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Infinera (NASDAQ:INFN)

Q1 2012 Earnings Call

April 25, 2012 5:00 pm ET

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

Ehud Gelblum - Morgan Stanley, Research Division

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

Kevin J. Dennean - Citigroup Inc, Research Division

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

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

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

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Michael Genovese - MKM Partners LLC, Research Division

Operator

Welcome to the First Quarter Year 2012 Investment Community Conference Call of Infinera Corporation. [Operator Instructions] Today's call is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the call over to Mr. Bob Blair of Infinera Investor Relations. Sir, you may begin.

Bob Blair

Thank you. 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, our competitors' products and prospects for the company in the second 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 the company's current press releases and SEC filings, including the company's annual report on Form 10-K filed on March 6, 2012, for more information on these risks and uncertainties. Today's press releases, including results of the first quarter of fiscal year 2012 and associated financial tables and investor information summary will be available today on the Investors section of Infinera's website at infinera.com.

The company undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. This afternoon's press release and today's conference call will also include certain non-GAAP financial measures. In our earnings release, we announced operating results for the first quarter of fiscal year 2012, 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 Infinera's website.

On this call, we will also give guidance for the second 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 Chief Financial Officer, Ita Brennan. I will start with some commentary on market trends and how we believe they will impact architecture and technology choices by service providers moving forward. Then I will provide an update on the reception to our new products and highlight some results from our first quarter before turning it over to Ita for a full review of our Q1 performance.

We continue to see 3 fundamental trends that are driving significant network traffic growth: cloud, mobile and video. First, cloud continues to grow in importance for our service provider customers across both enterprise and consumer applications. Forrester Research predicts that the cloud service market will approach $240 billion at 2020. Many analysts predict that most applications in the future will be cloud-based, increasing the role of the network. We see cloud growth driving a need for large amounts of optical bandwidth that can be provisioned quickly to absorb unpredictable spikes in the case of disaster recovery, over large workload shifts. In order to satisfy this without wastefully over-provisioning these networks, carriers will require an optical layer that delivers large pools of virtualized bandwidth that can be deployed quickly in minutes instead of days or weeks.

Second, mobile traffic is growing rapidly, driven by increasing access rates combined with an explosion of smartphones, tablets and wirelessly connected laptops. Industry analysts estimate mobile data usage will grow approximately 18-fold by 2016. There has been tremendous investment in 3G, 4G, and Wi-Fi infrastructure, but these are simply access methods into the wired backbone. We anticipate this dramatic increase in mobile traffic will require additional optical investment.

Finally, we believe that streaming video will continue to be a huge driver for added optical capacity. Video streaming from multiple sources, including user-generated content from YouTube, and aggregators like Netflix and Amazon, and content creators like HBO, will be our service providers delivering managed IPTV services. We are also seeing improved quality at each stream from standard definition to high definition and on to 3D. This growth in video traffic is being further amplified by cloud-based service delivery, mobile access and significantly increased wired broadband access capacity.

Overall, we see these trends underpinning the requirement for a significantly increased investment in optical transport spending. We believe this optical reboot is a cyclical transition that happens about once every decade. It has just begun, evidenced by some 19 million miles of optical fiber that were installed in the U.S. last year, the most since the boom year of 2000 according to research firm, CRU Group. All of this fiber will need to be lit, and Dell'Oro sees that the DWDM transport market going at a 5-year compound annual growth rate of 10% to $11.7 billion in 2016. We believe that the traffic growth and patterns for cloud, mobile and video data will require investment in a next-generation optical network that can scale smoothly to multi-terabits while simultaneously delivering increased intelligence and functionality. We believe that this increased intelligence and functionality will require OTN and MPLS switching integrated with DWDM into a single platform. Dell'Oro calls this segment optical packet transport, and it includes Infinera's new DTN-X and forecast it to grow at a 5-year compound annual growth rate of 22%, obtaining $7 billion by 2016.

Now the challenge. Operators continue to see a decline in basic connectivity fees in the face of this tremendous growth. For example, according to a telecom market research firm, TeleGeography, 10 gig prices linking London and Frankfurt are forecasted to decline 19% compounded annually from 2011 to 2018. Historically, operators solved this problem by deploying increased optical transmission rates that would lower the overall cost per bit. This faster pipe approach is no longer sufficient to meet the new demands of scale, increased optical network functionality and a lower total cost of ownership. Carriers need a new architecture to solve these problems, and we believe this, when paired with the commercial availability of scalable DWDM and integrated OTN switching, will drive a major secular transition. They need to move from a world of dedicated waves to flexible pools of nearly infinite capacity, from rigid over provisioned transport layers to an efficiently converged transport infrastructure and from manual operations to intelligent automation. This architecture needs to not only scale with lower operational cost, it needs to free up time and provide the tools to deliver new value-added services to drive profitable revenue. You see this secular transition intersecting with the optical reboot cycle, providing an unprecedented opportunity that Infinera is uniquely well positioned to address our DTN-X platform.

The DTN-X is ushering in a new era of next-generation network architecture, moving from the traditional world of multiple network layers, discrete analog optical implementations and manually provisioned all-optical networks to a converged high-performance automated digital optical network. This is not a vision. It's a capability that we are shipping this quarter, and only Infinera can deliver this now with DTN-X. Infinera is an innovator, not a commoditizer, and we have built a vertically integrated technology and supply model that allows us to develop and build leadership with all of the key technology elements required to deliver on this new architecture. We believe vertical integration and the associated R&D investments are mandatory to win in the next phase of this market.

As proof points, here is a sampling of leadership technology differentiators that we bring to the table with the DTN-X. First to architect and deliver a large-scale photonic integrated circuit, now delivering our third-generation 500-gig PIC are already demonstrating results from our 1-terabit PIC. First to architect and deliver FlexCoherent, a software-programmable Coherent transmission that optimizes reach and capacity while reducing costs. First to architect and deliver 500-gig long-haul super-channels, scaling capacity without scaling operations and upgradable to 1-terabit super-channels in the future. First to architect and deliver a platform that integrates 5 terabits of best-of-breed non-blocking OTN switching with best-of-breed DWDM transmission without compromise. First to architect and deliver a platform that is upgradable from OTN switching to MPLS switching that is also upgradable from 5 terabits to 100 terabits of switching capacity in the future.

