Jeff Hustis - Head-Investor Relations Thomas J. Fallon - Chief Executive Officer & Director Brad D. Feller - Chief Financial Officer David F. Welch - Co-Founder, President & Director.

Rod B. Hall - JPMorgan Securities LLC Vijay Bhagavath - Deutsche Bank Securities, Inc. George C. Notter - Jefferies LLC Alex Henderson - Needham & Co. LLC Michael E. Genovese - MKM Partners LLC Dmitry G. Netis - William Blair & Co. LLC Tim Savageaux - Northland Securities, Inc. Meta A. Marshall - Morgan Stanley & Co.

LLC Stanley Kovler - Citigroup Global Markets, Inc. (Broker) Jeffrey Kvaal - Nomura Securities International, Inc..

Welcome to the Second Quarter Year 2016 Investment Community Conference Call of Infinera Corporation. All lines will be in a listen-only mode until the question-and-answer session. Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Mr.

Jeff Hustis of Infinera Investor Relations. Jeff, you may begin..

Thank you, operator. Welcome to Infinera's second quarter of fiscal year 2016 conference call. A copy of today's earnings is available on the Investor Relations section of Infinera's website. Additionally, this call is being recorded and will be available for replay from the website.

Today's call will include projections and estimates that constitute forward-looking statements.

These may include statements regarding Infinera's overall business strategy, market conditions, market and growth opportunities, Infinera's results of operations, views on Infinera's customers and its products, integration of Transmode, as well as Infinera's financial outlook for the third quarter of fiscal 2016.

These statements are subject to risks and uncertainties that could cause Infinera's results to differ materially from management's current expectations.

Please refer to Infinera's current press releases and SEC filings, including Infinera's most recently filed quarterly report on Form 10-Q and subsequent filings for more information on these risks and uncertainties.

Please be reminded that all statements are made as of today, and Infinera undertakes no obligation to update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this call. Today's earnings release and conference call include certain non-GAAP financial measures.

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

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

Good afternoon and thank you for joining us on our second quarter 2016 conference call. Joining me today are Chief Financial Officer, Brad Feller; and President, Dave Welch. Today, I will go over financial highlights for Q2 and provide an update on our business and how current dynamics are affecting us.

I will then turn the call over to Brad, who will provide a more detailed review of our second quarter results and our outlook for the third quarter of 2016. I was very pleased with our financial performance in Q2, with revenue of $259 million, non-GAAP gross margin of 50%, and non-GAAP earnings of $0.21 per diluted share.

Overall, the first half of 2016 has been strong with year-over-year revenue growth of 28%, 50% gross margin, and 13% operating margin. Our recent results are supported by the latest industry studies, reporting that Infinera posted strong market share gains in long haul and data center, and a slight gain in metro.

Fueled in particular by our traction with ICPs, and wholesale and enterprise carriers, Infinera has continued to be the long haul leader in North America with roughly 40% market share as of the end of Q1.

Our strength with ICPs is also reflected by both Ovum and Dell'Oro, again ranking Infinera number one in worldwide market share in Q1 for combined ICPs and carrier-neutral providers. In Q2, ICPs and wholesale and enterprise carriers remained strong as these customers continued to invest in DTN-X for long haul capacity and Cloud Xpress for DCI.

Cable also performed well in the quarter and delivered strong results for the first half of the year, despite a near-term potential for demand and pricing pressures stemming from acquisitions in the industry. I am very pleased with our continued success in DCI as we posted another record revenue quarter for Cloud Xpress.

This outstanding DCI result enabled us to deliver strong revenue in Q2, overcoming the early signs of a softer spending environment from our traditional telco customer base that we began to see late in the quarter. Looking more broadly at the market, there are concerning signs of slowing demand in the primary markets we serve.

While the overall DWDM market is growing 6% to 8% in 2016, recent estimates from signal, AI, and Dell'Oro suggest that roughly half of this overall growth is attributable to China. Additionally, we are monitoring ongoing macroeconomic developments, though we cannot predict their impact on our business.

In my estimation, while demand appears solid in our smaller regions, like LATAM and APAC, we are seeing a softening demand environment from certain customers in North America and Europe. Now, to go more in depth on our different end markets, our long haul demand continues to be driven by capacity adds of deployed networks.

Leveraging available capacity in our 100-gig networks empowers customers to easily and quickly address traffic demand, either by plugging in 500-gig super-channel line cards or activating instant bandwidth licenses.

Our products that will incorporate our new Infinite Capacity Engine remain on track and will accelerate Infinera's differentiation substantially by equipping customers with even higher capacity line cards, enhanced fiber capacity, and materially lower cost of ownership.

Because current customers will be able to plug these higher capacity line cards into existing chassis, we expect to continue to see robust capacity fill activity and do not expect customers to meaningfully pause spending on existing networks in anticipation of the Infinite Capacity Engines.

While opportunities to fill deployed networks remains strong, winning new long haul opportunities has been challenging, as multiple large customers have recently completed footprint buildouts.

Certain customers have held off in investing in our existing solutions with the Infinite Capacity Engine on the horizon, and lighter telco demand has heightened competition for limited footprint opportunities available.

Additionally, coming off a record year in 2015, our subsea business has been hurt as we've managed through a technology transition period, which is limiting our success in certain submarine applications.

Although we continued to see a reasonable volume of new subsea opportunities over the first half of the year, our win rate was well below our historic run rate and below our expectations, which will meaningfully impact our subsea revenues for a period of time.

I anticipate that incorporating the Infinite Capacity Engine will improve this situation and allow us to recover share in subsea, which has been a traditionally strong market for Infinera.

Avoiding this type of issue in the future is precisely the reason we had accelerated our R&D cadence to deliver next generation optical engines more frequently in the future.

In summary for long haul, while near-term demand trends will make it difficult for us to grow the way we have over the past several years, my belief is that our new technologies and products will result in Infinera outgrowing the long haul market for years to come.

Moving now to DCI, where we had another outstanding quarter, adding two new invoiced Cloud Xpress customers and posting another record quarter of revenue. I'm very pleased that through the first half of the year, our revenue plan for Cloud Xpress is ahead of schedule.

