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Infinera Corporation (NASDAQ:INFN)

Q2 2014 Earnings Conference Call

July 23, 2014 17:00 ET

Executives

Bob Jones - Investor Relations

Tom Fallon - Chief Executive Officer

Brad Feller - Chief Financial Officer

Dave Welch - President

Analysts

George Notter - Jefferies

Simona Jankowski – Goldman Sachs

Sanjiv Wadhwani – Stifel

Alex Henderson - Needham

Ashwin Kesireddy - JPMorgan

Michael Genovese - MKM Partners

Dmitry Netis - William Blair

Brian Coyne - National Alliance

Operator

Welcome to the Second Quarter Year 2014 Investment Community Conference Call of 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 now would like to turn the call over to Mr. Bob Jones of Infinera Investor Relations. Bob, you may begin.

Bob Jones - Investor Relations

Thank you, Sharon and welcome to Infinera’s second quarter of fiscal 2014 conference call. A copy of today’s earnings is available on the Investor Relations section of Infinera’s website. Additionally, this call is being recorded and will be available for replay from the website.

Today’s call will include projections and estimates that constitute forward-looking statements. This may includes statements regarding Infinera’s overall business and strategy, market conditions, market and growth opportunities, Infinera’s results of operations, views on Infinera’s customers and its products, as well as Infinera’s financial outlook for the third quarter of fiscal year 2014. These statements are subject to risks and uncertainties that could cause Infinera’s results to differ materially from management’s current expectations.

Please refer to Infinera’s current press releases and SEC filings, including Infinera’s most recently filed Quarterly Report on Form 10-Q and subsequent filings for more information on these risks and uncertainties. Please be reminded that all statements are made as of today and Infinera 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.

Today’s earnings release and today’s conference call also include certain non-GAAP financial measures. These non-GAAP financial measures include 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 and further management does not consider these items to be related to Infinera’s core operating performance.

Pursuant to Regulation G, Infinera has provided reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures in its second quarter earnings release, which has been furnished to the SEC on Form 8-K and is available on the Infinera’s website in the Investor Relations section.

I would now like to turn the call over to Chief Executive Officer, Tom Fallon.

Tom Fallon - Chief Executive Officer

Good afternoon and thank you for joining us on our second quarter fiscal 2014 conference call. With me on the call are Chief Financial Officer, Brad Feller; and President, Dave Welch. I will touch briefly on the financial highlights for our second quarter and then provide an update on the market, our business and an overview of the competitive environment. I will then turn the call over to Brad, who will provide a more detailed review of our second quarter results and our outlook for the third quarter of fiscal 2014.

Following our solid first quarter results, we had an extremely strong second quarter. I am pleased to announce that we achieved record quarterly revenue, record 100-gig port shipments, positive GAAP and non-GAAP earnings and positive free cash flow. We continue to be well-positioned with the balance in growing customer base across verticals, increasing geographic diversity with a growing partner program and shifts in network architectures that are closely aligned with the innovations in both our current and soon-to-be expanding product portfolio.

Our revenue results were slightly above the midpoint of our previous guidance at $165.4 million, representing a nearly 20% year-over-year increase and 16% growth on a sequential basis. Gross margin came in higher than guidance at 43.3% and operating expenses were $57 million as we continued to successfully execute on our plan of growing footprint, expanding our gross margin, and increasing profitability. The combination of higher gross margin levels and lower operating expenses allowed us to drive earnings, which exceeded our guidance range.

We continue to see excellent DTN-X deployment momentum across a broad base of customer verticals in our second quarter. We added four new invoiced DTN-X customers in the second quarter, one of which was a new customer to Infinera. This positions us with 46 DTN-X customers to continue to capitalize on the 100-gig technology cycle.. These new DTN-X customers included a Tier 1 carrier in Mexico, one of the largest competitive carriers in North America, a Russian cable operator, and XO Communications, a long time DTN customer upgrading to our DTN-X platform. Three of these new DTN-X customers are existing customers converting from DTN. Approximately, one-third of our DTN customers have now converted to the DTN-X platform.

While not all DTN customers will require the scale necessary to convert. We continue to see a promising pipeline of activity within the installed customer base. In addition to the new DTN-X customers, we added a new DTN customer for a total customer count of 133 invoiced customers. We also continued to expand our international footprint. During the quarter we were pleased to announce SEACOM as our second customer in Africa and who have secured a multi-terabit upgrade in the Asia-Pacific region with AJC.

Further both customers that are new to Infinera were international. Last quarter I was pleased to report that Infonetics had selected Infinera as the top optical vendor in the world. This quarter we were honored to have Light Reading award Infinera, Company of the Year distinction. I believe these recognitions are a reflection of our ability to deliver superior technology, excellent customer service and most importantly that our solutions help to create a competitive advantage for our customers through time as a weapon, lower total cost of ownership, ease-of-use and unparalleled reliability.

