s 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 includes certain non-GAAP financial measures. In our earnings press release we announced operating result for the third quarter 2009 which exclude the impact of non-cash stock-based compensation expenses and restructuring and other costs associated with the closure of our Maryland fab. These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons. Please see the exhibit to the earnings 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.

On this call we will also give guidance including guidance for the fourth 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 future stock-based compensation expenses. We’ve also excluded the impact of restructuring and other costs associated with the closure of our Maryland fab from this guidance. For the remainder of today’s call we will be excluding the impact of these items as we discuss our third quarter 2009 results and our fourth quarter 2009 guidance when we refer to these results.

I will now turn the call over to Infinera’s President and CEO Jagdeeb Singh.

Jagdeeb Singh

With me today is COO Tom Fallon and CFO Duston Williams. We are pleased with the results we achieved in our third quarter. During the last year the context of the economic downturn it has been our strategy to focus on winning new footprint, advancing our industry leading technology, improving our margins and maintaining our operational excellence. In our third quarter we made solid progress on all these fronts. We grew our revenues and gross margin sequential to $83 million and 38% exceeding our guidance and our operating loss came in at $5.8 million better than our guidance of $12 to $13 million.

Earlier in the year we indicated that we believed Q1 may have been the bottom of the macroeconomic erosion for us and we believed that with two sequential quarters of growth in our business and our Q4 outlook this expectation has played out. We continue to expand our footprint with the addition of four new customers including two tier-1 customers which we have previously discussed Telefonica and Teliasonera. We achieved greater customer diversity as three customer accounted for 10% or more of our revenue none of which were level three which as you know has historically been our largest customer. Level 3 remaining in our top five customers and was just shy of 10% of revenue.

For the fourth quarter in a row, international revenue grew to 37% of our business in Q3 reflecting our continued success beyond our traditional strong hold in North America. It is important to note though that this metric will likely fluctuate from quarter-to-quarter due to period large spending by customers in either regional category. Our success with Internet content providers continued this quarter with a new eight figure win with another major player in this space. We expanded our total addressable market with further penetration in to the submarine and metro edge markets with new products.

Consistent with our 8K announcement during the quarter and our focus on providing the best solutions for customers, even if it’s not the first to market, we are on target to deliver our 10x40 gig PIC to our developers by the end of this year as we prepare to bring another disruptive technology to market. We’ve significantly strengthened our technology resources with the addition of an experienced engineering team at our new development center in Ottawa. This team has deep expertise in signal processing and complex modulation schemes, important building blocks for the next generation of optical transport and they were the core architects of Nortel’s 40 gig implementation.

The key to successful technology development is the quality of the team and we believe we now have the industry’s best signal processing team working alongside the industry’s leading PIC experts on our future implementations. The signal processing for our 10x40 gig PICs have been developed by our Sunnyvale team so the Ottawa group will be focused on generations beyond this.

Our ability to grow our revenue and expand our customer base in the current environment is significant for several reason. First, I validates that there continues to be significant WDM investment by our customers and second, it shows that Infinera is winning its fair share of that spending both in terms of new customer wins and with existing customers who are choosing to remain with Infinera as their WDM vendor of choice. It means customers are choosing our value proposition over that of our competitors including some of the biggest vendors from around the world.

Our customer rooster is now 66 compared with 49 one year ago. With the addition of Telefonica and Teliasonera this quarter we now have six tier-1 customers around the global of which three NTT, Deutsche Telecom and Telefonica are among the top five service providers in the world. It is also important to note that we achieved our third quarter revenue level with greater customer diversification than ever before.

As mentioned earlier three customers accounted for 10% or more revenue this quarter and our largest customer for the quarter was an existing but unannounced cable [inaudible] customer. One of our newest tier-1 service providers Telefonica was another one of our top five customers and even though level three was less than 10% of revenues this quarter we were still able to grow revenues nicely and exceed our guidance. We believe our efforts to diversify the customer base across regions and vertical markets and to decrease our reliance on any single account are succeeding and will continue to be positive for our business.

Another key factor in our business is our ability to successfully compete in the submarine networking market. The submarine market has enjoyed strong growth in recent years as increasing transcontinental traffic has risen sharply. According to date from independent analyst Ovum the submarine networking market is nearly $1 billion this year growing at 20% per year. This market tends to be fairly cyclical in nature and appears to be in an expansion stage today.