Of note in Q2, sales of the 100-gig Cloud Xpress exceeded the combined sales of 10-gig and 40-gig solutions, highlighting that ICPs are upgrading their datacenters to infrastructures that necessitate higher capacity optical interfaces.

A recent report from UBS estimates that ICPs account for roughly half of all cloud computing revenues today, and by the end of the decade could own more than three-quarters of the market. Our DCI business today reflects these trends, with revenue heavily concentrated with ICPs and carrier-neutral providers.

Recognizing that ICPs are poised to be the major players in DCI, we are striving to leverage our technology leadership and relationships to both expand our ICP market share and also achieve a more diversified business.

I am proud of our Cloud Xpress results to-date and believe that the market validated quality of our solutions, and customers' recognition of our product differentiated roadmap will enable us to compete effectively over the next few quarters, even as competition intensifies.

Looking further out, I remain optimistic that enhancements in capacity, power, and ease of use with the Infinite Capacity Engine will further solidify our DCI market leadership. Turning to metro, we had mixed results in the quarter.

While we continue to win deals on our pipeline of opportunities with large customers grow, spending from some of Transmode's traditional metro customers remains muted.

I am encouraged that mobile front haul and back haul opportunities continue to increase in response to wireless carriers seeking increased efficiency in their existing networks and planning for 5G which will necessitate significant growth in bandwidth to and from cell towers.

The revenue contributions from mobile solutions will likely not be significant for some time. They represent a sizeable future opportunity for Infinera.

Beyond mobile, the Transmode team's differentiated technology solutions and business approach have opened doors to large opportunities at customers that have historically not been receptive to Infinera. Unlike the long haul market, there are a variety of facets to metro.

From the core to the edge, there are varying capacity requirements, power thresholds, and technology intricacies. My view is that our evolving suite of purpose-built solutions that will be PIC-based in the metro core and application optimized at the edge will prove broadly appealing to the market.

As we near the one-year anniversary of the Transmode acquisition, although I am not satisfied with our financial results to date, I am undeterred in my belief that we have a substantial opportunity in metro.

I do expect more cross-sell wins this year, though envision that our significant cross-selling success is now more likely to materialize in 2017.

Based on customer interactions with the latest analyst estimates, metro market growth in 2016 is shaping up to be lower than predicted at the beginning of the year, an indication that the 100-gig metro upgrade cycle remains in the early innings.

We have the technology solutions, relationships, and the drive to win, and intend to be a significant player in the metro market for years to come. Putting this all together, overall bandwidth demand drivers are intact. We are in excellent position for the future, though facing difficult revenue environment in the near term.

While time is a weapon is the right business strategy for Infinera and our customers, its resulting short lead times impede our visibility, a dynamic which contributed to our not identifying the aforementioned softness that emerged in late Q2 any earlier.

Addressing this softness is particularly challenging right now as we simultaneously work through a technology transition to the Infinite Capacity Engine and our metro insertion is taking longer to ramp than anticipated.

Amidst our current challenges, I remain optimistic as we believe capacity additions to existing networks will remain steady and we have not lost any customers. Our customers continue to tell us that they value our differentiated solutions and experience and intend to continue investing with Infinera.

While we are clearly in a dissatisfactory situation, the Infinera specific issues we are facing are a function of timing and are not structural. Over time, as we incorporate the Infinite Capacity Engine into our products and create traction with the opportunities we see in metro, I'm confident of ongoing success.

In closing, we are well positioned for the long term as bandwidth demand continues to grow and we begin to introduce solutions that utilize the Infinite Capacity Engine.

Addressing bandwidth demand with a world-class team and offering the most scalable solutions for the fastest growing customers positions Infinera to deliver long-term profitable growth.

While results will be challenging in the short term, we are committed to winning in the long term and executing on the roadmap and technologies that will deliver that success. I continue to believe we have never been better positioned. As always, thank you to our customers and partners for their ongoing commitment to Infinera.

And thank you to our employees around the world. With that, I will turn the call over to Brad..

Thanks, Tom, and good afternoon, everyone. As Tom mentioned, we delivered strong financial results in Q2, with revenue coming in at the high end of our guidance range and non-GAAP gross margin and the EPS exceeding our guidance range.

Our success in the quarter was driven primarily by continued growth in DCI and execution on long haul capacity fill opportunities as we continued to deliver best-in-class profitability. Q2 revenue was $259 million, a 25% increase over the second quarter of last year and up 6% sequentially.

Our business continued to be broad based with our top five customers in Q2 comprised of two Tier 1s, an ICP, a wholesale and enterprise carrier, and a cable operator. Two of these customers were greater than 10% of revenue in the quarter, a wholesale and enterprise carrier, and a cable operator.

Contributions from DCI fueled top line growth in Q2 with Cloud Xpress revenue growing nearly 20% quarter-over-quarter. We also benefited from our sizable 100-gig installed base in Q2 as customers across multiple verticals invested in capacity adds to existing networks to address ongoing traffic demand.

Although fill activity was strong in Q2, our success winning new footprint opportunities was limited.

Through the halfway point of the year, revenue growth from ICPs and wholesale and enterprise carriers has been strong and I'm particularly pleased that revenue from our cable vertical was up significantly in the first half of this year as compared to last year both from Infinera classic customers but also new customers gained from the Transmode acquisition.

Revenue from our telco customers, however, did not keep pace with the other verticals, roughly flat over the first half, despite the inclusion of the Transmode revenues.

In Q2 specifically, while a number of our traditional telco customers continued to buy, across the broader telco accounts demand was weaker than expected, dropping off in the latter part of the quarter.

Looking at our geographies, North America remained our largest region in Q2 at 65% of total revenue, though we experienced a 4% sequential decline due to multiple large customers completing footprint build-outs. Internationally we had a solid quarter of growth, driven primarily by capacity adds to long haul networks.

In the quarter, EMEA remained steady at 25% of total revenue, while APAC and LATAM got back on track, coming in at 6% and 4% of total revenue, respectively. Service revenue in Q2 was $31 million, up 10% year-over-year and 9% sequentially.

We continue to have success delivering support services to our installed base, though are seeing some pressure on revenue with the less service-intensive Cloud Xpress becoming a bigger part of the mix and fewer current footprint installation opportunities.

