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Edited Transcript of INFN earnings conference call or presentation 7-Aug-19 9:00pm GMT

Q2 2019 Infinera Corp Earnings Call

SUNNYVALE Aug 12, 2019 (Thomson StreetEvents) -- Edited Transcript of Infinera Corp earnings conference call or presentation Wednesday, August 7, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brad D. Feller

Infinera Corporation - CFO

* David W. Heard

Infinera Corporation - COO

* Ted J. Moreau

Infinera Corporation - Head of IR

* Thomas J. Fallon

Infinera Corporation - CEO & Director

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Conference Call Participants

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* Alexander Henderson

Needham & Company, LLC, Research Division - Senior Analyst

* Balaji Krishnamurthy

Goldman Sachs Group Inc., Research Division - Associate

* Christian David Schwab

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* George Charles Notter

Jefferies LLC, Research Division - MD & Equity Research Analyst

* Jeffrey Thomas Kvaal

Nomura Securities Co. Ltd., Research Division - MD of Communications

* Jim Suva

Citigroup Inc, Research Division - Director

* John Warren Marchetti

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst

* Meta A. Marshall

Morgan Stanley, Research Division - VP

* Michael Edward Genovese

MKM Partners LLC, Research Division - MD and Senior Analyst

* Samik Chatterjee

JP Morgan Chase & Co, Research Division - Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* 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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Good afternoon and welcome to the Infinera's Fiscal Second Quarter 2019 Financial Results Conference Call. (Operator Instructions) Today's call is being recorded. If anyone has any objection, you may disconnect at this time.

I would now like to turn the call over to Ted Moreau, Head of Investor Relations for Infinera. Ted, you may begin.

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Ted J. Moreau, Infinera Corporation - Head of IR [2]

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Thank you, operator. Welcome to Infinera's Second Quarter of 2019 Conference Call. A copy of today's earnings and CFO commentary are available on the Investor Relations section of our website. Additionally, this call is being recorded and will be available for replay from the website.

Today's call will include projections and estimates that constitute forward-looking statements, including but not limited to statements about our business, plans, sales opportunities, manufacturing operations, products, technology and strategy, statements about the current status of our integration plans and synergies as well as statements regarding our third quarter outlook. These statements are subject to risks and uncertainties that could cause Infinera's results to differ materially from management's current expectations. Actual results may differ materially as a result of various risk factors as included in our most recently filed 10-Q as well as the earnings release and CFO commentary furnished with our 8-K filed today. Please be reminded that all statements are made as of today, and Infinera undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call.

Today's conference call includes certain non-GAAP financial measures. Pursuant to Regulation G, we have provided a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures in our second quarter of 2019 earnings release and CFO commentary.

I will now turn the call over to our Chief Executive Officer, Tom Fallon.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [3]

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Good afternoon and thank you for joining us on our second quarter 2019 conference call. Joining me today are CFO, Brad Feller; and COO, David Heard. After quickly reviewing our Q2 financial performance, I will summarize how we see the market evolving and describe the opportunity created by our innovation road map. I'll then turn the call over to Brad, who will provide a more detailed review of our Q2 results and an outlook for Q3 and the remainder of the year.

Over the past several months we've made tremendous progress toward building the New Infinera, an at-scale, optical networking innovator, as envisioned when we acquired Coriant in the fall of 2018. As we approach the 1-year anniversary of this acquisition, we are witnessing strong progress around the foundational pillars that support the thesis of our strategy.

First, with significant order and pipeline improvement from the largest consumers of optical technology, we are enhancing our scale, a mandatory ingredient to be a leader in this industry.

Second, as we near the end of our integration period, solid execution continues to support our expectation of returning to non-GAAP profitability and cash flow in the fourth quarter, just over 1 year from our closure of the acquisition. We are on track to substantially finish our integration work in the fourth quarter of this year.

And finally, our investment in differentiating innovation, which has remained robust through this integration period, has positioned us well for the next generation of optical spending.

Before elaborating further on these key pillars, I want to mention several recent notable events and provide an integration update. Last week we announced that we hired Nancy Erba as our new CFO. Nancy brings significant experience in running large-scale operations in industries that demand execution efficiency and is a great addition to the team. Welcome aboard, Nancy.

We've closed on a $100-million asset-backed loan facility with Wells Fargo to provide an additional cost-effective source of liquidity as we execute on our business plan. We believe this gives us the appropriate working capital flexibility needed to scale the Tier 1 relationships we've been developing in the market.

We have fully transitioned manufacturing from our Berlin facility and are successfully ramping production with Fabrinet in their variable, low-cost manufacturing center. These steps drive out significant fixed costs from our business and will have a positive impact on gross margins as we exit the year.

On the IT front, we have now completed a third and final systems implementation project on time and within scope. The New Infinera is now unified with one version of SAP, one version of Salesforce, and one instance of Agile. These unified systems will allow us to continue to bring down expenses and more efficiently run a significantly scaled business.

With these steps and many others, we have now implemented cost reduction activities that will deliver in excess of $100 million in non-GAAP OpEx savings and in excess of $160 million in combined non-GAAP, OpEx and COG savings in 2019.

And importantly on the innovation front, we taped out our ICE6 DSP, a critical deliverable required for us to lead in the next-generation optical performance.

While there's more work to be done, our integration progress remains fully on track as we continue to exceed the milestones outlined when we closed the transaction. These significant accomplishments laid a foundation for achieving fourth quarter non-GAAP profitability and capitalizing on future market opportunities.

Moving on to our Q2 financial results, we are towards the upper end of our guidance range with non-GAAP revenue of $307 million, non-GAAP gross margins of approximately 31% and non-GAAP operating expenses at $132 million. Revenue benefited from healthy demand from our top customer, the successful initial ramp of our new ICP customer and solid demand from other global Tier 1 relationships.

As we had anticipated during Q1 earnings call 3 months ago, the highlight of the quarter was the strength of our bookings, which grew greater than 15% quarter-on-quarter. We saw particular strength from Tier 1s globally, significant growth in subsea bookings and strong bookings from our new ICP customer. In fact, 2 of our top 5 bookings in the quarter came from customers that were new to the company. This strength more than offset continued weakness from our North America cable customer and has created a significantly expanded pipeline for the second half of the year.