As a result, we’re seeing significant activity there in terms of both the number and size of deals.

We believe that Infinera’s solution is especially well suited to the submarine market because it enables operators to increase capacity on their networks while taking advantage of the operational benefits of Infinera’s digital architecture which are not achievable with traditional WDM systems. We have already seen a healthy win rate in these deals including business with Telefonica and Global Crossing.

In addition to the immediate opportunities that we’re seeing in the submarine market, we’re also encouraged about the longer term prospects of our recently announced ATN to metro edge products. The new ATN products provide customers with a seamless end-to-end managed WDM solution extending the bandwidth management functionality of our existing metro offering deeper in to their networks. With the introduction of this product we now address all of the major categories within the $8 billion WDM space including submarine, ultra long haul, long haul, regional, metro core and metro access. Customers have asked us for the solution and we already have six customer commitments including the recently announced Deltacom purchase.

Finally, I wanted to take a moment to reiterate our 40 gig strategy. It’s important to emphasize that our goal is to be the best in the market with a 40 gig base product that solves the operational and cost challenges of our customers. We believe that our unique PIC based products will provide us with an even more significant competitive advantage in the 40 gig market than they currently do in the 10 gig market because of the cost and complexity associated with 40 gig technologies. We also believe that we are in the very early stages of the 40 gig market and expect that our integrated cost effective 40 gig product when introduced will enable us to capture a meaningful portion of this market and accelerate the adoption of the 40 gig by the mainstream market.

Our mission remains to be the world’s best provider of optical transport networks and consistent with our approach to the 40 gig market, our core strategy is always going to be one of differentiation. We believe that we are uniquely positioned to be able to provide the best product to solve our customers’ business challenges. We believe that our financial results, as well as our new customer wins, customer diversification, existing customer activity and continued progress with our industry leading technologies validate our strategy as a sound one.

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

Duston M. Williams

I’ll review our Q3 actual results and then follow that up with our outlook for Q4. The following analysis of our Q3 results is based on non-GAAP. All references exclude non-cash stock-based compensation and restructuring costs associated with the previously announced closure of our Maryland fab. Looking at the specifics for the quarter, GAAP revenues in Q3 were $83.4 million compared to our guidance of $80 to $82 million and versus $68.9 million in Q2. We had three 10% customers in Q3 including a top five cable company XO and Telefonica. Level three was slightly less than 10% of our GAAP revenues versus the 20% in Q2.

Gross margins in Q3 excluding a -3% or $2.7 million impact related to the restructuring costs associated with our previously announced fab consolidation efforts were 38% versus 31% in Q2. This compared to our guidance of 35% to 36%. Although the gross margins exceeded our previous expectations they were impacted to some degree by lower margins on large new customer deployments as well as TAM shipments being below historical norms. We invoiced about 100 more TAMs in Q3 versus Q2.

Operating expenses for the quarter excluding restructuring costs of $.6 million were $37.7 million versus our guidance of $41 million and versus $40.2 million in Q2. Good expense controls combined with lower than expected headcount additions and NRE charges which were pushed out to future quarters accounted for the majority of spending reductions. The overall headcount for the quarter was 970 versus 973 in Q2. Headcount additions in R&D during the quarter were more than offset by reductions associated with our fab consolidation efforts.

The operating loss for Q3 was $5.8 million versus our guidance which called for an operating loss of $12 to $13 million versus $18.6 million in Q2. Other income and expense for Q3 was a favorable $1.2 million versus a favorable $.5 million in Q2. Income taxes for the quarter reflect a favorable $1.6 million due to an adjustment related to a tax refund from last fiscal year. Net loss for the quarter was $3.1 million or a loss of $0.03 per share versus a loss of $18.2 million in Q2.

Turning to the balance sheet, the cash, cash equivalents, restricted cash and investments ended the quarter at $280.5 million versus $287.1 million in Q2. We used $8.3 million of cash from operations in Q3 versus a use of $18.8 million in Q2. DSOs were 61 days versus 72 days, inventory turns were three versus 2.6. Accounts payable days came in at 44 days versus 51 days and capital expenditures were $2.8 million in Q3 versus a similar amount in Q2.