I cite these achievements to highlight our innovation and technology leadership and to point out that only now are we seeing our competitors follow in our path with their roadmaps. We are confident that photonic integration brings higher densities with reduced power and space, lowering cost in multiple dimensions while delivering tremendous scale on a single line card. In the March quarter, 2 of our competitors purchased companies engaged in the research of integrated photonic technology, solidifying our long-held view that photonic integration is mandatory. We believe that we are years ahead of these competitors in terms of execution, investment and learning curve and in our IP portfolio. Based on our experience, we've also come to believe that truly understanding how to commercially manufacture PICs is an imperative for delivering our next-generation architectures and long-term success in this market.

While the industry is moving to a 100-gig technology, we are leading the industry by envisioning and delivering commercially available 500-gig FlexCoherent long-haul super-channels. The OFC/NFOEC trade show this year, a number of competitors followed us with announcements and slideware around flexible modulation and metro super-channels. While we appreciate our competitors' validation of the super-channel approach and the value it brings to customers, what is missing in these announcements is that their super-channel strategy doesn't meet the requirements of the long-haul network. In long-haul networks, capacity dictates the operational and architectural benefits of super-channels. They must operate over thousands of kilometers, and therefore must operate in a QPSK modulation format. So if our competitors deliver these metro super-channels in the future, they will be limited to applications of less than 700 kilometers of reach and are not applicable to long-haul networks. Only Infinera is delivering commercially available 500-gig long-haul super-channels today, well ahead of any competition.

We also believe the new architecture requires the convergence of DWDM and switching married with GMPLS automated control. Convergence is important to reduce OpEx and increase CapEx efficiency, while distributed switching delivers network flexibility for more add-drop points and a rapid deployment of bandwidth, all automated via GMPLS. Only Infinera brings over 10 years of experience in developing and 7 years deploying this converged architecture that are pioneering DTN and digital optical network.

Recently, we have seen a number of competitors announce their intent to retrofit switching to their DWDM platforms, and retrofit DWDM to their switching platforms. We continue to believe the new DTN-X, which has been purposely built from day one for this integration, would be the only platform on the market that allows all components, including the optical functions based on our PIC technology to deliver best-of-breed switching, integrated with best-of-breed DWDM without compromise. DTN-X has been recognized by carriers around the world for its leadership design and innovation, and we strongly believe it is uniquely positioned to capture the opportunity being created by the intersection of the cyclical, optical reboot and secular optical rearchitecture beginning this year.

At OFC/NFOEC this year, we announced our first DTN-X customer, Cable&Wireless Worldwide. A new Infinera customer, Cable&Wireless selects the DTN-X as the sole platform for their Europe to Persia Express Gateway, known as EPEG.

To date, we received DTN-X purchase orders from 4 customers, 1 from Cable&Wireless Worldwide and 3 from existing customers. We are in active contract negotiations with additional service providers. We believe this early traction is a tremendous sign of confidence in the DTN-X platform and affirms our view that this is an industry-changing event. Of the 4 Tier 1 trials planned in Q1, 2 resulted in purchase orders. One was split into phases and is ongoing, and 1 moved to an in-country trial now scheduled in Q2 at the customer's request. Looking ahead, we have 6 new trials planned for Q2, for a total of 8 planned trials in total. These trials are a combination of Tier 1 global providers, cable operators and bandwidth wholesalers, and they are also a mix of existing and potential customers.

I also want to note that we have started the OSMINE certification process to satisfy a North American Tier 1 associated with one of the purchase orders I mentioned already. As a point of clarification, by Tier 1, I mean a traditional large incumbent carrier, typically with in-region and out-of-region regulated and unregulated business. This definition does not include cable operators, Internet content providers or bandwidth wholesalers. We stated on our last call, we are expecting to begin shipping DTN-X in volume to customers this quarter and we expect revenue recognition in the second half of 2012. As we signaled on our February conference call, we are seeing some existing customers queue to DTN-X for new footprint. Implementing a new platform often includes a process of trialing, qualifying and running first office applications, which can take one or more quarters.

This transition result can reduce revenues in Q2 until revenue recognition kicks in for the DTN-X in the second half of the year. As the capabilities and early success of the DTN-X challenged the more traditional approaches, we see competitors aggressively pricing their 100-gig offering as they compete for the same footprint during the optical reboot. Gaining footprint now will advantage Infinera's gross margin opportunity over time more than others who are using less cost-effective commercially-available optical technology. This footprint will allow us to leverage the scale advantages of our PIC-based vertically integrated model that our customers fill these initial installs with up to 8 terabits of capacity. As a result, we are competing aggressively for these new footprint opportunities. Ita will describe how these factors are playing out in the near term when she provides our guidance, which will include some color on the expected revenue flow in the second half of the year when the revenues related to our early DTN-X success begins to materialize.

From our inception, Infinera's mission has been to transform the way telecommunications networks are built and to help our customers succeed. It is clear that our customers are entering a time of great challenge and great opportunity. We believe DTN-X provides a new architectural approach that moves the industry from a world of status quo and incumbency to a world of innovation, scale, efficiency and simplicity. We believe that this platform is squarely located at the intersection of 2 events, the secular inflection point requiring a new architectural approach and a cyclical optical reboot, continuing a renewed optical investment cycle. Infinera is uniquely positioned with the DTN-X and we are committed to winning.

Before turning it over to Ita, I want to thank the Infinera team for meeting our commitments to customers, allowing us to deliver on a promise of helping them succeed in their markets. And I'll close by thanking our customers for their continued business and partnerships as we move forward into the terabit age together.

Ita will now provide a detailed financial review. Thank you.

