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Executives

Thomas Fallon - Chief Executive Officer

David Welch - Co-Founder and President

Ita Brennan - Chief Financial Officer

Brad Feller - Senior Vice President of Finance

Jenifer Kirtland - Investor Relations

Analysts

George Notter - Jefferies

Scott Thompson - FBR Capital Markets

Michael Genovese - MKM Partners

Alexander Henderson - Needham & Company

Roderick Hall - JP Morgan Chase

Dmitry Netis - William Blair & Company

Subu Subrahmanyan - The Juda Group

Infinera Corporation (INFN) Q4 2013 Earnings Call January 29, 2014 5:00 PM ET

Operator

Welcome to the fourth quarter and full-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, operator. 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 first quarter of fiscal year 2014 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 release includes results for the fourth quarter and fiscal year 2013 and associated financial tables and investor information summary will be available today in 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 fourth quarter and fiscal year 2013, which exclude non-cash stock-based compensation expenses and amortization of debt discount on our convertible senior notes. 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 first quarter of fiscal year 2014. 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.

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

Thomas Fallon

Thank you. Good afternoon and thank you for joining us on our fourth quarter and full-year 2013 conference call. With me today are Chief Financial Officer, Ita Brennan; and President, Dave Welch. Also joining us is Brad Feller, our recently appointed Senior Vice President of Finance, who will become our CFO effective March 1. We welcome Brad to the Infinera team. I know he looks forward to meeting many of you in the months ahead.

I will touch briefly on Q4 and then I will review our strong performance for 2013. I will then hand the call over to Ita who will provide a more detailed review of our fourth quarter and full-year financial results and our outlook for the first quarter of 2014.

Our fourth quarter revenue was $139 million, at the high end of our guidance range and a 9% increase over last year's fourth quarter. Gross margin met our expectations at 41% and we generated positive free cash flow in the quarter and for the year. I am also pleased to say, we had another record quarter for our 100-gig port shipments. We added three new DTN-X customer commitments in the quarter, including one customer that is new to Infinera.

As we look to back, it is easy to forget how much we accomplished in 2013. Let me take you back to December 2012 when we hosted many of you at our analyst day. The DTN-X platform had only recently started to ship and it remained to be seen whether Infinera would be successful in achieving the financial goals provided at that meeting. I am pleased to report that for 2013, we successfully met or exceeded each of the targets set that day.

We said we would grow revenues at somewhere between the expected market growth rate for long-haul DWDM of 10% and two times that rate. Analysts now believe that this market is estimated to have grown 12% at the high-end of 2013. Our revenues grew 24% in the same period, at least double the estimated market growth. On profitability, we had targeted expanded gross margins for the year and made a commitment to disciplined expense control driving to improved profitability.

Gross margin expanded to 41% compared to our target of 38% to 40% while operating expenses increased 5% for the year, significantly less than our top line growth. The analyst day targets were expected to result in positive EBITDA and cash flow metrics for the second half of 2013. Our results have exceeded those expectations generating $4 million of net income and $12 million of free cash flow for the full year. There were also multiple, significant operating accomplishments during the year.

We ended 2013 with a total of 42 customer commitments for the DTN-X in just six quarters since its market entry. Of these, 15 represented new customers for Infinera, illustrating our market expansion and the displacement of competitors. We saw a number of existing customers expand their capacity with the DTN-X and we recovered market share in accounts where we previously lost business due to our lack of a sufficiently scalable 40-gig solution.

We also continued to see new ATN and DTN deployments as customers leveraged the full Infinera product portfolio to best meet their needs. We achieved the number one position in our 100-gig port shipments excluding China, confirming that we are taking share in this high growth market. According to the most recent long-haul revenue market share reports from Dell'Oro, we have a solid command of the number two spot in North America and in Q3 we displaced Alcatel-Lucent to become number three worldwide. Based on a rolling four quarters of revenue, [indiscernible] declared us a worldwide top ten optical technology provider for the first time in the company's history. We expect that we will continue to climb this leader board.

2013 was a year of innovation for Infinera's intelligent transport network solution. We have successfully taken advantage of this network architecture to accelerate significant architectural changes in the way providers build networks. We believe these technology innovations continue to demonstrate industry-leading optical scale and performance, convergence without compromise for increased efficiency, and intelligent automation that allows customers to use time as a weapon while simultaneously lowering operational costs.

In 2013 we began shipping SD FEC, further bolstering our optical performance and expanding our addressable market. We have shipped 100-gig SD FEC enabled ports in volumes to multiple customers. We have deployed our SD FEC super-channels on links over 9000 kilometers, demonstrating that we perform on some of the longest cables around the globe. And we have demonstrated world record P&D performance, allowing us to deploy 100-gig on poor quality fiber in markets where even 10-gig was a challenge.

We continue to lead the industry as the only company with super-channels in production. While our competitors continued to trial Metro reach super-channels composed of multiple cards, Infinera has deployed single card long reach super-channels in production across the globe. We are approaching 1 petabit per second of deployed production capacity and we believe that this commanding lead rests squarely on the competitive advantage provided by our PIC technology.