Our Q4 base operating outlook shows higher revenue as our new and existing customer wins should continue to aid revenue growth as we close out our fiscal year end. At this point gross margins appear to be up slightly from Q3 as we complete most of our recently announced large new deployments. We also expect Q4 TAM billings to approximate the levels of Q3. However, as we know TAM bookings can be somewhat volatile and several hundred more TAMs in any given quarter can have a positive impact on our gross margins. Operating expenses will increase in Q4 due to additional R&D headcount as well as increased NRE charges.

In addition to this base operating outlook for Q4 we will also conclude our restructuring costs related to the fab consolidation efforts. The following guidance for Q4 is based on non-GAAP results and excludes any non-cash stock-based compensation expenses and the Maryland fab related restructuring costs. Revenue of approximately $86 to $88 million; gross margins of 38% to 40%; operating expenses of approximately $42 to $43 million; operating and net loss of approximately $8 million to $9 million; and based on an estimated average diluted weight shares outstanding of 99 million this would lead to an EPS loss of $0.08 to $0.09.

In addition to the above outlook, as I discussed on our last earnings call, we expect to book approximately $2 million of restructuring charges in Q4 that are associated with the fab restructuring. Approximately 50% of this charge will be included in cost of goods sold with the remaining 50% included in R&D expenses. Operator if you would now open the call up for questions please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Michael Genevieve] – Soleil Securities.

[Michael Genevieve] – Soleil Securities

Just first a point of clarification, the op ex for fourth quarter of $42 to $43 million, that excludes stock-comp expense, is that right?

Duston M. Williams

That’s correct.

[Michael Genevieve] – Soleil Securities

On the new products can you help us with any kind of breakout on the under seas and the metro product? Is there any difference in gross margin profile on those products relative to each other and relative to the DTN?

Duston M. Williams

Every deal is different of course and every customer is different. I wouldn’t say there’s significant differences in gross margins. There’s some differences of course but I would not say they’re big differences.

[Michael Genevieve] – Soleil Securities

With the ATN, do you think that’s a product that you would expect to win new customers for that aren’t deploying the DTN or do you think that will primarily be long haul customers that want to expand the operating system to the metro?

Jagdeeb Singh

Obviously as we do with every platform that we have there’s a roadmap for the ATN like there is for the DTN and the submarine and so on that involve multiple releases over time. The functionality we prioritize for the initial release is in fact the functionality that our current DTN customers value significantly. So for example, one of the key things ATN let’s our current customers do is extend the bandwidth management functionality to the edge so they can for example take in four 2.5 gig streams, combine them in to a 10 gig stream on the ATN, deliver that to DTN in a way that the DTN can then split up and groom in different directions. You can’t do that today with a third party metro box. That’s a unique value the ATN offers to a DTN network that can’t be gotten anywhere else.

Having said that, clearly over time if we have a platform the intention would be to make it a fully competitive product that competes not only in customers of the DTN today but in new accounts as well.

[Michael Genevieve] – Soleil Securities

If I could just get one more in, on the share you think the optical market sounds like it is recovering pretty nicely so you’re winning your fair share but do you think that you’re gaining share or would you look at other vendors Ciena, Alcatel and others and think that they’re growing at about the same rate as you are in optical? Or is there anything notable in the competitive environment, any specific vendors you could call out as either gainers or losers at this point?

Jagdeeb Singh

Well, we won’t know their Q3 statistics until the analysts publish their reports which won’t be for a few weeks from now probably but I think what is clear is that we certainly continue to win a significant fraction of the deals that we actually compete on. Clearly, not everybody in the universe of optical products could be winning that many deals because that would add up to more deals than there are in the pipeline so we’re clearly growing more rapidly than many of the players. What we don’t have the data on yet is whether we’re growing more rapidly than everybody or not.

Operator

Your next question comes from Simona Jankowski – Goldman Sachs.

Simona Jankowski – Goldman Sachs

I did notice that this was the first quarter for you guys of sequential growth in the United States after four quarters of declines and this is besides the level three headwinds. So, I just wanted to get a little more color on what you think drove the strength in the US?