Going forward we believe we have substantial opportunities to grow our service revenue by both broadening our support offerings and also expanding the percentage of customers that utilize our services, including metro customers. Moving now to gross margin, non-GAAP gross margin for Q2 remained very strong at 50.4%.

Gross margin continues to be driven by differentiated cost structures enabled by our vertically integrated business model, a higher portion of long haul capacity fill and capabilities such as instant bandwidth. Additionally, service gross margin contributed to the overall gross margin strength, coming in at 60%, in line with recent results.

Despite achieving 50% margins for two quarters in a row, we are not at a point where we can generate margins at this level consistently.

For a period of time, we expect some pressure on gross margin related to competitive pricing pressures and investments we are making with certain key customers to maximize footprint growth in anticipation of Infinite Capacity Engine-based solutions coming to market.

While we still firmly believe in our 50% gross margin target in the not too distant future, it is important that we balance expansion and margin with key investments which will allow us to achieve this goal on a consistent basis in the future.

Now, moving to OpEx, non-GAAP operating expenses were $96 million in the quarter, growing sequentially in line with revenue and within our guidance range. In Q2 we continued to heavily invest in R&D to support the timely delivery of new products that incorporate technologies from the Infinite Capacity Engine.

SG&A expenses in Q2 were essentially flat as we continue to balance strategic investments with active cost management. Putting this all together, we coupled solid revenue growth with strong profitability in Q2, delivering non-GAAP operating margin above our guidance range at 13.2%, net income of $31 million, and EPS of $0.21 per diluted share.

On a GAAP basis in the quarter, net income was $11 million, or $0.08 per diluted share. The difference between our GAAP and non-GAAP results was attributable to approximately $11 million in stock-based compensation, $6 million of intangible amortization and other acquisition-related costs, and $2 million in amortization of debt discount.

Now, turning to the balance sheet, we had another solid quarter of cash generation, increasing our total cash, cash equivalents, and investments, as of the end of the second quarter, by $15 million to $376 million.

We generated cash from operations of $28 million in Q2, spent CapEx of $12 million, and were negatively impacted by foreign exchange of $1 million. Now, for our outlook for the third quarter of fiscal 2016, as Tom discussed, we are facing several near-term headwinds.

Multiple large customers recently completing network buildouts and challenges in our subsea business lead us to expect that winning new long haul footprint will be challenging for a period of time.

Additionally, although we continue to make solid progress, we are not yet realizing significant financial benefits from cross-selling metro solutions to Infinera's existing customer base or from sales of recently introduced products.

These factors, along with the demand weakness Tom discussed, are resulting in our third quarter revenue outlook shaping up to be extremely challenging. To add a bit of color to the situation we're experiencing, our bookings in Q1 exceeded our internal plan. And bookings for Q2 into early June were in line with plan as well.

Unfortunately, however, in the last weeks of Q2, our bookings declined dramatically. And thus far in Q3, the situation has not improved. While visibility is often challenging given our short lead times, we are very surprised by the speed and extent of this recent deceleration of bookings.

As such, for the third quarter, we currently project revenue to be $185 million, plus or minus $5 million. The midpoint of this range represents a year-over-year decrease of about 20%. Our revenue expectation reflects our ongoing challenge with visibility, which is limited even for opportunities we are confident in closing.

Obviously, we are very disappointed with this outlook and are taking steps to improve the situation.

While it is difficult to predict how long this challenging period will last, with the Infinite Capacity Engine on the horizon and a strong presence and reputation with the fastest growing customers in the market, I'm confident that we will restore strong revenue growth in the future.

As for the rest of our Q3 guidance, we currently anticipate non-GAAP gross margin to be 47%, plus or minus 200 basis points. The absorption of fixed costs across a smaller revenue base and the early impacts of the aforementioned strategic investments are driving this margin outlook in Q3.

Please keep in mind that, even during an investment period, we will have the ability to deliver gross margin results amongst the highest in the industry. Looking ahead in the near term, there could be more variability and pressure on gross margins as we work to accelerate revenue growth and opportunistically invest to capture footprint opportunities.

Over this period I want to emphasize that we will still continue to benefit from our vertically integrated model, capacity adds to long haul networks, instant bandwidth, and purpose-built products. In light of our revenue outlook, we are taking steps to curb the growth of operating expenses.

We currently anticipate non-GAAP operating expenses to decline to $87 million, plus or minus $2 million. We have enacted an aggressive plan to control spend across the board, having instituted a hiring freeze, and incorporated multiple expense controls to prioritize our most essential activities.

In addition, we have adjusted down our estimates in relation to sales commissions and incentive compensation as a result of the current financial outlook.

While we are mindful of the importance of controlling OpEx spend, our plan is to continue to invest in the R&D required for the timely delivery of Infinite Capacity Engine-based solutions, as this is a key component of our future success. You should expect our R&D as a percentage of revenue to run above our 20% of revenue target for a period of time.

As for other operating expenses, we plan to reduce SG&A expenses in Q3, balancing the need for growth with focus on critical spend areas. We continue to invest in the integration of the Transmode business, as well as key new end markets which will maximize our revenue opportunity moving forward.

We are committed to managing expenses tightly as we work through these near-term periods of reduced demand. Putting this all together, the midpoint of our projected guidance translates to a non-GAAP operating margin of roughly breakeven, plus or minus 200 basis points. EPS is expected to be breakeven as well, plus or minus a couple of pennies.

As for GAAP EPS, we project it to be lower than non-GAAP EPS by about $0.13 per share, primarily related to stock-based compensation expense and amortization of intangibles.

Wrapping up, while we had a solid financial performance in the first half, we face significant challenges in the second half of the year, stemming from both softer demand in the markets we serve and also certain issues that are specific to Infinera and our customer base.

Like other companies, our business has a variety of moving parts and challenges that can emerge from time to time, including large customers slowing spend.

While we can typically manage through a quarter in which one or two customers slow spend without significant impact to the overall results, in a period where multiple customers across multiple verticals slow spend, it is not something we can absorb.

The combination of major long haul footprint builds ending for customers, weakness in subsea, a delay in expected metro cross-sell success, and lower telco growth in North America and Europe will have a pronounced financial impact on Q3.

As we manage through this period, we're committed to prudently manage expenses, though not hinder activities focused on delivering our next-generation solutions and market expansion opportunities.