We ramped the deployment of instant bandwidth in 2013 and have a significant portion of our customers using this feature. Only Infinera with our PIC based super-channels, is able to provide 500-gig of service ready bandwidth that can be activated in 100-gig slices with one-click operation. Instant bandwidth helps align our business with our customers allowing them to build success based business while delivering services faster and using time as a weapon.

We unveiled our FastSMP technology, the industry's only hardware accelerated, shared mesh protection solution that enables network recovery from multiple fiber cuts. FastSMP is a key proof point of the intelligent transport network and offers a new approach in network resiliency that can compete with more expensive approaches previously performed at the router layer.

We also completed a successful demonstration of our packet technology and presented this to multiple customers in a week-long event in Japan, showcasing our ability to bring new switching capabilities into the converged DTN-X platform. We delivered working PIC model prototypes to system engineering in Q4 that will be used in the future network system and through other applications. While this is a key milestone, the PIC is only one of many steps to be accomplished in developing a differentiated Metro solution.

Finally, we made progress in the development of features to enable SDN-ready networks. We completed a successful demonstration with Brocade in our mutual customer ESnet, showing how SDN can leverage an intelligent transport network to support multilayer provisioning and router bypass. While the SDN market develops, we are managing our investments carefully but making significant progress in terms of defining and validating a solution with carrier customers. We intend to discuss additional details of our SDN strategy later in 2014.

Turning now to a market update. 100-gig has become the standard in long-haul optical transport and we believe we are still in early parts of a long investment technology upgrade cycle. Looking forward, there is a broad range of expectations about the growth of the long-haul DWDM market in 2014. After considering input of several industry analysts, our view is the market will grow approximately 8% for long-haul across 10, 40 and 100-gig, with the 100-gig driving all of the growth.

As I stated on our third quarter conference call, we remain confident about the intermediate term visibility of our business and our ability to grow at least as fast as the market. We are beginning to see this play out and you will hear when Ita provides our Q1 outlook.

OTN adoption remains strong. A survey by Infonetics showed that 86% of customers plan to deploy OTN and of those 94% prefer a converged solution for the core. Similarly, Dell'Oro says in their latest forecast report that they expect all of the total DWDM market growth to be with optical packet transport systems that integrate a centralized cross-connect, which is an OTN switch, with transmission. Infinera is at the forefront of this architectural shift and we not only see Tier 1 carriers deploying this converged solution, but also wholesalers, internet content providers and cable operators.

The competitive landscape changed substantially in 2013. The Chinese vendors were put in a box, while they still had a significant presence, they are no longer a significant disruptive factor in many developing markets and they are experiencing headwinds in some emerging economies. Large multinationals burdened with legacy technology and slow to innovate, are losing money or exiting the business. Market share gains are going to the best of breed innovators with the 100-gig and converged OTN switching capabilities. We believe this trend will continue and this over-served market will continue to consolidate with innovators who develop the best solutions coming out on top.

Our competitive position, delivering the industry's best technology, reinforces my confidence that Infinera will grow at or faster in the market in 2014. From a geographical perspective in 2013, we have seen increasingly strong traction in Asia Pacific. An area where Infinera has had a relatively small presence prior to the DTN-X. We announced wins in Australia, Hong Kong, Japan, New Zealand and South Korea. Just this month we announced two additional APAC wins. The first is for an extensive network with Telstra Global, who will be deploying our super-channel technology across multiple submarine routes in Asia.

We also announced a multiple route system with AJC, a subsea consortium of NTT, Verizon, AT&T, Softbank and Telstra, when we beat out the incumbent vendor. Revenues in APAC more than doubled year-over-year.

Turning to EMEA. We have continued to displace incumbent vendors in Western Europe, including those in the wholesale and tier 1 markets. We have announced DTN-X wins with TeliaSonera International, Belgacom International Carrier, Interoute, Deutsche Telecom, and DANTE. We have also entered new markets with an announced win with Rostelecom, Russia's largest service provider, and our first win in South Africa. EMEA revenues increased 29% year-over-year.

In North America we experienced significant DTN-X traction including much expanded buildouts with CenturyLink, MSOs, internet content providers and tier 2s. We also recently had a significant win a major domestic wholesaler who has been a long term customer of ours and we expect to see healthy growth with our North America wholesale customers. North America revenues increased 16% year-over-year.

Shifting to verticals. We continued to see strong progress in tier 1 penetration. We now have 15 tier 1 domestic and international customers, and our total 2013 tier 1 revenues increased by 43% over 2012. The DTN-X has clearly enabled us to penetrate this portion of the optical transport market. And an update on Verizon. We do not currently expect an opportunity for their recent RFP and we are resolute in our belief that our technology and solution is the best of class and we continue to engage with them for future opportunity. This is the only commentary I will be making about this situation. As Ita will discuss, this does not change our views on our growth prospects and financial outlook for 2014.