Ita M. Brennan

Thanks, Tom. This analysis of our Q1 results and our guidance for Q2 '12 is based non-GAAP. All references exclude noncash stock-based compensation expenses.

Total GAAP revenues in Q1 were $104.7 million, compared to our guidance of $102 million to $108 million. We added 4 new customers in the quarter, for a total roster of 102. The imminent completion of 3 previously announced mergers will reduce this number accordingly next quarter. We added one ATN customer in the quarter, for a total of 33 ATN customers. We had one greater-than-10% customer in the quarter, which was an Internet content provider, with one cable operator and 3 bandwidth wholesalers completing the top 5.

International revenues launched at $31 million or 29% of total revenues for the quarter. EMEA accounted for $26 million or 25%, with APAC and the other Americas representing 3% and 1%, respectively. Our service revenues for the quarter were $11.8 million, down from $18.4 million in Q4. Service revenues in Q4 were higher than normal, and included some catch-up amounts related to the renewal of a number of significant entitlement contracts. Services margins for the first quarter were at 60%.

Overall gross margins in Q1 were 40%, down from 42% in Q4, representing a lower services contribution, somewhat lower TAM shipments and a healthy common equipment mix. Operating expenses for the quarter were $52.5 million and below our guidance of approximately $54 million. This reduced spending versus guidance effected some changes and the timing of some nonrecurring engineering expenses and the effect of some R&D cost savings in the quarter.

Looking forward to the June quarter, we expect the operating expenses to be approximately $54 million, including OSMINE certification cost associated with the Tier 1 agreement and the rollover of some NRV costs on the first quarter.

Overall headcount for the quarter was 1,210 versus 1,181 in Q4. Headcount addition is primarily related to direct labor for manufacturing and some sales ads.

Our operating loss at Q1 was $10.4 million. Other income expense in Q1 was unfavorable at $0.1 million. Net loss for the quarter was $11.2 million, resulting in a loss per diluted share of $0.10 compared with our previous guidance which called for a loss of $0.10 to $0.14 per diluted share, compared to a loss of $6.7 million or $0.06 per diluted share in Q4.

Turning to the balance sheet. Cash, cash equivalents restricted cash and investments ended the quarter at $240 million versus $253 million in Q4. We used $5.8 million of cash from operations in Q1, versus $5.1 million in Q4. DSOs were 57 days, down from 65 days in Q4. Inventory turns were 2.5x versus 2.9x in Q4. Overall inventory levels increased to $102 million in Q1. DTN inventories remained higher than normal due to some excess supply put in place to mitigate the impact of the Thailand floods. Actions are now being taken to return DTN inventories to normal levels by the end of the June quarter.

The continued production of components for the new DTN-X product will move the complete system to production in the June quarter. As a result, we expect to drive increased DTN-X inventory levels in advance of recognizing revenue on the DTN-X in the second half of the year.

Accounts payable were 44 days, down from 53 days in Q4, reflecting lower inventory receipts at the end of the quarter. Capital expenditures were at $13.6 million in Q1 versus $16.1 million in Q4. Q1 CapEx included final payments on some of the FAB-related projects undertaken last year. Capital expenditures are expected to return to lower levels in the second half of the year and all DTN-X investment activities are completed.

Now turning to our outlook for the future quarters. As Tom mentioned earlier, adoption of the DTN-X has been strong and we are seeing some existing customers shift their new footprint demand to that platform. As a consequence, we experienced slower-than-expected bookings on our DTN platform in the first quarter and exited the period with lower-than-normal DTN backlog. We believe this is in part due to planned DTN-X transition and may also be reflective of normal seasonality. As our first quarter bookings have historically been lower than other quarters.

Based on our current visibility, we expect overall bookings levels to recover in Q2, with the DTN-X expected to account for a meaningful portion of those bookings. Since do not expect to recognize revenue for the DTN-X in Q2, this will likely result in reduced revenues for the quarter. However, this should allow us to enter Q2 with a healthy backlog and good prospects for top line growth in the second half.

At this point, we believe revenues for the second half of 2012 will range from approximately $230 million to $260 million.

Now turning to gross margins. As Tom mentioned, we have seen more aggressive pricing from competitors on a number of new 100-gig footprint opportunities. In most cases, we are responding with increased levels of upfront discounts in order to secure the initial footprint and have access to the future network fill. Each fiber and line system deployment will now support up to 8 terabits of capacity, providing the opportunity to sell additional high-margin network fill in the future.

On the cost side, we are executing well and are at or better-than-planned from an operations execution perspective. We are experiencing good cost reductions in FAB and expect, based on current trends, that the DTN-X line module cost will decline satisfactorily over time. We expect to recognize our first DTN-X revenues in the third quarter. While these shipments should help top line growth, they may have a negative impact to gross margins in that quarter as we fill the first and highest cost PICs produced in our FAB.

All things being equal, the initial footprint pricing dynamics described above, when coupled with the higher level of common equipment and the DTN-X ramp up cost we'd already factored into our 2012 model, mean results in gross margin for the year somewhat below our previous guidance of approximately 40%. Importantly, we believe executing on winning this new footprint now will allow us to capture the volume needed to leverage our 500-gig PIC baseline module cost advantage and drive to expanded margins in the future.

Looking beyond 2012, we believe that with falling revenue growth, our birth of the integrated models can deliver significant leverage and allow for good margin expansion. In addition, over time, we'd expect to see a more balanced mix of new footprint acquisition and network fill that should also improve our gross margin structure.

Now returning specifically to Q2 guidance. While we expect Q2 bookings to recover, a meaningful portion -- proportion are expected to relate to the DTN-X platform and will not drive revenues for Q2. In addition, the overall lower volume for the quarter, combined with the higher mix of lower-margin new deployments, are expected to pressure gross margins. TAM shipments are expected to be in the range similar to Q1 levels.

With these factors in mind, the following guidance for is Q2 based on non-GAAP results and excludes any noncash stock-based compensation expenses: Revenues of approximately $92 million to $100 million; gross margins of approximately 36% to 38%; operating expenses of approximately $54 million; operating and net loss of approximately $16 million to $21 million; and based on estimated average weighted diluted shares outstanding of 114 million, this would lead to a loss per share of approximately $0.14 to $0.18. Please note that the basic share count is expected to be 110 million for the quarter.

