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Infinera Corporation (NASDAQ:INFN)

Q1 2010 Earnings Call Transcript

April 20, 2010 5:00 pm ET

Executives

Bob Blair – IR

Tom Fallon – President & CEO

Duston Williams – CFO

Ita Brennan – VP of Finance and Corporate Controller

Analysts

Kevin Dennean – Citi

George Notter – Jefferies

Chris Glancy – Avondale Partners

Chris Casado – Stifel Nicolaus

Operator

Welcome to the first quarter of fiscal 2010 investment community conference call for 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. Sir, you may begin.

Bob Blair

Thank you. Good afternoon and welcome to Infinera’s Q1 2010 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 competitor’s products and prospects of the company in Q2 2010 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 1st, 2010 for more information on these risks and uncertainties. Today’s press releases including Q1 2010 results and associated financial tables and investor information summary will be available today on the Investors section of Infinera’s Website. 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 results for the first quarter of 2010, 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 of 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’ll also give guidance including guidance for the second quarter of 2010. We have excluded non-cash stock-based compensation expenses from this guidance, because we cannot readily estimate the impact of our future stock price on our future stock-based compensation expenses.

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

Tom Fallon

Good afternoon and thank you for joining us. With me today are CFO, Duston Williams; and Corporate Controller, Ita Brennan. We are pleased with the number we delivered in the first quarter, which showed revenue growth for the fourth consecutive quarter, a trend that we believe will continue in the June quarter.

We also posted gross margins that were improved over Q4 and slightly higher than forecasted, while achieving operating expenses that were slightly below our expectations. Against the backdrop of an improved technology spending environment, we continue to see robust demand from our customers, as we achieved record bookings again in the first quarter. We are encouraged that customers continue to embrace Infinera’s vision and roadmap to deliver the most cost-effective networks and to satisfy their current and future bandwidth needs.

This response from the marketplace has resulted in substantially improved near-term pipeline activity for Infinera versus a year ago. The key factors behind our sequential revenue growth and pipeline strength are continued new customer additions and healthy business with our current customers, including some of the largest. We are seeing this customer activity across multiple market segments, including the carrier, cable and Internet content provider spaces, with our expanded set of optical transport solutions.

In the first quarter, we added five new customers, three of them in North America and one each in Europe and Asia. The new Asian customer which we first mentioned in our January call has begun Infinera network deployments in both Japan and North America. These additions bring our total luster of customers to 74. We also added one additional customer for our new ATN metro edge products for a total of 7 ATN customers. We expect to add new customers to both our DTN and ATN in Q2.

We are also making good progress in another new market for our products, submarine network. During the quarter, we won our fourth submarine network and continued to see a number of potential opportunities in this area. With Global Crossing, our leading IP solutions provider a long-time Infinera customers, we are participating in a series of large overbuild in a global capacity expansion that they announced last month to meet growing demand for IP and Ethernet transport among their enterprise carrier and service provider customers.

We have been very active with our cable company and Internet content provider customers, including a new rollout of our combined ATN and DTN solutions with one of the largest cable operators. In addition, two of the world’s largest Internet content providers were among our top five customers in Q1, with one of them at 16% of revenues. Collectively, our cable and ITP customers essentially all leaders in their industries accounted for nearly 35% of our revenue in Q1, the high end of the historic 20% to 35% range we have seen from these two non-traditional segments combined.

We recently won a new opportunity that will extend our footprint in Latin America with an existing Tier 1 carrier customer, displacing the incumbent supplier and providing an upgrade to the customer’s Infinera submarine network and a new terrestrial deployment. The previously mentioned new customer win in Japan means we are now deployed with two of the top three carriers in Japan. These early wins in Japan are a testament to Infinera’s demonstrative commitment to quality, and we believe that our deployments with these highly regarded customers will lead to additional opportunities in this important market.

All of this activity represents substantially long-term investments by our customers. Essentially, they are betting the success of their businesses on the ability of the Infinera network to meet their current and future needs and they help differentiate themselves in their markets. We believe that these decisions confirm their belief in the industry’s only PIC-based digital optical network and our ability to address their future needs to bring Internet scale and economics to play in the digital optical networks. As pipes continue to handle larger capacity, with labeling speeds rising to 40 and 100 Gig, the services required to fill those pipes become more complex and diverse.