Given our belief in our tremendous long-term opportunity, we will have the courage to make key investments to further set us up for long-term profitable revenue growth. Despite our disappointing outlook, I'm steadfast in my belief that our strategy is sound.

We remain well positioned to address the opportunities ahead and deliver strong financial results over time. Growing market share in each market and consistently delivering 50% gross margin and 15 points of operating margin continue to be our objectives. With that, I'd like to turn the call over to the operator to begin the Q&A portion of the call..

We will now begin the question-and-answer session. The first question comes from Rod Hall with JPMorgan. Please go ahead..

Yeah. Hi, guys. Thanks for taking the question..

Hi, Rod..

I guess the first thing on our minds is to what extent this reads across to other companies that are exposed to the carrier world and the cable world and data center world that you guys are.

I'm hoping maybe you can help us with a little bit more color on how much of this is company-specific? How much of it is customers of yours that just aren't spending or maybe you've lost competitive bids or something like that? And how much of it do you think is related to wider market dynamics that had just rapidly changed here at the end of Q2? And maybe, Tom, if you could....

Yeah..

Couch your statements regionally so we get some feeling for whether there's a difference between Europe and the U.S..

current customers that have been acquired, TWC and Cablevision; customers being acquired, XO. Any time that happens in the short term, we've historically seen either pressure from availability of new POs or pricing.

I think a couple of our customers, particularly in North America, we have found, put themselves in an inventory position that is bigger than they want. I think that there was a phase they all went through where they were trying very desperately to acquire sufficient capacity for the explosion of demand that they were seeing.

And a couple of them are in a position where they have more inventory than they want, that will bleed off. We are not aware of any customers that we are really -certainly not losing or losing market share in. In North America, across the entire long haul space, we have seen in Q2 a significant fall-off in RFQs. Now, one of two dynamics is at play.

Either RFQs for long haul are happening and we're not being invited all of a sudden, which I think is not probable. Or there has been a slowdown in some long haul builds for a period of time. And that is my estimation, particularly in the telco space, which we commented to.

I believe that has to be a temporary dynamic because none of the demand drivers that are in place, whether it's to move to cloud, whether it's more video, whether it's just increased bandwidth requirements in general, are going away. But I do think that there's a – in North America, a little stall.

And I think there's a perspective that it's moving some to IP investment and some to metro investment. Whether that hurts other people or not, I can't answer. I did listen to part of Juniper's call, and they reflected a softening in some telco. And they also talked about significant pricing pressure in Europe.

We are absolutely seeing significant pricing pressure in Europe, more than typical, particularly in metro. We're also seeing in the wholesale space in Europe an incredibly demanding and challenging environment for – we've been very successful historically in that space.

Some of our customers there I think are trying to figure out what their business is going to be moving forward. And I think that they will figure that out. But right now, I think that there's a slight demand pause from them. We are seeing strength in general in LATAM.

And while APAC's not a large portion of our business, we are seeing wins in APAC, a lot around metro, but also some around long haul. So long story short, I think that we are seeing in parts of the market, a demand slowdown that is potentially industry-wide.

We are – for long haul, we are seeing pricing compression, particularly in Europe that I do believe is industry-wide. We are seeing submarine for us being industry specific, our Gen 4 technology is critical for us to retake a competitive leadership.

That's an Infinera-specific issue and that'll cost us some amount of money certainly in the second half of this year until we get the Gen 4 out. And I think that we also have the complicating factor of we're relatively new to the metro, and we are in the middle of a technology transition to Gen 4, or the Infinite Capacity Engine.

We are extraordinarily bullish on what that will do for the company. And I believe that at the end of the day, this is in my mind a bump in the road toward us achieving our objectives. And I'm still extraordinarily bullish about the opportunity of our company..

Okay. That's a very lengthy response. And thanks, Tom, for all that detail. I appreciate it all even more..

You asked a complicated question, Rod..

No, I really do appreciate the color..

Okay. Thanks, Rod..

Our next question comes from Vijay Bhagavath of Deutsche Bank. Please go ahead..

Yeah. Thanks. Yeah. Hi, Tom..

Hi, Vijay..

Yeah. Hi. So, I just wanted to build upon the prior question here, more in terms of use cases and where the build-outs were, like you could walk us through saying, fine, you saw some demand slowdown towards the end of June.

Were there any specific use cases that are architecture related? Like, for example, would the carriers or the customers of yours look to do something else architecturally? Is there an architectural reason kind of motivating this slowdown or is it just a demand pause, spending pause? Thanks..

No, it's definitely not any kind of use case application that we're seeing. In fact, the use case of cloud continues to drive – we've been very strong in Internet content. We continue to see lots and lots of demand there. We continue to see long haul demand interconnecting data centers. We've had strength in a number of classic of customers.

What we are seeing, like I said, is a couple of customers who've gotten over-inventoried. We're also seeing telco specifically mentioned, as being relatively soft. A submarine for us moving forward is relatively soft. And we're winning in the metro. There's lots of opportunities in the metro.

But we are I guess disappointed and surprised a little bit by how long it's taking to turn success in labs into success in field trials into success in creating substantive revenue. I feel comfortable that we're making great progress. But it is taking a lot longer than we had anticipated. And I'm disappointed in the results.

But it's not a use case issue. There are lots of use cases out there that are going to require more capacity..

Yeah. And then, a quick follow-on – no, thanks, Tom. It's very helpful.

A quick follow-on would be how long do you anticipate this funk to last? Would you have visibility saying, for example, will this last through year-end? Or ideally like lead on into early next year? Or is this short term?.

That's a good question. And I wish I had a good answer for you. For the same reason we don't give yearly guidance. It's because we have a hard time seeing very far ahead. And this fall-off happened extraordinarily fast. My anticipation, I look at this way, I'm going to assume it takes awhile because I want to make sure we approach this conservatively.

But at the same time, I'm not going to believe this is a winter storm that's going to last for a whole season. We're going to continue to invest steadily in R&D because I believe that getting Gen 4 to market is imperative. There's a lot of other things we're bringing to market that I think are imperative.

