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Executives

Bob Blair -

Thomas Fallon - Chief Executive Officer, President and Director

Ita M. Brennan - Chief Financial Officer

David F. Welch - Co-Founder, Chief Marketing & Strategy Officer, Executive Vice President and Director

Analysts

George C. Notter - Jefferies & Company, Inc., Research Division

Blair King - Avondale Partners, LLC, Research Division

Ehud Gelblum - Morgan Stanley, Research Division

Rod B. Hall - JP Morgan Chase & Co, Research Division

Michael Genovese - MKM Partners LLC, Research Division

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Nathan Johnsen - Pacific Crest Securities, Inc., Research Division

Kevin J. Dennean - Citigroup Inc, Research Division

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Infinera (INFN) Q4 2011 Earnings Call February 2, 2012 5:00 PM ET

Operator

Welcome to the Fourth Quarter Year 2011 Investment Community Conference Call with Infinera Corporation. [Operator Instructions] Today's call is being recorded. [Operator Instructions] I would now like the turn the call over to Mr. Bob Blair of Infinera Investor Relations. Sir, you may begin.

Bob Blair

Thank you. Today's call will include projections and estimates that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements address the financial condition, results of operations, business initiatives, views on our market and customers, our products and our competitors' products and prospects of the company in the first quarter of fiscal year 2012 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 company's current press releases and SEC filings, including the company's annual report on Form 10-K filed on March 1, 2011, for more information on these risks and uncertainties.

Today's press releases, including fourth quarter and fiscal year 2011 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 will also include certain non-GAAP financial measures. In our earnings release, we announced operating results for the fourth quarter and fiscal year 2011, which exclude the impact of restructuring and other related costs and noncash stock-based compensation expenses.

These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons. Please see the exhibit of the earnings press release for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and an explanation of why these non-GAAP financial measures are useful and how they are used by management, which will be available today on the Investors section of our website.

On this call, we will also give guidance for the first quarter of fiscal year 2012. We have excluded noncash stock-based compensation expenses from this guidance because we cannot readily estimate the impact of our future stock price on future stock-based compensation expenses.

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

Thomas Fallon

Good afternoon and thanks for joining us. With me are Chief Strategy Officer, Dave Welch; and CFO, Ita Brennan. I will spend a few minutes today commenting on the market, touch on our Q4 results and then provide an update on the reception to our new products before turning it over to Ita for a full review of our Q4 performance and Q1 outlook.

Internet bandwidth continues to expand with unabated growth, driven by video, mobile and cloud computing applications. Simultaneously, we are observing the transformation of the Internet into the primary and mission-critical telecommunications network of the future. We believe these trends are causing service providers to take a hard look at how they build and manage their next-generation transport infrastructure. This transformed transport infrastructure will need to: scale smoothly to multi-terabits of optical transmission, starting with a 100 Gig and quickly moving to terabit capacities; efficiently accommodate more fluid, cloud-based traffic demands and support mesh networking while maintaining the predictability and reliability of transport networks; and become a simpler and more cost-effective, requiring significantly less human resource, power, cooling and space per bit of traffic carry.

We believe that our recently launched DTN-X is optimized to accelerate this important transformation. Our competitors are starting to ship 100 Gig and present concepts and demos of 200 hundred Gig on a line card. Customers are testing our DTN-X today, with 500 Gig super-channel line cards, and we've already demonstrated technology to go to 1 terabit of super-channel capacity on a single card.

The DTN-X is the step function that service providers and in particular Tier 1 carriers need to properly prepare their networks for the high-capacity future. We believe that our new DTN-X, in conjunction with our enhanced DTN and existing ATN, all with control plane unification software, enable us to better address our traditional customer, as well as a new set of Tier 1 customers across verticals and geographies.

In Q4, we saw an active market in the cable, Tier 1 and bandwidth wholesale segments, while much of the industry conversation and our own go-to-market strategy centers around 100 Gig and greater than 100 Gig super-channel speeds. The 10 Gig market remains strong. It is a consensus view among analysts that 10 Gig will continue to grow in volume throughout the next several years. And we believe it will remain robust for another decade. In fact, we believe the strength of the 10 Gig market was a key factor enabling Infinera to achieve the #1 share position in the North America, terrestrial long-haul WDM transport and ROADM market, and advanced to #3 worldwide, based on Infenera's data for the third quarter of 2011.

Our view continues to be that 40 Gig will flatten out and serve as an interim solution as carriers continue to deploy more cost-effective 10 Gig for lower-capacity links and move to 100 Gig and 500 Gig super-channels for high-capacity links. Our opportunity is clearly defined, maintain leadership in the 10 Gig market and repeat that success with 100 Gig. We also continued to see an increasingly competitive pricing environment, which we expect to remain so as multiple vendors now compete with 3 DWDM transmission speeds: 10, 40 and 100 Gig. We are also seeing more [indiscernible] consolidation among our carrier customers, reducing the universe of customers and increasing the leverage of each customer as they become larger.

Our better-than-expected revenue performance in Q4 reflects continued the solid demand for DWDM equipment, along with the benefit of some unanticipated year-end budget spending by a number of our customers. We recovered well from the disruption caused to the optical supply chain by the historic flooding in Thailand, muting the negative impact to our performance that we had originally singled in November. Our operations team and supply partners worked tirelessly to deliver on our disaster recovery plan and ensure that our customers we're not hurt as a result of this catastrophe.