This complexity is further increased as the optical layer is being driven to cost-effectively implement more network functions with an ever-growing number of optical and electrical components to process and transport network data. As a result, we believe that the only way to cost effectively solve is complexity and scalability issues is through integration. As the only player with commercially deployed PICs, we believe Infinera is uniquely qualified to provide these solutions economically.

We believe that photonic integration will deliver the most cost-effective, not to mention, space efficient and power efficient solution for these optical challenges. In addition, Infinera’s investment in coherent technologies, which builds upon our significant experience building silicone AC chips, should enable us to meet the challenges of building higher bandwidth solutions. We believe the system is based on photonic and electrical integration with the best way to meet our customers’ needs for a cost-effective network that can enable them to carry the ever-growing traffic load, while still generating healthy financials for their own shareholders.

Our unique approach to the market has earned us a market-leading 32% share of the long haul the end market in North America, we believe that with the exception of the Chinese market, there are no structural issues that will prevent us from significantly increasing our current international market share of 10%.

Before turning the call over to Duston, I wanted to say a few words about our long-term business model and how this management team views it. We articulated a target model at the time of our IPO in 2007 with gross margins of 50%, operating expenses of 35%, and operating margins of 15%. Nearly three years and a worldwide recession later, we remain committed to achieving this model. We believe we can obtain a better than historic optical industry model because of our unique PIC-based value proposition, leadership in digital optical networking economics, and because of the leverage our vertically integrated model can achieve whilst you are operating at appropriate volume levels.

We are driving to achieve the target model first and foremost from topline growth and from ongoing careful consideration of our operating expenses. It is a delicate balancing act, because while we are building our footprint, we are also making significant investments in our future products. These investments extend well beyond the funding of our 40 Gig program and including investments in multiple products and technologies. We are pleased that some of these investments have already resulted in new opportunity for the company. For example, in the past year, we had introduced both an ATN metro platform and a submarine platform for the DTN. These new platforms have created substantial new revenue streams, nearly doubling our saleable market and both will require continued investments to remain competitive and to continue to solve our customers’ evolving network challenges.

On the expense side, our intent is to grow into our current expense structure, while continuing to make investments necessary to maintain our product leadership. We believe that the increasing breadth of our customer base and our expanding presence in geographic and product markets will help us achieve this objective overtime.

I would now like to ask Duston to provide his report on Q1 financials and our outlook.

Duston Williams

Good. Thank you, Tom. I will review the Q1 actual results and then follow that up with our outlook for Q2. The following analysis of our Q1 results is based on non-GAAP. All references exclude non-cash stock-based compensation and any restructuring costs. Total GAAP revenues in Q1 were a record $95.8 million compared to guidance of $92 million to $94 million versus revenue of $90.2 million in Q4.

Our services revenue for the quarter was $8 million versus $7.1 million in Q4. We originally expected our installation or EF&I related service revenue to increase in Q1; however it remained basically flat from Q4. We now expect to realize the increased EF&I revenue in Q2. The increase in the Q1 service revenue was driven by incremental extended hardware warranty and spares management related revenue.

We had two 10% customers in Q1 including Level 3 at 22% of revenue and an unnamed leading Internet content provider, not the same Internet content provider, that was our largest customer in Q4. In Q2, we expect Level 3 to account for a reasonable level of revenues, but significantly below its Q1 share and most likely below 10%.

Gross margins in Q1 were 41% versus 40% in Q4. This compares to our guidance of 39% to 40%. Similar to Q4, in Q1, we continued to experience strong common equipment sales, with chassis shipments coming in at their second highest level in the company’s history. Our TAM shipments were relatively strong, but slightly below the Q4 level, however remaining above 2,000 units for the quarter. This was in line with our expectations that we communicated on the Q4 earnings call.

It’s interesting to note that Q4 and Q1 reflected the first consecutive quarterly 2,000 plus TAM unit performance since Q1 and Q2 of 2008. The slightly better gross margin performance for the quarter was related to the shift in a portion of the lower margin EF&I revenues into Q2. Our service margins in Q1 increased to 69% due largely to the less-than-expected lower margin EF&I revenue. However, in Q2, we anticipate downward pressure on the service margins as EF&I revenue that we expected to realize in Q1 will roll into Q2.

