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Edited Transcript of ACIA earnings conference call or presentation 2-Nov-17 9:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 Acacia Communications Inc Earnings Call

MAYNARD Nov 3, 2017 (Thomson StreetEvents) -- Edited Transcript of Acacia Communications Inc earnings conference call or presentation Thursday, November 2, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John F. Gavin

Acacia Communications, Inc. - CFO

* Monica Gould

* Murugesan Shanmugaraj

Acacia Communications, Inc. - President, CEO & Director

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Conference Call Participants

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* Daniel Bartus

BofA Merrill Lynch, Research Division - Research Analyst

* Dmitry G. Netis

William Blair & Company L.L.C., Research Division - Equity Research Analyst

* Douglas Clark

Goldman Sachs Group Inc., Research Division - Research Analyst

* Fahad Najam

Cowen and Company, LLC, Research Division - Associate

* J. Yun

Deutsche Bank AG, Research Division - Research Associate

* Mark Daniel Kelleher

D.A. Davidson & Co., Research Division - VP & Senior Research Analyst

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Michael Edward Genovese

MKM Partners LLC, Research Division - MD & Senior Analyst

* Paul Jonas Silverstein

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* Quinn Bolton

* Timothy Paul Savageaux

Northland Capital Markets, Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Greetings and welcome to the Acacia Communications Third Quarter 2017 Financial Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Monica Gould, Investor Relations for Acacia. Please go ahead.

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Monica Gould, [2]

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Thank you, Stacy, and good afternoon, everyone. Acacia Communications released results for the third quarter ended September 30, 2017 this afternoon after market close. If you did not receive a copy of our earnings press release you may obtain it from the Investor Relations section of our website at ir.acacia-inc.com. This call is being webcast live and a replay will be available on the Investor Relations section of our website. With me on today's call are Raj Shanmugaraj, President and Chief Executive Officer; and John Gavin, our Chief Financial Officer.

Before I turn the call over to Raj, I'd like to note that during today's discussion there are references to our prospects and expectations for the fourth quarter of 2017 and beyond, projections on the size of our markets and market share, statements about our customers and new products and other forward-looking statements, which are based on the business environment as we currently see it and, as such, include certain risks and uncertainties. Please refer to our earnings press release and our SEC filings for more information on the specific risk factors that could cause our actual results to differ materially from the forward-looking statements described in today's discussion. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events.

In addition to U.S. GAAP reporting, we report certain financial measures that do not conform to GAAP. We believe these non-GAAP measures enhance the understanding of our performance. Reconciliations of these GAAP to non-GAAP measures, in addition to a description of the non-GAAP measures, can be found in today's earnings press release.

And with that, I'd like to turn the call over to Raj.

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [3]

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Thank you, Monica. Good afternoon, everyone, and thanks for joining us today. I'll begin with some financial highlights, following which I'll provide an update on the macro aspects of our business, and we'll then turn the call over to John Gavin, who will provide a more detailed review of our financial performance and outlook.

We are pleased with our execution and results in the third quarter of 2017. Our revenue was in the upper end of our guidance range, while non-GAAP net income and non-GAAP diluted EPS came in above our guidance range. Revenue increased 33% on a quarter-over-quarter basis from $79 million in the second quarter of 2017 to $105 million in the third quarter of 2017, while non-GAAP net income increased 77% from $10.8 million to $19.1 million and non-GAAP diluted EPS increased 76% from $0.26 to $0.46 for the same periods.

Our third quarter results were driven by a combination of continued global demand for our CFP and Flex 400G products as well as recovery of shipments that were delayed in the second quarter as a result of the quality issue. Revenue from our newer customer group, which we define as customers outside of our original 8 customers, increased 54% on a quarter-over-quarter basis and accounted for 31% of our revenue in the third quarter, up from 27% of our revenue in the second quarter of 2017.

During the third quarter, we had 4 customers that each represented more than 10% of our revenue, one of which was the direct hyper-scale customer that was a 10% customer in the fourth quarter of 2016. As was the case in the last few quarters, 2 of our newer top-tier customers were among the top 5 contributors to revenue in the third quarter. Additionally, 5 of the top 10 contributors to revenue are Tier 1 customers from our newer customer group.

In the third quarter, we also announced the addition of David Aldrich to our board of directors and audit committee. In addition to serving on our board, David is also the Chairman of the Board of Skyworks Solutions and its Executive Chairman. David's leadership and experience in guiding a global technology company has made him an excellent addition to our board.

Let me shift to a market update starting with China. In 2016, there was a significant year-over-year growth in the China market driven by the China Mobile backbone expansion. However, in 2017, the transition to provincial buildouts have been slower than anticipated. As you may recall, during our second quarter earnings call earlier this year, we stated that we were seeing some improved order rates in the third quarter due to one specific China Mobile backbone expansion, which has since been completed. At that time, we had indicated that we did not have any near-term visibility into the timing of the provincial buildouts. While there have been several planning discussions around the provincial buildouts, we are not seeing any improvements in our order flow due to these buildouts, and our near-term visibility in China remains challenging.