And I fundamentally believe in the demand drivers that are going to drive us opportunistically over the next several years. So, do I think it's a long recovery? I don't. Can I tell you that it's a one quarter phenomenon? I cannot. And we're going to approach it conservatively..

Thanks, Tom..

Yeah. This is – maybe I'll add one comment on there. What we find is that a lot of our customers, larger customers, that are engaged in is the transport of data center interconnectivity over the long haul. Those customers carry a large portion of the data in that application set.

The predictability of the base traffic demand in that market sector is sporadic, right? It's a less predictable demand cycle than one that's generated from aggregation networks.

This transition here, or it's not transition – this bump in the road, as Tom puts it, is the alignment of that lack of visibility into exactly what those demand cycles are and driving it. The presence – the architectures you were asking about, architectures are still solid and still the same.

And our position within these customers is still solid and still the same..

Okay. Thank you..

Thanks, Vijay..

Our next question is from George Notter of Jefferies. Please go ahead..

Hi. Thanks a lot. I guess I was curious. You guys said a lot here. It's a big reduction in expectation certainly for the September quarter. I guess I'm wondering if you can kind of put some of these explanations in a box in terms of how impactful they are. I mean, you talked about subsea.

You talked about completion of network builds, inventory, price pressure in Europe, lack of cross-selling.

I mean, is there a way to kind of parse out the step-down in expectations according to each of these factors or is it mostly one or another? And then, I guess related, how many customers are we really talking about? Is this 3 customers, 5, 10? How broad based is this?.

Yeah. So, George, I'll take a cut at it and let Dave and Tom add some color. The reality is we're not going to exactly size each of the different things. The metro situation is really just a lack of growth that we had anticipated. So the base business is relatively flat.

We're just not seeing the growth that we anticipated both from the traditional Transmode business or the XTC-2 kind of platforms. The large customer spends, right, we have several different customers who have spent a lot of money over the last several years that some are shifting demand to metro and IP.

Some guys just haven't laid out their plans for their next build. So, that is a relatively large piece of the challenge. Subsea, we've had a fair amount of success over the past several years. We continue to see a lot of opportunities. We're just not winning at the rate we did before.

Subsea is not a huge market, but it is a big challenge for us as we don't continue to win the follow-ons, right? And then, just in general, telco demand given the size of some of our customers, some of our Tier 1 customers, when those guys pause spend, it does put a hurt on us..

Got it.

And then, again, are we talking about 5, 10, 3 customers? What's the magnitude of this?.

Yeah. So, we've said in the past, one or two guys pauses someone can backfill it. This is multiple customers and multiple verticals. So, it's unfortunately the bad alignment of several customers..

Yeah. Across different verticals, George..

Yeah..

Got it. Okay. All right. Thank you..

Thanks, George..

Our next question is from Alex Henderson of Needham. Please go ahead..

Hey, guys..

Hey, Alex..

Hey, Alex..

So, a couple of related questions here. I mean, obviously, some of this is a function of you guys shifting to metro and still having to fight your way into that marketplace as the long haul slows.

Do you think the shift in spending priorities may have caused some hesitancy in the long haul as they shift their spending priority into the metro? Or do you think that this is more a function of M&A activity? How would you weight those two factors? And how big a factor is the transition in technology if you were to weight that? I mean, if you were to take those three pieces, how would you parse the pressure here?.

It's hard to be – for sure, Alex, but yeah. I think certainly, the transition in technologies I think is mostly constrained to the subsea area today. That is where fiber capacity is highly prized, and there's no trade-off for it. And I think that that's certainly an Infinera-specific issue.

I think across the larger customers that have slowed some spend, some of it is absolutely moving to metro builds. Not all of them, but some of them. And there's been clarity in the industry that over the last few years, the long haul market has grown faster than most people anticipated. And metro has grown slower than most people anticipated.

And I think that there's some shift to that right now. There's been a relatively hefty upgrade cycle to 100-gig in the long haul. There's been a relatively hefty investment in capacity expansion in preparation for needing to bring more capacity into the metros. And I think some of that spend is now happening in the metros.

That will not say – that does not say that capacity in the long haul is sufficient today, as new architectures within cloud, as 5G starts being prepared for long haul capacity. I just saw a report that says bandwidth in the long haul is supposed to grow somewhere in the 30% to 40% per year for the next five years. I believe that at least.

So, I think that there's going to be significant bandwidth growth continuing in the long haul. But in any one quarter or short period of time there'll be priorities of metro over long haul, and probably balancing out what would be historically an over-investment in long haul historically.

I do see some potential for the acquisitions to be causing some slowdown. But I think that's, like I said, temporary in nature. And I do think the competitive environment for metro is truly unbelievable. It is extremely competitive. And I think that's partly a dynamic that the metro market continues to be over-served.

And I think that that's going to continue to fix itself over the next couple of years. And there's going to end up being fewer competitors in metro. And we are going to be one of them. So, I think that Gen 4 will help us in the metro, bring a significantly differentiated platform to the market.

And in the mean time, we're going to have to go fight it out and probably adjust our margin expectations of what we can earn in the metro. When you look at some of our competitors in the metro space, they're growing relatively quickly. But they're doing it at the expense of margin.

Margins have been crushed, and it's almost inverse economies of scale; the more I sell, the less I make. And that's a hard concept for me and us to wrap our heads around. But we're going to have to go look at that until we can get our Gen 4 platform out..

So, just to be clear, you've got a number of M&A events happening to your customer base.

What portion of your customer shortfall was related to customers that were within that set?.

It's not huge..

Yeah. I mean, it's not huge, Alex, but if you think about it, some of this is pricing pressure, right? So when a customer doubles in size or roughly doubles in size, they're going to come back and try to pay for part of that acquisition through getting price reductions. So, that impacts us.

The other piece is just uncertainty, right? We've got customers that are being acquired that have to go check with the head office before they can spend. So, it's not huge, but it is meaningful..

That's meaningful....

Is it 25% of the gap in the third quarter number or is it less than that?.

Yeah, we're not going to size it exactly, Alex. But it is an impact. It's not the biggest impact though..

I think it's important, Alex, Brad mentioned like four or five different things that are confluencing together. It's a combination of all of them that makes this such a big drop and quite frankly, happening so quickly..

All right. See you at the (40:42), thanks..