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

Question-and-Answer Session

Operator

[Operator Instructions]

The first question is from Ehud Gelblum with Morgan Stanley.

Ehud Gelblum - Morgan Stanley, Research Division

Couple of questions, Ita, if we can go in -- and Tom, if we kind of get to the guidance and a piece of that. So we're looking at high -- mid-high 90s for Q2. How do you sure, and then it picks up in the to 30s or 60 for the significantly and in the back half of the year. How are you sure that the deposit in DTN, I know you said it's part of it seasonality, but how do you know the cost in DTN is going to be picked up by DTN-X? You're trialing 8 people right now. When you say you're going to recognize DTN-X revenue in Q3, is that with all 8 or is that only with like 1 or 2 of them? I'm assuming Cable&Wireless is probably the first one you'll recognize with, but when you saw the order book come down now for DTN, was that -- does it only come down for those 8 that are trialing DTN-X or does it come down with other guys as well?

Thomas Fallon

So first of all, we have orders for -- from 4 customers that we have already taken. And typically, if we've taken orders from a customer at this point in the cycle, we would ship at a revenue that -- in that current quarter. In this case, we follow on shipping but we won't be able to revenue that until the second half of the year. Two of the customers -- 2 of the opportunities would be for opportunities that are -- it would be incremental or what the DTN will service. So without the DTN-X, we would likely not have one of those deals. Two of the DTN-X POs that we received to date are from customers that had we not had the DTN-X, I believe they would have deployed the DTN because they're investing in the DTN-X as a scalable future versus the DTN wouldn't be able to satisfy it now. So I think that if I look at both the POs we've received, and the 8 trials in addition to the 4 POs, we're seeing a mix of new opportunities that without the DTN-X, we would not have an opportunity for, and we're seeing an opportunity for our current customers to continue a Infinera path by the next-generation architecture. So I feel pretty comfortable that the DTN-X will have an opportunity to sell to both types of customers, new and potential, but also current. And the fact that we are taking orders today, we have 4 to date from 4 different customers, and normally, we'll recognize that revenue. That revenue goes into the back half, which should be incremental, assuming that there's some level of continued internet demand for in general. So all things being equal, we feel pretty comfortable that the DTN revenue will have a continued, ongoing, healthy revenue stream and the DTN-X represents a new opportunity for new customers and opportunities that will be incremental to the company where the DTN would have satisfied it. It's a long-winded way of answering your question. Does that answer your question?

Ehud Gelblum - Morgan Stanley, Research Division

It sort of does. It does seem as though, from the 2 to the second of those customers, second 2 of those pairs, for which they would have bought the DTN but are now buying the DTN-X, it's somewhat of a push out from Q2 into Q3, Q4 but it's the same that they would have -- same demand that they would have had anyway. It sounds like you only have 2 customers that are actually adding DTN-X in that market expansion from the DTN-X. And so it seems pretty heavy to see $115 million, or let's say $120 million, $125 million revenue quarters in back half of the year, just based on 2 customers that will have incremental. What else gives you confidence?

Thomas Fallon

There's 2 customers to date, and 6 additional new trials scheduled for Q2. And these customers that we're trialing are pretty big opportunity type customers that typically the DTN would not have allowed us to win. So these are large-scale type customers that could buy a substantive amount of product. I don't anticipate -- certainly all 6 will get us POs in Q2. I'm hopeful that over a period of time, all 6 will give us POs. Not all of that revenue would recognize or happen in a year, but some of it will. And the DTN-X is opening a new class of customer and a caliber of customer that is trialing with us we are pretty satisfied with.

Ehud Gelblum - Morgan Stanley, Research Division

It sounds as though we're counting on those customers, whatever push on those 6, the trial in Q2 to come through and push to that $230 million to $260 million. So my guess is if they're trialing at Q2, that revenue doesn't get recognized at Q4. So it sounds like we're probably hugging $100 million in Q3 and up a much, much bigger number in Q4. Is that right?

Thomas Fallon

Well, I'm not going to give you our Q3 number. We gave you -- we spent a lot of time looking at what the opportunities are at the back half of the year. And as you know, the fidelity between quarters is challenging. But we feel comfortable with the $230 million to $260 million range in the back half. I did mention that we are in contract negotiations with a couple of other people, so it's not just we have 4 orders and we've got to start to work on some others. We are in the midst of contract negotiations with some other customers that I am highly confident will close this quarter.

Ehud Gelblum - Morgan Stanley, Research Division

Okay, great. One last thing, if I could. The competition, the competitive environment that you both talked about, that you both talked about. Is this -- it sounds like it's worse than it was 6 months ago. What kind of -- where -- what areas do you see it in? Do you see it in 10-gig as well, or is it only in 100-gig? Or do you see it -- is it from one customer or one competitor in particular or is the entire environment predicated it?

Thomas Fallon

Yes, I see, as we have said that for a period of time, we have been competing aggressively with the DTN and have had to make commercial terms that would allow us to compete where we didn't have 100-gig. So that's been fairly challenging and that's not new. What is -- well, I'm surprising a little bit, is that there is a lot of pricing competition for 100-gig footprint. And it seems to be coming more intense in certain areas, certain markets like submarine, it's, I would say, the most intense. And I think that people view like we do that the opportunity to fill fiber capacity for a longer period of time with more bandwidth, you have to win that footprint. So I think that there is a level of competition to make sure that there's an opportunity to create the fill based upon harder commercial terms upfront.

Ehud Gelblum - Morgan Stanley, Research Division

Wouldn't that competitor feel the same way that you do? And therefore, aren't we stuck in a situation with no national equilibrium?

Thomas Fallon

I assume the competitor feels the same way I do. I think that the opportunity for this industry always is the fill is where you are allowed to make a reasonable return and footprint right now, during a expansion of market I think is viewed as critical by the participants in that market. I think it's going to be fairly competitive environment.