However, we continue to believe long-term growth trends in China remain strong driven by the China broadband initiative enabling bandwidth to applications like video and 5G. We believe this is further supported by the recent China Unicom tender as well as the anticipated China Mobile tender, which is expected to be announced later this quarter, although the timing of these deployments is unclear. Furthermore, we anticipate provincial buildouts to be more gradual than we saw with the China Mobile backbone buildout.

Turning to the DCI market, we are seeing some improving market dynamics with some quarter-to-quarter variability along with some seasonality around the holiday season. In the first half of 2017, there was a lot of spending by hyper-scale providers to increase bandwidth inside their data centers. We believe that this bandwidth increase inside the data center will further drive spending to add DCI bandwidth between data centers in 2018 and beyond.

As cloud operators push data closer to the end user, the demand for coherent optical interconnects for distances below 100 kilometers is growing. Industry analyst, Signal AI, projects that the demand for these edge coherent ports will grow at the rate of 53% in the next 5 years. We believe our high-capacity coherent solutions, like our AC1200, are particularly important in these edge coherent applications where low power consumption and space optimization are important requirements.

DCI continues to be an important market for Acacia and we are focusing our new product developments in this market. For example, at the start of 2017, we had 2 products selling into the DCI market. This number has increased to 4 products as of today, and we expect it will further increase in 2018 with the upcoming addition of our AC1200.

In the metro market, our NEM customers that sell in Europe have told us that they are seeing 100G deployments starting to ramp. We're also hearing a similar message from our NEM customers that sell in North America.

With that, I'd like to provide you with an update on our new products and product roadmap, which we believe will enable us to meet these market requirements and help drive our future growth. We continue to make good progress with our CFP2-ACO and DCO products and anticipate that they will collectively contribute approximately 10% of our revenue in the second half of 2017. During the third quarter, we were able to ramp the CFP2-ACO to volume production and increase shipments to our direct hyper-scale ACO customer. Platforms that utilize our ACO module began ramping to volume in the second half of 2017 and we anticipate that demand for this product in these platforms will continue through 2018.

Our CFP2-DCO product completed qualification in the third quarter and is getting favorable reviews in the industry. One industry analyst commented in his ECOC coverage brief that our CFP2-DCO is, quote, "unrivaled in performance and power consumption." As we mentioned during our second quarter earnings call, we have over 15 customers for our CFP2-DCO. Our customers and their end customers are in various stages of qualification or deployment with this product and we anticipate further sales growth as market conditions improve. In China, carriers have adopted DCOs like our CFP module and we anticipate that our CFP2-DCO module will build on the success of our CFPs in that market.

Hyper-scale customers are looking to increase capacity while reducing size, cost and power consumption per 100 gig. Our AC1200 coherent module, which supports 1.2 terabits per second using 2 wavelengths of 600 gigabits per second each, is well-suited for these requirements. By increasing the capacity per wavelength, we are reducing cost and power consumption per 100G. By using our Silicon Photonic PIC and low-power DSP ASIC, we're able to offer this solution in a form factor that is 40% smaller than the competitive 5 by 7 modules that support 400 gigabits per second.

In addition, the AC1200 is based on our Pico DSP ASIC, which supports several advanced features that can enable a new level of software-defined networking. These features include tunable baud rate, our patented fractional QAM modulation and enhanced turbo product code FEC. We believe the combination of features, cost, performance, integration and low power consumption will make our AC1200 well-suited for a variety of cloud and carrier applications.

Customer qualification of our standalone PIC is also progressing. We anticipate sales for this product to begin ramp in the fourth quarter of 2017 as customers conclude their qualification and testing cycles. As discussed during our second quarter earnings call, we are seeing our silicon PICs with their small footprint and low power consumption displacing legacy optical components in some of our customers' coherent designs. As such, we believe the sale of our standalone PICs will help to expand the size of our addressable market.

Now I would like to provide more insight into product life cycles in China. Historically, we've sold our innovative low-power, high-performance modules early in the product life cycle due to time-to-market advantages given the complexity and cost of developing these products. Later in the product life cycle, we've enabled some of our customers to build their own custom line cards and modules for certain applications using our DSP ASIC and merchant legacy optical components.

These products are highly complex and are getting more complicated as we drive higher data rates in smaller form factors with increased levels of integration, like our CFP2-DCO and AC1200 modules. For this reason, we expect this trend of selling modules early in the product life cycle and then chipsets later in the product life cycle to continue although we believe our PIC will replace merchant legacy optical components to meet increasingly challenging size and performance requirements. We believe that sales of our standalone PIC and DSP ASIC along with sales of our fully integrated modules will help to grow our share and addressable market in China.

I would like to close by making some observations on industry trends. Moving to higher data and baud rates, our customers indicate that their new line card designs are transitioning away from a mix of ACO and DCO architectures to predominantly DCO architectures where the DSP ASIC and optics are closely integrated. We believe this trend plays into Acacia's strengths and is consistent with industry analysts' published commentary. Our ability to design high-performance products using our integrated silicon photonics and low-power DSP ASIC allows us to deliver high-density solutions in a range of form factors, both pluggable and board-mounted.