In part due to our success in adding new customers -- a significant portion of Q2 shipments were footprint expansion opportunities -- we've pushed our non-GAAP margin down to 31% from 35% in Q1, in line with our expectations entering the quarter. This footprint was about equally split between new customers and new opportunities with current customers. We view this footprint expansion as a great investment, one that creates the opportunity to earn higher-margin transponder fill over time, a dynamic we've experienced periodically through our history.

Following our third consecutive quarter of backlog growth, bookings momentum and positive order trends, we are increasingly confident in our near- and longer-term visibility. Albeit prudent in our guidance, we see healthy market demand we believe we are well positioned to capitalize on a number of industry and macro trends. These include the continued shift to the cloud, migration to open and disaggregated network architectures and a selection of trusted suppliers that have a robust technology road map for continued differentiation.

One important architectural trend is the continued momentum to a disaggregated network model in a growing number of customer networks. This is reflected in the significant growth of this segment, which is predicted to be a multibillion-dollar market over the next few years. Our Groove platform is meaningfully contributing to this trend, as bookings grew 75% quarter-on-quarter and 80% year-over-year. This platform not only opened up opportunity at the previously mentioned ICP but was also the cornerstone of the new Tier 1 win in Asia that began shipping in Q2.

The promise of disaggregation is also moving beyond the optical domain with significant customer interest at the IP edge. Not only will this bring customers a reduction in CapEx, the real advantage is allowing them to deploy services faster by breaking the chokehold that proprietary and closed devices have had on this market.

Our DRX, built with our field-proven hardware and software, carrier-class IP stacks, has now successfully completed lab trials with a leading Tier 1 customer and is slated for first office application in the second half of this year. While this market is still developing, the opportunity we see in 5G and DAA networks for this solution is validated by a significant pipeline of trials with some of the largest Tier 1s and cable operators around the world. In both of these use cases, we believe our timing is ideal for bringing this revolutionary architecture to the market.

It is also clear that some larger customers are becoming uncomfortable with their over-reliance on certain suppliers, opening up opportunities for the New Infinera. Whether for reasons of network security, continuity of supply, global politics and customer pressure or general overexposure, these customers are evaluating alternatives to their current solution. While generally we don't believe telcos will decommission working networks, we do see a growing interest by them to expand their networks with other vendor alternatives. During Q2, for example, we were awarded our first Huawei replacement deal with a Tier 1 in Asia, and we anticipate more of these opportunities arising over the course of time.

And finally, I see technology differentiation becoming significantly more important in vendor selection. Our customers participate in highly competitive markets, and their own competitiveness is closely tied to the underlying technology that enables delivery of their services. As we are invited to new opportunities, we see a shift in the customer buying criteria from primarily evaluating those available today to evaluating what we reliably will be able to deliver over the next couple of technology generations. In this regard, we are uniquely positioned in the market, with both ICE4 and our 600-gig solutions providing cost and performance leadership today, our ICE6 on schedule for delivering 800-gig in 2020 and ICE7 on the drawing board. Today we remain 1 of only 2 suppliers that have committed 800-gig over the next year.

As the optical supply chain continues to consolidate, our position in the market as a differentiated optical technology provider continues to be enhanced by our successful integration of Coriant. On that note, our integration plan has never been just about capturing cost efficiencies. As I noted earlier, we've maintained our R&D leadership in optical performance and now, with the most significant integration risk behind us, we can focus even more of our resources on technology development and productization.

As we communicated during our July 17 technology road map webcast, our focus is in 3 distinct categories: optical leadership, optical and IP disaggregated platforms, and automation that delivers network solutions.

In optical leadership, we have recently introduced our 600-gig solution with our Groove platform. In the first half of the year, we successfully completed 14 customer trials and had 18 additional trials scheduled for the second half. To date 5 customers have verbally awarded us wins, with one of them extending us a PO. This customer is also a new Groove win for us, and our technology road map was a critical decision criteria.

A significant number of other Groove wins have been based on our road map of offering both 600-gig and 800-gig technology, even if initial deployments are with lower-speed solutions. Based on these wins, we expect initial 600-gig revenue in the second half of 2019 with a significant volume increase in the first part of 2020.

At the heart of our portfolio is our vertical integration strategy of developing and manufacturing optical engines. As wavelength speeds continue to advance, we believe that vertical integration becomes a mandatory ingredient in the ability to fundamentally deliver the technology and to control the cost structure that makes it economically attractive. We view recent industry consolidation as a continuing endorsement of the vertically integrated strategy installed at our inception nearly 20 years ago.

We have recently achieved an important vertical integration milestone with the tape-out of our ICE6 DSP, putting us on track for first silicon this fall and 800-gig product delivery in the second half of 2020. As communicated during our recent road map webcast, ICE6 will deliver better spectral efficiency and lower cost per bit, not only at 800-gig but through a range of transmission rates from 200-gig to 800-gig, opening up a tremendous market opportunity.

Our customers will be able to use the same technology for applications spanning from short-reach data center interconnect to transoceanic lengths, improving their operating costs and simplifying their network architectures. While we remain only 1 of 2 vendors with published 800-gig solutions coming to the market in the near term, we are the only one promising 1.6 terabits of capacity in a single device. This level of integration in the DSP and corresponding optics is the core of Infinera's differentiation.

While our heritage has been focused on high-capacity optical integration, we continue to expand our toolbox of optical intellectual property. At ECOC in September we intend to lay out our plans for using this IP to bring a new architecture to the aggregation market with a unique pluggable strategy.

In summary, the combination of significant order momentum, pipeline improvement and customer wins has driven improved confidence and momentum in our business. We expect to grow our backlog in Q3 and are reiterating our 2019 revenue target of $1.3 billion and the expectation of turning cash flow positive in Q4. The benefits of the Coriant acquisition are materializing, and the finalization of integration is now within sight for the New Infinera. We have enhanced customer engagements with larger customers, driving opportunities while we are demonstrating success and driving scale. We are close to completing our integration work. We'll be in a company position to create profitability and positive cash flow. And most importantly, we have continued to invest for the future, bringing innovation to the market that should create customer and shareholder value.