In 2014 we believe that we will continue to add tier 1s to our customer list and that the percentage of our revenues from tier 1 customers will continue to grow year-over-year. In addition to tier 1 expansion, we are also seeing rapid bandwidth growth in business opportunities in the other markets we serve. Over the past few years, we have seen internet content providers and MSOs build and expand their own long-haul optical backbones and we expect this trend to continue.

Infinera is extremely well positioned in these markets with significant deployments at four of the top five MSOs, and three of the four top internet content providers. You are also seeing wholesalers to continue to expand their networks internationally, both terrestrial and subsea, to compete on a global basis. We believe Infinera is well positioned across all of these growing markets, providing a broad base of customers from which to grow in 2014 and beyond.

In summary, we had a great 2013 that was marked by strong execution across the board. We are serving a growing market with the 100-gig deployments not anticipated to peak in the market until 2018 or beyond. We believe we are very well positioned to continue our growth while remaining focused on enhanced profitability. Our focus in 2014 remains on winning footprint, gaining share and taking care of customers. We will pursue these efforts with a strong eye towards driving increased profitability and I am increasingly optimistic about our short, intermediate and long-term opportunity.

Before I turn the call over to Ita, I would like to personally thank the Infinera employees for the outstanding dedication and hard work that led to our achievements in 2013. I would also like to thank our customers for their strong support. Now I will turn the call over to Ita for a more detailed financial review of the quarter and the year and the guidance for Q1.

Ita Brennan

Thanks, Tom, and good afternoon. This analysis of our Q4 results and our guidance for Q1 '14 is based on non-GAAP. All references exclude non-cash stock-based compensation expenses and the amortization of non-cash debt discount amounts related to our convertible notes.

Total GAAP revenues in Q4 were $139 million, at the upper end of our guidance of $130 million to $140 million. This strong revenue performance is primarily related to the completion of a number of SD FEC subsea deployments in the fourth quarter that were not fully anticipated in our guidance. We recognized DTN-X revenue from 6 additional customers this quarter, 3 of which were new invoice customers to Infinera.

In addition, we also added 2 new ATN customers, taking our total invoice customer roster to 131. Note that starting in 2014, we will no longer report DTN-X customer commitments but instead we will revert back to reporting DTN-X invoice customers in line with our normal process. We had 1 greater than 10% customer in the quarter, an international tier 1 account who is also a new customer. Our top 5 customers also included a bandwidth wholesaler, a domestic tier 1, a cable MSO customer and an internet content provider, demonstrating good diversification across all of our markets.

International revenues totaled $64 million or 46% of total revenues, reflecting a particularly strong quarter in EMEA and APAC with the completion of key projects in these regions. EMEA accounted for $48 million or 34%, with APAC and the other Americas representing 9% 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.

Services revenue for the quarter were $24 million, up from $21 million in Q3, with gross margins at 59%, down from 69% in the prior quarter. We experienced an increased level of international deployment activity in Q4, however we expect deployment revenues in Q1 to return to more normalized levels.

Overall gross margin in Q4 was 41%, in line with our guidance of approximately 40%. Our product mix in the quarter reflected a significant amount of common equipment as we continued to win and deploy new network footprints. Operating expenses for the quarter came in at $56 million, slightly above our guidance which called for operating expenses of approximately $55 million. This increase is largely related to increased variable compensation associated with the higher revenue performance.

Overall headcount for the quarter was 1,318 versus 1,296 in Q3. The increase in headcount primarily reflects software related additions in R&D and some success-based headcount adds -- sales headcount adds. Our operating income for the quarter was $1.1 million. Non-GAAP other expense for the quarter was $0.9 million, which included $0.8 million of interest expense associated with our convertible debt. Net loss for the quarter was $0.2 million, or breakeven on a diluted earnings per share basis and at the upper end of our guidance which called for an EPS range of breakeven to a $0.04 loss.

Now turning to the balance sheet. Cash, cash equivalents, restricted cash and investments ended the quarter at $365 million. Excluding the proceeds of our debt offering of $145 million, this equates to a net cash balance of $220 million, up from $201 million in Q3. We generated $25.8 million of cash from operations in the December quarter and $35.2 million for the year. DSOs came in at 66 days, up from 56 in Q3. This increase is primarily related to the timing of completion of a number of key projects in Q4.

Inventory turns were 2.6 times, up from 2.3 times in Q3. Accounts payable days were 36 days, up from 29 days in Q3 Capital expenditures were $7.5 million for the quarter and $21 million for the year. This is consistent with our previous guidance for capital expenditures of approximately $21 million for the year and our target for CapEx at approximately 5% of revenue. Looking at overall cash performance for the year, we generated $12 million of free cash flow, exclusive of all proceeds from financing activities. This is in line with our commitment to exit the year having increased the cash resources while continuing to invest in new technologies and capabilities.

Now turning to our outlook for the first quarter and beyond. We are pleased with our financial performance in 2013 and the progress that is represented. As we look to 2014, we remain focused on leveraging DTN-X and 100-gig momentum to further increase our market share and as Tom mentioned in his remarks, to grow revenues at or faster than the market.