Another industry trend that we are seeing is hyper-scale providers becoming a larger portion of the optical market. These providers require higher-capacity solutions with shorter upgrade cycles. This trend favors suppliers like Acacia that are able to rapidly develop innovative interconnect solutions. In many cases, hyper-scale providers want to plug their DCI optical interfaces directly into a switch or a router and want power and size to be comparable to client optics. With the 400G ZR recommendations being made by Optical Internetworking Forum, we believe there's an opportunity for Acacia to implement power-optimized coherent interfaces in client form factors such as QSFP double-density or OSFP. These low-power coherent DCO products will require the same expertise that we've demonstrated we can deliver with our industry-leading CFP and CFP2 products.

We believe based on these industry trends, namely migration to DCOs, smaller, higher-capacity pluggable interfaces and rapid product innovation cycle needs in DCI market, that Acacia is well-positioned for long-term growth. We remain confident in our strategy and market position and continue to be focused on driving down the cost of our products in order to help our customers be more competitive in the markets they serve.

With that, I'll turn the call over to John for a more detailed review of our financial performance and our outlook for the fourth quarter.

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John F. Gavin, Acacia Communications, Inc. - CFO [4]

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Thanks, Raj, and good afternoon, everyone. I will start by reviewing our financial and operating performance for the third quarter of 2017. Then I will provide our outlook for the fourth quarter of 2017 before opening up the call to questions.

We are pleased to report that our revenue came in the upper end of our guidance range and our non-GAAP net income and non-GAAP net income per share exceeded our guidance range for the third quarter.

Total revenue in the third quarter of 2017 was $105 million, a decrease of 22.4% on a year-over-year basis from $135.3 million in the third quarter of 2016.

During the third quarter, revenue from newer customers outside of our original 8 customers increased to 31% of our total revenue compared to 25% of total revenue in the third quarter of 2016. In the third quarter, we had 4 customers that each represented more than 10% of our revenue, one of which was the direct hyper-scale customer deploying our Flex 400G product that was also a 10% customer in the fourth quarter of 2016.

Turning to gross margin, our GAAP gross margin was 43.9% in the third quarter compared to 46.8% in the third quarter of 2016. Non-GAAP gross margin, which excludes the impact of stock-based compensation expense and costs related to the quality issue that we announced in the second quarter, was 43.7% in the third quarter of 2017 compared to 47.2% in the third quarter of 2016.

Our GAAP and non-GAAP gross margin improved on a quarter-over-quarter basis from the second quarter, but were negatively impacted by semi-fixed costs related to our production operations and related overhead costs due to the lower revenue in the third quarter of 2017. In addition, our GAAP gross margin was slightly above our non-GAAP gross margin in the third quarter due to a %0.7 million reduction in the reserve for anticipated costs related to the quality issue from our prior second quarter estimates. As a reminder, our gross margin can fluctuate based on our quarterly product mix, the introduction of new products, new product ramp-up expenses, manufacturing yields and the impact of pricing changes as well as costs associated with the scale of our production operations and associated overhead costs relative to revenue levels.

GAAP operating expenses in the third quarter of 2017 totaled $37.2 million, or 35.5% of revenue, compared to $26.5 million, or 19.6% of revenue, in the third quarter of 2016. Non-GAAP operating expenses, which exclude the impact of stock-based compensation expense, were $31.3 million in the third quarter of 2017, or 29.8% of revenue, compared to $20.3 million, or 15% of revenue, in the third quarter of 2016. As discussed during our first and second quarter earnings calls, the increase in operating expenses during the third quarter was primarily driven by foundry and development milestone payments that came due during the quarter.

GAAP R-and-D expenses totaled $27.1 million, or 25.8% of revenue, in the third quarter of 2017 compared to $18.9 million, or 14% of revenue, in the third quarter of 2016. Non-GAAP R-and-D expenses totaled $23.4 million, or 22.3% of revenue, in the third quarter of 2017 compared to $15.1 million, or 11.2% of revenue, in the third quarter of 2016. The increase in GAAP and non-GAAP R-and-D expenses was primarily related to additional personnel costs as we ramped employee headcount to support our new development roadmap, as well as the timing of milestone payments for our new ASIC and PIC development programs.

GAAP SG-and-A expenses were $10.1 million, or 9.6% of revenue, in the third quarter of 2017 compared to $7.5 million, or 5.6% of revenue, in the third quarter of 2016. Non-GAAP SG-and-A expenses were $7.9 million, or 7.6% of revenue, in the third quarter of 2017 compared to $5.2 million, or 3.8% of revenue, in the third quarter of 2016. The increase in GAAP and non-GAAP SG-and-A expenses was primarily related to an increase in headcount and related expenses and professional services.

On our second quarter earnings call, we stated that we expected our non-GAAP operating expenses for the full year to increase 34% to 36% on a year-over-year basis. We now anticipate that range to be more in line with a 33% to 35% year-over-year increase. As previously discussed, we continue to strategically invest in our R-and-D organization in support of our development roadmap and the many growth opportunities that we see ahead of us with the goal of maintaining the pace and number of new products that we bring to market.