Operator

The next question is from George Notter with Jefferies.

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

I guess, just back on that prior question. So you're talking about revenues in Q2 in the high 90s. How many customers do you think you'll really experience and overhang in DTN demand from because of the DTN-X? And I guess I'm wondering, as we go out, we've got certainly many, many other customers in the folds of DTN. Is it logical that those folks potentially start looking at the DTN-X, you'd have additional overhang and demand on your hands as we go out through the balance of the year?

Thomas Fallon

Well, I think, the way I view it, is it's not -- most of our customers who are interested in the DTN-X, it's not like they flip a switch and they move from DTN to DTN-X. There's a different class of product, the DTN-X 400-gig capacity, a line card, and the DTN-X has 500 gig. It is a different class of product. Do -- have people been buying the DTN, awaiting for the DTN-X? And some range of customers have been because they see the ability to utilize the DTN and it continues to be a market leader in 10-gig and provide a very good economic solution. I think that -- I don't view it as much as they're making a decision to not buy the DTN. I see it as a decision that they're making an infrastructure, a network infrastructure that can scale to multi-terabit and in certain parts of their network, that's going to be mandatory. In other parts of their network, the DTN is going to continue to provide an exceptionally compelling value proposition. I don't know any customer that I have today for the DTN that is not going to buy more DTNs because of the DTN-X. That somebody is putting in a new core to their backbone or if somebody is putting in a massive new region, the DTN-X is a great way to do that, and DTNs are still going to be extraordinarily useful in regional, metro and in certain core applications where the bandwidth from the fiber is just not required.

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

Got it. Okay. So then if I were able to split out -- if I just step back and I look at the 2 classifications of customer opportunities, I mean, how would you parse that? Do you think that 50% of your current revenue today on the DTN would be ongoing over time and have a long tail to it, and you grow the DTN-X on top of that? Or is it the higher percentage or lower percentage? I mean, how should I parse the 2 opportunities?

David F. Welch

George, it's Dave Welch. Maybe I can contribute to the answer. The majority of DTN-X revenue in business that we have is going to continue forward. As we've had in any of our products, customers go through in cycles of looking at either adding new routes, lighting up a new rail or a new fiber on top of a current network that is growing. It's in those opportunities that are evaluating to put DTN-X in as opposed to DTN. So all of the fill associated with everything that we've deployed before, the lowest cost addition of bandwidth is to continue to do that. We expect that to go on, and that's going to, and that takes years to fully fill the deployed networks. So if -- you're right, it is a -- I put it in kind of a 15%, 20% of our DTN revenue or evaluating DTN-X proportion of that. And the rest of it is perfectly happy with the product that they have. They're going to continue on. And the majority of the DTN-X is frankly bring in new markets and new customers, and new applications of a product, of a scale that we haven't had before. And that's what most of the customers that we are bringing in, they are looking at their existing customers but they're looking at DTN-X for applications that we've never competed with before.

Operator

The next question is from Kevin Dennean with Citi.

Kevin J. Dennean - Citigroup Inc, Research Division

Just a couple of quick housekeeping questions to begin with. On services, Ita, I heard you mentioned that services were down off of the top sequential comp because of some catch-up revenues. There's a lot of utilities, services over time, should we think that about the service revenue snapping back 2 quarter or in that second quarter or do we stay around these levels?

Ita M. Brennan

Yes. I mean, I think if you look at Q4, that was particularly high, right? We had a good level of deployments happening in the quarter and we also have some catch-up stuff and some large annuity contracts, right? So I think Q4 was actually higher than our typical run rate. If you look back over time, I think the Q1 range we probably put some more deployments, probably a little bit higher than that. But that's probably more of a typical run rate for us on a normal quarter.

Kevin J. Dennean - Citigroup Inc, Research Division

And then on services gross margins, how should we think about that going forward? What's kind of the normalized range there? Because I would imagine that the gross margin level this quarter was a little depressed just on kind of revenue scale?

Ita M. Brennan

Yes. I mean, those margins do move around a bit depending on the deployment levels mix in there, right? I mean, I think if you look back historically, it's been anywhere from about say 58, up to as high as 65, 66, right? So that's been kind of the typical range. Now so the 60 is, it's not completely out of bounds, right? But it does have that range too depending on how much deployment stuff we're actually doing in the quarter. But the deployments will have lower margin than say the annuity service which has almost 100% margin, right?

Kevin J. Dennean - Citigroup Inc, Research Division

Okay, and then question for me is on gross margins and the impact of ramping your 100-G PIC. So it sounds like a little bit of a drag current quarter, maybe it persists for a while. You mentioned that you expect to drive cost down on a -- I think you used the word satisfactorily. But how should we think about the progression of gross margins through the year?

Ita M. Brennan

Yes. I mean, I think...

Kevin J. Dennean - Citigroup Inc, Research Division

And how big, I'm sorry to interrupt, but how big a drag are we seeing right now?

Ita M. Brennan

Yes, I mean, if you think about our gross margin through the end of the year, we've only talked about this 2 to 3 points of kind of ramping DTN-X overhead rate, if you like that's in there. And I think that's there probably through the end of the year, maybe it starts to get better in Q4, right, get a little bit in Q4, and then kind of burns off as we start to kind of be truly in full production and looking into the new year, right? So I think about the impact of the DTN-X through the kind of the end of the year is. We've got some impact in Q2. When we actually ship those initial units, we'll have a little bit more impact in Q3. And then in Q4, we should be starting to get back to some of the approach, the more normal production, but still not fully ramped up and not fully optimized, right?

Kevin J. Dennean - Citigroup Inc, Research Division

Okay. And last question for me, in your OpEx guidance, that's includes OSMINE cost?

Ita M. Brennan

Yes. I mean, what you'll see with OSMINE is it's going to be in every quarter probably between now and through the end of the year at least, right, and so it's for smaller amounts but it's spread out over a period of time. We had already kind of included that in our guidance that there would be some OSMINE activities so really we're just kind of fine tuning that, but it's always kind of been built into the OpEx guidance.