Duston M. Williams

Again, it’s just the buying patterns there wasn’t any new win there. However, we did have some new deployments with existing customers. Some of that obviously in the US that helps that so again, any given quarter you’re going to see strength in various regions.

Jagdeeb Singh

If I can add, I think we distinguish between new customers and new wins and new deployments within current customers and we certainly had new deployments, new wins that we won in our current customer base where they were building our new layers of their optical transport network, did RPs and chose Infinera for those networks and that’s obviously one of the key drivers for the growth that we’ve seen this year.

Duston M. Williams

Some of the top two customers as you saw there were both US deployments so significant revenue driven from those two customers.

Simona Jankowski – Goldman Sachs

Then you did say that you added four new customers and I believe that at least one or two of those were new ATN customers which would imply that for the DTN you maybe only added two or three customers. I just wanted to see if that was accurate and if so is that a bit low on the DTN side?

Jagdeeb Singh

No, that’s not accurate but it’s a good question though. We added four customers but the way that the math worked on the ATN piece is we have six today, the four that we had at the end of the quarter all were existing customers so that didn’t sway the count there. The two additional customers that make up the six total ATN customers are new customers outside of DTN purchases.

Simona Jankowski – Goldman Sachs

So you’re saying those two additional ones came in this calendar quarter?

Jagdeeb Singh

Correct, in Q4.

Simona Jankowski – Goldman Sachs

Then another question on the ATN which is my understand is that it’s not a PIC based product and so assuming that’s the case where do you see the biggest differentiation? Is it really mostly having to do with the interface with your DTN and the bandwidth management extension that it enables or do you think that there are going to be other elements that are differentiating? And, related to that what do you think is going to be the gross margin impact of that product?

Jagdeeb Singh

Well, if the product weren’t differentiated we wouldn’t have done it we would have just bought a third party product or done a partnership. The bandwidth management functionality is pretty critical. The fact that customers can now, as I mentioned earlier, take in say four 2.5 gig streams, combine them together in a single 10 gig stream and then have that be groomed i.e. switched and mux’d or demux’d through the DTN network that they already have is a really significant advantage that they cannot derive any other way.

That enables them to have end-to-end bandwidth management and end-to-end transparency so they can pick up traffic in their metro edge nodes and deliver it all the way through the network without the need for excess cap ex on back-to-back transponders or back-to-back bandwidth management systems and so on. That’s a pretty significant advantage we believe and that’s one of the key drivers behind the wins that we’re seeing in that product line.

Simona Jankowski – Goldman Sachs

Clearly, it’s a pretty significant differentiator for existing customers who already use the DTN but I guess the question was just more of as a standalone metro platform given that it doesn’t have the massive differentiator that the PIC gives you guys in the DTN, how important is that bandwidth management interoperability in a standalone metro product?

Jagdeeb Singh

Well I guess two quick comments on that front, one is keep in mind that the PIC that we sell exists on exactly one of our [fruz] as [inaudible], one [mind] card contains the PIC everything else that we sell really is designed to complement the PIC and make it more compelling in the networks. This is another example of that kind of functionality. For example we sell amplifiers today that don’t have PICs in them but that are needed in order to build a long haul optical network. Metro edge falls in the same category. That isn’t to say that we’re never going to have a PIC in the metro it’s just to say that the particular applications that the ATN is targeted for is in fact extending the bandwidth management capabilities of the DTN towards the edge.

The second quick point that I would make is if you talked to customers that buy the DTN platform today, clearly the PIC is one of the key differentiators of the platform but the other key differentiator is in fact the bandwidth management capability. No other WDM system has built in integrated bandwidth management or switching capability. So, if you look at every other competitor in the WDM space, in order to switch traffic you need an external bandwidth manager. You need a switch of some type like the CoreDirector for example. The DTN has that functionality built in to it. So, it’s a pretty significant part of the overall value proposition and that’s really what the ATN is designed to extend all the way to the edge.

Operator

Your next question comes from Brent Bracelin – Pacific Crest Securities.

Brent Bracelin – Pacific Crest Securities

I had a follow up question on the new product side, what was the revenue contribution from metro and submarine in the quarter? Was it meaningful, what percentage of sales and how should we think about that as a driver going forward?