GAAP operating income was $8.9 million, or 8.5% of revenue, in the third quarter of 2017, down from $36.8 million, or 27.2% of revenue, in the third quarter of 2016. Non-GAAP operating income in the third quarter of 2017 was $14.6 million, or 13.9% of revenue, compared to $43.5 million, or 32.2% of revenue, in the third quarter of 2016.

Our non-GAAP operating income in the third quarter of 2017 excludes $6.4 million of stock-based compensation expense as well as a $0.7 million benefit resulting from the reduction in our reserve for associated costs related to the quality issue, from $7.8 million to $7.1 million. We anticipate that our remediation efforts with respect to the quality issue will be substantially completed in the fourth quarter though we do anticipate increased litigation expenses as we defend the class action lawsuits that have been filed, in part related to the quality issue.

EBITDA in the third quarter of 2017 was $12.1 million compared to $39.6 million in the third quarter of 2016. Adjusted EBITDA, which, in this quarter, also excludes the $0.7 million benefit resulting from the reduction in our reserve for anticipated costs related to the quality issue, was $17.8 million in the third quarter of 2017 compared to $46.2 million in the third quarter of 2016. The decrease in EBITDA in the third quarter was primarily driven by a lower gross profit from a lower sales volume and increases to operating expenses in support of our new product development and the continued scaling of our operations.

Our GAAP effective tax rate was a negative 87.4% in the third quarter of 2017 compared to a positive 5.7% in the third quarter of 2016. The change in our GAAP tax rate resulted primarily from ongoing recognition of excess tax benefits from the taxable compensation on share-based awards as well as from a decrease in geographical change in profitability from 2016 to 2017. Our non-GAAP effective tax rate for the third quarter of 2017 was negative 22.9% compared to positive 6.3% in the third quarter of 2016. The decrease in our effective tax rate was driven by a decrease and geographic change in profitability from 2016 to 2017.

GAAP net income in the third quarter of 2017 was $18.5 million, or 17.6% of revenue, compared to $34.9 million, or 25.8% of revenue, in the third quarter of 2016. Non-GAAP net income in the third quarter of 2017 was $19.1 million, or 18.2% of revenue, compared to $40.9 million, or 30.2% of revenue, in the third quarter of 2016. The decrease in our GAAP and non-GAAP net income in the third quarter was primarily driven by a lower gross profit from a lower sales volume and increases to operating expenses in support of our new product development and the continued scaling of our operations partially offset by favorable changes in our tax provisions.

Based on a fully diluted weighted-average share count of 41.8 million shares, this translates to GAAP diluted earnings of $0.44 per share and non-GAAP diluted earnings of $0.46 per share in the third quarter of 2017. This compares to GAAP diluted earnings of $0.86 per share and non-GAAP diluted earnings of $1.01 per share in the third quarter of 2016 based on a fully diluted weighted-average share count of 40.7 million shares.

Now, turning to the balance sheet. We ended the third quarter with cash, cash equivalents and marketable securities of $348.5 million and no debt. We generated $45.1 million of cash from operating activities during the first nine months of 2017, of which $7.3 million resulted from operating activities in the third quarter. All of this cash generation was driven by our GAAP net income.

Now, I would like to turn to our outlook for the fourth quarter of 2017. As noted in today's earnings press release, in the fourth quarter of 2017 we expect total revenue to be between $83 million and $93 million and non-GAAP net income to be in the range of $8 million to $15 million with non-GAAP diluted earnings of $0.19 to $0.36 per share based on an anticipated 42.1 million shares outstanding.

We have faced multiple challenges throughout 2017 including the slowdown in the China market given the delay in provincial buildouts, lower-than-anticipated order rates from our DCI customers, and the quality issue that we announced in the second quarter. The timing of provincial buildouts over the next few quarters remains unclear, creating visibility challenges in the China market.

Despite these headwinds, we believe that the fundamentals driving the market for advanced optical interconnects remain intact and that, through our investments in the development of innovative new products and technology, we remain well-positioned to take advantage of opportunities as overall market conditions recover. Our product portfolio continues to expand to better serve the needs of our customers in the 3 growth markets of metro, DCI and China. We continue to believe that our operating model and strong balance sheet will position us well for future growth.

I will now turn the call back to Stacy to open up the call for questions, after which, Raj will wrap up with some summary remarks. Stacy?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Vijay Bhagavath with Deutsche Bank.

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J. Yun, Deutsche Bank AG, Research Division - Research Associate [2]

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This is Brian Yun on for Vijay. I just have 2 questions. First, can you give us more color on demand trends at your hyper-scale cloud customers? Any insight into the types of conversations with your hyper-scale customers would be helpful. And then, second, Facebook recently noted plans to double CapEx in 2018. Could Acacia benefit from that increase, specifically with the AC400 or the AC1200 module?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [3]

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So let me take a crack at that. I think as we said in our -- in the script, that we are seeing -- we are more optimistic about the DCI market in the second half than we were in the first half. They spent a lot of investment in the first half building bandwidth inside the data center and we see that moving slowly into the DCI outside, connecting the data centers. If you look at the improving dynamics, we reach the hyper-scale guys, as you know, in some cases directly as well as indirectly. And what we've seen is the second half revenue is up over the first half revenue by quite a bit. And so they have started deploying our AC400 product and so we are seeing -- we are more bullish although we do have, as we said before, quarter-to-quarter fluctuations with some seasonality around the holiday season. And so with that caveat, we believe the DCI market is positioned well for us as we move from -- into second half of 2017 moving into 2018 as well. In terms of just products, we can't really directly comment on any one particular customer on this. We see the category of DCI market as a good opportunity for both the AC400, as well as, as you know, the AC1200 is getting a lot of interest from the hyper-scale guys and that's getting a lot of pull-through from the NEMs. And so we are obviously very excited about the AC1200. That product samples in the first half, ramps in the second half. But we not, at this point, can talk specifically about any one customer deployment.