We continue to see video, cloud and the increasing mobile and wireline access speeds driving continued bandwidth growth across our markets and anticipate 100 gig will be the technology of choice for many years to come. In addition we are seeing ICP starting to build mega data centers populated with hundreds of thousands of servers. These servers are making the transition from 1 gig to 10 gig mix speeds and this combination is driving significant bandwidth demand between data centers. With deployments in three of the top four ICPs, we have early insight into their future product requirements and I believe this combined with our PIC technology puts us in an advantage position with both ICPs and other cloud and data center providers.

On that note, I would like to make a few comments on this rapidly growing data center interconnect market and also the Metro market. We see the datacenter interconnect market segmented into long-haul and Metro. We see the very high capacity Metro portion of this data center interconnect market which we were calling Metro cloud as distinctly different from a more traditional Metro aggregation market driven by telcos and cable operators. We believe that large scale a 100 gig in the Metro will happen first in the Metro cloud market starting in earnest in early 2015. And that 100 gig in the Metro aggregation market will become interesting in late 2015 or early 2016, a view shared by many industry analysts.

We also believe application optimized products required for the Metro cloud market due to the cost, size and power requirements of these massive data centers and that we have the right technologies, including our highly scalable PICs to best address this emerging market. In September we will be hosting Insight Infinera 2014, a technology and markets summit and we will provide a deep dive look into these emerging opportunities and Infinera specific plans to win in this market. From an overall market perspective competitors remain aggressive, but I see a more rational pricing environment as most real competitors are determined to create sustainable and profitable business models.

In regard to Infinera I continue to be optimistic about our opportunities. In the short-term I am confident given our significant order backlog and the increased customer demand we are experiencing. Brad will give more specifics on this during his portion of the call. In the intermediate term our visibility had returned to more normalized levels with significant amounts of pipeline activity, but more typical fidelity around the timing and probabilities of certain deals pertaining to Q4 this year and Q1 of 2015. That said, I continue to be convinced in our ability to gain share in a long-haul market on a yearly basis as well as take meaningful market share with the new products we are going to introduce over the intermediate term. We will discuss this further at our September Insight Infinera event.

Longer term, I am increasingly encouraged that Infinera will continue to demonstrate strong performance based on our technology and architectural leadership and the necessity of transport playing a more strategic role in the networks of the future. As we continue to talk to customers and industry analysts, we see several shifts occurring that are driving this conviction. First, networks are converging with more intelligence being driven into the optical layer. In Dell'Oro’s latest forecast they had indicated that they are likely to collapse the core optical switching and packet transport into a single category because of the trend of convergence of WDM and digital switching. Infinera pioneered these conversions and we believe the DTN-X is the innovation leader in this category which is expected to be the fastest growing part of the long-haul the DWDM market for the five-year compound annual growth rate of 16%.

Second, the migration of high capacity requirements into the Metro provides a new opportunity for us to use differentiated PIC technology to bring customers the experience they have grown the count on in the core. The overall Metro market is estimated to be over $7 billion by 2018 with the main growth driver being 100-gig according to Dell'Oro. This high-capacity 100-gig segment, which we plan on addressing, represents a significant opportunity for expansion. Third, the emerging high-capacity metro and long-haul cloud market is an opportunity we believe will be best served with high-capacity PIC-based solutions. While this category is currently tracked as part of the overall DWDM market, we believe that this market will grow extremely quickly and may add to the overall TAM of the DWDM market.

Finally, as SDN and NFV trends mature and the higher networking layers become more virtualized, we believe that the evolving transport layer will become more strategic, a significant paradigm shift in the last decade, where the optical network was often viewed as a set of static pipes. If architected thoughtfully, this new converged transport layer can play a key role in enabling dynamic network programmability and automation and provide the responsiveness and adaptability demanded by our customers evolving networks.

While networking flexibility becomes paramount, we believe optics will be the primary network scaling mechanism, requiring continued innovation at the physics level create breakthrough capacity increases. This intersects directly with the domain of our differentiated and highly defensible PIC technology, where we are confident we had a multi-year lead over the competition. As higher value is placed on the optical layer, whether in the core or metro, I believe Infinera will be one of the few companies that have the architectural and technological innovation, balance sheet strength, and demonstrated executional excellence to be successful in these growing markets.

In summary, we are pleased with the performance of the business in the second quarter and first half of the year. We have entered the second half of 2014 with solid momentum and believe fiscal 2014 will be another strong year for Infinera. Our focus for the remainder of fiscal 2014 remains winning new footprint, driving toward our intermediate business model financial goals and beginning the process of expanding into and winning adjacent markets. Finally, I would like to thank our customers, employees, and partners for their ongoing commitment to Infinera.

Now, I will turn the call over Brad for a more detailed financial review of the quarter and our outlook for the third quarter.

Brad Feller - Chief Financial Officer

Thanks, Tom and good afternoon everyone. As Tom mentioned, we reported revenue of $165.4 million for the second quarter of 2014, an increase of nearly 20% as compared to the second quarter of 2013 and just above the midpoint of our guidance range. Our revenue increased by nearly 16% on a sequential basis as we continue to see strong demand for our products across multiple customer verticals. As was the case in the first quarter, our top five customers in Q2 came from a variety of customer verticals, including two Internet content providers, a cable MSO, a Tier 1 and a bandwidth wholesaler.