I want to thank our employees for their hard work in creating the positive momentum in our business. I'd also like to thank our customers who share our vision and are creating the optical networks of tomorrow.

Now I'd like to hand the call over to Brad for a more thorough review of the financials.

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Brad D. Feller, Infinera Corporation - CFO [4]

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Thanks, Tom, and good afternoon, everyone. Today I will discuss our Q2 highlights and provide our outlook for Q3 and the remainder of fiscal 2019. The detailed recap of our Q2 results is available in the CFO Comments area on our Investor Relations website.

Q2 non-GAAP revenue of $307 million represents a 4% sequential increase, coming in towards the upper end of our $290 million to $310 million guidance range. Revenue improved during the quarter due to strength within the ICP vertical as well as with global Tier 1s. Our ICP vertical exceeded expectations, driven by a new ICP customer deploying our Groove DCI platform. This new ICP relationship, which came as a benefit of the Coriant acquisition, contributed to the sizable footprint expansion we experienced during the quarter. Our Tier 1 strength was fairly broad but was particularly good with our largest North American customer and our largest APAC customer.

During Q2 we won both several new customers and new opportunities with existing customers, and each contributed to strong backlog growth. We saw solid demand from a number of customers in North America, including from our largest customer, which represented 13% of total revenue in the quarter as they continue building new routes with us. In addition, our revenue within LatAm doubled in the quarter as we saw some recovery in spend across this region.

As additional color on Tom's commentary about our expanded Tier 1 relationships, 8 of our top 10 customers in the quarter would be considered Tier 1 scale customers. We believe that these relationships, along with the new ones we are now creating as a combined company, provides a solid foundation for future growth opportunities. As we commented on during our last earnings call, we saw a robust pipeline of opportunities in Q2 that we expected would drive growth in the second half. The good news is that we were able to convert those opportunities into a strong bookings quarter in Q2, contributing to significant backlog growth entering Q3.

Also of note, following the Coriant acquisition, we have a more diversified customer base. Our top 10 customers represented 43% of revenue in the second quarter of 2019 as compared to 67% in the year-ago quarter. This more diverse customer base allows us to offset continued soft spending within our cable vertical.

Non-GAAP gross margin of 30.7% was slightly above the midpoint of our 28% to 32% guidance range. As we expected going into the quarter, we experienced significant footprint expansion with both existing and new customers. As we've stated throughout Infinera's history, this initial footprint often requires an upfront investment that carries lower gross margins. However, given the size and scale of many of these customers, these investments typically generate a very strong return once customers expand capacity within these networks, resulting in a significant margin expansion opportunity in the future.

Moving now to operating expenses, we continued to make solid progress with our OpEx synergies as Q2 non-GAAP OpEx came in at $132 million compared with our $135 million guidance midpoint and well below the pro forma levels of the combined companies from a year ago. While we take actions to reduce our overall OpEx spend, we are focusing our R&D dollars in areas where we can differentiate and where we see the best opportunity for the company. Our ability to differentiate with our solutions has always been a key principle of Infinera.

Taking it all together, we had a non-GAAP operating loss of 12% and a non-GAAP net loss of $0.24 per share, both metrics better than our guidance range, although both significantly below our longer-term expectations. As we continue to take the key actions necessary to transform the company and benefit from increased scale, we expect financial results will continue to improve.

Turning to the balance sheet, total cash and investments finished the quarter at $140 million. The ending cash balance was slightly below our expectations, as we made a decision to invest in working capital to support second half revenue growth and accelerated some integration spending. These impacts were only partially offset by operational outperformance in the quarter. These investments in working capital represent the building of a strong asset base, which we expect to benefit our cash position as we work it off over the second half of this year.

In order to provide us the flexibility to absorb working capital fluctuations such as those described above, as we continue to transform the company and pursue large new customer opportunities, last week we closed a $100 million credit facility with Wells Fargo. We believe this facility satisfies our near-term capital needs, although we do have the ability to upsize this facility by $50 million in the future if certain conditions are met and the need arises.

Turning to the third quarter, we have some important integration milestones which we are closely managing. First off, we are tracking ahead of our financial synergies and are on track to complete the integration by the end of the year, with future synergies to come with vertical integration.

Second, we have now transitioned our Berlin manufacturing operations to Fabrinet in Thailand. This program is 6 months in the making, and we have a high degree of confidence in Fabrinet's ability to ramp up our products in line with the plan. We will continue to closely manage this transition and expect a smooth ramp.

Third, in early August we went live with a new combined ERP system. As of today, there have been no major issues, and we expect a smooth transition, though complete validation has not yet been accomplished. This is an important step in finalizing the integration, driving synergies and having full financial and operational visibility across the organization.

Now to our guidance for the third quarter of fiscal 2019. As mentioned earlier, our Q2 bookings increased materially in the quarter, representing the third consecutive quarter of backlog growth. As we continue to see a strong pipeline, we expect another solid quarter of bookings in Q3, which would allow us the opportunity to once again build further backlog.

For Q3 we currently anticipate non-GAAP revenue of $330 million, plus or minus $10 million. This would represent a 7.5% sequential quarterly increase in revenue. Looking at the second half, we expect a continued solid pipeline of opportunities and strong backlog will allow us to reach our $1.3 billion revenue target for the year.

On gross margin, we anticipate Q3 to be another quarter of strong footprint deployment with both new and existing customers. While we have been pleased with the opportunities we are winning, many of these networks take advantage of our unique ability to pre-deploy bandwidth, allowing our customers to react quickly to their customers' demand with our instant bandwidth capability. In these cases the initial deployments have a very small percentage of bandwidth activated. As a result of these upfront investments, the anticipated gross margin expansion is projected to shift out by a quarter.