Q1 is typically a down quarter for the industry, the customers taking time to finalize their budgets and spending plans. However, this year we are seeing increased urgencies in customers to complete deployments in Q1 and order gear to enable Q2 network turn up. With this in mind, we expect our revenues for the first quarter to range from $137 million to $143 million. As regards to gross margin in 2014, we expect gross margin for the year to remain in the low 40s. In a period when we expect to deploy significant amounts of new footprint while winning new strategic accounts and expanding our share in existing accounts.

We believe further gross margin expansion towards our mid-term target of 45% when our current customers begin to consistently add higher margin sales to previously deployed DTN-X networks. We have now completed our operating plan for 2014 and reaffirm our commitment to increase operating expenses at a lower rate than revenue growth to support ongoing profitability and help drive towards our midterm business model.

In summary, our guidance for Q1, which is based on non-GAAP results and excludes any non-cash stock-based compensation expenses and the amortization of non-cash debt discount amounts is as follows. Revenues of approximately $137 million to $143 million; gross margin of approximately 40%; operating expenses of approximately $56 million; operating income of approximately $1 million income to $1 million loss; net income of breakeven to approximately $2 million loss. Based on estimated average weighted diluted shares outstanding of $125 million, this would lead to an EPS range of breakeven to $0.02 loss. Please note that the basic share count is expected to be 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 is going to come from George Notter with Jefferies. Your line is now open.

George Notter - Jefferies

I guess I want to know if anything has really changed in terms of your visibility looking forward. You made a number of comments, I think, in the monologue about optimism around the short, intermediate and long-term. I think if I go back to last quarter you made comments about confidence in the intermediate term. I guess I am just trying to figure out if anything has really changed here in terms of your visibility and the outlook at all and if you could kind of walk us through that, that would be great. Thanks.

Thomas Fallon

Sure. The big change is, George, last time I was feeling comfortable with the intermediate term and now I remain comfortable with the short, intermediate and long term. And quite frankly the intermediate term, we have said was kind of a two to four quarter outlook, we went out [ph] eaten into that window. What we had anticipated is actually coming to fruition. The conversations that we had with our customers late in the year have turned into build plans and POs. And we feel two things, I think comfortable certainly with Q1. As Ita said, our industry is typically down about 18% quarter-on-quarter to Q1 over Q4. So we are actually guiding to an up quarter in Q1 and that’s pretty unusual for us and the industry.

And this has, I don’t think it's a one quarter play. I see fundamental demand from a number of our customers that I feel very comfortable about the first half of the year. And I also feel about the longer term. I still believe as I stated in the call, this is a multiyear upgrade in technology cycle. I think reports I have recently read said, it continues to grow at least through 2018, and I suspect that’s a little conservative. We also have a very robust pipeline of new products that I feel good about.

So I am overall pretty comfortable and confident with where we sit both from an industry perspective and our position within that industry.

George Notter - Jefferies

Got you. And then the other one I wanted to ask was just on, your development on PIC chips. You said something in the monologue that I think I missed. Could you just repeat what you said? Perhaps it was development of 1 terabit chip or a Metro chip, I cannot remember.

Thomas Fallon

Yes. And if you remember at the beginning of last year we stated we would -- one of our deliverables would be a PIC that was designated for specific use within a metro platform, not just a metro platform but would be used in our metro platform. Would be delivered full working prototypes or pilot units will be delivered to system engineering by Q4. And it was a reflection that we did indeed do that. We also reflected, and I think this is important, it is one major milestone but it's only a major milestone and a series of major milestones on our way for us to deliver a differentiated, high-capacity metro solution. So don’t over read and estimate when we will have a metro product out there. We will make product announcements at the appropriate time but we continue to make progress on a lot of technology fronts and that’s an important one for us.

George Notter - Jefferies

Got you. And then can you remind us where you guys are in terms of 1 terabit capability on the PIC side?

Thomas Fallon

We have demonstrated it. We have not made any further announcements in regard to that. And I think that certainly the PIC has the capabilities of going 1 terabit, 2 terabit, probably more than that. We believe that it is uniquely capable of doing that in an economic fashion. And we will bring that to market when we think that it is appropriate for the market at the time. Coming to market I think, we still get some people saying 500-gig on a LAN card is too much, which is funny. We will bring that to market when we think it's the right time to bring that to market and it's the appropriate priority for our R&D dollars.

Operator

Our next question will come from Simona Jankowski with Goldman Sachs. Your line is now open. Our next question will come from Daniel Martins with FBR. Your line is now open.

Scott Thompson - FBR Capital Markets

This is actually Scott Thompson. I dialed in remotely. I wanted to ask you a question about the metro opportunity. I am starting to hear a little bit of chatter on the industry edges about a lot of traffic staying in the metro and how that may impact the longer haul 100-gig. Can you guys help set our expectations on what they expect around metro, I guess, not only in the first half but more in the second half and how it might impact the long haul. Thanks.