Duston M. Williams

Brent, we haven’t historically broken out individual pieces of the business like that. At some point in time perhaps we’ll look at the ATN piece but historically we have not done that.

Brent Bracelin – Pacific Crest Securities

Given the spike in revenue sequentially, 21% sequential, I would have thought that TAM shipments, at least billings would have been a little bit higher. What’s been the interaction so far with service providers relative to their bandwidth needs? How should we think about kind of capacity right now and the backbone?

Jagdeeb Singh

I think that TAM shipments certainly have gone up and as Duston indicated in his comments we shipped more TAMs in the third quarter than we did in the quarter prior so that’s obviously the right direction. We just think that TAMs are not where historical indications would suggest that they ought to be, if you look at it relative to TAMs per customers for example. So, there’s still obviously we expect room for more TAM shipments over time. But, having said that, there clearly was an increased uptake of TAMs in the quarter compared to the previous quarter and that we think is directly driven by increased bandwidth demands on the part of our customers.

Brent Bracelin – Pacific Crest Securities

Then my last question for you Duston on the fab consolidation, when that’s actually finally behind you would you expect a snap back to the kind of 40% plus gross margins? Can you kind of give us a little update on that relative to the gross margin profile and timing of the fab consolidation?

Duston M. Williams

Last call what we talked about there was in Q2 of 2010 by those efforts we’d expect 2%ish gross margin improvement. We didn’t correlate that to a specific margin number but we did say that we’d expect at least a 2% improvement and those efforts have been going just fine and probably maybe just a bit ahead of schedule.

Operator

Your next question is from George Notter – Jefferies & Co.

George Notter – Jefferies & Co.

I wanted to ask about the gross margin improvement sequentially. Obviously you had a lot of help from higher revenues, increased levels of TAM shipments, I know also there was some product discounts that you had expected to flow through in the June quarter I think fell in the September quarter. I guess I’m trying to understand when I look at the seven point improvement in gross margin sequentially I’d love to sort of parse that out in terms of puts and takes and how much came from volume, how much came from TAMs and give us a sense for what drove that?

Duston M. Williams

We’re not going to get in to the exact specifics there but again, you’re right we had several large deployments in Q2. We’ve got less of an impact in Q3 including the Q3 results so that helped margins. Now, we had guided to 35% to 36% so we knew we were going to see some improvements there but Q3 still has some of that impact in it quite honestly. TAMs, we mentioned about an extra 100 TAMs so that helped all things being equal by about a percentage point there. In Q3 we also had probably a little help with some customer mix that has also helped margins in to Q3. As we look in to Q4 we still have some of those one time deployments but we do expect maybe a little bit of margin improvement and that’s why we guided to 38% to 40% margins.

George Notter – Jefferies & Co.

Then anything new just on the competitive environment in terms of pricing? I mean obviously you’re getting some benefit on margins just through growth in the top line, TAM mix and so on but has anything changed competitive in terms of the pricing environment?

Jagdeeb Singh

I would say things seem pretty consistent with where they have been. Obviously the common always tends to be under more pressure than the transponders do and I don’t think there’s been any kind of a dramatic change in the competitive pricing environment that we’re aware of.

Operator

Your next question comes from Analyst for Sanjiv Wadhwani – Stifel Nicolaus.

Analyst for Sanjiv Wadhwani – Stifel Nicolaus

Just a follow up on the competitive question environment, can you guys share any thoughts on the Nortel auction process and how that might be impacting the environment in general?

Jagdeeb Singh

The question is regarding M&A and obviously we have a long standing policy of not commenting on M&A activity. Is that the question?

Analyst for Sanjiv Wadhwani – Stifel Nicolaus

It’s more is there any impact I guess from a competitive standpoint as this process is kind of evolving?

Jagdeeb Singh

Obviously as you know Ciena has been announced as the stocking horse bidder for that asset. To be quite honest we don’t really see a big difference in terms of the competitive environment or competitive dynamic regardless of where that asset resides, whether it resides with Nortel like it use to or if it resides with Ciena for example. The underlying fundamentals of the asset don’t change. The issue with the 40 gig approach has been and remains the cost structure of all the complex modulation schemes and so on. There’s really nothing that Ciena or anybody else for that matter could bring to fundamentally change that.