On the positive side, we have now officially completed the transition of our Berlin manufacturing to Fabrinet, which significantly improves our cost profile and reduces fixed costs. We expect this transition to have a positive impact to margins as 2019 progresses and we begin to sell the lower-cost inventory.

Rolling up the various components, we currently anticipate Q3 non-GAAP gross margin of 32%, plus or minus 200 basis points. Based on the further benefits from the Berlin manufacturing transition in Q4 and as our product mix begins to level out in the period, we continue to expect non-GAAP gross margin in the mid-30s range for the fourth quarter of this year. Keep in mind that our non-GAAP gross margin in the first quarter of fiscal 2019 was 35.3% and was representative of a more normalized product mix. Since then we have taken multiple actions to lower our cost structure, providing us confidence in our ability to achieve these gross margin levels as we exit the year.

With regards to operating expenses, we have made tremendous progress with driving down our operating expense levels. As mentioned, we have now completed the migration onto one global ERP system, allowing us to further drive efficiencies in the business. As we still need to stabilize on the new system, we expect only a minor benefit to operating expenses in Q3, leading us to anticipate non-GAAP operating expenses of $130 million, plus or minus $3 million for the quarter. As we progress into Q4 we expect to be able to drive further expense reductions, allowing us to finish the year in the mid-$120 million range for non-GAAP operating expenses.

Putting it all together, we expect a Q3 non-GAAP operating loss of approximately 7% and a bottom line non-GAAP loss of $0.17 per share, plus or minus a couple of cents. In relation to cash levels in the third quarter of fiscal 2019, as we articulated on our last call, we expect a significantly smaller cash reduction driven by improved operating results and working capital benefits as we utilize the inventory built to support the factory transition. As we move into the fourth quarter, we continue to believe that our improved financial results, fueled by our strong backlog position and diligence on working capital, will lead us to both non-GAAP profitability and cash generation.

This will be my last earnings call here. However, I want to reiterate that I continue to be very optimistic about the future of Infinera. I'm appreciative of the great experience and the committed people I've had the opportunity to work with on this journey, and I believe Infinera is well positioned to complete the transformation that we began with this acquisition. I'm excited to hand the CFO reins to Nancy, as I believe she's the right person to take the company forward, as she brings a strong financial and strategic background along with the hunger and dedication to drive change in the business. Thank you for your support over the years.

With that, I will turn the call over to the operator for the Q&A portion of the call.

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Questions and Answers

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Operator [1]

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[Operator Instructions.] Today's first question comes from Rod Hall of Goldman Sachs.

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Balaji Krishnamurthy, Goldman Sachs Group Inc., Research Division - Associate [2]

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Thanks. This is Balaji on behalf of Rod. Congrats on the stabilization in the quarter, and Brad, our best wishes for your next move as well. I think my question really is focused on the recent announcement on Acacia's acquisition by Cisco. Maybe if you want to comment on the state of the merchant solutions and if you think that there's other suppliers available for your future needs and if you want to comment on your own potential to be a merchant supplier. Thank you.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [3]

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Yes, so a good question, and we're certainly seeing a lot of interest there. A couple of things.

One, I personally believe this is good for us and it's good for the industry. I know Raj, I know Bill very well. I am 100% confident they're going to continue to provide us the technology that we need in the platforms today, and they're going to make available technology if we choose to in the future. We have been clear; we will make our own DSPs and optical technology, and we will also buy where it makes commercial sense to do that. And I fully believe that that technology will be available to us.

Two, I do think it makes our own strategy around vertical integration, quite frankly, more valuable. There are fewer choices every day on the market, and I think that this DSP technology and soon to be the optical technology, the value of being able to control that value chain are going to become more appreciated. And I think it underscores some of the basic value and opportunity of Infinera.

In regard to will we make our technology potentially available to the merchant, 2 quick points. We have been approached in regard to our ICE6 by some people who I think may be in conjunction with this Acacia-Cisco announcement are now interested in diversifying and looking at other suppliers. I also see that at the point that it's resonating with the market that we are 1 of 2 choices in 800-gig, and lots of people need 800-gig besides the 2 people that are making it. So people are approaching us to discuss opportunities in DCO. I don't know if anything will materialize, but clearly, it's something directionally that we are going to spend time on.

I was very clear on my script that at ECOC, we will discuss where we're heading with our pluggable strategy. You should pay attention to see how we're planning on commercializing parts of optics and DSP.

Balaji Krishnamurthy Q; That makes sense. If I could ask just one more question, it was good to see the increased spend with your Tier 1 customer in Mexico. Do you see the LatAm revenue levels in the quarter as sustainable going forward? I recognize it's pretty small so it can be lumpy, but just wanted to get your comment on that.

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Brad D. Feller, Infinera Corporation - CFO [4]

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Yes, I think as a combined company, we have a pretty diverse customer base in LatAm, and I think there's lots of opportunity there, so I continue to see going forward the opportunity to continue to grow those revenues. The large customer that I referenced historically has been quite a large customer and continue -- to see them start to come back with spend would be another nice phenomenon.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [5]

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We're also winning new customers in LatAm. There's substantial investment happening there, and I think we're well positioned.

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Operator [6]

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Our next question comes from Jeff Kvaal of Nomura Instinet.

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Jeffrey Thomas Kvaal, Nomura Securities Co. Ltd., Research Division - MD of Communications [7]

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Could we begin by talking about what looks beyond the integration a little bit? It sounds like you're making great progress on putting everything together ahead of schedule. Where -- what kinds of improvements can we think about for the margin structure once we get beyond the fourth quarter? Is it possible for us to be talking about a low or even mid-40s number at some point in the future?

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Brad D. Feller, Infinera Corporation - CFO [8]

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Yes, that's a great question. So obviously, as we continue to take out some fixed costs and exit the year, that is a great accomplishment for the future cost structure, and we're going to continue to work down operating leverage. As we put out, and we've had a very successful quarter, as Tom mentioned, with the Groove platform, which is a compact modular platform going forward, substantial year-over-year growth 80%, that is a sled-based architecture. Modular platforms will continue to be sled-based.