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Operator [4]

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Our next question comes from Dmitry Netis with William Blair and Company.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [5]

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I have a couple of clarifications and then maybe a high-level question. On the customer front you had top-4 customers. With exception of the ICP, were the other 3 customers kind of the usual suspects?

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John F. Gavin, Acacia Communications, Inc. - CFO [6]

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Dmitry, this is John. Yes, they would be some of the previously reported greater 10% customers. Yes.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [7]

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Okay. So China, you had o1 in China and 2 in Europe. Is that fair?

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John F. Gavin, Acacia Communications, Inc. - CFO [8]

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I'm sorry. Repeat that please.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [9]

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One is the Chinese Tier 1 and then the other are 2 European customers.

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John F. Gavin, Acacia Communications, Inc. - CFO [10]

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Correct.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [11]

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Okay, great. And then on the CFP2-DCO and ACO, it sounds like, if you do the math according to what you had said, kind of 10% of revenue in the second half, that implies $19 million if you take the midpoint of the guidance in Q4 for this category. Does all of the $19 million in second half come from the ACO part? Or will you actually see some DCO part as well? And if so, how much?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [12]

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Yes. So I can take a crack at it. We're not breaking it into individual parts. But no, we have a good component of the DCO as well. The ACO has ramped earlier and it is a quarter ahead in terms of the ramp. So it is earlier in the cycle. But there is, as you know, some DCO revenue as well. That is it is ramping in Q4 and obviously we are excited about this product for '18.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [13]

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Okay. So what should we be expecting? Like mid-single digits, low-single digits type revenue contribution? Or could it be even higher than that?

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John F. Gavin, Acacia Communications, Inc. - CFO [14]

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Is your question, Dmitry, in the quarter or percentage…

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [15]

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Yes. Well, I mean it sounds like it only is going to come in in Q4, right, the DCO part?

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John F. Gavin, Acacia Communications, Inc. - CFO [16]

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Yes. As Raj said, Dmitry, DCO is a little bit further behind where the ACO was from a qualification and ramping perspective. So it will be moving up into higher volumes in Q4.

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [17]

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Yes. There is sampling revenue as well. We do get revenue at sample so there was third quarter revenue on DCO as well. It's not all back-ended into fourth quarter.

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John F. Gavin, Acacia Communications, Inc. - CFO [18]

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We don't break down the exact percentages by product.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [19]

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All right. I though I'll ask. Okay. And then another clarification. I didn't hear you guys call out the margin, gross margin for the fourth quarter. I guess, I haven't done the math, how it shakes out, but I guess there's some component of OpEx versus the margin to get to the bottom line here, guidance that you gave. Can you give us a sense where the margins are in Q4, gross margins are?

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John F. Gavin, Acacia Communications, Inc. - CFO [20]

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Yes, Dmitry. We're not going to guide specifically on margin. We don't guide on that. But just to give you a rough idea, we did improve about 100 basis points in gross margin on a non-GAAP basis from Q2 to Q3. We believe that in the fourth quarter, we'll resume a much more normalized mix between chips and modules. The last 2 quarters, Q2 and Q3, it's been a much lower chip weighting in terms of what's typical for us, and we expect that to resume back up to more normal level in Q4. So that should give us another 100 basis point to 200 basis point improvement there based on mix. But it is mix-dependent in terms of where that would be. But that's what we see at this point in time for Q4.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [21]

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Got it. Sequential improvement, correct, John? Just to make sure.

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John F. Gavin, Acacia Communications, Inc. - CFO [22]

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That's correct, Dmitry. Yes, sequential improvement, yes.

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Dmitry G. Netis, William Blair & Company L.L.C., Research Division - Equity Research Analyst [23]

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Okay. If I may, one last question. I just want sort of a high-level thought here. I had picked up on Raj's comment that the modules -- and this is something you've been kind of not really putting out there, but I've heard you this time loud and clear -- that the modules are sort an early product cycle type product and then the chipsets come later in the product cycle. And sort of this kind of architectural thought that a customer would take a module for a time-to-market standpoint and then migrate to their own line card. It seems like that becomes a new norm going forward, which you guys just addressed. And if so, what is the impact to the model? What's the -- well, let's say the way to maybe look at it is what would be the mix of the DSPs and PICs and modules, say, 3 years from now or 5 years from now?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [24]