Although vast majority of our Q4 revenue was 10 Gig-related, we did achieve our first 40 Gig revenue addressing pent-up demand from key customers. We saw a broad balance across our customer base in the fourth quarter, with the top 5 customers accounting for approximately 40% of revenue. 2 cable companies were among our top 5 customers, including one in excess of 10%. I am also happy to report that one of our Tier 1 customers is one of our top 5 for the second consecutive quarter. As a reminder, our strategy has been to demonstrate our value in the international and regional networks of Tier 1 carriers with the DTN and then to leverage the multi-terabit scalability, efficiency and simplicity of the DTN-X to earn an insertion opportunity in their core backbone networks.

On the customer win front, we added 5 new customers in the fourth quarter. This gives us 16 customer additions in 2011, for a total roster of 98. Given that we were primarily shipping our 10 Gig DTN for most of the year, the growth and stability of our customer base is a testimony to the importance placed on the Infinera value proposition, anchored of course by our differentiated digital, optical approach to the network. In another validation, we now have 36 network customers, customers who have purchased multiple products from us across multiple applications.

On the new product front, customer interest in our new DTN-X, since its launch, has been very strong, which we believe is in recognition of the unique advantage Infinera's integrated platform brings to market, the only platform operating integrated DWDM and OTN switching functionality without compromise. As a reminder, this platform is fundamentally 3 products in one: A DWDM transmission system that will support the world's first 500 Gig super-channels based upon 100 Gig of FlexCoherent channels, upgradable in the future to 1 terabit super channels, unleashing highly efficient DWDM transmission capacity at the lowest operational cost; an integrated OTN switching system that will scale from 5 terabits in its first release to 100 terabits in the future and will enable operators to efficiently tame these large pipes, through the grooming of traffic down to 1 Gig granularity; and third, a system that is designed to be upgradeable to MPLS switching in the future, which will further enable convergence of the network for improved efficiency, reducing the number of interconnections between layers while preserving network investment.

Infinera pioneered the integration of OTN switching and DWDM with the DTN in 2005. Leveraging this unique learning for more than a decade of development in 7 years of field operation, the DTN-X integrates 3 technology-building blocks to deliver value and differentiate itself from the competition: 500 Gig photonic integrated circuits with FlexCoherent DSPs; custom switching ASICs and a multi-terabit nonblocking switch fabric; and intelligent GMPLS control plane software that scales to thousands of nodes.

The DTN-X design has been optimized to meet the needs of Tier 1 carriers and addresses their need to prepare for extremely, high capacity in dynamic networks, opening up a large and new market for Infinera. Competitors are following Infinera's architectural lead, announcing integrated solutions. However, unlike the DTN-X, design for this integration from day 1, competitors are taking existing systems and adding DWDM or switching after the fact. This approach results in a compromise between the switching and transmission capacity of these systems. This does not occur with the DTN-X. We believe that DTN-X will be the only platform on the market that will allow all components, including the optical functions based on our PIC technology, to be consistent with Moore's Law, delivering best-of-breed switching integrated with best-of-breed DWDM, without compromise.

The DTN-X is on track with lab trials in Q1 and volume production starting in Q2. We have begun to scale the production capability, and the 500 Gig PICs have been released to manufacturing. On the trial front, we have scheduled 4 DTN-X lab trials in our current quarter. All 4 of these trials are with Tier 1 carriers, reflecting a mix of both new prospects and current customers, with 2 located in North America and 2 located in Europe.

In addition to these trials, we've had numerous demonstrations of the full DTN-X system. While we are pleased with the early interest by the carriers in our DTN-X platform, it is important to note that Tier 1s often have extensive qualification testing and that a lab trial is only one of several steps toward revenue. In the quarters ahead, we will be -- report to you on additional trials and DTN-X wins.

Infinera's mission is to transform the way telecommunications transport networks are built. Our first step on this journey was the DTN, introduced in 2005. This platform delivered the world's only commercially available 100 Gig photonic integrated circuit, the world's first optical transport platform that integrated DWDM, OTN switching and a GMPLS control plane into one platform, and the world's first digital optical network.

Our customers have validated this architectural approach of integrating photonic elements, platforms and network layers, delivered network scale, efficiency, simplicity and reliability. We are now taking this decade of experience on our scaling and improving upon this architecture with the DTN-X. Infinera is delivering on a promise of the terabit age in 2012 and preparing our current and future customers to transform their networks to scale efficiently across the next decade. This is what the network will be.

Before turning it over to Ita for a detailed review of our Q4 performance and our outlook for Q1, I want to thank the Infinera team for their continued commitment to innovation and their focus on execution, allowing us to make sure we deliver on the promise of helping our customers be successful in their markets. I want to say a special thanks to our supply partners that helped us navigate a uniquely challenging Q4. And I will close by thanking our customers for their continued business and partnership as we move forward into terabit age together.

Ita will now provide you her review of Q4 and outlook for Q1. Ita?

Ita M. Brennan

Thanks, Tom. I'll review our Q4 actual results and then follow that up with our outlook for Q1 '12. This analysis our Q4 results and our guidance for Q1 '12 is based on non-GAAP. All references exclude noncash stock-based compensation expenses.

As I outlined on the September call, our revenue guidance for the fourth quarter had a wider range than normal due to uncertainty around the timing of revenue recognition on a number of large deals. The flooding in Thailand, which occurred just after our call, triggered notification from the supplier that they would not be able to achieve their previous supply commitments. This increased the uncertainty around our revenue guidance and required us to expand the range of potential outcomes in the subsequent press release.

As Tom mentioned in his remarks, we were successful in securing supply of impacted components and met most customer requirements. In addition, we completed and recognized revenues on all 3 large deployments that were targeted for completion at or around at the end of the quarter. This included recognizing the first revenue from our 40 Gig solution. As it often happens in the industry, we also had a number of customers approach us with some year-end budget money, and we were pleased to be in a position to accept and satisfy that demand in the quarter.

All of these factors resulted in total GAAP revenues in Q4 of $112 million compared to our original guidance of $100 million to $110 million and our revised guidance after the Thailand flood of $85 million to $105 million. Our revenues were broadly diversified across our customer base, with one greater than 10% customer in the quarter, which as Tom mentioned, was a cable provider. We saw a healthy mix of new footprint deployments combined with continued strong TAM shipments. International revenues amounted to $34 million or 30% of total revenues for the quarter. EMEA accounted for $24 million or 21%, with APAC and the other Americas representing 5% and 4%, respectively. Our service revenues for the quarter were $18.4 million, up from $13.6 million in Q3, reflecting the completion of a number of large deployments and the renewal of some significant entitlement contracts. Services margins were favorable at 68%. Overall gross margin in Q4 were 42%, up from 41% in Q3, reflecting continued strong TAM shipments, improved volumes and a healthy services mix.

Operating expenses for the quarter were $53 million, in line with our guidance and compared to $52 million in Q3. Looking forward to the March quarter, we expect operating expenses to be approximately $54 million, reflecting increased R&D testing and verification activities as the DTN-X product moves closer to final release.

Overall headcount for the quarter was 1,181 versus 1,151 in Q3. Head count addition is primarily related to direct labor for manufacturing and for the software verification adds for R&D.

Our operating loss for Q4 was $6.3 million. Other income and expense for Q4 was favorable at $0.1 million. Net loss for the quarter was $6.7 million, resulting in a loss per diluted share of $0.06 compared with our original guidance, which called for a loss of $0.08 to $0.12 per diluted share and compared to a loss of $9.2 million or $0.08 per diluted share in Q3.

Now turning to the balance sheet. Cash, cash equivalent, restricted cash and investments ended the quarter at $253 million versus $276 million in Q3. We used $5.1 million of cash from operations in Q4 versus generating $4.1 million in Q3. DSOs were 65 days up from 60 days in Q3, mainly due to shipments occurring later in the quarter as we work through supply issues.

Inventory turns were 2.9x versus 3.5x in Q3. As a result of executing on our disaster recovery process, some double sourcing occurred and we exited the quarter with higher DTN inventory levels. We expect to consume these inventories in the first and second quarters.

We also began production of components for the new DTN-X products and plan to ramp this production in the March quarter. As a result, we expect to drive increased inventory levels over the coming 2 quarters, in advance of recognizing revenue on the DTN-X in the second half of the year. Accounts payable days were 53 days, up from 43 days in Q3, again, reflecting delayed receipts from suppliers in the quarter.

Capital expenditures were $16.1 million in Q4 versus $5.9 million in Q3, for a total of $39 million for the year. As we look to 2012, we expect CapEx to average approximately $10 million per quarter for the first half of the year and then return to the lower levels in the second half.

Now turning to our guidance for Q1 '12 and beyond. We may experience some seasonality in the first quarter as service providers typically take time to plan their annual budgets and deployments. As a result, we've been somewhat cautious with our assumptions around TAM shipment volumes for the March quarter. In addition, reflecting recent success and new footprint wins, we plan to take revenue on a number of significant deployments of both new and existing customers, driving a stronger common equipment mix.

As mentioned above, we will ramp DTN-X rate of production in both our FAB and module factories this quarter. And depending on volume and yields, this may drive some gross margin volatility. As we look beyond Q1 '12, we see good overall demand for our products and strong interest in the DTN-X platform.

Revenue in the second quarter may be tempered by some existing customers choosing the DTN-X for their new footprint deployments. We expect that the shipments and acceptance criteria for these initial DTN-X deployment may push revenue recognition for this business into the September quarter.

With these factors in mind, the following guidance for Q1 is based on non-GAAP results and excludes any noncash stock-based compensation expenses: revenues of approximately $102 million to $108 million; gross margins of approximately 38% to 40%; operating expenses of approximately $54 million; operating and net loss of approximately $11 million to $15 million; and based on estimated average, weighted diluted shares of outstanding of 110 million, this would lead to a loss per share of approximately $0.10 to $0.14. Please note the basic share count is expected to be at $108 million for the quarter.

Operator, would you now please open up the call for questions? Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from George Notter of Jefferies.

George C. Notter - Jefferies & Company, Inc., Research Division

I guess I wanted to -- just get updated on, again, the delivery of the DTN-X. Can you just layout for us which milestones are still in front of us in terms of -- I don't know if it's software verification or -- just walk us through what's left in terms of development to get that shipping commercially?

Thomas Fallon

Sure, George. This is Tom. We are in 2 phases right now. As we mentioned, we are in the process of doing customer lab trials. That's always a good way to validate that the performance that you are expecting matches the market requirement. So that process has started, and I anticipate that we will both do well and discover things that we need to work on. The vast majority of the work is, as you point out, in the back-end testing process and system validation testing, is a product of magnificent scale. And with that scale comes complexity. And we are going to make sure that when we introduce this platform, it comes with the reputation of quality that Infinera delivers. So the bulk of the remaining time is in system validation testing, making sure that the switching functionality works as planned. All the alarms on the system that are quite absolute -- all work as designed. And I suspect we will stumble across some bugs that need suffer fixes, so that's really the next major milestones. The development work is vastly done.