Our next question comes from Michael Genovese from MKM Partners. Please go ahead..

Hey. Thanks a lot. So, I heard basically from you guys here that long haul is slowing down, that metro is taking time competitively, specifically for you guys. And then, Cloud Xpress is doing very well. And I'm not surprised by any of those things, although I am surprised by the magnitude of the guide.

But I think the most important thing to get to here is for the metro, I know you've been asked this, two or three times already. But further clarification is great.

But on the metro, how much of it is actually delayed spending versus these long sales cycles, your product upgrades, you coming to the market later than some of the other competitors versus – so, again, how much of it is company-specific and how much do you actually believe the metro market is slowing? And what would be the reasons that you could figure out for why the metro market would be slowing, if it is?.

Yeah. So, I'll try and answer that. Overall, the metro market isn't slowing. To introduce a new product into the metro platform in a number of the key areas that we are seeing strength in is out in the access end of the spectrum. They don't go and massively deploy access in all of their metro simultaneously. They go do it out in a step-function.

They prove it out within a particular size network. And once they prove it out, then they make it available to all their additional metros. And it takes a period of time. So, an actual ramp-up in the access network may take a couple of years to perform it. The value of it is substantial.

Our visibility and opportunity for metro deals coming in, in Q2 was substantially higher than Q1 in that. So, we are seeing a lot more opportunities. And we were advancing those opportunities at a very good clip. But the timing it takes for that to realize into real revenue, especially on the access side of the network, takes time.

And there's nothing you can do for those because it's just – it's too many sites, right? The number of locations on how these things get deployed is much greater than in a long haul network. And that's just – that's the nature of an access side.

And the core side of the metro application, which is really an extension off of our long haul system – well, that is a higher dollar per site opportunity than an access portion of the network. And those things are starting to convert. And those are mostly Infinera classic customers adding on our metro portfolio on to their networks.

Those are going well. The opportunities are going. Pricing pressure is definitely a reality in the metro, especially as 16QAM-type of technologies impact the metro, which is not a dynamic in the long haul. And those transitions, those wins are coming. We talked about Telia. I think we've made announcements.

You've got a couple of other wins in that category. But it takes time for them to prove it out and test it in their lab and turn it into revenue..

Great. Good answer. Thank you. And just for my follow-up, maybe for Brad.

If we get a 300 or 350 basis point sequential decline in gross margin, is the biggest factor there volume? Or is it mix? Is it competitive pricing? I mean, what are the two biggest features there?.

Yeah. I mean, the biggest one, Mike, is actually volume-driven because it's the absorption of fixed costs, right? So, we've got an infrastructure, whether it's in sales, support, new process introduction, this kind of stuff, that is fairly studied and built based on a much higher revenue base.

So, because we believe in the opportunity – in the longer term opportunity, we're not going to cut that back in one quarter, so it has more of a drag on the margins. So, that's the biggest thing. There is some amount on pricing pressure and some of the investments, but the fixed cost absorption is the bigger piece..

Great. All right. Well, good luck guys. I hope the visibility improves sooner rather than later..

We do, too, Mike..

Our next question comes from Dmitry Netis from William Blair. Please go ahead..

Okay. Thank you very much. I'm going to probably ask seventh question on the call about this. But again, kind of as you look at the softness or pockets of weakness in telco, submarine, metro, some of the standout performers clearly are DCI and ICP.

So, can we – well, what are you guys baking in into maybe Q3 and maybe Q4 as you look into the second half of the year for those two verticals? Is that – I know Dave said there's sporadic demand from those two.

But do you have enough in the pipeline to continue to see that perform kind of to your expectations? And can you describe maybe competitively what are you seeing out there from the competitors that are coming in with the new products out there as well?.

Sure. So, obviously, we are baking into our guide what we see happening. And we see still healthy opportunities for data center capacity in general, and the wholesalers that carry that traffic.

But we are seeing increased competition for the first time really in this quarter, both from the Infi (46:40) solution, as has been talked about a little bit, though we think that's fairly contained. And we're also seeing entrance in to the market that we're now competing with for purpose-built solutions that are more in the model of a CX.

We still think we have a substantive lead from an experience set. We've been now selling to and listening to customers, and putting in features that they value. We believe without question with our Gen 4 road map that it continues to remain the technology leader as other people are just now entering the market.

But we do see entrants it the market that appear real for the first time. We still have healthy CX expectations for the quarter, though we are not anticipating that growth like we've had over the last couple of quarters. Last couple of quarters have been quite outstanding. Part of it is new competition.

Part of it is spend cycles from a certain – from certain of our customers that are in an off-spend cycle because of either fiscal year's budgets or project planning. But we do anticipate certainly a healthy demand, very healthy demand, over the long term, and even in the short term continued expansion into that market space.

Not only with our traditional customers, but we're also continuing to win new customers with that CX platform..

Okay. Very helpful. And as a follow-up, can I ask a two-part question? Number one is it kind of follows up to the previous question on DCI opportunity in this Infinite Capacity Engine.

Is there any timing to when the platform will be available? Or was it something you're going to disclose at the Analyst Day or Investor Day you're planning at the end of August? Just kind of give us a sense when that will be ready to go and commercially available.

And then, the second part to the question is kind of as you kind of go into Europe, I want to zoom in a little bit on Europe and maybe ask you to kind of describe what you're seeing out there as far as the competitors driving this pricing pressure. Is it the Alcatel-Lucent's now being part of Nokia that are being really aggressive? Is it the U.S.

competitor group, kind of guys like Cisco maybe? Is it the Chinese potentially that are playing there that's driving the price down? Any color on that front would be really helpful, too..

Yeah. I'll answer that one first. Our view in Europe is pricing is being probably driven down by Coriant and Alcatel. And we're also seeing in certain applications Huawei in their new DCI space be even more competitive than I'm used to seeing as they enter in a new market.

I mean, virtually or literally giving applications away, particularly around the DCI space. But I do think it's a couple people leading and a lot of people following along because the market price is being set, quite frankly, very competitively by a couple of price leaders.

In regard to when we will talk about our products based upon the Infinite Capacity Engine, our anticipation is that at inside Infinera, we will tell people what our specific plans are for introduction of that technology into platforms..

Great. Thank you very much..

Thanks..