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Yes. So, Dmitry, I want to clarify that comment. We were -- I was addressing specifically China where -- not about all the global customers, in fact. So that was specific to customers in China where they can do more investments. As it pertains, we do have other customers outside of China who have completely gone back to modules after trying to design their own line card using even our ASIC. And so it is not the new norm, as you would call it. I there are cases, some cases, and that's what I was trying to address within China. And even there, I would -- it's obviously the goal for us is to grow share with the customer as they do this as well because I think as they move, they continue to buy our -- I mean these products are complicated and very hard. And so as we get into smaller form factors, the early Pico stays for quite a long time. So we do anticipate the margins being there for longer. And as they migrate into line cards, in some cases, for certain applications, we will be able to sell PIC as well. So the point I want to leave you with is the components plus the module sales will be providing overall share growth even within that customer. And that's the goal we are working towards. So it's not a shift in this. We don't see, I mean, any dramatic change to the shift itself except that we grow share within that customer.

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Operator [25]

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Our next question comes from Michael Genovese with MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD & Senior Analyst [26]

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First, in terms of just like a point of clarification. Can you help us quantify the size of the revenues that were pushed from 2Q into 3Q because of the quality issue? I mean was it something in the sort of $10 million to less than $15 million range?

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John F. Gavin, Acacia Communications, Inc. - CFO [27]

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This is John. Welcome to the group. Yes, so we had this question on the last call and it's very difficult for us to exactly gauge how much of, say, some of the turns business, if you will, that comes later in the quarter that might have been affected by that. We did see, however, some business that we knew would have to get shipped and delivered, because of the capacity challenges we had in Q2, out into Q3. But that's a small amount of revenue in terms the total increase quarter over quarter. It's a small amount.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD & Senior Analyst [28]

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Okay. Switching gears then, following up on this discussion of a customer in China that takes modules in the early stages, but could shift to components later in the life cycle. What is the timing of that? I mean is that qualification work already underway? When should we expect, as we move through 2018 and 2019, to start to actually see that shift impacting their purchasing patterns?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [29]

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Yes. I mean I don't think that it's a hard and fast -- I mean, for example, what I will say is that the CFP-DCO, this is the product that we've been shipping for 3 years, we are not familiar with them developing that kind of a product. They're still going into line cards so it's not -- it was a statement that was made earlier, a question that was asked, about what are our customers doing. So this is for specific applications. And that module, the CFP module, has been shipping for 3 years. So we do not anticipate the smaller, the pluggable and the smaller form factor product, in the first few years, anything happening to them. I mean 4 to 5 years would be a good guess, but that's a guess at this point because we don't know of any plans they have to do -- that they are doing at CFP-DCO that has been shipping for a few years for us.

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John F. Gavin, Acacia Communications, Inc. - CFO [30]

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And Mike, this is John. From a business model perspective, again, as Raj said earlier, this is something that we've done with some of our select strategic customers for a long time. So from a model perspective, this doesn't really change our mix, if you will, from modules to chips or vice versa from what it has been. It's just we were just explaining that, through the life cycle of how some of these products roll out, that's how some of our customers tend to do designs within later parts of the cycle for specialty applications, and that's when they're buying DSPs in those cases.

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Operator [31]

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(Operator Instructions) Our next question comes from Tal Liani with Bank of America.

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Daniel Bartus, BofA Merrill Lynch, Research Division - Research Analyst [32]

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This is Dan Bartus on for Tal. So I wanted to ask on China, I guess more of a clarification, too, because you might have mentioned it. But to be clear, what products, when you think about the provincial builds in 2018, what products do you expect the Chinese carriers to want for those builds? And then related to whatever product or form factor that is, what does the competition look like for those?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [33]

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Yes. So, Dan, this is Raj. Let me take that. So pretty much what -- the 3 products that we have today that are shipping, which is the CFP-DCO, the CFP2-DCO as well as the AC400, are the 3 products that we anticipate, has been used in -- actually, the CFP and the AC400 has been used in the backbone build and we believe all 3 products will be used in the provincial buildout. We also have a high-performance CFP that we have come out with, which is based on our latest 16-nanometer low-power, high-performance ASIC. So that provides additional performance benefits as well. So we anticipate all 3 products to continue to play well in the provincial buildout.

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Operator [34]

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Our next question comes from Paul Silverstein with Cowen and Company.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [35]

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I'm going to apologize to you and the others on the call and hope you'll indulge me because I was on another call earlier. So I do apologize if it's repetitive. But, Raj and John, if I could take you back to the competitive landscape issue. And a couple related questions. It's really one question, but related parts, which is if we look at Inphi, who is making a lot of noise about their new M200 and claiming the performance is better on a like-for-like basis versus you, and if we look at the age-old issue from the time you went public of folks shifting to line cards and either using your DSP in ASIC and doing the integration work themselves, can you update us on your view of where the competitive landscape stands, how much it's changed? And looking at your roadmap with respect to the ball grid array technology, can you update us on where you're at and how you think that will change things, if at all?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [36]