Now obviously the PIC does bring something to change that but nobody else in this industry has a PIC. So, our view is that relative to where that asset ends up, it doesn’t fundamentally change the competitive dynamic that we’re seeing in the marketplace.

Analyst for Sanjiv Wadhwani – Stifel Nicolaus

Then just to follow up on the two additional customers that you mentioned that came on specifically I believe for the ATN project. Did they join specifically because you had the ATN project or was more a DTN/ATN combination? Can you shed some light on exactly these two new customers were acquired?

Jagdeeb Singh

I can say that for one of those customers in fact the ATN was the driver behind the whole deal and that’s been a really significant part of the win. We’ll be talking more about that customer over time obviously as we announce it formerly. But, we’re certainly pleased by the fact that the ATN was able to not only compliment the DTN in many networks but literally be the driver for new wins in other situations like the one that I just reported to you. We haven’t announced the customers so I can’t say anymore about that but we do plan to provide more information about ATN customers.

Operator

Your next question comes from Alex Henderson – Miller Tabak & Co.

Alex Henderson – Miller Tabak & Co.

First off can you talk a little bit about the four new customers in the quarter who you displaced and who you were up against in those competitions?

Jagdeeb Singh

I think that we can say that two of the four were Telefonica and Teliasonera and we obviously are not at liberty to talk about our customers proprietary networks. Customers don’t always publicize their vendors but I can say that the displaced vendors were the usual suspects. There are handful of players that are global telecom communication equipment vendors and you can assume that those vendors were the incumbent so the large multinational optical telecom equipment players were the incumbent at those accounts.

Alex Henderson – Miller Tabak & Co.

The second question and this is more of a bookkeeping question, as I understood your guidance you said an $8 to $9 million loss at the operating line and at the net income line which would imply that you’ve got some material movement within those two line items between there, the interest/other and the tax line. I assume the tax line normalizes back to about $100,000 a quarter the way it was. Does that imply some reversion on the other gains line back to more of a breakeven type number? How do I think about that?

Duston M. Williams

No, you should think about it as interest income hovering around $500,000. It was a little less than that this quarter offset by some level of tax provision, a couple hundred thousand maybe and some other miscellaneous things that we always have running around in there to kind of net back to zero.

Alex Henderson – Miller Tabak & Co.

Can you give us any sense of what you think your headcount will do for the fourth quarter?

Duston M. Williams

It will go up to some degree but on a net basis probably not up all that much as we continue to finish up some of the fab consolidation efforts and what headcount you will see vastly dominated by R&D.

Alex Henderson – Miller Tabak & Co.

Can we go back just to the operating lines, if I’m reading the income statement correctly that’s a pretty good increase sequentially from the third quarter to the fourth quarter on operating expenses. Can you give us a little more granularity on what exactly is driving that?

Duston M. Williams

Again, what we expected was with some large development efforts that we’re doing we again thought there would be some significant NRE charges, several million in the quarter and those aren’t easy to predict. Right now, we’re pretty sure anyway that those have moved to Q4 and that’s why we’ve actually bumped the outlook up from the $37.7 to the $42 to $43 level range.

Alex Henderson – Miller Tabak & Co.

So a couple of million dollars on the R&D line from the NREs?

Duston M. Williams

At least.

Alex Henderson – Miller Tabak & Co.

And I assume that the G&A which was surprisingly low in the quarter snaps back as well?

Duston M. Williams

It probably snaps back a little bit. We had in the prior quarter some consulting things that we were working on and things like that that were a onetime pop that came back out. So, there will be some other things floating around in there so it will come up probably not exactly where it was but it will come up in the quarter.

Alex Henderson – Miller Tabak & Co.

One last question and then I’ll cede the floor, can you talk a little bit about the grooming functionality in your products? You’re talking about four streams of grooming capability in a 10 gig product but I would think as you get to a 40 gig product that you would need to significantly increase the number of streams that you’re able to groom at and particularly as we get towards the edge of the network. Again, you referenced four streams of grooming at the edge which seems awfully coarse for edge applications. Can you talk a bit about how we should reconcile those?