As we start to put our own vertically integrated optical technologies, those products themselves increase in their gross margins by 20 to 25 points over what we're seeing today. So where you're seeing a bit of muted margin footprint that's out there today, it's great for us because we're winning new Tier 1s, as Tom said, that are looking for somebody that provides the existing technology today that's unique in their ability to provide 600-gig, which we get a bit of better margin structure. And as we get to 800-gig, we will have the industry-leading cost structure.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [9]

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So I agree with everything said. Nancy's just getting on board. She'll take over as CFO officially the first part of end of August. We will plan on having an Analyst Day. We will update officially our outlook of the business model before the end of the year. We need to give her a chance to get smart on the topic.

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Jeffrey Thomas Kvaal, Nomura Securities Co. Ltd., Research Division - MD of Communications [10]

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Okay, thank you all. And Brad, thank you for all your help over the years.

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Operator [11]

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Our next question today comes from Alex Henderson of Needham.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [12]

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I was hoping we could talk a little bit about the 800-gig chipsets. You've obviously now announced that you've finished taping down the ICE6. Does that increase your expected probability of getting them back without any issues? I had been estimating around an 85% probability that when it came back, it would be running well. Can you talk about some of the reasons why your success should be better than the problems that both NEL and Nokia appear to have run into on their 600-gig DSPs?

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Thomas J. Fallon, Infinera Corporation - CEO & Director [13]

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Yes, I can't speak to the specific challenges they might have had, but I can only tell you this. We are on schedule to our original schedule with our ASIC. It is non-trivial accomplishment to tape out. Our history of taping out and having first silicon is we've never had to completely respin an ASIC, so I have high confidence. We have never put as much resource or diligence or tools on validating the design as we have this time. We made sure to work with world-class partners in every aspect of the technology going into this. We saw that we need to minimize any unnecessary risk wherever we could, so we spent the appropriate money making sure that we were as bulletproof as possible. So I have high confidence.

Second of all, a lot of the technology that's in ICE6 is actually not the first time we're bringing that technology to market. We've been doing subcarriers for a long time. We have been doing probabilistic shaping. We have been doing SD-FEC gain sharing. The values that enhance the performance of optical, we are taking them to next generation. This isn't first generation for us, and I think that that will be an advantage moving forward.

But Alex, having said that, until it comes back in October and it works, it doesn't work, so I'm going to keep my fingers crossed. I have high expectations.

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Alexander Henderson, Needham & Company, LLC, Research Division - Senior Analyst [14]

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Have you guys heard or talked to anybody that is familiar with the, whether Ciena's taped down yet or whether -- where their 800-gig chip is? Because we haven't been able to find anybody who suggests that they've already seen this product in the field in any form or fashion. I'm a little concerned that they're suggesting that it's available so soon when I can't find evidence of it. Have you heard any evidence of that being in the field?

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David W. Heard, Infinera Corporation - COO [15]

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No, we're not -- Alex, we're extremely focused on our own execution there. And I'd add to Tom's comments, it's not only on the DSP, but last year at ECOC with our PIC, our ICE6, which is our sixth generation of doing this, and it gets harder to marry that photonic integration with the DSP every generation, we demonstrated over a terabit per wave capacity, and it's over 100-gigabaud at 64 QAMs. So we've actually provided to the industry almost a year ago our operating results and open transparency. The PIC is ready to go. The DSC is taped out. That's what we're focused on, on getting to market. So everybody else is very focused on the race between us and Ciena. All I know is this is our sixth time at bat, and the market of 2 isn't much better than a market of 7 or 8.

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Operator [16]

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Our next question today comes from George Notter of Jefferies.

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George Charles Notter, Jefferies LLC, Research Division - MD & Equity Research Analyst [17]

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Brad, best of luck. I do have some balance sheet-driven questions here. Can you help us just understand where we are in the restructuring efforts, just in terms of the costs? I think if I go back to the announcement of the Coriant deal or maybe soon thereafter, you guys talked about a $75 million to $80 million total cost on cash restructuring. How much of that is behind you at this point and how much of it is still in front of us? And then --

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Brad D. Feller, Infinera Corporation - CFO [18]

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Yes, so George, we still have another quarter in Q3 of higher levels of spend around integration. As we get into Q4, it drops down pretty significantly. And then as David mentioned, expect to ramp the initial -- or ramp down and complete the initial integration. So basically, you've got 1 more quarter left of heightened spend and then it drops off pretty significantly in the fourth quarter.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [19]

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The integration costs, George, are roughly what we had said, so in that same ballpark. And as Brad said, they ramp off dramatically in Q4. Q3 is about the same as Q2 was from an integration cost perspective.

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George Charles Notter, Jefferies LLC, Research Division - MD & Equity Research Analyst [20]

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Got it, okay. Fair enough. And then if I just look at the cash quarter-on-quarter, $140 million this quarter, it feels like there's quite a few moving parts in that number. I'm hoping you can walk me through some of those. So for example, there was, I think, an issue with a customer outage that may have affected cash. I think there was a legal settlement you referenced in the CFO commentary. I know in prior quarters there's been some factoring. But can you walk us through those moving parts and give me a sense for how much cash was burned organically, in a sense, Q-on-Q? Thanks.

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Brad D. Feller, Infinera Corporation - CFO [21]

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Yes, so George, overall the majority of the burn is just the cash from operations that, as we've said, will continue to drop off, will get lower in Q3 and then flip to positive in Q4. The increase in Q2 was really a strategic decision we made to pay ahead some prepaid to some of our contract manufacturers, build some inventory to make sure we can meet the demand for the second half. So working capital hurt us to the tune of about $20 million. We also increased the integration costs so that we could accelerate it and get the benefits in the P&L faster. Those are the biggest moving parts.

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David W. Heard, Infinera Corporation - COO [22]

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Yes, I would just add that the delta versus expectation was the decision we made to increase working capital associated with the integration and with the stronger second half booking and transformation work that we're doing as we move the Berlin facility to give our customers smooth delivery of those higher bookings.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [23]

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One of the things that might not be well understood, that certain optical components are, quite frankly, on allocation, and it's a challenge to make sure you have sufficient supply. So as you have a ramping environment, it's pretty important for us to make sure we have the supply covered.