David Welch

Yes. I will try and answer that. This is David Welch. In a couple of areas on what the market directions are and then how we plan to address that. There is a couple of questions in there. First question is, when does the metro market, is it ready for 100-gig deployment in volume. We think that that is something that’s probably closer into the late '15, '16 type of timeframe, when 100-gig becomes a dominant player in the metro space. So as people -- there has always been historically a variation of cashing if you will, or content, stays in the metro or it gets moved around the long-haul. We don’t see any real change in strategies there. The only difference between now and the older networks is you do have an overlay of large nationwide networks of data centers to deal with and integrate.

The volume on the long-haul market from all of our customers continues to grow consistent with what they have told us in the years past. And we have seen a slowdown in the volume of data in the long-haul. For Infinera's play in the metro, we do supply our current product for high capacity metros and we are deployed in high capacity metros today. What we will continue to do is build out our capabilities in our feature set in order to impact that, and we should be in a good position to impact that as 100-gig becomes a strong player within the metro space. 100-gig will be a significant player in the metro space in the late '15 beginning '16 type of timeframe.

Operator

Our next question will come from Mike Genovese with MKM Partners. Your line is now open.

Michael Genovese - MKM Partners

Your 1Q guidance is up 12% year-over-year at the midpoint. Does that seem like a good target or is there reasons to think as it moves through the year that that would accelerate or decelerate.

Ita Brennan

Yes. Obviously, Mike, we have guided Q1 and then put some guard rails around what we think for the year, right. I think what we have seen for Q1 this year is obviously a little different from what we have seen historically. We have got pretty good visibility from customers into what they plan to do certainly in the first half of the year. And people are certainly laying out plans around the 100-gig and 100-gig deployments. I think that’s a vastly better place than where we passed there at this time last year in terms of just visibility to what was happening. You know in terms of what happens through the rest of the year, we are at this point not kind of laying out a quarterly view of that.

Michael Genovese - MKM Partners

All right.

Thomas Fallon

We want to say, if I looked at what I see in our space, any number of people that we compete with in some way, shape or form, missed their number for Q4 and reflected that they are going to have a tougher Q1. I am personally pretty optimistic about the robust demand that we see both for Q4 that was a good quarter, a very good quarter, and for Q1 which I think having an up quarter off of Q4s, outstanding.

Michael Genovese - MKM Partners

Yes. And I want to congratulate on a good year and a good 1Q outlook. On the gross margins, you guys gave us some full year information, saying remaining in the low 40s. Do you think that -- so you came in at about 41% this year, do you think that we can be up year-over-year? And then beyond that question, how long can this process of filling channel card take? And should we think about gross margins being significantly better in 2015 or could it be 2016 before we see something like that?

Ita Brennan

Yes. I think we have been pretty consistent in saying that for 2014 the most important metrics is still around growing share, taking footprints, right. And that’s why we are kind of sticking to our view that margins for '14 will be in the low 40s as we move through that, right. We are starting to see fill into some of the earlier DTN-X networks that we deployed and we are seeing customers coming back and adding capacity into those networks. So I would expect that you will see that kind of expansion of gross margin as you move through, into '15 and you start to balance out that mix. I mean if we think about to Q3 and the margin expansion that we saw there with some product mix shifts. So clearly that does drive the gross margin. It's more a matter of when are you going to be shifting from footprint wins to adding capacity into those networks.

Thomas Fallon

And I would reiterate, the most important thing for us to do right now is gain footprint, win customers and grow our market share. Every platform, every network that we want to franchise on, we will have the opportunity to fill that network for a decade. It's a great opportunity for us to be able to take advantage of this growing market, our leadership in the market. And to be able to do that with very very low margin, common equipment and still maintain in the 40s, I am pretty delighted with that. And quite frankly, if margin goes up a lot more than that, it's probably because we are not winning enough footprint.

Michael Genovese - MKM Partners

Right. Final clarification, quickly. Do you classify Rostelecom as a tier 1 carrier?

Thomas Fallon

Yes, we do. We are deployed in the regulated portion of their business in Moscow. So that is -- we kind of view it as a, is it a regulated business, a PTT, and that qualifies within that, yes.

Operator

Our next question will come from Alex Henderson with Needham & Company.

Alexander Henderson - Needham & Company

I wanted to follow up on Mike's good question there on the gross margins, just to pin down the mechanics here. Just to be clear, the continuation of the low 40s gross margin is not a function of a change in pricing conditions or of increased competition or alternation of pricing dynamics but rather it's strictly a function of the mix of customers' installations. Is that correct?

Thomas Fallon

Yes. Mostly mix not of customers but a mix of product. Now we sell kind of three products. We sell an optical amplification layer. Now that carries very very low margin. And we sell commons that includes sheet metal and some common equipment that carries fairly low margin. And we sell the fill, which carries good margin. So really it's a matter of product mix. When you win a new customer, when you build a new network, you are putting an optical infrastructure that will last for the lifetime of the fill of that fiber. That’s an expensive proposition but you get the opportunity to reap the benefit of that for a very long time. And we are in a position where [indiscernible] 40 plus points of margin. We are creating cash, growing market share. I am pretty happy with that position and I am going to be willing to grow market share under those conditions for us as fast and as long as we can.