Jagdeeb Singh

That was just an example. I mean obviously, that system is designed to take in [inaudible] and so on in addition to OC48s so clearly that was only an example. But, you’re absolutely right the edge is going to have a finer granularity of grooming as a requirement. The point I was making simply was that you don’t get any grooming at all if you use a third party box there. The ATN is what allows you to get that to have the grooming capability. Obviously over time as we continue to add functionality, we just continue to add more and more capability on that product line including more interface types and more line rate types and so on.

Alex Henderson – Miller Tabak & Co.

But the grooming on the PICs are still four streams, correct?

Jagdeeb Singh

The grooming on the DTN is at the 2.5 gig level, that is correct. It’s not a PIC dependency it’s a switch fabric on the DTN itself.

Alex Henderson – Miller Tabak & Co.

So when you go to 40 gig it would still be 2.5 and therefore you’d have more streams of grooming?

Jagdeeb Singh

Well, we haven’t announced the details of the grooming on the 40 gig product. We’ve announced the 40 gig PIC and we’ve talked about the timeline for when we think that will be in the market but we haven’t talked about the system around that. You can assume the system that goes around the PIC will also be obviously a next generation system so it will presumably have more functionality than the DTN has today.

Operator

Your next question comes from Analyst for Mark Sue – RBC Capital Markets.

Analyst for Mark Sue – RBC Capital Markets

I was just hoping you could reiterate the timeline as to when you will be bringing that 40 gig to market? And, also potentially comment on the pricing pressure you’re seeing on the 10 gig.

Jagdeeb Singh

On the 40 gig we can reiterate what we said during the quarter in our 8K, basically what we said is that we’re on track to provide the 40 gig PIC to our internal developers this year as we promised over a year ago. Secondly, we also indicated that four our previous generation system, for the 10 gig system it took roughly a year and two years to get a PIC based system to the market after we got PICs to developers. So, using that math you can kind of extrapolate and figure if the lead time between PIC and system were the same as it was in the 10 gig case that gives you an idea of when we think you might have systems in the marketplace for 40 gig.

Analyst for Mark Sue – RBC Capital Markets

Once again, just on the pricing pressure on the 10 gig can you comment on what you’re experiencing?

Jagdeeb Singh

I think we haven’t seen any dramatic change in the pricing environment. Obviously individual deals tend to be more or less price competitive depending on the customer dynamic and the only consistent theme is that the common equipment tends to be under more pressure typically than the transponders do and that of course is built in to our whole business model where we expect lower margins on the first end commons and much higher margins on the TAMs and the transponder equipment. But, overall I wouldn’t say there’s been any meaningful change or any dramatic change in the pricing environment that we’re in.

Operator

Your next question comes from Blair King – Avondale Partners.

Blair King – Avondale Partners

Just a couple of questions, the first one would be just if you could if I recall question there was a 150 basis point or so discount that was expected to flow through in the third quarter and I’m just curious if that actually did happen? Then, a follow up to that.

Duston M. Williams

Are you talking about onetime related discounts?

Blair King – Avondale Partners

Yeah, I think there was a discount, if I recall correctly, given to a customer in the first quarter that was to flow through the second and third quarter some of which was taken last quarter and then there was a balance coming in to this quarter. Is that correct?

Duston M. Williams

That might have been where we were talking about Q1 and Q2 impacts. At any point in time we’ve got various discounts flowing through the P&L and previously what we were talking about is things got flushed through in Q1 and Q2 quicker than we thought but I can’t remember referencing anything specifically for Q3. We do have the large deployments which are lower margin com equipment that we’ve referenced several times that continue to impact the margins to some degree.

Blair King – Avondale Partners

So then maybe just a follow up there Duston would be if you look at the gross margin guide it looks like at the midpoint anyway it’s up about 2.5% on relatively flat TAM shipments. Is there any way you can kind of tell us or give us some color as to what is going on there and what we might be able to extrapolate out of that in to 2010?

Duston M. Williams

As these deployments flush through the P&L, the larger ones, we would expect margins to increase along with the TAM shipments. We still are not at the levels that we were back in 2007 and the beginning of 2008 so clearly we would expect at some point those TAM shipments to resume in 2010 which has pretty good leverage on the margin.