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Operator [24]

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And our next question today comes from Christian Schwab of Craig-Hallum Capital Group.

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Christian David Schwab, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [25]

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Brad, good luck on whatever is next in your journey. My question has to do with, Tom, you were first a few quarters ago to mention traveling across, in particular Europe at the time, that there was tremendous interest in people seeking alternatives to Huawei, which would lead to future business, but all telecom narratives usually move a little bit slow. Now that you've seen your first Huawei replacement in Asia, can you give us an update on a multiyear outlook and possibly give us any idea of the magnitude of the opportunity you may have?

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Thomas J. Fallon, Infinera Corporation - CEO & Director [26]

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Well, as you pointed out, the telcos move at a fairly methodical cadence. I believe that the trend is set and there's going to be increasing decisions made to minimize the risk. There's a number of factors, as I said in my script. Some of it's political, some of it's continuity of supply, some of it's national security. Some of it, quite frankly, comes from customer pressure. There's a number of customers, some of the ICPs, who will not allow their traffic to be carried across Chinese gear. So if that becomes more of a mainstay, there are fewer and fewer telephone companies or telephony companies, people carrying Internet traffic. There are going to be 2 using the Chinese gear.

I think all of these things play, and all of them are actually causing people to second-guess the presence of that level of investment they have in their network. And I think that we've won the first one. I think that we will win more over time, but it's going to be, I think, relatively slow. I do see, quite frankly, Huawei countering pretty hard in regard to making billion-dollar investments in a number of countries to balance this out. So this is in no way, shape or form done, but I do believe that the direction forward is more pressure will be applied to people who are delivering the gear from China, and it's an opportunity for us.

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Christian David Schwab, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [27]

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Great. And then my last question has to do with you guys being approached by customers for your ICE6 technology. Can you quantify, should any of those customers actually lead to design wins or use of your product, is there any way for you to give us an idea of the revenue opportunity that could be there over time?

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David W. Heard, Infinera Corporation - COO [28]

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Yes, so it's probably early innings for us to be talking about that. We certainly have the capability, as Tom mentioned. The Cisco acquisition of Acacia shows the valuation that we have for our DSP and vertical integration, given we build similar DCOs for our product line that are a substantial portion of the shipping volume of what Acacia ships. But it's a little early for us to talk about. And as we said, as Nancy gets on board and we look at our long-term model with the second phase of vertical integration, and this is a potential, we'll be able to reveal a bit more.

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Operator [29]

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

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [30]

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A couple of questions. First one would be on the cable front. You did see what looks to be a pretty steep sequential decline in Q2. However, if you look at what the operators are saying and doing with regard to their second half capital budgets as well as some equipment suppliers with similar exposure to some of your major customers, that does seem to be turning a bit in the second half. I wonder if you have any visibility to cable as a vertical bottoming in Q2 and whether you see any rays of light in terms of resumption in spending in the second half. And I have a follow-up.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [31]

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In regard to cable bottoming, I'm going to rely, quite frankly, on what the industry talks about as we look at CapEx numbers, et cetera. And I think that could be happening. We have a range of cable customers. Some of them are investing more, and some of them are investing less. The one I think you're probably referring to is the one that came down for us significantly. Candidly, we are not putting anything really in Q3 and a very, very muted amount in the rest of the year, and we're going to wait for a recovery. It's very dangerous to take broad, general things and apply them to a specific scenario. Everybody will have a different scenario of how much inventory do they have in their warehouses, et cetera. So I would encourage caution on taking an industry dynamic and applying it to any specific customer scenario.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [32]

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Very good, and you're, as you just stated, not really building any of that into Q3 or the second half?

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Thomas J. Fallon, Infinera Corporation - CEO & Director [33]

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Correct. We're taking a conservative approach and we're hoping to be pleasantly surprised.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [34]

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And one question, if I could, on back on the Huawei replacement situation. I wonder if you can describe the specifics of that -- not in terms of the customer, of course -- but in terms of the sales cycle, whether that was right in the wake of the ban, just something where the overall political pressure that's been mounting over the last year -- describe how long that took to go from initial inquiry to close.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [35]

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Yes, this is a -- it's a PTT in Asia, so it's a significant potential customer. It is a customer that the Coriant side of the house had actually been working on for a couple of years, so this is not like all of a sudden this new pressure came out and they did an RFQ. This is a relationship that's been being worked for a long time. I think that the opportunity to have an alternative to Huawei presented as an opportunity to expand as an initial new vendor, and what I get excited about is these PTTs never pick somebody for one deal. We have our first deal with them; it's a non-trivial deal, but it's not going to change the company's landscape. But the opportunity to become a significant supplier over time is real, and I think that this is a meaningful direction and it's a meaningful opportunity. But I don't want you to think that this new political pressure caused them to send out an RFQ in response. It's been a relationship in development for a couple of years.

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David W. Heard, Infinera Corporation - COO [36]

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Yes, just to add a little bit that jumps onto the Huawei piece, as we look at these Tier 1s, and as Brad mentioned, we lay out that footprint expansion with Tier 1s, I think part of the strategic logic of the Coriant acquisition was our expansion globally and to diversify the network. And as Brad mentioned, moving from 67% top 10 to 43% further diversifies us. But these PTTs and Tier 1s do take time. We have been pleasantly surprised that we've closed 7 Tier 1s and new PTT opportunities since the beginning of this year in 2019. So it doesn't happen quickly, so we are not pounding our chest here, but it does give us ample opportunity to be able to scale those opportunities for both revenue as well as very important gross margin growth.

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Timothy Paul Savageaux, Northland Capital Markets, Research Division - MD & Senior Research Analyst [37]

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Thanks very much and all the best to Brad.

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Operator [38]

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Our next question today comes from Michael Genovese of MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [39]

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Two questions. First, on 600G, just where were we in the quarter? Was it mostly orders and what level of orders? And were there any revenues at all for 600G, and what do you expect the second half to look like for that technology?