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Yes, Paul, let me take that question. So obviously we can't discuss specific other companies' commentary. But in our view, the landscape hasn't really changed a whole lot. I think we -- our 16-nanometer product, which is high-performance is still the only one that anybody can build a CFP2-DCO, for example, which is the smallest form factor out there because it can support the power. And it also the one that is -- as we said, these are quite hard designs the smaller you get. And so we believe that that product will be selling into markets, especially markets like China where they have adopted the CFP well and this will be adopted as well and selling into these markets for a while. And then if you look at the high-performance sector of the whole competition, there, as well, we are very well-positioned. We are winning more designs on the high-performance end with AC1200 and the Pico-based designs that we talked about earlier. And we believe we are continuing to distance ourselves with high-capacity ASICs, high-performance ASICs, as well, in this. And so our products, for example the AC400 Denali has been deployed across many trans-Pacific links requiring ultra-high performance. And so I think if we look at it and say we are very comfortable with our position in China and we do not have any issues at our major customer or in the overall market. We are continuing to gain share both in the pluggable segment as well as in the high-performance segment. And I think when we talk about other designs, it is, as ACO opportunities and architectures move towards DCO, you're going to see more DCOs coming into the market and there's probably more people doing it. But from a competitive position for us, that's actually good because we've been saying all along DCOs are the way to go. So it actually plays into what we believe would be our strengths, creating more of a DCO market.

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Operator [37]

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Our next question comes from Mark Kelleher with D.A. Davidson.

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Mark Daniel Kelleher, D.A. Davidson & Co., Research Division - VP & Senior Research Analyst [38]

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I just wanted to focus in on the revenue guidance for Q4. You've got a lot of things going your way; the DCI market, you've got some improving dynamics there. You've got new products shipping. The AC400 is doing well. Yet, the midpoint of the guidance is down about 16% sequentially. So I'm just trying to understand where you're seeing incremental weakness the most. Is it China has slowed down more? Is it DCI has slowed for one quarter? I'm just trying to understand that guidance. And as a follow-up, if you could just break out China as a percent of revenue that would be great.

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John F. Gavin, Acacia Communications, Inc. - CFO [39]

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Hey, Mark. This is John. So in terms of the Q4 guide from where we are from Q3, if you look at it, it's really the majority of it is in China. As Raj had said on his prepared remarks, we're not seeing the visibility yet from the much-anticipated provincial buildout process. We also had stated on the Q2 call that in Q3 we saw some extension of the backbone orders that were coming through. Those did happen, but that process is now complete. And so our visibility today in China for Q4 is really what's driving some of the quarter-to-quarter revenue guide that we gave. There's a little bit of seasonality from the DCI side of the business. But, as Raj had mentioned earlier, first half to second half of '17 saw, especially the direct hyper-scale side of our business go up meaningfully half-over-half. So that is still a good market for us, but it's going to be down a little bit from Q3 to account for the other aspect of what's driving our guide in Q4. And then the last part of your question, I think was the China percent in terms of overall revenue. Our lead customer there in Q3 was 31% in Q3.

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Operator [40]

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Our next question comes from Fahad Najam with Cowen and Company.

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Fahad Najam, Cowen and Company, LLC, Research Division - Associate [41]

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I just wanted to revisit your comment about your guidance for CFP2-ACO and DCO revenue in the second half '17. If I take your North America revenue and approximate that that's your hyper-scale customer, and I suspect that's a CFP2-ACO customer, you're already doing about $11 million from CFP2-ACO. So if, taking the midpoint of your guidance, CFP2-ACO and DCO combined would be $19 million, are you saying that the $9 million, or approximately $9-or-so million, would be from DCO? Or is it maybe de minimis revenue from DCO? Just help us understand a little bit better on the mix.

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John F. Gavin, Acacia Communications, Inc. - CFO [42]

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Yes, Fahad. This is John. We had talked about this a little bit earlier in the call. In terms of ACO, Raj had mentioned that that was already, from a qualification standpoint, out through the market a little bit ahead of where the DCO was. So in the first part of the second half, we would have had some traction there from the ACO side of the business. But now in Q4 we're seeing some ramping activity occur on the DCO product. So it's a combination. We're not going to break down by product specifically what the breakdowns are, but suffice it to say that both products are now in production and moving up the ramp curves.

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Operator [43]

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Our next question is from Meta Marshall with Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [44]

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I wanted to dig in a little bit into your kind of second-largest customer. And like just looking at the numbers from the 10-Q, it looks like they're going to be down kind of over 50 -- if we're doing a run rate, going to be down around 50% this year. And that was kind of a customer into the DCI market, or at least as I understood it. So explaining that decline, is that primarily you're going direct with customers now? Is that they're diversifying kind of vendors that they use? Or just end customers kind of diversifying who they use? It would just be helpful to get kind of a context for what caused such a stiff drop off in that customer.

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [45]

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Yes, Meta. We're not going to get into details of our customers' business because they had it on their call. You're right, in that year-over-year, quarter-over-quarter basis they are significantly down for us. They are pretty much engaged with us on multiple generations of product design. So it's not -- we don't believe they are providing coherent interfaces using alternate solutions. They did talk about losing share at a major ICP. And it was not that they lost the account, but that they did have to share. In 2016, they had a much bigger share of that same ICP and they had to reduce the share in 2017. And so it was pretty much a reduction in the ICP. And they do have a new product, as well, coming that they are well-positioned on some of these ICPs without our new products. And so it's pretty much what they had said. It's they've seen a significant downturn on their ICP space and they've indicated that in their earnings calls.