Operator

The next question is from Rod Hall with JPMorgan.

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

I just wanted to drill into the pipeline a little bit more, just to make sure I understand it. So I understand that you've got these 8 trials running. I wonder if you could say whether those are limited by the availability of equipment or is that the total number of people that are interested in trialing the DTN-X right now? Just some kind of indication, where we are in the process of spending trials up. And if you could elaborate on the -- maybe how many people you've got active in the DTN-X sales pipeline, that would also be useful. Just kind of figure out what the potential for additional trials is and how the whole sales cycle might progress?

David F. Welch

Yes, let me -- this is Dave Welch. Let me see if I can answer that for you. And I probably will not be able to answer it satisfactorily. But the interesting thing that backed off and talk about high level, the interest of the DTN-X is great. There is a significant -- across our customer base, they see various values of that is that we have, at the beginning of the quarter, where we are today, we have a number of committed trials to come in either in our lab or their lab to be able to execute on what I would call the present as a qualification process trial as opposed to a early evaluation trial. So in that discussion, many early evaluation trials that we engage in into varying degrees with our customers. If we look at our 100-plus customers that we've engaged with over the years, we're not going to have 100 guys walk in here and evaluate the product. We're going to have -- it typically is a larger capacity network and they're going to come here and evaluate our product and they're going to try and time that for when they see new applications and new capacity builds in their cycle to come on out. And I -- so it's not just the availability of the product that dictates when they but it. It's the availability of the product in times when they need it, when they need to make that technology transition. So the interest is high. I don't want to go through and quantify that. But we have a -- I think the general mixture of what we see of new customers, new applications and current customers and old applications with current customers, that make sure that we are presenting to you is fairly consistent as we look forward .

Bob Blair

Just to clarify kind of what you're saying there. The A trials, you guys have talked about, those you classify as qualification trials and then you're saying there's a bunch of other customers that are in early evaluation stage is on the product is that the right way to think about it?

Thomas Fallon

Yes, this is Tom. The trials that we're doing, the 8 we're talking about is a level of typically takes couple of their engineers, customer engineers, 3 to 5 days, and it's is typically linked to a deployment opportunity that they are truly evaluating a product against. That is a, what we consider a trial here. So there's one finite capacity, but more importantly, there's a customer desire to make a final decision on a product to go through this level of testing. In addition to that, as Dave pointed out, there are a lot of demonstrations, there are a lot of customers coming in. Will they get a couple hour lab tour, and be able to see the gear working, play with it for couple of hours. That's for them to get a sense of what is available. And as they're going into some type of RFI or some RFQ point, whether they want to include Infinera on that. And then above that, we have just pipeline coating. So we have a lot of pipeline activity where our sales guys are bringing us opportunities, responding to bids, depending on our success with that bid, that could either lead to a demo where they could test and say that we want to have Infinera have a shortlist and then that would to a trial. So the trials we are doing are fairly late-stage in the cycle and they're fairly intense from a customer perspective on the amount of time commitment they had to spend, both here and in preparation for it, because they typically have; generated a test plan of what they want to do when they're here.

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

Okay. And you're saying, Tom, that it is capacity limited. So that, if you had unlimited capacity in your labs, you'd probably, you might have more than 8 trials.

Thomas Fallon

Yes, I don't know. It's hard to say. I mean, you can only do so many. It's not infinite. A trial takes -- a successful trial takes about a week. So we're doing about 8 this quarter, a quarter is 13 weeks. Now if somebody came in and said, listen, I really want to trial this, we have an opportunity, we're going to take that trial. If they say we have an opportunity for Q4, they'll probably say we want to trial it in Q3. I'm trying to cram as many in as possible. I'd rather be horribly successful with the ones were doing.

Operator

The next question is from Alex Henderson with Miller Tabak.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

So I just wanted to talk a little bit about the trajectory of margins and the pricing commentary. It's quite obvious when you look at the results out of Ciena over the last 18 to 24 months that part of their problem is that they've been shipping at very low cost, a lot of chassis, and not shipping a lot of blades into them because they go out 40% loaded. And it takes them at least 1 year to 1.5 years from the time they get shipped to those chassis out to absorb that initial slug of capacity, so which end up with this chassis versus TAM mix being quite negative. Is it not reasonable to think that if you have successful DTN-X, that you would see a similar window to absorb the initial capacity that goes out loaded on the DTN-X boxes and therefore, active pricedown to get that valuable footprint in order to have the opportunity to sell TAM into the future periods?

David F. Welch

Okay, let me see if I can do some insight on that. There's absolutely a variation in gross margin between first-in cost and fill cost. Our product architecture and our product cost structure is different than our competitors, and that allows a different profile and a different recovery period from first-in cost. What Tom tried to infer in his commentary is that the upside margin for Infinera, based on our advanced technology and our photonic integration that we're vertically integrated on our Coherent technologies, et cetera, allows us to have a gross margin recovery that we believe is much faster than some of our competitors out there.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

I wasn't trying to imply that it would be the same margin structure, but the structure that I just depicted where you're talking about shipping primarily chassis in a new product launch for a better part of the year before you start to see the absorption of the initial capacity that shipped along with the chassis on the first install to get the TAM sales and that after the tax and if that's 12 months, that would imply that you're not going to get the high-margin TAM revenue in until well into 2013.

David F. Welch

Yes, I think that the -- keep in mind, our system is made up of 3 pieces, there is common chassis, there is long-haul bandwidth, which is what our photonic integrate circuits deliver, and then there's a tributary access. Our tributary access is a smaller granularity that our 500-gigabits. And our initial deployments will go out with a small capacity of tributary bandwidth, and but they will quickly deplete that tributary bandwidth and will start adding on, and so our margin profile, it won't be 12 months for margin recovery.