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Thomas J. Fallon, Infinera Corporation - CEO & Director [40]

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Yes, there were orders -- 1 physical order, 5 commits. I still believe 600-gig is going to be a very significant technology adopted into the market, and it's got to be differentiated around how many did you sell versus how many are making a decision on your platform based on your technology road map? 200-gig today, 600-gig today, 800-gig tomorrow. We have a number of Groove wins that are rolling out 200-gig today with an expected upgrade path to go to 600-gig at the beginning of next year. That's why they picked the Groove. So I actually believe that we will absolutely get revenue this year, but the revenue ramp will be next year. But the decisions are being made based upon the road map of 600-gig and 800-gig availability.

The 600-gig is simple. It offers lower dollar per bit than alternatives on the market today, and that's what customers want, but they have a long certification cycle. They're going to do it when their network planning cycle is appropriate, and I see most of the people we're talking to planning for the first half of next year for big installs.

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David W. Heard, Infinera Corporation - COO [41]

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The nice piece in that Groove platform and the compact modular space, which we're #2 now in the market with the aspiration to be #1 is, again, the Groove is in a real groove here in terms of its ability to offer the 200-gig, 600-gig, and then that platform architecture moving forward to 800-gig at the lowest cost per bit. So it's been a real vehicle to get insertion opportunities into these Tier 1s, into these ICPs, that when they scale, they go fast and hard.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [42]

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Okay. Great. And second question. Brad, I guess you're shifting out the GMs by quarter, when they're going to go up to mid-30s. What's the chance of them shifting out again? It seems like they could shift out again for either good or bad reasons, right? It could be that we get so many new orders that they're going to stay down here for yet another quarter. But how confident are you in these fourth quarter mid-40s -- sorry, mid-30s -- which seem important to get to breakeven or above? What's your level of confidence they won't shift out again?

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Brad D. Feller, Infinera Corporation - CFO [43]

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Yes, so Mike, you are right that the reason they declined in Q2 was a very good reason. That's a great opportunity for us and for our shareholders. If you look at the different components to the increase in margin over the second half of the year and especially into Q4, one is a mix shift, which we -- you shouldn't read it as though we don't expect to be still growing footprint in the fourth quarter. But what generally happens is there's more year-end money, which tends to be licenses. There's less new networks that are built in the fourth quarter. We will have the benefits, the full benefits of Berlin, the full benefits of all the fixed costs we're taking out. And the reason I gave the metric around Q1 is Q1, before we did all these cost reductions, we hit those same mid-30s gross margins. So things happen in the market, but I am confident that we have a great opportunity to go meet those numbers.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [44]

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Great. Brad, we're going to miss you.

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Operator [45]

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And our next question today comes from Meta Marshall of Morgan Stanley.

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Meta A. Marshall, Morgan Stanley, Research Division - VP [46]

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I wonder if you could just describe the relationship that took place with the new ICP. You mentioned it was a new Groove customer, but that that relationship may have come through Coriant. So just background on that new customer win. And then just what you're seeing as far as time lines of maybe past Cloud Express customers and how long it's taking them in the testing process as they look at Groove.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [47]

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So a couple of things, Meta. One, the Groove was brought to us with Coriant. What was interesting is that when we announced the acquisition, they actually took the Groove product out of their lab and said, “We're going to wait until we feel comfortable with this acquisition before we go and recertify it.” After we got the acquisition accomplished, they put it back into their lab and retested it and certified it. So it's been actually a really great validation that they are comfortable with both the technology and the combined entity, that the Groove is a platform that we are going to continue to invest in.

They made the decision probably at the beginning of Q2 and we started shipping in Q2 in fairly significant volumes, and we see a very, very nice pipeline of opportunities for this platform right now, doing data center interconnect. But they're also now talking to us about other opportunities and other platforms. So I'm excited about that overall platform, and I think that they will probably be one of the customers that upgrade to 600-gig in the first half of next year.

The second question, how long will it take for CX customers to migrate? You're presuming that all the CX customers are going to migrate. Some of them will; some of them won't. We still offer the CX2; we still offer the XT-3300 and we offer the Groove today, and each is, quite frankly, preferred by some customers. Clearly, the growth of the company is moving to the Groove.

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Operator [48]

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And our next question today comes from Simon Leopold of Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [49]

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A couple of things I wanted to check on. You did indicate that you expect to generate cash from operations in the fourth quarter, which would of course imply that you expect to burn cash in the third quarter. If we just think about the midpoint of your guidance, could you give us some sense of how much cash you anticipate burning, whether there's any one-time items in there or something we should be conscious of?

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Brad D. Feller, Infinera Corporation - CFO [50]

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Yes, so the expectation for Q3, Simon, is $20 million to $30 million overall cash reduction in the quarter.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [51]

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Great. That's very helpful. And you had a GAAP/non-GAAP difference in revenue. It sounds like you had a credit you provided to a customer from something last year. I don't quite understand that. Could you explain what happened there?

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Brad D. Feller, Infinera Corporation - CFO [52]

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Yes. So we had a discussion with the customer this quarter. They had to compensate some of their end customers. We agreed to reimburse them for those warranty costs. That will be given to them in the form of credits over time.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [53]

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Great. Appreciate that. And Brad, I just want to thank you for your help and wish you best of luck. Thanks a lot.

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Operator [54]

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Our next question today comes from John Marchetti of Stifel.

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John Warren Marchetti, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Analyst [55]

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Last quarter, Tom, you talked about an Asian customer who delayed some of those orders, that you took it out of the book because you weren't sure how that looked. But just curious where that stands now, if that was behind some of the APAC strength in this current quarter and if it's in there for the second half of the year. And then secondarily, last quarter there seemed to be a lot of excitement or enthusiasm around the subsea market. Didn't hear much of that during your comments today. Was just curious if you could characterize what you're seeing in that market as we look out in the second half of the year.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [56]

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Yes, so 2 things. In regard to the Asia customer that we pulled out of Q1 and then did not put in Q2, we are also not contemplating it in our Q3 guidance or Q4 guidance. We still think it's an opportunity. My bet is it does come in, but there are some issues around it that make us too uncomfortable to commit to it at this point. So I'm going to wait and watch and work to continue to have the opportunity. If they do build the network, it's ours, I'm sure. But it's become a big enough question mark that I'm not going to contemplate it in the outlook. But my view is there's a reasonable likelihood that it would occur sometime this year.