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Operator [46]

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Our next question comes from Doug Clark with Godman Sachs.

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Douglas Clark, Goldman Sachs Group Inc., Research Division - Research Analyst [47]

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I have just 2 kind of financial questions, again going back to the commentary on implied fourth quarter guidance. I understood your comments on kind of full-year OpEx being up 33% to 35%. If we use that and your comments on gross margins being up a little bit, I just want to make sure we understand kind of what tax rate is happening, if that's going to be a recoup of taxes. And then, secondly on R-and-D, again that point of it being up 33% to 35%. Can you give any indication on if this is kind of a peak spending rate and some of the qualifications should draw down? And basically do you expect to grow OpEx next year or keep it flat or decline?

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John F. Gavin, Acacia Communications, Inc. - CFO [48]

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Yes, Doug. This is John. I'll take that. So you're correct. In Q4 we'll definitely have some impact in terms of the effective tax rate. That will probably also be in a range of a negative 12% to, say, negative 14% in Q4. We'll still see some of the effects of things that happened in Q3 carry forward and affect our rate in Q4. That's what we expect at this point in time. So that's how you would bridge that. In terms of OpEx, you're right. We did talk about making that adjustment in '17 from 34% to 36% year-over-year growth down to 33% to 35%. In '18, from a non-GAAP total operating expense perspective, we do expect to continue to make investments on the product development front. We've talked about this on previous calls; that our investments in R-and-D are very strategic to us. It allows us to maintain our innovation and maintain the pace and number of products that we do produce. Generally, while we're not guiding on any OpEx numbers in '18, we have done some recent planning exercises and have done some sizings. I would say that year-over-year growth there would be somewhere in the 17% to 19% versus it being a lot higher growth rate year-over-year in the '17 year over '16.

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Operator [49]

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Our next question comes from Tim Savageaux with Northland Capital Markets.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [50]

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I have a question on the web-scale front. And that is, for your 10% customer, I think in the past you'd guided to, well in previous quarters I think you said that you expected that customer to come back on the list and they did. I wonder if you might offer any similar commentary for either Q4 or '18 with regard to do you expect to continue to have 10% customers that are direct web-scale operators? One the one hand. And then kind of as a part of that question, for your 10% customer this quarter, was that the customer that was part of that CFP2-ACO?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [51]

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Yes. So I think the good news, Tim, is that this customer, as we had indicated before, is ramping the AC400 both in their DCI and DCI long-haul market. So they are ramping. And it took a little while to continue the ramp. So that's where they came into being a 10% customer. But as we said before, as well, we do see quarter-to-quarter variability with these hyper-scale guys and especially when it comes down to the (inaudible) there is some seasonality as well. And so I'm not going to sit and say every quarter that they will be 10%. But that is -- it won't be significantly lower as it was before because they are continuing to ramp the product. And I think in terms of the -- it was not ACO. This was the AC400 product, as I said. And so we are shipping, as we said before, AC400 to -- I mean the ACO to another hyper-scale customer and that has not reached a 10% scale. I think we said before that there is a limited number of platforms using it and that platform that is using the ACO we see continuing through 2018, but we're not making any predictions about the size or being the 10% in that particular customer.

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Operator [52]

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And our last question will be Quinn Bolton with Needham and Company.

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Quinn Bolton, [53]

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Just wanted a quick clarification and then a question just on the clarification. Raj, I just want to make sure you said that you think your largest customer in China is not looking to in-source the CFP-DCOs, where they'd be looking to use the silicon PIC and the DSPs would be on other line card based solutions. Is that correct?

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [54]

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I think what -- I mean the question is that is there -- are they doing CFP-DCO and will they be continuing to buy CFP-DCO and, of course, CFP2-DCO? And that was what I was addressing, Quinn, is that they are not -- from what we know, they are not doing their own CFP. And so they will be buying CFP as well as CFP -- I mean CFP-DCO as well as DCO-CFP2 and AC400. But they do have, as I said before, for custom designs, they have additional line cards. There's more line card designs. They do have an ultimate solutions that they would use for other applications. So we're going to see a mix of -- we're going to continue to see a mix of these products where they use their legacy platforms for some applications and, of course, continue to buy modules from us, not just the pluggables, but as we come -- they're buying the AC400 then they will be -- I anticipate them buying AC1200 and other products from us as well.

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Operator [55]

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I would now like to turn the floor over to Raj Shanmugaraj for closing remarks.

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Murugesan Shanmugaraj, Acacia Communications, Inc. - President, CEO & Director [56]

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Thanks, Stacy. I would like to wrap up by thanking our employees around the world for all their hard work this quarter. Our talented employees are responsible for delivering Acacia's innovative development roadmap, which is creating excitement among leading service providers and hyper-scale providers around the world. We believe we are well-positioned to extend our technology and market leadership position in the coherent market long term. We look forward to updating you no our progress next quarter. Thank you.

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Operator [57]

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This concludes today's teleconference. Thank you for your participation. You may disconnect your line at this time.