Thomas Fallon

We also -- it's important to remember that the optical that they referred to, the DTN-X completely compatible with the optical layer we've been shipped, selling for a long time. And that invariably carries a very low margin. So customers who already have our optical infrastructure, we will have the opportunity to upgrade them and achieve margin recovery much faster than if you're deploying the overall optical layer in addition.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

Okay. Second question, could you talk to -- you've got a very large install base of customers. My count's a little over 100 now. Can you tell me what portion of those would actually have a network that could handle a DTN-X sized platform? Because obviously the bandwidth is substantial compared to some of the smaller competitor -- smaller service providers?

David F. Welch

Yes. That's a, it's a little bit of a hard question to answer and I think the pertinent question is to answer more on a dollar basis as opposed to a number of customer basis. And I think that being -- anyone who is truly on the long-haul business will, at some point in their cycle, have an interest in the DTN-X. Our customers that are in the metro, more of a metro or metro regional network, their reach is going to -- it will take longer for those capacity demands in areas that are more fiber-rich to take advantage of it. Our business is, it's not a super majority, but it's certainly a majority of our business is through long-haul carriers and subsea carriers that have an interest in that immediately.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

Over half of your customer base is still metro or regional, and therefore, would not be likely candidates for even moving to a DTN-X. So when we look at the customer base of 102 and say, okay, half of that is 50, we're doing 8. It gives us a better handle on what portion of the customer base is viable candidate for a trial?

David F. Welch

Yes, I don't think, I'm not sure I can give you what the accurate number is on the quantity of customers at this point. So I had to defer that question another time.

Thomas Fallon

You also need to be careful of assuming that every customer is going to trial it. If it's a DTN customer today, there's a reasonable percentage of them that will not do a trial. They will do a first office application, 2 of the first POs we have were not based upon them coming in and doing trialing. They know our gear, they know the software releases, based upon a previous release. They're very comfortable, saying we're going to roll this out based upon our history with the company.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

One last question and I'll cede the floor. Because it's on the same basic concept which is -- can you talk a little bit about what portion of your customer base that are looking at the DTN-X product would have a acceptance criteria that would cause an extended delay in the timing of the recognition of the revenues? I know you're saying you're going to have revenues in this back half of the year, but are some of the installations in the back half also going to be deferred into 2013 for revenue rec purposes?

Ita M. Brennan

Yes, I mean, I think we talked about before obviously very much with existing customers, with existing contracts, and what we're seeing is those customers are not really trying to go change the terms of their contracts. So if we have customers in that book who are taking revenue and allowing us to take revenue on shipments and on receipt, we're not seeing people comment they want to change that for the DTN-X, right? I think for new customers, they haven't used the products before, then you will see a longer acceptance period.

Thomas Fallon

And on submarine, invariably where there's new product or old product, they want to see the submarine link up and running for a period of time before they will sign off on it. And that's to me less to do with the DTN-X and more to do with the submarine market.

Operator

The next question is from Sanjiv Wadhwani with Stifel, Nicolaus.

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

Tom, I just want to take a crack at the second half trajectory. If you look at your revenue run rate over the last 6 quarters or so, and this is rounded up to about $100 million a quarter, if you're guiding to $230 million to $260 million for the second half, and if you assume that $100 million comes from the DTN every quarter, does that mean that the DTN-X is going to be between $30 million and $60 million for the second half?

Thomas Fallon

Well, the way you did it, it would. We just spent a full day with all of our sales team on rolling up and looking at very specific DTN-X opportunities. We are typically hesitant to give out guidance beyond the quarter. We have not done that. We're doing that this time because, quite frankly, we think Q2 is an anomaly. Revenue is down. But we have the opportunity. We've won 4 new DTN-X customers. We have a pipeline full of trials that are coming and we are in negotiation with a number of other DTN-X opportunities. We either believe that we are going to win those and what we're going to start shipping and taking orders for in Q1 and Q2, and start shipping in Q2, translates into new opportunities or it doesn't. We believe it does. So we wanted to share with you our observation. And it's based upon a roll up of what we've done with all of our various regions, on the opportunities that they see, both for the DTN and the DTN-X. And the reason we are creating a kind of out-of-process guidance for that is because I don't believe that revenue reflection of Q2 is representative of the opportunity that we see with DTN-X. We started taking orders for DTN-X in Q1. We never have 1.5 quarters until we recognize revenue. This is an anomaly on there. And quite frankly, any forecast can be wrong. We would not give that forecast unless we had done the work and the diligence of being able to say this is what we can touch and see.

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

Got it, fair enough. I guess, the other question, on the OSMINE certification as it's going through. You've already done some prior certification with Qwest and I'm trying to figure out if it's -- this is DTN-X with the same customer, brand-new customer? Any color there?

Thomas Fallon

Well, I'm not going to give any color there. We've done 2 OSMINE releases. We did our release 3. With OSMINE, we did our release 6. And OSMINE and that was a customer request. OSMINE is a non-trivial expenditure in the DTN. We did it based upon a specific request from a customer. We are also doing, as Ita has said, we had baked OSMINE into our planning, but we're also doing at a specific customer request and that's all I'm going to say about it.

Operator

[Operator Instructions]

The next question is from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

I just wanted to ask another follow-up, on the second half trajectory. So can you just give us a sense for when you think begin DTN-X revenues will cross over the halfway point in terms of the percent of the total? I mean, it sounds like that might even happen exiting this year, but do you think that will be exiting this year or more first half of next year?

Ita M. Brennan

Yes, We're not in a position to do that yet, Simona. We will provide more color kind of on the product split as we can report the actuals, but we're not going to try to project that at this time.

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

Okay. And then a couple of follow-ups on the margins in the next few quarters as well. I think there was some helpful discussion there on how long you think it will take for the proportion of common equipment to TAMs to normalize and it sounds like you thought that would be less than a year before, that aspect of pressure on margins is released. And please correct me if I misunderstood that, but the follow-up is, there's also kind of the yield aspect in terms of your PICs which are, obviously, new technology and much larger. So how long do you think before kind of the yield and the manufacturing aspects of your new PICs normalizes back up to what your historical 10-gig or 100-gig PICs have been?