Ita Brennan

Yes. And I think Alex, if you look at the pricing data that’s coming out of the industry analysts, some of them, it's pretty much what you would expect to see, right. I mean it's in that 15% plus or minus decline. We anticipate those in our plan and we need to drive cost reductions that offset those. That’s not new for this business. So that’s all kind of build into that view f the world from a gross margin perspective.

Alexander Henderson - Needham & Company

Part of the reason why I asked the question in that format is that the, obviously the events that were widely discussed over the last month or so relative to tier 1 in the U.S. combined with announcement of a win at TeliaSonera [ph] by a competitor that we would not have considered competitive with you guys, does raise the question if there is some desperation pricing going on out there or any type of discontinuity or disenfranchisement that might alter the pricing environment. So you haven't seen any of that?

Thomas Fallon

I think in aggregate the pricing environment is pretty normalized. We are probably seeing, as Ita mentioned, about 15% reduction. Having said that, on any given day with any given customer, it could be critically important to a supplier to not lose that opportunity, you know the difference with must win and can't lose. And I think it's the can't lose customer you will see behaviors that are at times, I think, irrational. We see some of that without question. We try to act rationally in all of our transactions. Though I am suspecting we would be accused of acting irrationally also. But I think that it is a fairly normalized environment. I think the competitive landscape is getting better not worse in general. I think there are a clear differentiation between innovators, commoditizers and those that are trying to, quite frankly, stay in business. And I feel very comfortable with our position of both for winning market share and building a healthy profitable business over time.

Alexander Henderson - Needham & Company

Okay. One last question and then I will cede the floor. The comment about urgency from your customers and urgency on installation, is that indication of an acceleration in RFP activity, RFI activity or is just a symptom of a couple of your specific customers? Is that a broader phenomena?

Ita Brennan

No, I think it's across both of those, right. We are definitely seeing RFI activities with accounts that we don’t do business with yet and also with our own customers. You know laying out plans that are more comprehensive because obviously this is a significant upgrade cycle for them.

Operator

Our next question will come from Rod Hall with JPMC. Your line is now open.

Roderick Hall - JP Morgan Chase

I just wanted to -- thanks for the questions by the way, I just wanted to ask you, I guess a specific and general question on the [indiscernible] speculation about the tier 1 deal. And I guess the first question is more broad, though and that is, we as analyst we always tend to look for keys under the street light in the night but there's a lot of other places we could be looking for the keys. And because we've got the deal we've all been focused on so much, there's been a lot happening in optical around the world really, not just in the U.S. I just wonder if you could comment on how material that deal is or isn't to the overall picture as you see it now. I know that back when we started talking about it, maybe it might have looked more material than it does now. I just wondered how things have moved on and how it looks opposed against the rest of your business opportunities and then I have a follow-up to that.

Thomas Fallon

Well, I am not going to talk about the specific deal. We signed a non-disclosure agreement that says we won't discuss that deal for a long period of time. I am going to talk about what I consider important macros in the world. I have long said that where the industry continues to move from a capacity perspective, who is building the biggest networks, who is putting in the most capacity, the buck has moved. Today it is the internet content providers, it's the wholesalers, cable people are putting in gigantic amounts of capacity. And we are extraordinarily well positioned in those spaces that are grow extraordinarily quickly. That’s not to state that the tier 1 market isn't relevant to us. It is relevant to us. And as I stated on the call, we are up to having 15 tier one customers. Some of those are relatively large size, some of those are relatively young and have the opportunity to grow.

We are going to continue to go after every place in the market but I don’t believe that our success hinges on any one or two customers. The market is growing rapidly. The 100-gig market is growing extraordinarily rapidly. We are exceptionally well positioned in that and it's going to be, I think, in a very long, healthy cycle. And we are going to grow where that customer base values our simplicity, our quality, our ease of use, our time as a weapon, all the attributes that we bring to that market. And we are going to go after everybody, we are going to win some, we are going to win a lot and we are going to lose a few. And I feel very comfortable about our outlook.

Roderick Hall - JP Morgan Chase

Can I just follow up on one comment you made there, Tom. You say you have a NDA, that makes sense. Are you NDAd indefinitely or if you lose the deal, can you not talk about it still, or can you talk about it once it's over? Just to understand exactly how that falls [ph]?

Thomas Fallon

For three years, I believe is the term, and I am going to honor that NDA.

Roderick Hall - JP Morgan Chase

Okay. Okay. Just one more question and then I will cede the floor. Can you talk a little bit about what's going on in international distribution. I know that was a topic of conversation last quarter. Give us an update on where you are at with that. Maybe, I don’t know if you said anything earlier about the regional split of the new customers, can you give us any idea with that looks like?

Thomas Fallon

In Q4 I think our overall international business was 46%. So we are continuing to grow our international presence. And we are doing that both with a direct approach but we are also using a channel partner strategy, so with our channel strategy. We have had a couple of channel relationships, partners this last year that have made really, really great progress. We have announced a number of key wins that we won with these channel partners. Channels represented about 8% of our revenue last year and 12% in Q4. We are going to continue to use these partners to go into places of the world that on our own we either don’t have yet the relationships or there is too much a necessity of having a local presence. And we are going to find the best partners in the world. We are going to go and use them to sell our product. We have got, I guess, some very good relationships, so we started this initiative a couple of years ago and I think that it's really beginning to bear fruit and we anticipate continuing this channel program, investing more in it and growing it over time.