In regard to subsea, kind of my error on really not talking about it. Brad talked about it a bit in his script. We had a very strong bookings quarter in Q2, particularly with ICE4. ICE4 continues to lead the industry in spectral efficiency. It's, quite frankly, what a lot of subsea decisions are made around. We got our consortium PO in Q2, which was a substantive win, both from the technology. It's a win from the deployment across a number of routes that will happen over the next 3 quarters. It's -- one of the challenges of winning at a scale of this size is between the time we get the PO and ship it and then recognize revenue, that's part of the gap between revenue recognition that causes a little bit of a challenge for us, why we have to make an investment in inventory because that inventory is ours until they allow us to invoice it, and they don't allow us to invoice it until they have it up and running and tested. But it's a huge win because the consortium has a number of Tier 1s that we want to do business with, and we had them all here a few weeks ago, and we're going to use that as an opportunity to go on a calling card.

We continue to win subsea in ICP and we continue to see the ICP space be a hotbed for subsea activity. So overall, I am still very excited about subsea. And I'll tell you, when I talk about people looking at technology generations, the people who look at subsea are the ones who probably poke at technology generation the hardest, because what they're looking for is constantly improving dollar per bit, lock per bit, and the reach that a bit can go. They are really pushing it hard. And that's where I think our ICE6 positions us very well, selling what we have today but also selling the promise of our capabilities as we go deep dive into what our performance of ICE6 is with them.

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Operator [57]

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Our next question comes from Samik Chatterjee of JP Morgan.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [58]

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I just wanted to start off with the ICP revenues, if I could. Brad, you saw a sequential improvement in the revenues from Q1 to Q2, I think $20 million to $29 million, roughly. Can you help us with how much of that was attributable to the new ICP that you started to ship to, and also how you can (inaudible) the ramp in revenues with ICPs for the remainder of the year. Particularly, are you continuing to expect a ramp with the new customer that you're now shipping to?

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Brad D. Feller, Infinera Corporation - CFO [59]

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Yes, so Samik, the majority of the growth in the quarter was that new customer and that was their initial ramp. We expect them to continue to ramp as the year goes on. They would actually have liked to us have shipped more in the quarter, so we actually built some backlog with that customer. So expect them to continue to grow, not only through the course of the year, but as Tom mentioned, I think the opportunity with that customer is significant. One, as we transition to 600-gig, as we have subsea opportunities, it's a very big opportunity for us.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [60]

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You'll also see the ICP grow from a revenue perspective in Q3, and not just from that customer.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [61]

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Got it. Also, if I can just ask you on the strength you're seeing with the North American Tier 1s and if you can go into a bit more detail there, what's driving the strength. I know you mentioned 5G and you also mentioned subsea. What are you seeing on the metro side as well in terms of investments? Where do we expect most of the 5G investments to come in?

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Brad D. Feller, Infinera Corporation - CFO [62]

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Yes, we should delineate between book. Again, the 3 quarters of building out backlog and that continuing for the remainder of the year is different than the strength we're talking about in these new Tier 1 wins. In many cases, when these Tier 1s deploy, they're deploying new design wins, so some of them are getting new design wins on the open compact modular platform that we're talking about, the Groove going forward, based on our optical leadership. And some of these, both North American Tier 1s and we talked about global PTTs that are considered Tier 1s, are also completing, as it were, beginning their architectures for 5G and DAA access architectures. And that's where we're starting to see those initial design wins.

What you first get with the Tier 1 is a design win, is a trial period, in some cases paid for, in some cases unpaid. And then they begin rollouts. I would like to reinforce that in the -- getting back to growing bookings and backlog, that happens as they scale those opportunities, which is a multi-quarter, multiyear for 5G and DAA and a very large opportunity. So again, design wins on the edge of the network with our distributed router platform as well as our front-haul/backhaul platform and in the compact modular business with the Groove.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [63]

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There's also, Brad talked about North America Tier 1 Spring. That came from our classic product, building long-haul product and winning new routes. So one of the things that we've been really delighted with is the amount of new routes we are winning with 2 of our North America Tier 1s in the classic long-haul space. And that makes me also believe that they're not building these routes to not fill. They fill them over time, and I do believe that even though we are paying a little bit of a margin pressure on this in the near term, the fact that we're winning substantive new routes with these 2 Tier 1s that have been long-term partners is a good sign.

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Operator [64]

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And our next question comes from Jim Suva of Citi.

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Jim Suva, Citigroup Inc, Research Division - Director [65]

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And thus far your questions and the details to those have been very and appreciated. But I have one thing that maybe my hearing's off or I'm getting too old, or maybe I heard it wrong and maybe you can clarify. Brad, on your prepared comments, you mentioned that there was like a gross margin push-out? And if so, can you help us better understand why, or maybe I just completely heard that wrong, and give us some details around that. Again, I apologize if I heard it wrong. Thank you.

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Brad D. Feller, Infinera Corporation - CFO [66]

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Yes, so Jim, when we looked at the second half of the year earlier, we expected a bit more of a ramp of the gross margin in Q3 and then a further ramp into Q4. So although we are increasing the margin from Q2 to Q3 and still believe the opportunity in Q4 is strong, the amount of new footprint we're building in Q3 is going to push that growth of the Q3 increase in margin into the fourth quarter. That's what I was commenting to.

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Operator [67]

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Thank you. This concludes our question-and-answer session. I'd like to turn the conference back over to Infinera management for any final remarks.

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Thomas J. Fallon, Infinera Corporation - CEO & Director [68]

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I'd like to thank all of you for your time today, and I look forward to updating you on our continued progress. Before signing off, I would like to thank Brad for his partnership and his friendship. He has been truly committed to Infinera, and I wish him the very best. Have a great day.

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Operator [69]

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Thank you, sir. Today's conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.