We had two greater than 10% customers in the quarter, our North American Tier 1 service provider and an Internet content provider. Demonstrating the continued strong demand for the DTN-X, we added four additional DTN-X invoice customers this quarter, including one new to Infinera and three existing DTN customers who transitioned to the DTN-X. This brings our total DTN-X customer count to 46.

We continue to see strong RFQ activity with additional customers looking to adopt the DTN-X platform, which we expect to add to our DTN-X customer count in the near future. International revenue totaled $29 million or 18% of total revenue. EMEA accounted for $19 million or 12%, with APAC and Latin America each representing 3%. Coming off a relatively soft first half of the year, we anticipate growth within multiple international accounts in the second half of 2014.

Service revenue for the quarter was $23 million, an increase of 30% year-over-year driven by both increased deployment services as we continue to win new routes and higher ongoing support revenues as we continue to grow our installed base. Service revenues increased sequentially 24% largely as a result of increased deployment activities.

Moving next to gross margin and operating expenses, our overall non-GAAP gross margin for the second quarter was 43.3%. This is significantly better than the midpoint of our guidance of 40% as increased selectivity more than offset certain new footprint deployments that shifted into Q3. Service gross margin was 60% in the quarter, down both sequentially and from the year ago period as a result of the increased mix of deployment services. We are excited about the higher overall gross margin levels, but are cautious that as we continue to grow footprint in the second half of the year, our ability to maintain these levels will be highly dependent upon the continued trend of customers adding significant new capacity to their networks. Our non-GAAP operating expenses came in at $57 million, which is below our guidance of approximately $59 million as certain R&D spending pushed into the second half of the year. Our SG&A expenses were relatively in line with our expectations.

Taken altogether we achieved a non-GAAP operating margin of 9% for the quarter, demonstrating the leverage in our financial model as we continue to grow revenue. This is a significant improvement versus 4% in Q1 ‘14 and an operating loss in the year ago period. In Q2 our interest and other expense was $700,000 and tax expense was $600,000. The shares used to compute diluted non-GAAP EPS during the second quarter were 127 million up from 125 million in the prior quarter as a result of stock issuances.

In total this resulted in non-GAAP net income for the second quarter of $13 million or $0.11 per diluted share. This is $0.07 higher than the midpoint of our guidance driven by higher gross margin levels and lower operating expenses. We are very proud of the financial results we are able to deliver in the second quarter and believe that these solid results represent yet another proof point of our ability to deliver strong financial results over time.

Now summarizing Q2 results on a GAAP basis, we had net income of nearly $5 million or $0.04 per diluted share. A significant improvement as compared to a net loss of $10 million or $0.09 per diluted share in the year ago period. On a sequential basis we turned $0.04 loss in the prior quarter into $0.04 of income in Q2. The difference between our GAAP and non-GAAP results during the second quarter was due to stock-based compensation expense of $7 million and $2 million of amortization of debt discount.

Now turning to the balance sheet, cash, cash equivalents, and investments as of the end of the second quarter were $355.5 million, an increase of over $6 million from the previous quarter, largely driven by the strong overall profit levels of the business. We generated cash from operations of $10 million in Q2 as compared to using $15 million in operations in Q1, a net improvement of $25 million quarter-over-quarter. As we have stated in the past cash generation is one of our top priorities and we remain confident in our ability to generate cash over the course of the full year.

Moving next to our outlook for the third quarter of fiscal 2014, we currently project revenue to be in the range of $165 million to $175 million. The midpoint of this range represents year-over-year growth of nearly 20%. As mentioned on our Q1 earnings call, we expected to see elevated revenue levels in both Q2 and Q3. This is playing out in our results and our outlook as we continue to see strong demand across a customer base at new customers as well as growth with the existing customers. Although we remain very optimistic about our core business and as Tom mentioned, our intermediate visibility has returned to more normal levels, causing us to be cautious about our ability to maintain revenue at these levels as we exit the year.

We currently project non-GAAP gross margin to be in the low-40s. Where we end up will depend largely on whether we continue to see increased selectively across our customer base, or whether there will be a pause as customers digest the capacity they purchased in Q2. We have consistently stated that this year is about footprint win in the growing 100 gig market. So the ultimate gross margin result will depend on the mix of footprint and fill.

We currently anticipate non-GAAP operating expenses to be $61 million plus or minus $1 million. Our year-to-date R&D expenses are quite a bit lower than plan. And we will need to ramp the levels of spend a bit over the remainder of the year to ensure we can deliver on our planned road map. Although there may be minor fluctuations in our operating expense levels from quarter-to-quarter, we remain committed to our target of R&D expense at approximately 20% of revenue on an annual basis. Maintaining this level of R&D expense is important to allow us to continue to develop additional features for our long-haul offerings, but also allowing us to expand into adjacent markets.

With regards to our SG&A expense, although we will need to increase spend over time to support growth, we anticipate this to be slower than revenue growth, driving additional financial leverage. At the midpoint of our projected guidance, this should translate to a non-GAAP operating margin of 6% plus or minus 100 basis points, largely dependent on the gross margin results. The combination of interest and other expense is expected to net out to approximately $500,000 and tax expense should be approximately $600,000. We currently expect the diluted share count to be approximately 128 million shares and project non-GAAP EPS to be $0.07 per diluted share plus or minus a couple of pennies. We currently expect GAAP EPS to be lower than non-GAAP EPS by about $0.07 per share primarily related to stock based compensation expense.

On the balance sheet, we currently expect to generate positive free cash flow in the third quarter. The first six months of the year represented strong execution in the business, reinforcing our view that the 100 gig market is growing and our belief that we will be able to grow our business faster than the market during 2014. We are excited about the opportunities we continued to see with both the new and existing customers. We are also excited about the additional technologies we are developing for both the long-haul and adjacent markets. Additionally after delivering the strong financial performance in Q2, we are increasingly excited about our ability to deliver solid financial results over the course of 2014.

With that I would like to turn the call over to the operator to begin the Q&A portion of the call. Sharon?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from George Notter with Jefferies. Go ahead sir. Your line is open.

George Notter - Jefferies

Hi there. Thanks very much guys. Can you hear me?

Tom Fallon

Yes.

Brad Feller

Yes.

George Notter - Jefferies

Great thanks. Alright, so I wanted to touch on your commentary about intermediate visibility I guess returning back to normal levels, (indiscernible) are you talking about there, are we looking at kind of Q4 being below seasonal norms, is it a byproduct of bookings or backlog, is it just simply that this large customer you have got here in Q2 and then now also in Q3 just kind of rolls over and finishes up their network build I mean can you kind of give us more flavor for what’s going on there? Thanks.

Dave Welch

Sure George what we have said historically is kind of normal visibility is we had a really good feeling for the first quarter and not much data yet supporting definitive answer for the quarter after that. The last couple of quarters we have been pretty clear that visibility was higher than usual and we had pretty much – pretty good two quarter look. So I think we are kind of back to the normal. The current quarter we understand pretty well. Next quarter we have a lot of indications that there is a lot pipeline activity. We see lots of RFQs. There is lots of potential new customers but there is just less fidelity around the specifics of those on either timing or if we will win.

I think one of the reasons is we have been carrying bigger backlog than we desire. I have been I think pretty crystal clear for years now about time as a weapon. And we can only do that obviously if when customers order they get that product pretty quickly. We have been running a couple of weeks longer in lead time than I desire from a customer support perspective. So as we have ramped up we are going to bring that back down to what I consider normal levels where we represent another unique value proposition to our customers. And we have longer lead time and more backlog as it takes longer for people to get their gear. They also then have to digest that gear. And I think that in conjunction with visibility being more normal, we also have a little bit of higher backlog that causes other people’s plans or our customers’ plans to be less clear. There is nothing in my mind alarming about this view. It’s just going back to normal.

George Notter - Jefferies

Got it. Okay. Fair enough. And then I also wanted to ask about the gross margins obviously real strong here in Q2 and you talked about 2014 being a year of footprint grab, can we think a little bit about 2015 I think in the past you guys have kind of talked about the market potentially going back to a more normal mix of line cards versus chassis, how do you see that playing out and what gives you the confidence that we kind of return to that more normal mix and what does that therefore translate into terms of what gross margins could look like out into next year? Thanks.

Brad Feller

Sure. So we – as we have talked about in the past on a normal basis between 18 months and two years after initial deployments customers will come back for their next layer of fill. Obviously, we saw some strong fill activity in Q2 which is why you saw the stronger gross margin results. We still expect in 2015 to continue to grow footprint but that level of fill we expect to continue to ramp up and become stronger and stronger throughout 2015 to where you start to get to on a more steady-state basis a more normalized mix. And as a result you start to see margins more like our midpoint model of 45 points.

Tom Fallon

The longer it takes us to get there George quite frankly the better off we are in long-term shareholders, but I agree with Brad we anticipate that that starting to balance out next year.

George Notter - Jefferies

Great. Thanks very much, guys.

Brad Feller

Thanks George.

Operator

Your next question comes from Simona Jankowski of Goldman Sachs. Go ahead. Your line is open.

Simona Jankowski – Goldman Sachs

Hi, I did have one follow-up on the gross margin question. So I think you discussed the interplay of the mix there between fill and footprint, but can you also give us an update on where you are in terms of both utilization and yield in the fab and I have recognized you don’t disclose the precise numbers, but if you can just give us the sense for how much head room is there as well?

Tom Fallon

Yes. So Simona, I can give you some directionality but we breakout that level of detail. You can believe that the team continues to drive up the yields of the products in the fab. And as we continue to grow the overall revenue numbers, we are increasing the levels of capacity that we are absorbing in the fab. There is still some room to grow there though.

Brad Feller

I will give a slightly more color. I would say our yields overall are at or slightly above plan, so we are executing to what we think we actually have a lot of experiences now. We are being a little bit favorable on the current yield we are experiencing. And on the capacity perspective, we do marginally increment income capacity periodically with CapEx, but we still have a reasonable amount of headroom to afford ourselves a lot of growth with the current infrastructure.

Simona Jankowski – Goldman Sachs

And so as we think about you guys expanding into adjacencies, as you started to detail in terms of the Metro opportunity, I mean roughly how many years should we think about you having headroom ahead of you in terms of capacity and how many points of gross margin upside do you think there is to grow into as you expand your revenue base?

Brad Feller

Yes. So Simona, it really depends on how much success we get in these adjacent markets. As Tom mentioned there is a reasonable amount of headroom there, but we like the new products we are coming out and our hope is that we run out of capacity quicker than longer. So that’s kind of the dynamic I would look at in terms of that component.

Simona Jankowski – Goldman Sachs

And then just last question on the…

Tom Fallon

Simona real quickly, this is Tom. Some of our CapEx in the fab has a fairly longer lead time cycle of both buying it and then deploying it somewhere in the 18 months to 3 year type of timeframe. Don’t anticipate us making any of those purchases this year, but as we start making those kind of decisions we would certainly make that available to the shareholder community, because it’s a long-term investment.

Simona Jankowski – Goldman Sachs

Sure, sure. Appreciate that. And just one last question on the timing of the Metro opportunity which I think before you had kind of talked about the real volume in the industry which is typically what you look to intercept happening more towards the end of 2015, but now you kind of broke that opportunity up into two parts kind of the aggregation piece and the cloud piece and it sounds like the cloud piece you think will be taking off in early ’15, so is that a little bit of change in the timing of when you think you will be intercepting that opportunity?

Tom Fallon

We are going to try to always intercept opportunities as the opportunity becomes interesting which is with volume. And you can anticipate we are going go hard after both the cloud interconnect market and the more long-haul market or aggregation market. And Simona, I am in hold off on giving any more details because I am excited about people coming to visit us in September to get a deep drive on what we are doing.

Simona Jankowski – Goldman Sachs

Okay, sounds good, I’m planning right. Thank you.

Operator

Our next question comes from Sanjiv Wadhwani of Stifel. Go ahead. Your line is open.

Sanjiv Wadhwani – Stifel

Thank you. Tom, I wanted to ask you about some of the M&A that’s taking place in the industry specifically with your customers, you guys have some decent exposure on the cable side, I would love to get any details on if you are seeing any sort of lumpiness in spending because of M&A and then thoughts on sort of spending in that vertical going forward? Thanks.

Tom Fallon

Yes. So far, we have not – we have commented on this before seeing any disruption of spend. I anticipate that through this year, there won’t be a positive or negative impact. I think as that specific deal I think you are referencing comes closer to fruition we will have a better insight into it for next year. So I think it’s too early to call what it means for next year. For this year, I think it doesn’t have any impact at least to us, I can’t speak for everybody in the industry, but not to us.

Sanjiv Wadhwani – Stifel

Got it, okay. And then Brad, I think for next year you were commenting about sort of gross margins and as you see more fills etcetera that will help gross margins, you commented about 45% sort of which is more normalized midpoint. Are you sort of guiding to 45% gross margins for 2015 or any color over there, thanks.

Brad Feller

Yes. So, Sanjiv, we don’t guide over more than a one quarter period, I’m just trying to give you a feel for the fact that they should be in those types of levels over the course of the year, obviously that can change from quarter-to-quarter but you should see a step function up in ’15 and in ’16. In the longer term, we think there is even more headroom from there as we to smartest point continues to fill the fab and growing these adjacent markets.

Sanjiv Wadhwani - Stifel

Got it, that’s helpful. Thank you.

Brad Feller

Sure.

Operator

Our next question comes from Alex Henderson of Needham. Go ahead, your line is open.

Alex Henderson - Needham

Yes, let me start up with the most mundane, there was little crackling on the line when you gave the EPS number was wondering if you could just repeat it?

Brad Feller

It’s a $0.07 plus or minus $0.02.

Alex Henderson - Needham

Plus or minus, thank you. The question I wanted to ask as you made a tantalizing comment about soon to be announced new products, obviously you’re not announcing them here, but can you give us some sense of when we might be anticipating those product announcements, any granularity on that?

Tom Fallon

I like to use the word tantalizing. That gives me great expectations that will be great interest. We have a history of not bringing things to market or launching things or really expressing them and so, they are pretty closed to being ready to go to customers. I’m not never been an advocate of doing kind of product launches away ahead of time. So, you should anticipate that it’s in the relatively near-term.

Alex Henderson - Needham

Super, I look forward to hearing about those at the Analyst Day, I guess.

Tom Fallon

It is in the quiet period so, we have to be very careful of not talking at all about finances.

Alex Henderson - Needham

There you go.

Tom Fallon

You were tantalizing about products and technology.

Alex Henderson - Needham

Yes. So, can you go a little bit into a little bit more granularity in the European theatre on whether the situation in the Ukraine Russian markets are having any impact on you guys in any form, fashion or other variable?

Tom Fallon

Yes, I think, Brad commented that the first half of the year was a little slower in Europe I think part of it is just North America, has been remarkably strong. But we don’t see any fundamental problem in the bulk of the European business and we anticipate as had commented that in the second half of the year, we see some reasonably good opportunities and I anticipate as a percentage of business that will increase. In regard to Russia specifically, we’ve commented before that we’re continuing to sell in Russia. On the last call, we made a comment that we’re staying mindful of the uncertainty and if anything in the last quarter that uncertainty in my mind has grown quite substantially. We continue to see in Russia. We continue to see opportunities in Russia and I continue to be growing more cautious on baking that into our forecast in the near-term.

Alex Henderson - Needham

Okay. So, is there any financial risk as a result of those transactions in terms of exchange rate swings or cost elements that we should be thinking about?

Brad Feller

No, no, Tom’s commentary that the current business we don’t expect to see any impact, it’s just – it may impact the timing and size of future deals.

Alex Henderson - Needham

Okay. Going back to the metro side of it for a second, Sienna made the comment that 20% of their sales of coherent went into the metro last quarter. Would you characterize the market currently as straight cloud interconnect within that context of the granularity that you gave earlier? It seems like the coherent market is seeing some move into metro, but it’s not clear from what’s been said whether you would – which category that would fit into?

Brad Feller

Yes, there as Dave Welch - we have started before we do supply some of our products in the high capacity metro or even metro regional markets. The application of that is high-capacity aggregation rings and/or high-capacity datacenter connections to that. That is – if you look at the historical numbers of the growth rate and total unit volume that we expect out of the Metro market it is insignificant to the opportunity that’s out there. So currently we supply with the exclusion of China we supply – are the largest supplier of 100 gig technologies out there. And we expect to the Metro market to turn on as Tom indicated from volume perspective from the data center connections start turning on more so in ‘15. And the aggregation rings late ’15, beginning of ‘16. You will see applications within that, prior to those dates but from a volume perspective I don’t think they will really be that accelerating until those timeframes.

Tom Fallon

One of the things I’m asking I think about Alex is we certainly understand that today, there are some 100 gig coherent being deployed in the Metro. I pick the word interesting for the volume of it carefully. If you look back on the long-haul market, the initial 100 big coherent entered the market in 2010, the market became interesting 2012, 2013 timeframe. That’s when the bulk of the decisions were made, that’s when the bulk of the dollars started to ramp, it’s when market share was earned. And it’s the path we followed with the DTN-X and I think has served us quite well. So when we say that 100 gig in the Metro because interesting in 2015 late ’15, ‘16, you should kind of map into that kind of model.

Alex Henderson - Needham

Okay. One last question then I will cede the floor. So in looking at companies like Google pushing out 500,000 server data centers these hectare scale plants and then connecting them with DWDM systems, will there be a difference in the scale of the initial deployments, when they do a data center to data center build in terms of the capacity necessities that implies that then your typical build on a long-haul back bone or Metro back bone, I would assume that they would have much larger initial point-to-point capacity needs and therefore the utilization of the box would be higher initially than the traditional loadings, is that correct?

Tom Fallon

So the right way to think about and to scale these 100 acre types of data center scenarios is 0.5 million servers, you have got 70-30, 80-20 type of internal traffic to external traffic. So yes, the scale of the connections of the external traffic from these large data centers can be large. It is unclear of how many of these huge data centers will be built, but it’s certainly a great opportunities to see the bandwidth growth associated with that. So if you want to do your math and you think about the type of traffic and really 70-30, 80-20 is not a bad ratio for the traffic that stays in the building versus the traffic that goes outside the building.

Alex Henderson – Needham

So the loadings are going to be comparable smaller, bigger, can you give us some sense of what the initial builds look like?

Tom Fallon

I think if you take your number of 500,000 servers and they are operating at various stages of 10 gigabit or 40 gigabit types of capabilities you can add up bandwidth pretty quickly and what that looks like.

Alex Henderson – Needham

Thanks.

Brad Feller

It’s obviously pretty high fill rates within the internet content provider space in comparison to more traditional markets.

Alex Henderson – Needham

Thank you. That’s very helpful.

Operator

Our next question comes from Rod Hall of JPMorgan. Go ahead. Your line is open.

Ashwin Kesireddy - JPMorgan

Hi, thanks for taking my question, this is Ashwin on behalf of Rod. I was hoping you could clarify one the comments you made it on sustainability of momentum being dependent on capacity expansions, is that more related to revenue momentum or gross margins upside. My second question really is on Tom you talked about having the technology and capability to support inter – data center interconnects now what additional features do you think you will need to have in order to develop for traditional Metro product, I guess and finally, and then I was hoping you could comment on the concerns around CapEx related to Tier 1s here in the U.S. and probably juxtapose that with your moderated view on medium-term, is there any underlying softness in the market or does it make sense that this concerns are on CapEx will have any impact on the optically generally?

Brad Feller

So, I will take the first part of the question and let Tom address the second part. The first part of your question related to gross margin, so we were talking about where in the low 40s margin will end. We will depend highly on that mix of footprint and fill.

Tom Fallon

I want to make sure we didn’t confuse you talking about capital expansion internally in the short-term driving margin issues. There is no substantive CapEx expenditures planned internally right now. So, I don’t want you walking away saying or thinking we have to go and put a lot of CapEx into expanding the fab. We have good yield profile. We have good availability to expand our output based upon our current CapEx infrastructure with normal spend of what 5% of revenue on that. So, you shouldn’t assume any kind of change in model of that. Does that answer the question?

Ashwin Kesireddy - JPMorgan

Yes, thanks.

Tom Fallon

In regard to Tier 1 CapEx, and I am going to Dave talk about technology for ICP. Tier 1 CapEx, I made a couple of comments, we are up to now 16 Tier 1s. We had a Tier 1 that was a top five customer. Our business with Tier 1s continues to be robust. Is the Tier 1 market afford us lot of opportunity to grow with that? It does. But we are not seeing any kind of specific challenges. I know I have made this comment before typically when people ask about Tier 1s, they are specifically asking about AT&T and Verizon CapEx. We don’t have real exposure to that. So, I don’t really have any insight for you other than the comment, I continue to believe that, those two players in that market continue to get undo type of view for how much of the market they are. They are important, but I think that other spaces, Internet content, cable, wholesale are driving a huge amount of the CapEx expansion. And for transport, the discussion around the Tier 1s defining the market, I really think is not a good service to the view. In regard to the technology for the Internet content space in addition to PICs, I don’t know Dave if you want to make any comments or…

Dave Welch

I mean, the Internet content space along with frankly a good chunk of the restaurant market, their number one need is scalable technology, the ability to deliver high bandwidth and the growth of bandwidth for that. If you look, here you are in a transition from 10 to 100 gigabit, 40 gigabit being a very short lift opportunity, it’s a huge – it’s a result of a shift in high capacity demand still growing. So, the technologies are very similar. This is where our original focus, which was on developing photonic integrated circuits, in order to manage high-capacity opportunities, and developing intelligent transport networks for the convergence of digital and optical technologies and a kind of a platform. It has served us well and we’ll continue to service very well. Being optimized – optimize offerings for high-capacity at scale deployments is directly – it’s kind of the target of our technology choices.

Ashwin Kesireddy - JPMorgan

Okay, thank you.

Operator

Our next question comes from Michael Genovese of MKM Partners. Go ahead sir. Your line is open.

Michael Genovese - MKM Partners

Great, thanks a lot. Listening to your commentary, it sounds to me like the Level 3 100-G footprint build may have slipped into the third quarter from the second quarter, can you comment on that?

Brad Feller

Yes. So, Mike, we can’t comment on any specific – what mobile will do in the third quarter, this kind of stuff, what I will say about Level 3 is we mentioned that they were going to come on as the 100-gig customer this year. They have – they have ramped probably a little bit slower than we expected, but for the year, we think they will do a nice piece of business with us and will be a great customer in a 100-gig for a long time.

Michael Genovese - MKM Partners

Okay. For the record ports in 2Q, can you just generally talk about in general terms, the percentage that’s tied to new footprint build in that quarter and then the percentage that’s channel fill related to networks that were built in previous quarters. Can you give us a sense of that?

Tom Fallon

Maybe I can make a comment. We don’t break it out between how much of our build is for new build or fill. The vast majority of our networks to-date are likely filled that we have deployed. So, there is still a tremendous amount of growth to be had in that and we continue to put on significant amount of new footprint every quarter and we expect that trend that to continue.

Michael Genovese - MKM Partners

Okay. And then last one from me, just a comment about the fourth quarter that you made, I think Tom you said something about a flat to down quarter, which makes sense, but I just wanted to clarify whether you are using 3Q or 2Q as the base, which we might be flat to down from in 4Q?

Tom Fallon

Yes. Most importantly, I did not comment that it will be flat or down or up. We said that that we have gone to more normal visibility. I think Brad commented that based on that visibility, it brings us more uncertainty of whether we will be able to maintain the revenue of Q3. Please don’t read anything more into that, than what we said.

Michael Genovese - MKM Partners

Okay. Well, congratulations on the great results and guidance.

Tom Fallon

Thank you very much.

Operator

(Operator Instructions) Our next question comes from Dmitry Netis of William Blair. Go ahead. Your line is open.

Dmitry Netis - William Blair

Thanks. Two quick ones for me. Nice win there with XO obviously existing customers. Yes, in the past I think Tom, it covered around 10% of revenue somewhere in that ballpark, is it reasonable to expect that during this DTN-X cycle this customer can achieve sort of the same revenue breakdown?

Tom Fallon

Well, I am not going to comment on what percentage they might have been in the past. It varies so much quarter-to-quarter and year-to-year. Obviously, they are a very large customer. We have a great relationship with them. They have the potential of buying a lot of gear, but we are not a soul source there. There is another person that is also qualified in that we have earned a second spot. And I think we are going to have a lot of good opportunity with them, but I’d cautious of baking in any kind of percentage of our corporate revenue based on them.

Dmitry Netis - William Blair

Okay. And are there deploying as we speak or is this sort of a timeline issue?

Tom Fallon

They are deploying as we speak and I anticipate they are going to deploy for a long, long time.

Dmitry Netis - William Blair

Great. Okay, good. And then the second question on the R&D that 20% of revenue, is that an annual number, I think that’s what you said? If that’s the case, are you basically guiding that both ‘15 and ‘16 should be modeled at that 20% on the annual basis?

Brad Feller

Yes, that’s the target and it will have some small fluctuations from quarter-to-quarter, but 20% of revenues is what we are targeting. Obviously, we have alluded to several times in both Tom’s and I’s prepared remarks about going after adjacent markets. So, we do think 20% of revenue is a good level for us in balancing both our future roadmap, but also looking at the profitability of the business.

Tom Fallon

Yes, I will comment. Just a clarity on what Brad said, I think for ‘15 certainly 20% is a reasonable number to model. I think over time what we have said that as achieved certain scales, we believe that we should be able to bring that down as a percentage. We will always be a technology company. We will always be a deep R&D company. Beyond ‘15, quite frankly, I don’t know enough yet to say what the number will be. So 20% is the max, but at some point, you should think about it’s not a permanent 20%. I don’t know what the scaled number is, but it’s not a permanent 20%.

Dmitry Netis - William Blair

Right, right. That helps. And then the reason I ask this question because you obviously have this spur of activity with regards to metro launch and product development. And coming in 2016, I get that there is different items on the roadmap, but whether they take as much of R&D as metro is what I was trying to ascertain here. So, thank you very much. That’s helpful.

Tom Fallon

You bet.

Operator

Our next question comes from Brian Coyne of National Alliance. Go ahead sir, your line is open.

Brian Coyne - National Alliance

Hey, guys. Thanks for taking my call. Two quick ones. First, help me understand just maybe a little bit of your commentary around sort of the more normalized outlook. If you go back to the end of the last quarter, would the improvement in the outlook that you had sort of into 2Q and – is that really driven by that one large North American order, that’s being deployed or was it sort of more broad-based? And so I guess I am just trying to understand when you are thinking about little farther out into Q3 and Q4, is it just because that one order sort of that sled moves through the business and then everything else kind of really didn’t change or it was more the visibility sort of also impacted by any changes in any other customers?

Tom Fallon

I think if you look at our results over the last couple of quarters we have been pretty consistent that we have had a pretty mixed bag of customers as top five, cable guys, internet content guys, wholesalers, Tier 1s. And what I would say is that we are in a very fortunate position of having a lot of opportunities spread a lot across a lot of vertical places and we had this incremental order that was substantive on top of that. That created one bigger backlog than we feel comfortable maintaining while promising time as a weapon, but it created hugely beneficial visibility, because of the combination of both those things or all those things hitting simultaneously. So, it was a much broader base than one big order from one guy.

Brian Coyne - National Alliance

Got it. That’s helpful. And then I guess secondly, your comment on the more rationale pricing environment, sort of does that imply – I mean, is it just simply the fact that some of the legacy guys aren’t showing it maybe quite as consistently or is there something else perhaps that’s just driving the rationality that you are seeing? And I guess sort of the follow-on to that is, does that condition in the pricing environment give you any additional headroom to maybe price a bit more aggressively as you look to gain (indiscernible) sort of over the next year, year and a half?

Tom Fallon

I am not going to advocate that we price more aggressively. I think we are pricing fairly and we are competitive. And I think our customers appreciate the value proposition. And I think that part of it is the winners, I think being defined in the 100-gig market are becoming pretty declared. I have actually had some customers on deals we have won tell me that the competition was so slow and these are with some people that were, I would say, financially not necessarily as solid as others that it causes them alarm that if they are pricing that way, it makes them concern for the competitors, our competitors’ long-term viability. That’s a nice place to be for a change when low price actually can cause a customer to be concerned about the long-term liability. I think that as I have said there is going to be new winners and new losers as we move to this 100-gig coherent, the supper-channel market. I firmly believe we are a new winner and I think that the market continues to be over-served and it’s going to be rationalized over the next many years both in the long-haul that’s already started and in the metro and we are going to try to accelerate that by going hard into that space. So, for the most part, it’s still very, very competitive. It’s till over-served, but I am seeing and this might change quarter-to-quarter, I am seeing currently fairly rational behavior.

Brian Coyne - National Alliance

That’s great, Tom. Thanks a lot and nice job in the quarter.

Tom Fallon

Thank you.

Operator

And I am showing no further questions at this time. So, I will turn the call back over to Mr. Fallon.

Tom Fallon - Chief Executive Officer

Thank you guys very much for joining us this afternoon for your questions. We look forward to updating you on our continued progress and hope to see you in September.

Operator

This concludes today’s conference. Thank you for your participation. You may now disconnect.

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Source: Infinera's (INFN) CEO Tom Fallon on Q2 2014 Results - Earnings Call Transcript

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