We continued our careful consideration of expenses during the quarter. Operating expenses for the quarter were $46.3 million versus our guidance of $47 million and versus $43.6 million in Q4. The slightly better-than-expected operating expense performance was primarily attributable to differences, timing differences for certain NRE and prototype charges. The overall headcount for the quarter was 999 versus 974 in Q4. Virtually all the headcount additions occurred within R&D. The operating loss for the quarter for Q1 was $7.3 million; other income expense for Q1 was a favorable $0.2 million versus a favorable $0.4 million in Q4.

Net loss for the quarter was $7 million, or a loss of $0.07 versus our guidance which called for a loss of $0.10 to $0.11 per share versus a loss of $6.5 million in Q4. Now, looking at the balance sheet, cash, cash equivalents, restricted cash and investments ended the quarter at $277.2 million versus $275.5 million in Q4. We generated $2.3 million of cash from operations in Q1 versus a use of $2.7 million in Q4. Q1 reflected our first positive cash flow from operations since Q3 of 2008.

DSOs were 56 days versus 71 days. Better linearity within the quarter attributed to this improvement. Inventory turns were unchanged at 3.2, accounts payable days came in at 42 days versus 41 days and capital expenditures were $4.7 million in Q1 versus a $4.4 million in Q4 of ’09.

And turning to the Q2 outlook, much like Q1, we entered Q2 with good visibility based on solid backlog. It also appears that Q2 will continue to exhibit a healthy mix of business spread over our carrier, Internet content providers, and MSO customers. Our Q2 operating outlook calls for our fifth consecutive quarter of sequential revenue growth. At this point, gross margins appear to be flat to up slightly from Q1, impacted in part by the anticipated recognition of a large amount of low margin EF&I revenue in Q2.

In general, we continue to be cautiously optimistic about the shipment level of our TAMs, which have higher gross margins. We are currently assuming that Q2 TAM shipments will be roughly equal to that of Q1. Having said, we are encouraged by the number of TAMs booked during the first three weeks of Q2. Operating expenses for the first two quarters of 2010 should average around $47 million. Q2 expenses may increase somewhat from Q1, however any increase will be primarily reflective of some NRE and prototype rollover from Q1 and potentially some likely increase in commissions and incentives due to the revenue out-performance versus planned.

We continue to be committed to our previous target to exit 2010 as an operating expense run rate in the mid-40 million range per quarter. We believe any potential deviation from those expense targets will be solely related to additional commissions and incentives if we are fortunate enough to continue to outpace our internal growth points.

The following guidance for Q2 is based on non-GAAP results and exclude a non-cash stock-based compensation expenses. Revenue of approximately $99 million to $101 million, gross margins of approximately 41% to 42%, operating expenses of approximately $47 million to $48 million, and an operating loss and net loss of approximately $5 million to $6 million, and based on average and estimated average basic weighted shares outstanding of 98 million, this would lead to an EPS loss of $0.05 to $0.06.

Operator, if you would now please open the call up to questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) The first question does come from Kevin Dennean with Citi. Your line is open.

Kevin Dennean – Citi

Great, thanks very much. Tom, just wondering if you can give us an update on the 40-Gig solution development, how you feel you are moving along in that process?

Tom Fallon

Hi, Kevin, yes, we sent I think last time; we delivered the 40-Gig shipment module to our systems developer in Q4 as we had back in September, and we gave as a reference point for 100-Gig chip, 10-Gig module that with 12 to 24 months later, we delivered systems. And that’s the same reference point that I am going to give you today, and I not going to give any updated guidance for you on that at this point.

Kevin Dennean – Citi

Okay. Fair enough. Just moving on to, I think I heard that Level 3 is expected to drop off in the next quarter, and I think I heard that it could be less than 10%?

Duston Williams

Correct.

Kevin Dennean – Citi

Okay. Duston, I am wondering, can you give us some insights as to what’s behind that, that sequential drop-off, and also in the last couple of quarters, has Level 3 been an outsized buyer of TAMs, in other words, are they within their revenue mix, would you say they are buying primarily TAMs?

Duston Williams

Yes, let me take the first part of that, you know, what’s causing the drop-off in Q2. Well, we always thought that the Level 3 revenues would drop off during 2010. Now, Q4, Q1 Level 3 revenues increased by over 100%. So, going from 10.5 million to 21 million, there’s just no way that they have done to stay at the 21 million level and quite honestly we don’t expect that and 21 million was a pretty good quarter for Q1.

I think the good news there, you know, coming down to maybe 10% or less of revenues, what that does mean is that our other non-Level 3 customers will be growing significantly in the quarter. So, we look at that as pretty good news there.

Kevin Dennean – Citi

Right. And would you say that they have been an outsized buyer of TAMs that their mix is skewed more towards TAMs or would you –?

Duston Williams

They have been buying a pretty well rounded mix of products.

Kevin Dennean – Citi

Okay. And last question for me, Duston, it looks to me like G&A popped quite a bit in the quarter, any one-off drivers there, anything that we should think about that?

Duston Williams

Well, I think last call we mentioned there would be some consulting costs both in Q4 and Q1. So, that’s sum of what you are seeing there in G&A, some increase in consulting costs. And I believe this is probably some incremental incentive also in G&A there and some other little stuff that as part of the primary drivers.

Kevin Dennean – Citi

Okay. Great. Okay, thanks very much, appreciate it.

Operator

(Operator instructions) The next question comes from George Notter with Jefferies. Your line is open.

George Notter – Jefferies

Hi, thanks very much guys. I guess I was trying to better understand, you know, your commentary about improving visibility of business, is that something that you see generically throughout the marketplace, is it a function of market share capture or anything going on with specific customers that you have, I mean, anymore flavor about improving visibility in backlog would be helpful?

Duston Williams

Yes, George, this is Duston, and Tom can chime in here too. You know, we have been fortunate, obviously we have added a fair amount of customers over the last several quarters, and I think more importantly, the amount of business that we are seeing from existing customers has been pretty strong and it hasn’t just been strong in one segment, it’s been very well rounded for us quite honestly. So, that’s given us some better insight and obviously encouragement and then just the raw backlog numbers, you know, as we go into – you know, we don’t disclose backlog on a quarterly basis, but as we go into Q2, the backlog is quite honestly pretty robust as we have gone into Q2 here.

George Notter – Jefferies

And then I didn’t hear it on the monologue, but can you talk about Tier 1 customers, it’s the same question I think we ask every quarter. Certainly, it seems like with Internet content providers and cable operators coming in and out of other revenue stream, you know, maybe it mattered a little bit less, but can you talk about where you are in Q1, an update there would be great?

Tom Fallon

Yes, George, we have the same six Tier 1s that we have had, we won three Tier 1s last year and we continue to have activity with, I would say, probably at least currently half of the Tier 1s that we have won footprint with. We are currently in ongoing opportunities to win further business with some of which we imply on the call today without naming any names, that we have won some ongoing business with them. So, we are continuing to have ongoing Tier 1 wins within in the current set. We are also having ongoing dialogs with Tier 1s than we have not won yet, and/or not discuss them specifically. But as you know, there are opportunities, take a long time to win. I continue to believe we are well positioned to continue to win Tier 1s, and just as importantly or more importantly, the ones that we have won, we have executed extremely well, and they are to my belief, every one of them is more impressed with this now than when we actually won the initial rollout. So, we have done a good job of exceeding our expectations and I think that over a period of time, we will continue to grow with them.

George Notter – Jefferies

Got it. And then last thing, any comments you could make about new Tier 1 customers coming into the revenue stream this year, is that reasonable to think that we would have other Tier 1s coming in for revenue recognition this year?

Tom Fallon

I am not going to comment on any potential Tier 1 wins.

George Notter – Jefferies

Thank you.

Operator

The next question comes from Blair King with Avondale Partners. Your line is open.

Chris Glancy – Avondale Partners

Hi guys. This is actually Chris Glancy in for Blair King. I was just going to touch on the submarine wins real quick. How should we think about the gross margin there relative to some of your other business? And it seems like with there being so many more optical line players, non-revenue producing equipment and whatnot, there could potentially be lower margin sales, but if you give any color around in kind of different pricing strategy you use or how we should think about sub win gross margins? That would be great. Thanks.

Duston Williams

Yes, this is Duston. Probably want to talk about strategy from a pricing perspective there, but you know, what we have seen so far quite honestly is the opposite a little bit, the higher margin profile in the submarine business. Now, we are not assuming necessarily that, that holds, but so far, it’s been a little bit higher margin business.

Chris Glancy – Avondale Partners

Okay. That helps. And also you guys used to break out how many chassis you shipped or some indication of a level and route kilometers deployed during the quarter, are you still doing that or can you comment on that at all?

Duston Williams

We haven’t talked about lately the route kilometers deployed. You are right; there was a chart at one point in time that we put that out there. We have not done that lately. The only comment on the chassis we mentioned on this quarter was the second highest in the history. So, it kind of gives you a feel for the level there, but we haven’t disclosed the specifics.

Chris Glancy – Avondale Partners

Okay. And last one for me, I am wondering the Internet content provider that’s in the 10% customer list this quarter. You said it’s not the same as the one in 4Q09, is it the same that was in 4Q08, I believe that was a different Internet content provider?

Duston Williams

It’s the same that was in that quarter, correct.

Chris Glancy – Avondale Partners

Okay. That’s it. Thank you, appreciate it.

Duston Williams

Okay.

Operator

The next question comes from Sanjiv Wadhwani, Stifel Nicolaus. Your line is open.

Chris Casado – Stifel Nicolaus

Hi, this is actually Chris Casado in for Sanjiv. Just a few questions, one, if you could comment on any changes in dialog, positive or negative I guess with the ongoing Tier 1s that you carried in the quarter, given Ciena and Nortel acquisition and how that new platform is rolling out? And second of all, if you can just reiterate what your target is that you need to hit, you know, to get your operating – target operating model from a revenue perspective and given the strength that you have (inaudible), do you finally get there sooner or later or any timeframe on that will be helpful?

Tom Fallon

On the first question, this is Tom, I couldn’t quite understand regarding Tier 1 and regard to Ciena Nortel?

Chris Casado – Stifel Nicolaus

Correct.

Tom Fallon

So, we have ongoing dialog with Tier 1s at an ongoing basis. We clearly are watching and trying to utilize the Ciena Nortel integration to our advantage. I think the biggest advantage will continue to play out as Tier 1s, almost all of them have a dual-sourcing strategy and any of them that had Nortel and Ciena as source Number 1 and Number 2, are going to have to come up with a new second-source strategy. We certainly have engaged in conversations around that, but it is too early to tell you how any of those conversations will yield, and I think that in addition to having an opportunity of being a viable second source, I think that there’s ongoing questions around the financial strain that is integration will put under the new Ciena empathy, being a significant net debtor.

So, we are going to continue to use those two points to our advantage and continue to press opportunities around the world for not only Tier 1s, but other customers. In regard to achieving our long-term business model, I am actually going to ask Ita to answer that. Ita as you know is our incoming – actually our current Controller and our incoming CFO to replace Duston, and she will be responsible with the rest of us to assure that we achieve our long-term business model. Ita?

Ita Brennan

Yes, so Chris, we haven’t any specific time out there around the business model, but we do see that once we reach kind of a steady state business. The model is still very achievable of 50% [ph] growth margin each levels are achievable. They are highly dependent on kind of product mix and customer mix, you know, how fast do we grow the business. We had a reasonable track record over the last couple of years, adding new customers. And if we seek kind of a return to historical growth levels with those customers, then that would certainly put us on the right track to kind of achieving that 50ish gross margin profile. And the other thing that should help us along with the growth and services revenue (inaudible) that will help from some hardware warranty and other higher margin service revenues that should also come on track there. But you know, in terms of specific timing, we would have to see how it goes there, but we have certainly seen some pointers kind of heading in the right direction.

Chris Casado – Stifel Nicolaus

All right. Thank you very much.

Operator

(Operator instructions) One moment for the next question please.

Tom Fallon

Thank you again for joining us on today’s call. We look forward to keeping you informed of Infinera’s progress in the months and quarters ahead. As you know, Ita Brennan will be succeeding Duston as Chief Financial Officer at Infinera at the end of Q2, and I am excited about having her join the senior executive team. I also like to once again acknowledge and thank Duston for his tremendous contributions in leading and building the Infinera finance organization for the last four years. We wish Duston the very best. Thank you.

Operator

This does conclude today's conference call. You may go ahead and disconnect.

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