Blair King – Avondale Partners

A couple of other quick ones then, if on the top line I think last quarter there was some conversation around inventory acceptance and revenue falling in to the third quarter that just didn’t happen in the second quarter. Can you give us an idea of what portion of that inventory accounted for the third quarter revenue?

Duston M. Williams

We don’t give that level of detail but you’re right at any given quarter we have stuff that we’ve shipped waiting for customer acceptance. Just like the end of Q3 we had a reasonable amount of inventory that we’ve shipped that is awaiting customer acceptance. So, we have that every quarter, some quarters are bigger and some are smaller but anything that was at the end of Q2 has been flushed in Q3, anything here at the end of Q3 will be flushed in Q4.

Blair King – Avondale Partners

Just lastly on the geographic distribution you may have mentioned this but did you give a breakdown on sales between the US, Asia and Europe?

Duston M. Williams

We didn’t provide that level of detail. Europe was a fairly big piece, Asia specifically was not a big percentage this quarter.

Operator

Your next question comes from [Michael Genevieve] – Soleil Securities.

[Michael Genevieve] – Soleil Securities

Just a couple of follow ups here, when I talk to carriers especially about metro regional applications but increasingly I think in the long haul, it’s a small market today of packet optical transport but it seems more important and more what carries want going forward in terms of optical gear having layer two connection oriented switching in aggregation capabilities. I consider you guys to be sort of a pure play DWDM company, do you have a roadmap to address packet optical and layer on some of these technologies such as VLAN switching, T-MPLS and [PLSCT] and things like that. Is that something you’re looking at and do you agree with me that the market might be headed in that direction?

Jagdeeb Singh

Yes, first of all we completely agree that is very much the direction the market is likely to head down. We’ve said for a while that the whole premise behind our product is that by lowering the cost of the OEO conversion with the PICs we can take the signal from the optical photonic domain in to the electrical domain and once you are in the electrical domain you can see the bits you can start applying all of the processing power that is available in silicon and that includes not only things like low level techniques like signal processing, coating, modulation equalization to improve the quality of the signal transmission but it absolutely includes things like bandwidth management whether it’s done at the TDM level like we have today so you can switch SONET and OTN levels but also includes packet functionality.

The key point that we’ve made in the past is that if packet optical becomes a reality in the optical transport network then we believe no company is better positioned than Infinera because we have a low cost means of going from the optical domain into the electrical domain which is mandatory before you can even process packets at all. We very much think that’s a real possibility for the future of the network and we think that would be actually a good direction for the industry going along with Infinera strengths.

[Michael Genevieve] – Soleil Securities

I want to ask you about the statement you made about another internet content provider and an eight figure opportunity, a couple of things I want to parse there. First of all, when you say another if you could just remind me have you actually announced the names of any Internet content providers because if you have another would mean a different one than the ones you’ve been talking about. Second, when you say opportunity how certain of an opportunity is that, that that will actually lead to that kind of magnitude of actual purchase orders from the customer?

Jagdeeb Singh

On that later part I can clarify, when we say opportunity I actually meant win. That’s a done deal, it’s not a hope, it’s a win that we already have. To your first question, we have not announced sort of other major players in that category but we have said that we have some of the top names in the Internet content space as customers today and the key point I was making on that comment was we’ve now won another i.e. in addition to the ones we have, another major name in the Internet content space and we wanted to just quantify that by saying that it’s an eight figure deal to make it clear that it’s a significant customer and a significant win. But, we’re obviously not at liberty to disclose the name of the customer at this point. Over time, if the customer is comfortable and we’re comfortable we might do that but at this point we’re simply saying it’s another major win meaning it’s a new Internet content provider that was not a customer before and now is and it’s a sizeable win.

[Michael Genevieve] – Soleil Securities

Very quick, can you just remind us when the CEO change over happens?

Jagdeeb Singh

December 31st will be my last day on the job and Tom Fallon will take over on January 1st. Actually, that’s a good note to end the call on. I just want to thank you all for joining us today. We remain focused on being the best provider of optical transport networks and our new win momentum and financial results continue to provide evidence that our distributed solutions are resonating with customers and prospects as the industry’s best most cost effective solution. We look forward to reporting our progress on our next earnings call. Thank you.

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Source: Infinera Corp. Q3 2009 Earnings Call Transcript

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