Our next question comes from Tim Savageaux from Northland Capital Markets. Please go ahead..

Hi. Good afternoon. And I wanted to follow up briefly on some of the vertical questions. And if I heard you right, the cloud business may not grow at the same rate in the second half and may see some declines. But that's been a bright spot.

And I imagine, given the pricing commentary in metro, it seemed what we had was a customer issue with Transmode last quarter that's kind of been maybe added to, to some degree, by market issues. But – and so, confirm if that's the right way to look at it.

But even with some more conservative assumptions there, and let's just assuming you're able to stay flat in Q4, you're looking at something on the order of a 15% or so decline in long haul for the year. Trying to reconcile that relative to your overall market growth rate commentary, I think it was 6% to 8%, maybe half of that's China.

I don't know if that's half the growth rate or how you meant that.

But are we looking at a situation where we're kind of under-growing the market by that wide of a margin, understanding some of that's maybe subsea and temporary? But if you can just sort of comment on that kind of direction of thinking and that sort of whether that growth rate or rate of decline for long haul is (51:56)..

I'll start by answering some of your cloud commentary. And I think that what you've articulated is kind of how we view Q3 in regard to cloud. In regard to the commentary on metro, with a customer – historic Transmode customer last quarter, it was actually I think a Q1 dynamic.

And the good news, quite frankly, is, as Brad had said earlier, the metro – our business has not actually declined. It's, you can call it, nominally flat to a little bit up. We've been able to backfill that business successfully. The challenge is growing it substantively with new wins that roll out for revenue.

As Dave said, there's a fairly long gestation cycle between a win and then materially impacting revenue. That gestation cycle is longer than I had anticipated. We are creating wins. And as Dave said, looking at our RFQ from Q2, I believe it was a record for us on the number of metro RFQs that we received. So, there's lots of activity.

We're making lots of progress. The gestation cycle is just significantly longer than we thought. And it's compounded by prices compressing extraordinarily fast. And we've been playing unfortunately a little catch a falling knife game. And it has not been as successful as – in hindsight, we should have been more aggressive sooner.

In regard to long haul market share, in Q1, the industry analysts said we gained market share in Q1. It's hard to understand right now what's happening in the dynamics of the long haul space. As we said, in Q2, there were very, very few RFQs that we received. If we're not receiving, we're anticipating other people aren't receiving them also.

We do believe the long haul is all real-time numbers, right? The long haul space outside of China will probably grow 2% to 3% this year. Are we going to grow market share or lose market share? Too early to call. But I think there's a reasonable chance we'll grow market share in long haul this year.

It just won't be 3x the market growth that we've shown the last couple of years. So, we've grown market share. We've grown three times the growth in long haul the last three years. We knew that at some point that would meter out. It just has metered out a lot faster than we thought.

And I believe that we will stay neutral to grow market share because I don't know of long haul deals we're losing. We're just not seeing that. So, that's my kind of read of the situation, Tim..

Okay.

And as a quick follow-up, is there any kind of indication of maybe some legacy technologies falling off, I mean, to the extent 10-gig is still any type of meaningful part of the equation here?.

No – I don't – the – from a technology cycle point of view, the only place which you talked about earlier is in subsea..

Yeah..

And we'll be out of that one pretty shortly. Don't see any issues in and around other technology cycles..

Well, our 10-gig business in long haul is very, very small. So, that's not the issue..

Actually – yes..

Yeah..

Our next question comes from Meta Marshall from Morgan Stanley. Please go ahead..

Hey. Thanks for taking my call. A couple of questions. You mentioned making some investments in customers as a reason for the gross margin pressure. And I just wanted to get a sense of whether those were existing customers that are kind of expansion projects.

Or were those new customers that you were looking to get into and just a sense of the categories they fall into? And then, the second question was just Transmode kind of customer issues seem to be related to a particular customer kind of waiting to see whether they were going to win additional, a bid to provide capacity for ICPs.

And I just wanted to get a sense of whether that decision had been made away from them and that was part of the reason for the pause or unrelated. Thank you..

Okay. So, Meta, in terms of the investments we're making, it's a combination of both new and existing customers. So, we have some existing customers that we are growing share with that are great longer-term customers that when the Infinite Capacity Engine comes out, we want to make sure we have more and more of their footprint.

It will take some investment upfront, though, to go expand that business. It is something we've done in the past and has been very successful for us. We also have some newer customers that we're getting opportunities with that are going to take us some investment to get in the door with.

Now, these are all opportunities that are great longer-term margin profiles. They're potentially very large opportunities. We're not going and taking dumb deals that will never be profitable.

It's just a matter of making that investment upfront, make sure that we are in with that customer, then we can maximize the benefit of the Infinite Capacity Engine when it comes out..

And this plays on one of our strengths. As a leader in gross margin in the industry and to be able to make those investments and sustain a guide of 47% plus, minus, that's an incredible position to be in to be able to make those investments for our upside..

Yeah. And, Meta, to address your Transmode question, we had highlighted a customer last quarter, those – although the customer is still there, the volume hasn't increased with that customer..

Got it. Thank you..

Our next question comes from Stanley Kovler of Citi Research. Please go ahead..

Hi. Thanks for taking my question. I just wanted to ask if we can get back to looking at just specifically the long haul and if I back out what – I guess what I think would be next quarter's service revenue and if we get, back out some metro.

Is it fair to say that your long haul business is kind of back to 2013 levels on a quarterly basis and we can kind of plot a path back over time? Is that the trajectory we should be thinking about? And the other side of the question would be specific to metro and perhaps even on subsea, can you help us understand the features or the feature sets that are maybe stalling the opportunities for you here, especially in metro? I mean, what are some of the things that you need to get from a product standpoint besides Infinite Capacity Engine to get the 100-gig (59:24)? Thank you..

I'll address the first part and then let David address the metro question. From a long haul perspective, we're definitely not down to the 2013 levels. We've grown that business very significantly with our DTN-X technology over the last several years. To Tom's point, it's just not growing at the 20%, 25% we did over the last years.

And so, there is some challenges with that business. But we are still a significantly bigger business than we were back then in long haul. And we have a tremendous opportunity with the Infinite Capacity Engine to get that on another significant growth trajectory..