George C. Notter - Jefferies & Company, Inc., Research Division

Got it. Okay. So I guess just -- I guess, more finely tuned to delivery. I assume the delivery then for trial as late Q1, is that fair to say?

Thomas Fallon

Well, we've said -- is that, we scheduled -- have scheduled -- or for Q1 and that volume production will occur in Q2. We -- I am reaffirming that, that's our current plan. Of the 4 trials we have scheduled, we've actually completed one. And so we are marching down the path.

George C. Notter - Jefferies & Company, Inc., Research Division

Great. And then, you mentioned earlier that there were some pent-up demand associated with the 40 Gig line card delivery and then certainly some budget for our shelves also here in the quarter. Can you tell us how much that was relative to the $112 million you printed here?

Ita M. Brennan

Yes, I mean, I think the year-end budget is up probably low single-digit millions of dollars. It wasn't more than that, right? I mean, we executed on those large opportunities that we talked about in the original guidance, and then we saw some upside kind of in that range.

George C. Notter - Jefferies & Company, Inc., Research Division

Got it. Okay. And then, I'm sorry, the piece attached to the 40 Gig delivery, was that -- I, guess it was also a budget flush or...

Ita M. Brennan

We didn't put a number on that, but that the 40 Gig piece was planned, right? I mean, we had talked about that on the last call that we had some subsea 40 Gig business that was kind of on the bubble from a rev rec perspective and that happened. I don't think we've put a specific number on that. But it's a large subsea deal, so you can imagine that it's in a multiple millions of dollars.

George C. Notter - Jefferies & Company, Inc., Research Division

Got it, okay. And then, just as I look out over the balance of the year and I think about you guys ramping the DTN-X. I mean, how should I think about that in terms of the margin profile? Safe to say that it'll come initially at lower margins, you were considering yield issues and then over time, the margins ramped. And how would that compare to the current margin profile of the existing DTN?

Ita M. Brennan

Yes, I mean, it's tough to kind of plot it out on a quarter-by-quarter basis. We did -- we looked at the plan for the last call and we guided kind of to that 40%, approximately 40% range for the year. I think for the first quarter, we put out a range of 38% to 40%. That's kind of just to reflect some. We haven't got a ton of visibility of TAMs yet for this quarter. Hopefully, they'll come, but as of right now, we wanted to be somewhat careful about what we included in that guidance. We did see a healthy mix of comments as well as in Q1, which is probably maybe more that we might have expected initially. So we are winning new footprint and we are seeing customers putting in new line systems even in Q1. Whether that gets sold out completely with DTN or DTN-X will depend on what the customer needs, but we are seeing kind of heavy comments mix. So that's kind of impacting the margins in Q1. So I think, depending on where our revenues actually turn out for Q2, we could see some kind of lower margin impact there maybe. And then on the back end of the year, then we'd start to ramp some volume and start to utilize some of the overhead that's already in the comps number. We should start to see margins kind of improve, but averaging out that 40% is kind of what our current plan would say.

Operator

Blair King from Avondale Partners.

Blair King - Avondale Partners, LLC, Research Division

Ita, a couple of quick questions. One for you and maybe one for Tom. When you mentioned in your prepared remarks about the revenue in the second quarter, potentially being tempered by the DTN-X, does that imply or should we read into that, that the second quarter revenue should be down from the first quarter?

Ita M. Brennan

Yes. I mean, it's hard to tell at this point, right? I mean, we are seeing a dynamic where really just on the new footprint deployments, I think that the existing DTN business is continuing to transact as normal. But when customers are looking at new deployments, depending on what exactly they're going to need that capacity, is they'll either deploy DTN or they may want to start to deploy the DTN-X. If it's DTN-X in Q2, that may push out to Q3 from the rev rec perspective because there'll be some acceptances in some other criteria.

Thomas Fallon

Blair, this is Tom. The DTN and DTN-X are guided toward different markets. They're guided towards some different customers, some customer overlaps, some customer and markets overlap, but they're really specified to be 2 product lines or 2 products in one family. The issue that Ita brings to rise is, as we introduced a new platform, my goal is that the customer base picks Infinera. And I don't have a preference, quite frankly. If the DTN does it better for them, that's great. If the DTN-X does better for them, that's great. And now we have that DTN-X tool and their toolbox. Some customers who might have bought a DTN might decide to go to the DTN-X because it has obviously more headroom. If that were to occur, then at the end of the day, we're winning the footprint. We're going to enjoy that business for a long time. But it causes some volatility that we don't control right now, and what we want to do is win footprint and help customers make the best choice for their long-term success. So she's just letting you know that there's an unusual dynamic at foot in Q2 that is new for our customer base.

Blair King - Avondale Partners, LLC, Research Division

Right, I understand that perfectly clear. The second question I had was, Tom, maybe you could just -- there's been questions in the past over the sort of the acceptance rate of not just Tier 1s, but just broadly the customer base in general over the 100 Gig market, as well as the 500 channel -- the super-channel product that have yet to come into the market. And that, that acceptance rate is ultimately what determines the ramp within that product. So if there's -- you may not have a lot more clarity this quarter than you did a quarter ago. But the extent that you do, maybe you could talk a little bit about how you see that market unfolding for you this year. A little bit more than just what you've done in terms of explaining the back half should be able to ramp, and then if you think of...

Thomas Fallon

I'm very optimistic that this platform, the DTN-X, is going to be very well received by the Tier 1 markets. We've designed it for the scale of their networks. We designed it for the complexity of their networks. I think that they want to converge network layers because they see that the way that reduce network costs over time. It's much less of a discussion around transponder cost. It's much more a discussion around network cost. And I think the DTN-X is uniquely ready in the platform case to do that. I think that the DTN and DTN-X -- it's important that people don't confuse the DTN-X -- the DTN wasn't accepted into the core of Tier 1s. The DTN-X actually had fairly good receptivity into Tier 1. It's just not into the core of their networks typically. And that's because I firmly believe we introduced the DTN, which was a 10 Gig wavelength platform 7 to 8 years after 10 Gig was brought to the market. I think carriers need to make sure as they're certifying new platforms, they're doing it on a relatively early end-of-the-technology life cycle to make sure they get full advantage of the investment they make. I think that our DTN-X platform with 100 Gig is at the very earliest part of the 100 Gig market, and we're quite frankly creating the 500 Gig super-channel market. I was very clear to point out that the 4 customer trials, lab trials we have scheduled for Q1, they're all Tier 1s, 2 in Europe and 2 in North America. That's pretty darn good for a brand-new platform that's still not released to market. So at the end of the day, Blair, as you know, all of this is interesting, PLs will matter and wins will matter, and we'll be clear to you on what those are when they occur. But I'm pretty optimistic with the progress we're making to date.

Operator

Ehud Gelblum of Morgan Stanley.

Ehud Gelblum - Morgan Stanley, Research Division

A couple of questions. The 4 trial customers you have right now for the DTN-X, are they existing customers of your DTN? Or any of them new people, new carrier customers?

Thomas Fallon

It's a mix of existing and potential new.

Ehud Gelblum - Morgan Stanley, Research Division

So in that 4 is at least 1, possibly 2, new customers that are not currently Infinera customers?

Thomas Fallon

At least one.

Ehud Gelblum - Morgan Stanley, Research Division

Excellent. The -- when you look at your Q2, and you were talking about, again, this concept of potentially stalling some of your DTN customers with the concept of the DTN-X coming out momentarily. I'm still a little unclear as to whether the concept is that we should be looking at Q2 as being a potentially down quarter or not. Because then, you were, additionally, were talking about how their market is to -- toward different customer bases. So I'm just trying to correlate this to and how we should look at Q2 and the kind of the pacing for that, for the rest of the year. Is it 2 scenarios? In one scenario, Q2 end up being down, and the other scenario, Q2 ends up being up? If you can just kind of walk us through how you're looking at that. And then what is the gross margin profile in both scenarios? If people hold out for DTN-X in Q2, what does that mean for gross margin if they don't? What does it mean for gross margin?

Ita M. Brennan

Yes, I mean, it's not that clear at this point exactly how it's going to play out. And what I mean, what we're trying to do is to kind of at least paint some of the boundaries around what we see could happen, right? I mean, I think, on the DTN-X, the key is -- the product is really -- and a lot of the opportunities that we're seeing with the product are with new customers, right? So that's back to Tom's comment. But we're obviously -- there will be existing customers as well who have the capacity and will want to adopt to DTN-X. I think what we're seeing in Q2 is we have customers who are deploying new footprint and they're putting in DTN to satisfy capacity. And as soon as they can shift to the DTN-X, if they require that capacity, then they will look to do that, right? How that plays out specifically in the quarter is tough. And I don't think we see the existing run rate, DTN business being impacted. It's more on the choice on new footprint deployments and the timing of those, and that's tough to call, right? I think from a gross margin perspective, it's -- if there's a -- if volumes are higher, we'll better margins. If they're lower, if you take your revenues down, then you will see some impact to margin, right?

Ehud Gelblum - Morgan Stanley, Research Division

But does it matter -- it doesn't matter though the types of revenue that we'll see in Q2 in Infinera's?

Ita M. Brennan

I think, either way, I don't think we'll recognize revenue from DTN-X in Q2, right? So it's really going to be a DTN revenue base in Q2 either way. The question is, do we impact kind of any growth that we would've expected to see in Q2? Because we see people waiting to transition to the DTN-X or not, right? But I think the DTN base is there. We're not looking to -- there won't be a DTN-X impact in Q2 from a margin perspective.

Thomas Fallon

I'm going to add 2 comments. One, well, the backdrop to me is what's happening in the macro market for transport. And we are seeing relatively steady demand across all of our markets. I think that, that's a very healthy thing for our business regardless what the people are using, DTN or DTN-X. We're seeing a lot of activity. We're seeing a lot of activity in various markets. And I believe, even the industry group is now saying that the long-haul market should experience some relatively good growth this year. I think there's a question, certainly in North America about AT&T and Verizon. But I don't have anything to add to that. But I can tell you, across our customer base, we're seeing people making investment decisions. So the backdrop is, I believe that the environment for this year should be reasonably healthy. Q2 adds a new a dynamic that is new, because we're introducing a new platform. And we believe that on the DTN-X, assuming we're fortunate enough to have the opportunity to sell it to people, we'll have a longer acceptance cycle. A lot of our customers will allow us to accept upon shipment. These are people that have larger install base with us. We ship the product. We ship add-ons. And they allow us to recognize revenue because they pre-certified it. The DTN-X probably has a longer certification system or process than recognized revenue on shipment. At least for the first bit, it will be through certifications. That creates a revenue recognition dynamic that Ita is trying to, in full disclosure, share with you.

Ehud Gelblum - Morgan Stanley, Research Division

So for once, actually, it's a good thing that you don't have this Q1 exposure? You're actually seeing positive trends versus a lot of your competitors or not. So as we look finally at Q3, how confident are you that you can actually recognize DTN-X revenue in Q3? Where do you think the cause of this revenue recognition is due on the new platform? It could push out in Q4, possibly Q1 of 2013, in terms of when you can actually start recognizing DTN-X revenue.

Ita M. Brennan

I mean, I think we're sticking to kind of the guidance that we have out there, which has revenue in the second half. We've ramped production in Q2, and then we'll just have to let it play it out. We'll update you obviously on the next call as to where we are. We'll be closer at that point. We'll have more visibility, right?

Operator

Rod Hall of JPMC.

Rod B. Hall - JP Morgan Chase & Co, Research Division

Thanks for taking my question. I just had a couple of things to ask. Tom, I just wonder, on the trial, if you could -- you guys could clarify what the pipeline for trial looks like. I mean, you've got these 4 people that are trialing. Is that -- have you had to cut it off? Do you have other people in line that want to trial it, but you're just trying to limit it to those 4 Tier 1s? Or do you expect, by next quarter, when you guys report to us to be talking about a considerably larger number of trials, and can you just give us any idea how many we might be looking at? And then I also just wanted to ask about the DTN-X. I mean, let's say, it all goes well. Let's say that the Tier 1s want to buy it. How are you guys fixed for production? I mean, are you feeling pretty good about your ability to serve demand? And what are you doing about distribution? Let's say, if you get those headline customers, I guess you will definitely get a longer line of people who want to come in and look at the product and potentially purchase it. Do you feel like you've got the distribution in place to handle that kind of demand if it comes through?

Thomas Fallon

On the first line of trials, we very specifically have decided to just talk about current quarter trials. And I think that, that's just the prudent thing to do. So we're only talking about the ones that we have scheduled for Q1. There is a pipeline of requests beyond our Q1 committed trials. But I'm not going to give you any more clarity on that. My goal at every quarter will be to give you an update on previous trials, current trials of the current quarter and any activity of sales we might have achieved. So it doesn't completely answer your question, but hopefully, it gives you a flavor for our thinking. In regard to the DTN-X fulfillment capability, I'll just talk philosophically for a minute. If you remember last year, we said we're going to raise our sales headcount because we had spent a significant amount of money bringing what we think is a very significant platform in technology in the market. And our view was it would be inappropriate not to have invested in enough salespeople to sell the product. That's in place. The sales guys are out, I think, being productive. Certainly, the trials make me think that. And the customer interactions I have make me know that. We're going to take the same philosophy to manufacturing. In our business, being a vertically integrated manufacturer, if you look back on the 100 Gig market last year, it was forecasted at somewhere between $100 million to $200 million, somewhere in the area of 1,000 wavelengths or so. If we are successful at doing 1,000 wavelengths, even if that's 100% of the market, that's insufficient for us to build the business model that we need. Our job is twofold: one, to deliver a compelling solution to the market based upon our 500 Gig technology and cause the industry to adopt 100 Gig as a primary vehicle and we are going to put the manufacturing capability and are putting the manufacturing capability to effect that.

Rod B. Hall - JP Morgan Chase & Co, Research Division

Okay. And then I just wanted to clarify one thing too. Maybe Ita is the right person to ask or maybe Tom. But these 5 and 10% customers, would you expect the same ones in Q1 again? Or do you think that mix of top customers is going to change materially as we head into Q1?

Ita M. Brennan

Yes, I mean, typically, if you look at that top 5 list, they do rotate in and out of there, depending on whether we're doing new deployments, et cetera, with them, right? So that's always a good mix across the segments. But it tends to be a different player on a quarter-over-quarter basis.

Operator

Michael Genovese of MKM Partners.

Michael Genovese - MKM Partners LLC, Research Division

I just -- 2 quick questions. One, can you just comment on what you're seeing in the pricing environment? And then, #2, I was going to ask using coded language, but since Tom, since you've mentioned the names AT&T and Verizon, I'll just come straight out and ask if either one of those are in these 4 trial customers that you have for the DTN-X?

Thomas Fallon

So I'll answer the first one first, on pricing. Pricing is a fairly interesting dynamic because there's now 10, 40 and 100 Gig all being for footprint. We continue to see 10 Gig come down at a fairly significant pricing, kind of historic run rates of 10-plus percent a year. And typically, this long in the cycle of a technology that starts tempering itself. It doesn't seem to be tempering. I don't think it's accelerating, but it's not tempering. So I think that 10 Gig pricing is going to continue to be downward. 40 Gig is I think trying to keep up with that downward trend. To the best of my view on 40 Gig Coherent, there really isn't a crossover yet. I think it's close to. Some people will say it's crossed over. Some people say it hasn't. My view is it's roughly at parity. And as long as it's at parity, unless you have fiber constraints, or you want to make sure your network has more capacity in the future, 10 Gig continues to be a fairly good economic answer. I believe that 100 Gig is still early on in this technology cycle. I think that my view is 100 Gig will achieve a crossover with 10 Gig, at the same time or approximately the same time as 40 Gig. I think that's why we continue to believe there's a 40 Gig squeeze that will occur. I think a number of people who have 40 and 100 today are selling a large install base of 40 Gig, with the ability to upgrade to 100, because for them, that allows them more margin. And an upgrade path to 100, I think that is not an unreasonable approach. Infinera's approach is going to be, install with 100 at good competitive price and be ready to upgrade to 100 -- to a terabit. And I think that if you look at Internet demand growth, I think going from 40 to 100 is an interesting step. I think going from 100 terabits to a terabit or 500 to a terabit is really the problem set that needs to be solved. So I'm pretty compelled to believe the value proposition that we bring to the market, we can do that competitively on a fair return and bring our customers great value. In regard to the second question, which was, are AT&T and Verizon within that fold of people are on trials? We're not making any comments on who -- any of those 4 are.

Michael Genovese - MKM Partners LLC, Research Division

If I could just get a quick follow-up here on the margins, really it's the pricing environment. With the outlook this year for 40% gross margins, and it's obviously a transition year in the product portfolio. But is this still reasonable to assume a long-term target of 50% gross margins? I believe that's probably still the guidance that's out there for the long-term margin?

Ita M. Brennan

I mean, that is the long-term business model. I think, as we look out, we've guidance that comes at 40% through '12, and then into '13 you start to see that margin expand as you start to get more volumes around the DTN-X and more balance kind of common versus sale in the networks. I think that's -- it will expand out into '13, and then beyond, you'll start to approach that higher kind of 50% range. So it is kind of an expansion over time as you grow kind of the top line.

Operator

Simona Jankowski of Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Just to clarify first. Of the 4 trials, are those customers who are committed to buying the product at this point or are they still more evaluating, so they could still not convert to customers?

Thomas Fallon

Anytime that somebody's doing the trial, I think the intention is to evaluate whether they -- it solves a problem for them in their network. As I tried to explain on the call, the trials are a first step of a many step process toward a customer deciding that it is something that they want to put in their network. I think that companies are far too busy to send people to our labs for several days of testing just to be entertained in the California sun. So I think that it's an indication to me that what we're bringing to market represents a solution to a problem set that they either have or have in the future. But it's just a first step in a many step process toward a purchase decision.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Based on your historical experience, what percent of trials typically convert into customers?

Thomas Fallon

Yes, I mean, we don't have that, or we don't give that type of statistics. The best way of looking at it, the people that are trialing our gear have a serious need for DWDM bandwidth. They are in our purchasing cycle. They're evaluating our product seriously for these considerations.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

And you mentioned that some of your competitors have a 40 Gig system that is upgradable to 100 Gig. Among carriers who have adopted such a 40 Gig system, do you feel like they have effectively committed to that competitor's 100 Gig roadmap? Or are any of them trialing your product and do you still feel like you have an opportunity to convert them to the DTN-X?

Thomas Fallon

So I think the -- anytime you have a current customer, you have a certain level of incumbency. There isn't in this space, there isn't a hard lock in it that inhibits that business to go into another competitor as well.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Great. And then just lastly, can you just clarify what you meant about the segmentation of the DTN and the DTN-X? It's clearly, they both can and tend to sell into the Tier 1 customer base. So did you just mean more that within a single customer, they can target different parts of the network? Or if you can just expand on kind of the Tiering that you're referring to?

Thomas Fallon

As we've talked about before, our DTN product for national Tier 1 markets really hasn't been fully appropriate for a large Tier 1s. The DTN-X is, does meet their maximum fiber capacity, their density, and now that the integrated OTN switching that satisfies a lot of key sectors. So by bringing the DTN-X to market, we subsequently improve our accessible market from that. So there will be a new market addition on the DTN-X, as well as some overlap with our current DTN customers, as well as a bunch of our significant amount of our DTN customers are perfectly happy at the capacities and positions we've been at. As we've talked about North American share in the past, we have developed the #1 position within North America without the existence of the largest Tier 1 customers in North America. We think by bringing the DTN-X on board to complement that market position, that'll broaden out our accessible market.

David F. Welch

If you also look at the DTN versus the DTN-X, a single card on the DTN-X comes with 500 Gig of capacity. That's more capacity than the entire DTN chassis handles. So it's -- they can certainly work on the same application, but if you need significant scale, you're going to go with the DTN-X. If you don't need something that goes up to that capacity, the DTN is an exceptionally affordable and proven platform to achieve simplicity, efficiency and scale.

Operator

[Operator Instructions] Nathan Johnsen of Pacific Crest Securities.

Nathan Johnsen - Pacific Crest Securities, Inc., Research Division

You talked some about crossover points between the various speeds. I was wondering if you guys look at, I guess, the yield roadmap for DTN-X and kind of what you're assuming for price reduction on the DTN. Just wondering where you guys actually see a potential crossover point for DTN-X versus the DTN. I mean, is that a 2013 event? Or is that maybe not right way to think about it?

David F. Welch

I'm sorry, crossover point from a...

Nathan Johnsen - Pacific Crest Securities, Inc., Research Division

From a cost per bit.

David F. Welch

We think that the DTN, you're going to look at it from a network point of view as opposed to people try to take systems companies and push them down into a transponder market. It's not -- it's a network market. From a cost per bit, if I have a large mesh network with integrated OTN, the DTN-X is a better performer out there, just strictly because of the integration of the OTN switch. You've absorbed a lot of gear that would've otherwise sat in another chassis next to your DWDM platform. Now for a guided -- I -- has a non-large mesh network, but it's really looking at a single point-to-point type of network and is happy with capacities in the terabit or less range. DTN is going to be a preferred economic solution for you. And so at a network level, if you measure -- using to the network level, you're going to come up with a different answer. If you try to push both of these products into a transponder equivalent pricing, you're not going to come up with a right answer because it's not a component, it's a system.

Nathan Johnsen - Pacific Crest Securities, Inc., Research Division

All right. That's very helpful. And then, looking at the yields of, I guess, the key DTN-X components. I guess, particularly that the PIC -- I was wondering how the current yields for that product compare to previous PIC generation, just whether those are on track at this point.

David F. Welch

So yes -- so specific on numbers, we don't put out numbers on either. I -- when we define production, we define our ability to meet entitlement yields, which should mean I can get to a proper economic solution for DTN and DTN-X, and let's say it's for comparable in that range.

Nathan Johnsen - Pacific Crest Securities, Inc., Research Division

Got you. And last one for me. You guys have talked about the future integration of MPLS capabilities. I'm just wondering if you could provide an update on when you guys expect that to be added as a capability and whether you see that feature capability being important for purchasing decisions now.

David F. Welch

I -- so we've talked about that the DTN-X system that is system that's compatible with upgrades to include MPLS technologies in it. We are absolutely marching down that path and we think the complement of all bandwidth management technologies, which, at the optical level, at the OTN level, and at the MPLS level, in a common platform, is what's required in the marketplace. And the DTN-X offers that or offers the migration to include that. We haven't put a date on the integration of the MPLS and I think we're at the stage where we want to do that just yet. But I -- we've got a fair amount of expertise, announced that understand that problem. It's safe to say we're working down that path. Let's see, I apologize, I forgot your second question.

Nathan Johnsen - Pacific Crest Securities, Inc., Research Division

Just curious whether that's been thought about in purchasing decisions now or if that's something you guys will start pushing to the customer later.

David F. Welch

Yes, I'd put it in the area of an interesting topic for architecture teams, but not in a decision-making topic. They like to hear on where my -- where their networks are going to go several years out. They like to -- they need to have a vision that says that my network level, that my cost per bit and my power per bit, et cetera, are all decreasing. And they understand that layer convergence is part of that solution for them. But their decisions now are not being dictated by a need for an MPLS today.

Operator

Kevin Dennean of Citi.

Kevin J. Dennean - Citigroup Inc, Research Division

Just a few random questions. I guess, Ita, for you, should we think about the investment in sales force ahead of the DTN-X? Should we think about those as being largely complete or do we need to think about bringing more headcount on board mid-year?

Ita M. Brennan

Yes, I know, I think we deliberately ramped ahead of the revenues last year. And we feel like we're pretty well positioned from a headcount number and expense right now.

Kevin J. Dennean - Citigroup Inc, Research Division

And then -- okay. And I know you're not giving the mix of 40G. But within the gross margins this quarter, specifically product gross margins, was there any noticeable impact from 40G, given that it's a non-tech merchant-based solution?

Ita M. Brennan

There's a little bit of a difference, but not enough to kind of impact the corporate margins. And the mix of it was not significant enough that it would drive corporate margin impact.

Kevin J. Dennean - Citigroup Inc, Research Division

Is that a function of it not being a substantial difference or not being a big enough part of the mix?

Ita M. Brennan

Probably a little bit of both, right? I mean, the impact is not that significant, and it didn't drive enough revenue to get to move the needle on that basis, right?

Kevin J. Dennean - Citigroup Inc, Research Division

Okay. And last one for me. Dave Welch was just talking about eventual development of MPLS capability. Do we need to think about, some point in 2012 or 2013, a step up in R&D expense to support that effort? Or is that process underway now and it's already in the numbers?

David F. Welch

It's baked into the numbers. We're not -- we're staying within consistency with our R&D burns that we've communicated to you. We've been working on the problem. And we think we've got some good things that we can add in that space, and you'll start to see -- maybe we'll start talking about that maybe towards the end of the year or whatever or what our plans are.

Operator

Sanjiv Wadhwani from Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Just 2 quick questions on the DTN-X. First question is, I know you've highlighted trials with 4 Tier 1s. Any color, at least in North America, whether they are just regular telcos or MSOs or Internet companies? Any color over there would be helpful.

Thomas Fallon

We're not going to comment or any more clarification on that.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And with the trials that are starting this quarter, what sort of the next -- that is probably for a software application. Is that sort of something that happens in Q2? Is that Q1 event? Any timing on that or any clarity over there that is the next step indeed?

David F. Welch

I think it's all consistent with what we've said repeatedly. It's been -- we'll try and engage customers this quarter. We're going to ship volume products in Q2. We'll have manufacturing capable of shipping volume products. And we're going to realize revenue in Q3. And so different customers have different processes. Some are faster than others, some are slower than others. And I'm not sure what else, other detail you want to get into.

Thomas Fallon

Thank you for joining us this afternoon and for your questions. We look forward to staying in touch in the months and quarters ahead with reports on our continued progress. Have a great day.

Operator

Thank you. That does conclude today's conference. Thank you for your participation. You may now disconnect from the audio portion.

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