Ita M. Brennan

I mean, I think in the comments and the remarks, we are seeing good traction kind of in the FAB around the costs and it is trending kind of as we expected, right? So I think we have -- we'd originally guide at 40% gross margin for the year, with kind of some of the volatilities that we're seeing and I think we'll be somewhat below that, but not -- if we get the top line in there and the revenue growth that we're projecting then, not significantly off of that, right? if you look beyond that, I think what starts to happen is we take out some of the DTN-X overhead type margin impacts that we've had. You'll start to ramp some volume. And then you really do start to see kind of the flow-through on the model, right, where you start to truly ramp the FAB and have leverage the fixed cost there in the FAB, and then you can start seeing margins expand again through kind of next year.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Right. But that's more of an overhead comment. What about just the yields themselves? Somewhere the variable cost is about to the fixed cost drag?

Ita M. Brennan

Yes, I mean, the yields are ramping along kind of a similar relative curve as they did with kind of the Gen 1 and Gen 2 products, right? So we would expect to hit entitlement yields sometime next year, right? I'll ask Dave to kind of maybe talk a litte more about...

David F. Welch

Our yields on our PICs, I caution you that the question you're trying to get at is what the cost structure is of our business yields, of our PICs, are -- they're ahead of schedule, they're fine. The PICs work, the usual capabilities and technologies there and we can make as much as we need of it. And we sell systems, we sell networks. These are highly complex things that which the PIC is an enabler for cost structure and elsewhere in the system, but it is not a dominant cost structure. We are not a component company.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Okay, fair enough. And then just last quick one. And I realize this might have been too recent to kind of have all the details, but in terms of the proposed acquisition of Cable&Wireless by Vodafone, is there any change there that you think might happen relative to your involvement either in terms of incremental opportunities at Vodafone or maybe a change in how Vodafone wants to run that piece of the Cable&Wireless business?

Thomas Fallon

Yes, I think there's 2 parts of the question in my mind. One does it affect what our current plans are in the short term with rolling out the DTN-X with Cable&Wireless? I don't believe that there's any impact to the current plan we have of rolling out the DTN-X against the current contract with Cable&Wireless. For longer term, it's a much bigger question. I don't think that the acquisition will close. Earliest will be August. I think latest is October. And I think that more than likely, new decisions will probably have a period of reluctance to make big commitments to anything. I feel very comfortable that the current PO and plan of expansion with their EPEG network is on track. Beyond that, somehow I think it's too early for anybody to say what will happen.

Operator

The next question is from Michael Genovese with MKM Partners.

Michael Genovese - MKM Partners LLC, Research Division

Tom, you spoke earlier in the prepared remarks pretty enthusiastically about the optical reboot cycle and the expansion for optical. And then meanwhile, we're on this side, pretty angsty about carrier CapEx this year. Is it strong? Is it weak? Is it front-end loaded? Is it back-end loaded? Is there an optical cycle or is there not? So when you talk about all this efficiency being made, this capacity going into the network and capital dollars being spent, is there something that's happening this year in your view or is it more of a 2013, 2014 event?

Thomas Fallon

Well, I think it's mixed. I mean, a lot of discussion happens around AT&T and Verizon CapEx. And for good and bad, we're not supposed to do that right now. My commentary on kind of optical reboot is based upon 2 things. I just see, quite frankly, the investment happening in wireless, the investment that has to at some point translate into core networks. I see what's happening with the data center distribution. I see what's happening with all of those types of activities. And at some point, there has to be a sort of CapEx. That's part of it. The second part is I see the amount of quoting and activity that we have. And it's quite substantial right now. Certain areas of the market are making decisions without question for this year, and those include cable, those include submarine, those include a number of activities that are happening in Europe. There are some very substantive builds being planned. So that is outside of, quite frankly, in the market of what is AT&T and Verizon planned spending on CapEx. Those are very big numbers. I certainly anticipate and hopefully the DTN-X will help us boost the progress of having -- that have to remain to our conversation. But I see the opportunities and a lot of people are saying Europe is soft. Our Europe in Q1 was actually pretty darn good, and we see lots of activity there. I think people are making investments where their networks are needing to expand for new services, whether they are low-latency commercial services or cloud services or just video content. I see substantive investments being made.

Michael Genovese - MKM Partners LLC, Research Division

Great, that's a great answer. And then just a follow-up question. But early in your response from an earlier question you talked about OSMINE -- I'm sorry, you talked about evaluations of DTN-X, early stage to late stage. And typically, where in that process would a request from a customer to OSMINE, would it be earlier or later in the evaluation process?

Thomas Fallon

It is socialized early in it, and it is finalized in a contract phase where you'll do it or I'm not buying from you.

Michael Genovese - MKM Partners LLC, Research Division

So but along with that, I mean, just generally speaking, I mean, so they say you do that or I'm not buying from you. Do they promise you anything...

Thomas Fallon

Yes. Quite frankly, they're very reasonable people. They use OSMINE certification to help run the back end of their businesses. They have no desire for us to indiscriminately spend money on OSMINE if they don't have a business need that they think the DTN-X can help solve. We're doing it based upon the strong belief that they have every intention to roll out the DTN-X. OSMINE is a gate to that. Obviously, the product has to go into their network, and it will go into their network, but it has to be successful when it goes into their network. So that's up to us to make that happen. And I have every confidence that we will make that happen. So I believe, OSMINE to me isn't a threat, it's an opportunity that basically says we're going to roll out your stuff in the network. But for us to mass deploy your stuff, you've got to do it in the context that makes our business successful and you have to do OSMINE for that. And that's why we are doing it. And before when we rolled out OSMINE historically, both release 3 and release 6, it's been an extremely good investment for us.

Thank you, all, for joining us today on the call. We appreciate your interest and questions. We look forward to keeping you informed on our progress in the months ahead as we execute our significant opportunities for the DTN-X and our strategy to win the marketplace. Have a great day.

Operator

Thank you for participating in today's conference call. You may disconnect at this time.

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