Operator

Our next question will come from Dmitry Netis with William Blair & Company. Your line is now open.

Dmitry Netis - William Blair & Company

So hate to take the dust off of last quarter's record but if you could just tell us how much of the slippage last quarter is causing this tough side in Q1 outlook.

Thomas Fallon

Well, I am going to take issue with what you call slippage. We very specifically try to guide for the quarter with the opportunity that we see. We said very clearly on the call last time that we saw probably no end of the year budget flush. I think we were correct in comparison to what a lot of people in the industry saw. So I would not consider it slippage, I consider it Q4 was Q4, Q1 in the first half of this year or Q1 in the first half of this year.

Dmitry Netis - William Blair & Company

Okay. I saw that you had some billing acceptance issues on a couple of purchase orders which didn’t come in, I think for which you said you would expect to see in Q1?

Ita Brennan

No, I think our commentary, if we kind of go back to that, was more given the spending levels that we had seen through the year, we didn’t think that it was necessary to go on a big budget left on table that would cause a budget flush. And the follow on to that had been, you know we thought people were very interested in getting builds in place right out of the shoot of the beginning of '14. That’s pretty much what we had seen. It's a bit of an academic argument to try to parse it apart the way you are. I think really what we are seeing is people have upped their budgets, they have upped their budgets fairly quickly for a Q1 and they are starting to spend money.

Thomas Fallon

What Ita did make a comment on and maybe this is what you are referencing, the midpoint of our guidance last quarter was 135, we came in at 139. And she said that the overhead was a little bit because some deals that we didn’t know if they would close in Q4, actually did close in Q4. Customers gave us acceptance of those networks because they won't determine live, which I think is great news.

Dmitry Netis - William Blair & Company

Very good. I appreciate that color. I think that’s exactly what I was referring to. But it's good to see intrinsic growth from existing and new customers transpiring here in the first half.

Thomas Fallon

I agree. There is nothing like our customers' customers demanding more internet capacity.

Dmitry Netis - William Blair & Company

Great. And then the second question also on the, kind of GO splits, and I know we have talked quite a bit on that already. But clearly you are seeing a good traction in EMEA, APAC. You have noted last quarter I believe as well, that you see a lot more opportunity in North America over the next 12 months. And so now excluding this tier 1, what's left in North America? Are we still -- are there pockets of opportunities you think you will win? I mean if you give us an update on North America specially, given that December quarter was a little weak in terms of your sales in that region.

Thomas Fallon

I won't go to the, it was weak in Q4, but I will talk about how it's going to be moving forward. CenturyLink, as we said, has had a very strong quarter with us. I anticipate we are going to have lot of opportunity with CenturyLink moving forward. I stated and I am surprised nobody has asked questions on it, that we won a significant North America wholesaler in Q1 that’s been a long term customer. I think that’s going to drive a significant portion of business moving forward. I said we had four of the top cable providers, that certainly leads number one of them to go get, and we are going to go after that. I said we had three of the top four internet content providers, that leaves one of those to go after.

So if you don’t think we are hungry, you don’t know us. We are going to after all of them. We are going to grow our business. We are going to win market share and we are going to take advantage of our position in this market.

Dmitry Netis - William Blair & Company

Okay. And then on Level 3, I mean that’s been always your marquee customer over a number of years. Is that a 2014 opportunity? I think it was going to be decided in terms of 100G play there in the first half.

Thomas Fallon

I would replay what I just told you, which is we won a large North America wholesaler who has been a long-term customer of ours.

Dmitry Netis - William Blair & Company

Okay. Very well, thank you for that. And then just maybe last thing on the submarine deals you guys were winning. Are these competitive bids that you are taking share from someone else? And who exactly are you taking share from in those submarine Asia Pac deals?

Thomas Fallon

Yes. The submarine market is extraordinarily competitive now. Not everybody can play because there is a technology limitation and you have to have cutting edge technology, but they are hyper-competitive. And each one of those we won, it was won, highly competed for, and one in particular we said we displaced an incumbent. So assume every time we win a submarine deal, it's because we won it. Both from a technology perspective, a value perspective, which includes price, service and support perspective, the whole deal. And I think that we are going to have a lot of opportunity in submarine moving forward. Our SD FEC is a huge gap closure in a performance issue that we did have and we don’t have that anymore.

Operator

Our next question will come from Subu Subrahmanyan with Juda Group. Your line is now open.

Subu Subrahmanyan - The Juda Group

Tom, I wanted to ask again about the trajectory you saw existing fourth quarter, some business actually getting pulled in, and then first quarter being stronger than normal. When you look at it, is there any particular trend line to it, geographically, customer type wise. And when you look at it, how much of this is just timing of a couple of deals versus something more fundamental happening the way you see it.

Thomas Fallon

Well, first I want to clarify, we did not pull business into Q4. We had some very, very big and complicated submarine deals in Q4. And in submarine deals you have to install it, you have to turn it over, and they have got to run traffic on it until they accept it. And the acceptance was always going to be borderline, kind of Q4-Q1. And to our great pleasure, the installs went well. The acceptance went well and they wanted to turn it on, our customers wanted to turn their network on and start carrying live revenue revenue generating traffic. That’s why we were at the very high-end of our guide. I wouldn’t consider it pulling it in, I would say that things lined up well. And usually if you have ten things that can happen and not all of them do, you know most of them happened this time.

In Q1, I am going to ask Ita to give more flavor on where it's coming from. But we are seeing fairly strong demand across the board but I would say a little distributed towards North America in Q1.

Ita Brennan

But again it's a combination of customers, existing customers, just kind of truing up for their deployment for '14, and then there is also some new customers in there as well that were starting to ramp some volume with, right. That we would see kind of ramp as we move into the year.

Subu Subrahmanyan - The Juda Group

Sure. Then I had a follow-up, on the 100-gig builds in general, are you seeing the broadening in North America, do you expect international to be a bigger percentage of revenue in 2014? And is that part of what's impacting gross margin as you think about it?

Thomas Fallon

I don’t think international -- I mean in Q4 it was 46%. I think that’s at the very high end of my guess. I would believe that over time a healthy mix of international is probably 40% to 45%, in that range. And I think that I would be comfortable with that expectation. But that means we have to grow, continue to grow our international business but we will grow North America best.

Ita Brennan

Yes. And in terms of the gross margins part of that, Subu, I mean by far a bigger driver is going to be product mix etcetera than it is actually between the different geographies.

Operator

(Operator Instructions) We will take another question from Daniel Martins with FBR. Your line is now open.

Scott Thompson - FBR Capital Markets

Hi, guys, Scott circling back. A couple of quick ideas here. One is, you talked about having three of the four top content service providers. What do you expect of those guys this year? I mean they seem to be growing CapEx investment, network investment at a pretty brisk pace. Are they sneaking up on some of the larger tier 2, tier 1 players at this point as a group, or will it take another year or two before they get there. Secondly, the seasonality and the early, maybe early start to optical deployments in '14. Do you think that’s more of an industry thing or is it more of a, it's your specific thing? Thank you.

Thomas Fallon

Well, with regard to internet content providers, I don’t know how their networking CapEx spend compares to tier 1s and tier 2s. I can tell you that they are building big networks, they are building big long-haul networks, they are building big metro networks. I see, when I talk to them, no slowdown in the growth of internet traffic that they are experiencing. I continue to see them being very committed for making sure that they have the capacity necessary to growth their businesses. So I think that how it compares to other tiers of industry, I don’t know. All I know is it's a very healthy business. It's a growing business and we are well positioned.

In regard to seasonality, once again I can't -- we are peer play, optical DWDM company. I can't talk to how various companies CapEx are going in various. As far as my view on CapEx, here is want I think about CapEx. I think that one, the CapEx they spend with us is going to grow. Two, the CapEx they spend on legacy technologies is going to shrink. How that balances out on overall CapEx, I don’t know, but there is no fundamental slowdown in the capacity that I see our customers wanting to put in place in the short and medium term.

Scott Thompson - FBR Capital Markets

Okay. And then as a follow-up to that. You mentioned in your comments early in the call about some stabilization around competition and things that might be stabilizing factors for margins. Can you expand on that a little bit and when we might be able to see potentially a bit of relief in gross margins, anything there?

Thomas Fallon

Well, as Ita pointed out, I mean the relief in gross margins mostly comes as we start getting more fill than we get new footprint. And I hope that that balance doesn’t happen for a while. I like the balance we are at right now where we are winning lots and lots of footprint with reasonable amounts of fill so that we are creating the opportunity for an annuity that is margin rich. I think that what I see in the market, I mean clearly, Nokia, Siemens went away, [indiscernible] I applaud those guys courage into both trying to build this into an independent enterprise. I think that they have got a lot of work cut out for them. And I am not a believer that private equity companies are going to go into this, because they just lose a lot of money upfront getting a lot of footprint so we could make money later. Maybe I am naïve but that’s my view. I think that [indiscernible] quite frankly, is doing well and I think that they have a good technology. I continue to believe that it's going to be more a two vendor world then the eight or nine vendor world it's been. And I think we are well positioned as a [indiscernible] to be the leaders in that market. I think that some of the large multinationals, you could only so much money in this business for so long before you have to take a step back and say what are we going to do differently. And I see that occurring and playing out over the next year. So I feel very comfortable that the industry while still over competitive, is in a beginning phases of getting better.

Operator

And I am showing we have no further questions.

Thomas Fallon

Well, thank you for joining us this afternoon and for your questions. I would like to thank Ita for her many contributions to the company and I wish her the best in her new adventure. I am also delighted to welcome Brad as we enter this new phase of our company's journey. We look forward to updating on our progress in the future. Have a great day.

Operator

And with that we will conclude today's conference. Thank you for your participation. You may disconnect at this time.

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