Yeah, one of the things that I would encourage you to not go back to 2013 when we were rolling out a brand-new platform in the DTN-X.

The difference this time is that if it's just a technology issue, which, like I said, I don't think it is, but our customers can go now with our Infinite Capacity Engine in the chassis, they already have, the chassis they already deployed, and with an in-service upgrade to this new line card that carries more than twice the capacity.

It's a much easier upgrade cycle. We've already won that customer. They already have the Infinera infrastructure ready to be upgraded versus putting in a whole new infrastructure. So, I think it's a substantively more straightforward decision for them to make and a substantively easier win for us to have. But I still go back.

And for most of the long haul state, I don't believe most of our challenge today is a technology transition. It is the fact that we are not seeing quotes for long haul, and I don't think that that's an Infinera-specific issue..

Yeah. So, let me try and address your feature question. To be clear, our metro trying to create the mode – or seeding the momentum in the metro is not a feature problem.

What we've tried to explain is that in the nature of an access-oriented metro product line, where – which is where we're differentiated the most, it takes time to be able to deploy those out because of a number of access nodes that you have to have in order to generate the same amount of revenue for that.

The overall opportunities are big and great, but it is a – it takes more time to invest in it. There's no feature shortage. A matter of fact, in most – in things like Mobile Fronthaul, we're feature-preferred in these technologies, so that, no shortcoming in metro features as far as slowing us down.

On the subsea, the feature that we do refer to there, which is the only place that I see any type of feature shortness, and it is a short-term issue, and that's all about fiber capacity. If I'm deploying new capacity on a fiber over the next quarter, Infinera's product line has slightly less capacity than the alternatives out there.

That is solved by our Gen 4 engine and actually becomes an advantage, slight incremental advantage to us when we get our Gen 4 engine out. And that, we'll be through that transition here pretty quickly from that. If I can add on a couple of statements on the long-haul trajectory, this is – to Tom's point, this is not a product transition issue.

This is a – our customers carry a large portion of the long haul data center interconnect. Their growth, averaged over the course of the year, is very high. We continue to be the supplier for those customers, no loss of market share. However, their deployment of that bandwidth has taken a pause and their spending style.

And then, those pauses between various customers unfortunately happen to line up this quarter, right? But no loss of market share, no loss in that our customers are still deploying substantial amounts of capacity for that application, and hence why we believe that this is a pause and not a reset to our business..

Thanks, Brad..

Our next question comes from Jeff Kvaal from Nomura. Please go ahead..

Yes. Thanks very much.

I guess two questions, and one is what – when you were talking to your customers about them wrapping up their footprint plans, what were they telling you about what they would be buying after they finished a given product or project? And I'm a little surprised that they would yank the rug out from under you so quickly, given that they were finishing a project that might have been something that you could have had a conversation about..

Yeah. So....

Okay. Go ahead. Sorry..

Yeah. So, Jeff, the reality is even though we're close with our customers, a lot of our customers aren't very forthcoming with exactly what they're planning to do. And especially in some of our bigger verticals, it's even more challenged. They don't tell anything – anyone anything about their business.

And so, that's the challenge we have is they don't always lay out exactly what they're planning to do. In certain cases, they've talked about it. But timing is not certain on when they're going to do that..

It varies by customer. Some of our customers were very clear to us that when they were done with this long haul build, they were going to move some of their spend to the metro. Other customers have implied or talked about that when they finish this build, they will start planning on an overbuild, a next-generation new one.

A lot of those have now moved out in time to a degree from a couple to several quarters. That's the surprising part to me. Usually, when we see our customers finishing builds, there's a number of customers who start new builds at the same time.

So, the fact that some of our customers were telling us that they were finishing their builds, that we knew they were finishing their builds, the surprising part has been the lack of new builds that are filling that hole. That is a unique situation over the last several years that we're not familiar with.

So, as Brad said, some people won't talk about it. Some people did give us plans that are moving. Some people did what they said, which was moving spend priority over to the metro. It's all a combination..

Yeah, I think that there's a – in the old history of telecom, where the aggregation networks, the data for those aggregation networks are driven by human-to-human interactions, you're able to spread that over out a sea of large numbers. Now, a lot of the bandwidth is consumed by machine-to-machine communications.

In that environment, build infrastructure, absorb it; build infrastructure, absorb it, is much of a stronger tendency, plus the people that are doing that and trying to come up with projections of bandwidth, they don't have 1,000 people working in there to go do their planning. They have a handful of people to go do their planning.

And that makes for a different dynamic than the way the telecom business was a decade ago..

Okay, thank you for that. My second question then comes to OpEx.

And that is to what extent would you consider further squeezing your operating expenses if revenues don't come back over one or two or three quarters?.

Yes. So, Jeff, we'll continue to watch that quarter-to-quarter. What we don't want to do is cut our spend that cuts our opportunity in the future. We will be very mindful of what we do spend. As I think you've seen, we've taken significant actions already. But we'll play it as we go.

But we will continue to invest in the future because that is what – is the opportunity we believe in..

Yeah, I'll be a little bit more emphatic. We've been I think very prudent in how we've adjusted our expenditures. We've stopped hiring. We are addressing any type of discretionary spending. But I mean it. I've never been compelled that we have a huge opportunity in front of us. I think Gen 4 is a monumental capability that the industry will absorb.

And we are going to continue on track of bringing Gen 4 to market across various platforms as soon as we possibly can.

We are also going to continue to invest in next-generation technologies, like Gen 5, so that we never end up with a technology gap again because it's too difficult to gain market share and then lose your position because of a six months' or a one-year gap. We're going to bring our cadence of bringing that technology to market.

We're going to continue to improve it to being less than it is today. Having said that, we are being prudent on what are the new things we're starting. We're not going to start some things that we would like to start. But we recognize that we are in a fiscally challenged position and I prize very much creation of cash and not losing money.

So, we're going to try to balance that. I don't believe this is a long-term protracted downturn. If it turns out to be such, we will react in a different fashion. But that's not what I plan at this point..

Thanks, Jeff..

Thanks. As always, thank you to our customers and partners for their ongoing commitment to Infinera, and thanks to our employees around the world. With that, we'll see you – talk to you next quarter. Bye-bye..

Thank you..

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect..