Jeff Hustis - Infinera Corp. Thomas J. Fallon - Infinera Corp. Brad D. Feller - Infinera Corp. David F. Welch - Infinera Corp..

Vijay Bhagavath - Deutsche Bank Securities, Inc. Alex Henderson - Needham & Co. LLC George C. Notter - Jefferies LLC Doug Clark - Goldman Sachs & Co. Meta A. Marshall - Morgan Stanley & Co. LLC Rod B. Hall - JPMorgan Securities LLC Dmitry G. Netis - William Blair & Co. LLC Patrick Newton - Stifel, Nicolaus & Co., Inc.

Jeffrey Kvaal - Nomura Securities International, Inc..

Welcome to the Third 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 third 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, as well as Infinera's financial outlook for the fourth 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 third 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 third quarter 2016 conference call. Joining me today are Chief Financial Officer, Brad Feller, and President, Dave Welch. Today, I will go over our financial highlights for Q3, provide an update on our business and market dynamics and discuss our latest product announcements.

I will then turn the call over to Brad, who will provide a more detailed review of our third quarter results and outlook for the fourth quarter of 2016. In Q3, we delivered revenues of $185 million, non-GAAP gross margin of 49% and non-GAAP earnings of $0.05 per diluted share.

While our results met guidance, we continue to see soft demand in the markets we serve, particularly North America and to some extent in EMEA.

Recent reports from Dell'Oro and Cignal AI estimate that the overall DWDM market outside of China in the first half of 2016 was roughly flat, and of note, Cignal AI estimated that North America DWDM revenue in Q2 came in at its lowest quarterly level since 2014.

To be clear, while our current challenges are largely Infinera-specific and attributable to not yet being a sufficiently diversified business, current market conditions are doing us no favors. We are seeing this weakness reflected by our number of RFQs in Q3 remaining at a relatively depressed level.

My inclination is that several of our largest customers have already ordered up to their annual CapEx allocations, hence we are not planning for any benefit from year-end money in Q4 and are seeing certain opportunities pushed into next year.

While I am not satisfied with our current financial results and anticipate a difficult environment for the next few quarters, we do see strong opportunities in the horizon as we prepare to deliver next-generation solutions to our customers whose networks will increasingly come under pressure from ongoing bandwidth demand growth.

I remain confident that these customers in North America, EMEA and the rest of the world will resume investing substantially with Infinera across long haul, DCI and metro.

Going into more detail on our Q3 results, total revenue declined considerably as expected, largely due to our long-haul customers pausing their spend and lack of new wins in Subsea. Restoring our long-haul business will take some time as our largest customers had completed footprint builds and had shifted their spending priorities in the near term.

Despite the current tepid spending environment, particularly with our telecom and wholesale customers, we view long haul as a solid growth opportunity over time and continue to invest in new innovations.

The good news is that we are starting to have visibility into several new footprint opportunities over the next few quarters and expect capacity fill activity, which is currently lower than typical, to also recover in 2017.

In line with industry analysts, my expectation is that current softness in long haul will subside in 2017 and the long haul market will resume growing at a mid single-digit level. Moving on, DCI made a bright spot and an outstanding growth opportunity for Infinera.

As anticipated coming off of record results in Q1 and Q2, DCI revenue was down sequentially in Q3 though we see a strong pipeline building for the rest of the year and into FY 2017. I am particularly excited about early customer feedback and significant future opportunities associated with the Cloud XPress 2.

This is our first announced product enabled by the Infinite Capacity Engine, with initial shipments planned in Q1. As we near the two-year anniversary of introducing Cloud XPress as the industry's first purpose-built DCI platform, I'm very pleased with our progress.

According to Cignal AI, Infinera's market share in purpose-built DCI was an impressive 94% in Q2. While this market is still young, it is poised to take off. Recent reports from multiple industry analysts project the purpose-built portion of the DCI market will grow roughly 60% annually into a multi-billion dollar market by the end of the decade.

Our best-in-class technology, relationship with ICPs and our nearly two-year lead in the market have put us in an excellent position to deliver the solutions our customers need and to grow our DCI business substantially as the worldwide market leader.

Additionally, we are starting to see Cloud XPress sold into a few traditional metro networks, as some service providers are moving to adopt technology architectures similar to Internet content providers.

On the topic of Metro, in general we are seeing our target customers taking longer than expected to invest in upgrading their networks, and in some cases, taking a phased approach, focusing initial investments on network hotspots.

That being said, while our Metro business hasn't grown as quickly to-date as I had expected, we continue to progress in Q3, selling XTM Series into long-haul customers who are seeing the benefits of an integrated solution.

My view is that it is only a matter of time before our target customers begin to more significantly ramp their metro investments to support bandwidth drivers such as cloud networking, video and increasing mobile data consumption.

Looking ahead, I anticipate additional Metro wins this year and believe we're on track to begin generating more significant cross-sell revenue synergies in 2017.

In addition to cross-sell opportunities, our Metro team has opened promising longer-term opportunities with providers that were not traditional Infinera customers, an operating portfolio of differentiated tactical optical solutions around edge applications such as Mobile Fronthaul and Mobile Backhaul.

I remain confident that over time, we will achieve significant market share gains in Metro and that will be an important growth driver for Infinera. Shifting now to technology and products. We made several important announcements in Q3 that represent the beginning of the next phase of Infinera's technology leadership.

Customers increasingly require solutions that are scalable, highly automated and low power. Our recently announced Cloud XPress 2 embodies all these attributes, delivering 1.2 terabits per second of line-side capacity in a 1 RU form factor, and operating a broad set of open software and automation features.

Our ICP customers are telling us this platform is hitting the sweet spot. To me, CX2 is a testament to the value of vertical integration, which enables us to profitably deliver an open, compact and cost-optimized platform by controlling our value chain and innovation destiny.

Staying with the theme of driving automation and open networking, software is an increasingly important element of flexible, efficient and open networks.

We view our recent introduction of the Xceed Software Suite as an important step towards our vision of delivering a truly on-demand, programmable and open optical network layer, something that has already been validated by two customers who have purchased and are deploying this solution.

The Xceed Multi-level Software Suite, when combined with ongoing hardware innovations, will enable our customers to fully and uniquely realize the benefits of SDN from an intelligent transport network.

Finally, in August we joined Facebook's TIP project and we were the first transport vendor to test interoperability with Lumentum's white box line system.

We believe that our Xceed software, web-scale products like CX2, and a growing ecosystem including interop with Lumentum's white box line system and Arista's CloudVision platform, Infinera is delivering a new level of open networking for our customers.

In closing, Infinera has succeeded historically by delivering solutions that solve the most complex networking challenges our customers face. While our current performance is unacceptable, we see tremendous opportunity with our Infinite Capacity Engine portfolio.

Customers are clamoring for its capabilities and doors are opening to significant network builds that we have not been invited to before.

With our next generation of products to begin shipping in Q1 and a new accelerated development process that has future optical engines already in works, we are in a strong position to continue to drive innovation and economics in the market.

Considering the growth of bandwidth, I believe that just as servers transition to multi-core processors to scale effectively, the power of large-scale multi-channel optical engines will be critical to the future of optical networking advancement.

While I expect the next few quarters to be challenging, our unique technology capabilities and commitment to delivering what customers value positions us to restore our growth and profitability trajectory in the midterm.

Longer-term, with unrelenting bandwidth growth and the ongoing evolution in network architectures, I believe Infinera has a massive opportunity, an opportunity I am confident that we will execute on. We look forward to sharing more with you at Insight Infinera 2016 on November 17.

As always, thank you to our customers and partners for their ongoing commitment to Infinera and thank you to our employees around the work. Now I'll turn the call over to Brad for more detailed financial review of the third quarter, plus our outlook for the fourth quarter..

Thanks, Tom and good afternoon everyone. While our financial results in Q3 were not up to our standards, we delivered on our quarterly financial guidance with in-line revenue and non-GAAP gross margin and EPS that exceeded our guidance ranges. Q3 revenue was $185 million, down 20% year-over-year and 28% sequentially.

Our top five customers in the quarter consisted of two Tier-1s, two cable operators and a wholesale and enterprise carrier. Two of these customers are greater than 10% of revenue; a wholesale and enterprise carrier and a Tier-1.

In the quarter, we experienced revenue declines broadly across our customer verticals, mainly due to our largest customers shifting their spending priorities and from temporary pauses in spend from certain customers.

Looking ahead, I anticipate that the ICP vertical will be a source of strength as the Cloud XPress continues to win a large portion of market opportunities, and we expect the CX2 to drive substantial opportunities with both new and existing customers.

Growth in ICP traffic, which is often carried across wholesale and telco customer's networks, should also support a broader recovery, which we believe will take shape over the course of 2017, as we deliver Infinite Capacity Engine enabled solutions across our portfolio.

Our improvement will also depend on Metro, where we are making steady progress with cross-sell opportunities and anticipating growth in the second half of next year, driven by the release of new products.

Looking at our geographies, North America revenue was very disappointing in Q3, accounting for only 56% of total revenue and declining sequentially 38%, as customers pause spend or shifted it to other portions of the network.

The significant decline in North America contributed to international revenue rising to 44% of the total, its highest quarterly percentage contribution in nearly three years.

On a positive note, International revenue was boosted by a strong quarter in LATAM, which grew 54% sequentially, as we successfully executed on key opportunities supported by partners in the region. Revenue from EMEA in Q3 declined 20% sequentially, as we experienced challenges in long-haul and steady results in Metro.

As for APAC, revenue was down 26% sequentially, due to subsea weakness and timing of customer buying patterns.

Turning now to margins, non-GAAP gross margin of 49.2% in Q3 was stronger than anticipated, primarily due to product mix, delays in deployment of certain lower-margin investment deals and one-time benefits including improved warranty results.

We continue to make targeted investments aimed at preserving existing business and winning new customers and routes in anticipation of the release of our next-generation of products over the course of 2017.

As such, over the next several quarters, my expectation is that non-GAAP gross margins could fluctuate in any given quarter in the low to mid forties range. As a reminder, even during investment periods, like we anticipate over the next several quarters, our gross margins should remain relatively in line with those of our top competitors.

Over time, as we release our next generation of products and further diversify our customer base, my expectation is that our margins will steadily climb back to the levels we have demonstrated for the past several quarters.

Now moving to OpEx, non-GAAP operating expenses of $85 million in Q3 came in at the low end of our guidance range, as we enacted cost controls in light of lower revenue expectations and realized some one-time benefits, including adjusting our incentive compensation payout estimates downward.

Considering the current revenue environment, we are continuing to aggressively manage spend, while still prioritizing R&D required to support the timely delivery of our next generation of products. Putting everything together, our non-GAAP operating margin of 3.6% and EPS of $0.05 per diluted share, both came in above our guidance ranges.

On a GAAP basis, we incurred a net loss of $11 million or $0.08 per diluted share. The difference between our GAAP and non-GAAP results was attributable to approximately $10 million in stock-based compensation, $6 million of intangible amortization and other acquisition-related costs and $2 million in amortization of debt discount.

Turning to the balance sheet, we generated cash from operations of $5 million in Q3. Overall, working capital changes negatively impacted cash flows in the quarter, as we increased inventory due to Gen 4 PICs transitioning into production and our taking longer-term positions on certain external components that are in high demand.

This use of cash, along with declines in AP and deferred revenue, more than offset our AR decline, which occurred as a result of the lower revenue levels.

In Q3, total cash and investments declined by $20 million to $356 million, as we spent $17 million to acquire the remaining 4.2% of Transmode shares and made a $5 million strategic investment in a private company. Also in the quarter, we spent CapEx of $10 million and had cash inflows from stock activities of $7 million.

Now, moving to our outlook for the fourth quarter. We currently project revenue in Q4 of $175 million, plus or minus $10 million.

Although several of the dynamics we thought would begin to improve in Q4 have in fact improved, we are facing the difficult situation whereby customers not only don't have incremental year-end money, but are also delaying purchases to next year as they have burned through their annual budgets early and are unable to get additional funding approved.

While this appears to be largely a timing issue, I think it also reflects a generally soft spending environment amongst our customer base.

Despite our current challenges, I'm confident that as we bring our new generation of products to market, and bandwidth growth continues to pressure our customers' networks, we are well-positioned to restore strong revenue growth. As for gross margins, we currently anticipate non-GAAP gross margin in Q4 to be 41% plus or minus 100 basis points.

This expected decline is largely driven by investments we are making to bridge existing customers to our new products and win new customers to fuel our future growth.

In addition, we don't have strong visibility to the same levels of fill activity that we have enjoyed throughout the year and our cost structure continues to be negatively impacted by lower volumes. In Q4, we currently anticipate non-GAAP operating expenses to be $90 million plus or minus $2 million.

This expected sequential growth is attributable to certain one-time benefits from Q3 that will not recur in Q4 and there being an extra week of expenses in our fourth quarter.

Absent these one-time impacts, our Q4 OpEx would have been sequentially down as our cost control measures are enabling us to fund spending in vital areas such as for prototypes required for the release of our new generation of products. In Q4, we will maintain our hiring freeze and continue to prioritize only the most essential activities.

Putting this all together, the midpoint of our projected guidance translates to a non-GAAP operating loss of 10%. Non-GAAP diluted EPS is expected to be a loss of $0.14 per share 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. In closing, maximizing our long-term opportunities requires us to make substantial investments that could result in an operating loss for a period of time.

Given the massive opportunity we have ahead of us, particularly as our next generation of products hit the market, as much as I don't like to have an unprofitable quarter, my belief is that the investments we are making will prove worthwhile, enabling significant market share expansion and profitability growth over time.

As always we will remain committed to balancing prudent expense management, with investing in next-generation solutions and market expansion opportunities. I strongly believe that we are on the right path towards getting back to delivering the best-in-class growth and profitability to which our shareholders have grown accustomed.

With that, I'd like to turn the call back over to the operator to begin the Q&A portion of the call..

Our first question is from Vijay Bhagavath at Deutsche Bank..

Yes, thanks. Hi Tom, Brad..

Hi, Vijay..

Yeah, hi.

My question is, at a bigger picture level which is you have been given these growth rate assumptions for DCI, Metro, long haul, optical in the past, has anything hinged in your planning assumptions, Tom, on DCI, Metro, long haul looking forward? Would be good to get kind of the before/after on your growth rate assumptions and then also any updated assumptions on the competition.

Has competition meaningfully increased or stayed about the same in DCI, Metro, long haul? Thanks..

Yeah, so in the DCI space, the analysts' forecasts are continuing to be approximately, I think, 60% a year for quite a while, and we see that probably being realistic. As we said in Q3, our DCI business was down off a couple of record quarters.

We're seeing very strong Q4 demand and we see a very strong pipeline of opportunities into next year, particularly for our new CX2 platform. I think that that's going to spur a lot of opportunity both with classic data center interconnect people, but also other people who are looking for immense capacity in a very straightforward, simple box.

So I'm pretty comfortable with analysts' expectations in the DCI space and I believe that we have every opportunity. I don't think we're going to preserve our 94% market share, but I think we're going to continue to be the market leader in that. We are seeing some, I would say the beginnings of real competition in that space.

People have introduced products, oh gosh, probably 18 months ago now, and for the most part, they haven't been real. There are starting to be inroads. We're seeing a few people winning some deals internationally, probably more than domestically, but some in domestic too. I think that that's normal.

I think some people will want a multi-vendor solution, and while we have seen some competitors win, I have not seen them win in what I would consider our largest DCI space yet. And I think that as long as we bring out our CX2, that's a market, one that I feel comfortable we're going to have a very good presence in.

In the long haul space, I do think the market has slowed and I only have a microcosm of it. But I can certainly speak to our customers, they've slowed. But also the industry analysts' reports say that long haul, outside of China, has also slowed down. I do think it'll grow this year, probably in the 2% to 4% range is what I think analysts are saying.

I think we will clearly not do that well in long haul this year and I think that my expectation is that the long haul will continue to grow in the mid-single digit range over the next several years. I don't see any abatement of fundamental demand, of fundamental traffic.

Quarter perturbations, and I do believe that we are being hit in Q4 by CapEx limitations by some of our biggest customers. That doesn't alter the fact that they need more capacity. And so far, we continue to be their provider of infrastructure and I'm anticipating next year that that recovers.

I believe that when we get our next-generation platform out, that will help us tremendously. One of the challenges we have right now, our Gen 3 product is excellent product, our customers are very happy with it, but it's very difficult right now for us to win new customers with our current Gen 3 technology.

To really be aggressive, to really be compelling for a new customer, we need to get our next generation out and that will help us grow our long haul share. I think we'll start retaking market share. So that's kind of my view of the world, Vijay..

Yeah. Perfect. It's very helpful. A quick follow-up on is what gets the business back to a recovery mode? Is it one of your top long haul customers purchasing new capacity? Is it some new design win in Metro? I want to understand what's the trigger or the catalyst to get the business back to recovery mode? Thanks..

So I'll make some comments and I'll ask Dave to answer. I think there's a couple of things. One, it's not any one thing. One of the reasons that I think we continue to be more susceptible to volatility is we continue to be too much in North America.

So we need to continue to expand our presence outside of North America, not by shrinking North America, but by growing our presence elsewhere. I think we're actually making good progress in that arena. We're making progress in Latin America. We've done reasonably well in Europe. Our market share actually is staying firm in Europe.

In Asia we're actually growing a lot of opportunities that we see. So I think one is to diversify more geographically. Two, we need to continue to be less of a long-haul provider. We've become more diversified than we were certainly a few years ago, but we need to continue to lead and grow and push this DCI interconnect.

I think we have every opportunity with our next-gen products to absolutely take a significant portion of that market growth. We need to get our Gen 4 product out so that we can have a re-competitive position in subsea. Subsea is – it doesn't drive most of the business, but it's a portion of the business that we need to have.

So we need to get our Gen 4 technology, our next-generation technology into the market. We need to have 16QAM into the metro and other places. So all those things we are doing, it's not going to be one customer that drives that.

We need to go bring this technology to market in all spaces, Metro, long haul, DCI, and we need to capitalize I think our complete differentiation around our overall technology portfolio. We've done this before. Unfortunately we are somewhere between two quarters and four quarters late on this next-generation technology of what we should have done.

Mistake on my part a few years ago. We are going to have that technology across our portfolio next year, and I think that we have a great opportunity.

Dave?.

Yeah. I'll just add on a couple of comments to reiterate what Tom had there. One is we expect as the new year starts on that some of these issues around CapEx that we are seeing at tail-end of this year start opening back up. Two, the Gen 4 technology will start moving out to customers here very shortly.

And Insight Infinera will lay out our multi-platform approach for that technology and get into more details on how that impacts both the data center, the metro, the long haul and the subsea marketplaces.

And I think as that capability, all indications, if I use the DCI as our first market assessment from that and the demand that we're seeing from the DCI 4 or Gen 4 technology, I expect to be very successful across our platforms with that technology as we roll that out over the beginning of 2017..

The next question is from Alex Henderson at Needham..

Thanks. Couple of questions if I could. There were a number of things that you said you needed to get cleaned up in order to get these new products launched.

One was the integration of the Metro operating system into a single – you know truly unified operating environment, a single pain of glass, which I think you were talking about having done around year-end.

Is that on track?.

Well, there's a difference of – I think Alex, there's a difference of operating system versus network management. So I don't believe I ever said we'd have a single operating system by the end of this year. What I talked about was a more tightly coupled network management.

Our future roadmap has a single operating system, but that was never a this-year discussion..

The question I think was as you described it, network management..

Yes..

From the service provider's perspective, not having to mess with two management systems.

Is that on track?.

Yes. You know if we break it down into management, control plan and data plan, what we have right now is, a management plan is from a customers' perspective sees a unified management plan across our platforms. It will be out – has been coming out, but will be finalized in this quarter.

The data plan connectivity between the platforms is also – is part of our Q4 release; so I am happy with that. Control plans, actually the deploying the circuits, that's not fully integrated. That's really where we get into the integration of the operating systems. The embedded operating systems, that will happen over a longer period of time.

But from a management plan, data plan, connectivity, will all be there, right? We also talked about, and we launched, I want to say in August, our Xceed platform. That Xceed platform will be a vehicle that we tie all of our product offerings together in order to be able to both manage and control that. So that capability is going to be expanding.

And they're using that, so you indicated, Tom indicated, even though we just introduced it towards the end of last Q3, we're getting good acceptance from our customer base out there and we have a couple of deployments going on already..

Yeah. One of our first deployments will actually be across a TM and DTN-X customer base. So, we're hoping we'll have a good opportunity to validate that to the market, you know the people that Xceed provides a real value of helping to deliver an end-to-end solution..

Yeah..

The second piece of that puzzle was the DSP. Obviously you guys have been running much longer cycles than some of the other players that seems to have gotten you behind the curve on that.

And if I understand correctly, you're in the process of turning a new version of the DSP which would then enable FlexCoherent to next-gen Metro products to be ramped up with the Infinite Capacity Engine.

When you look at the DSP investments you're making, one, is there a step-up over the next three or four quarters to accelerate that process and impacting R&D? And two, is that a longer-term change in your R&D profile that will require you to spend more on R&D in order to invest, instead of a 4-year cycle, maybe an 18-month cycle, i.e., adding $20 million to $30 million to your DSP development costs on an annual basis? Is that the right way to think about that?.

No. Right question. Let me – all right, Gen 4 comes with our new DSP engine and so that's in operational. We expect to start shipping that to customers pretty quickly. Insight Infinera, we'll get into more detail about the multiplatform rollout of what that technology is. Very happy with that.

It does everything that we had hoped it to do as far as managing the reach capabilities across the system.

What's key in the DSP architecture is make sure you've got DSP architecture that allows end-to-end connectivity across our platforms where appropriate, and I feel comfortable that we will achieve that across our platforms and be able to have meshed, optically-meshed networks that will take advantage of that.

Going forward, we will up the pace of our DSP. We are confident with our ability to do that within our current R&D profiles.

Don't expect any major spikes in our R&D in doing that, but we expect to get onto a – you know maybe a – whatever, substantially more rapid deployment process of our DSP engines and it comes coupled with kind of – you got to understand the detail of how we do our engineering to see that base comes out, but net-net the optical engine advantages and differentiators that we brought to the market for the last 11 years is now going to happen on a much more frequent basis..

The next question is from George Notter at Jefferies..

Hi there. Thanks a lot, guys.

I guess job one in the self-help program here is to get that 2.4 terabit shipping in the DTN-X and I understand you kind of want to have folks to wait to the Analyst Day to, I guess, disclose more details there, but I guess I just want some comfort to know that that's relatively soon after the delivery of the Cloud Xpress 2 with that same chip.

Is that fair to say?.

Yes. There's a sequence of products, the first product to come out will be the CX2. And then we'll come out with our complements to our XT and our DTN-X chassis platforms in a relatively rapid sequence for that.

The hard part of this, of all the development or a good chunk of it wraps up into making sure your optical engine does what it's supposed to do. And that's the same engineering needed across all platforms. So once we release one, it looks a lot alike for the rest of the platforms. And so we expect to be able to bring these out pretty quickly.

And we'll get into more detail..

Hey, George, you're asking the question is if it comes out, the CX2 is the first thing and then the DTN-X is the next thing. We've got a number of things that are going to roll out at Insight Infinera that make that too simple of a view.

So I do encourage you to wait until Insight Infinera, but we've got a whole product portfolio that we will talk about, that includes the Infinite Capacity Engine..

Got it..

And George, I made a comment in my prepared remarks about the Gen 4 PICs moving into production. So that should give you some tickler as to – that those are on track and moving forward as we would imagine..

Got it. Okay. And then I also wanted to ask about the gross margin profile for the next, I guess, set of quarters. We're talking low- to mid-40s now, and it seems like that's obviously a good-sized step-down relative to what you guys were thinking, say, three months ago.

I guess I want to make sure I understand what's driving the new view? I guess I presume that some of this is about forward pricing the current products to be more aggressive in this kind of gap period before you deliver the new stuff, but maybe you could kind of confirm if that's right or not right? And then just talk more broadly about why the change in estimates?.

Yeah. So, George, I think the analyst community thought it was higher, but I was trying to be very clear in the past that our margins would be in the low- to mid-40s. Obviously we're at the low end of that in Q4.

But you've got it right in terms of what we're doing is, in a lot of cases forward pricing the Gen 4 products based on current technology, we are being more aggressive on deals to win new footprint with existing customers and also new customers.

We're also leaning more into the instant bandwidth side of things which is – are all great things for us to do for the longer-term margin of the company, it's just an investment period for right now that hurts us..

The next question is from Doug Clark at Goldman Sachs..

Hi. Thanks for taking my question. My first one is a follow-up on that.

And as part of your fourth quarter gross margin guidance, you said that line card fill would be down and presumably some of that's correlated to just the CapEx spends of your customers, but why is line card fill not more of an offset to some of the more aggressive pricing on some legacy products in the interim?.

Yeah. So, Doug, I chose my words fairly carefully. I said we didn't have visibility to it. And you're right that the CapEx challenges at customers is not going to help the situation.

Conceptually, there should be a fill that still happens, but when a lot of our big customers come and say, I'm out of money for the year, and we tend to have a lot of the year-end money be in line-card ads, instant bandwidth licenses. I just don't see that happening this quarter because of those CapEx challenges..

Okay. That makes sense. And on the services side, it looked like there was actually a nice lift in at least GAAP gross margins for services.

Can you talk a little bit about what's going on there?.

Yeah. Unfortunately it's just less deployments, right? So as you have less – as you know our services has two main components to it, the deployment side of things and the ongoing maintenance activities. The ongoing maintenance activities continue to be strong, but as the mix shifts away from deployments, it has the impact of improving those margins..

Doug, one of the things that we've been clear on historically is that as we put out more footprint and as we do more instant bandwidth, that means more footprint. That's a good thing for a company even if it has short-term margin in it.

Usually we have in the last several quarters had a balance with that with some fill that we've had either from other installed networks or instant bandwidth. I think right now you're see us be willing to be aggressive for deals that over a reasonable period of time are exceptionally good for Infinera, but upfront we have to take a margin hit.

I still believe that that is the best thing for our company to do. Get our installed infrastructure out there and create an ability to install both instant bandwidth licenses and FRU (36:54) in the future. I think that this short-term lack of FRU (37:01) visibility, I think it is because of a CapEx limitation. I believe it has to go away.

The next way, the best most inefficient capital use for expanding capacity if you have an Infinera network is to buy a FRU (37:12) from us and I don't believe that there's any reduction of bandwidth requirements and we're not losing footprints. So I'm a big believer that this is an investment toward a better future..

Next question is from Meta Marshall at Morgan Stanley..

Great. Thanks, guys. I wanted to dig into the Europe market. You know you had clearly mentioned that that was an area where you hoped to get more aggressive, but last quarter you talked about the competitive environment there being particularly aggressive. So just wanted to kind of get an update on that.

And then, second, one of your competitors has had or seemingly had kind of good success in Europe with some of the web scale customers, highlighting their depth of portfolio, is that a fair view and something you think you can get back kind of as your Gen 4 product comes out? Or just how do you think about the web scale market in Europe as well? Thanks..

So, in general, I continue to see a lot of price competition in Europe. There is a wholesale space where we're very strong. There's overcapacity from a perspective of number of people serving that market, and the wholesale pricing is being collapsed. That puts a tremendous pressure back on the equipment providers which we're seeing.

We are doing reasonably well in our traditional business there from the long haul perspective. We've actually held market share in Metro that we're not growing market share there. Our business grew as fast as the market did over the last year, that's not good, it's not bad. I think when we get our next generation optical engine out, that will help us.

In the web-scale, I think I know who you're referring to. I think that where we have a distinct advantage is when it's very, very large scale deployments for high capacity. That's where our CX platform does extremely well.

I think as more and more North America providers move their architectures and data centers into Europe, we actually have a number of European deployments, these are with North America providers, our ICPs that have European data centers there, we actually do very well there.

I do think we have an ability to extend our success into smaller-scale ICPs there and we need to, quite frankly, get more aggressive with that when we have our new platform out. So that's where I think there's opportunity.

I've also, I think if you've witnessed, if I am talking about the same competitor that you are, they have experience as incredible margin collapse as they've grown their top line. I will say we responded probably not as fast as we should have at being more aggressive on pricing and we are fixing that..

Got it. Thank you, guys..

Thanks..

The next question is from Ashwin Kesireddy at JPMorgan..

Yeah. Hi. It's Rod Hall for Ashwin..

Hi, Rod..

I've got a couple of questions, I guess.

I wanted to ask you about, I know you're going to go through detailed product phasing on 17, and so I don't want to get into that, but I do want to ask when you start shipping product GA are we looking at normal testing delays, like field test delays at your customers? Or is there any way that you could see that accelerating so people deploy a little bit quicker and maybe you recognize revenue (40:40) a little bit quicker? So that's the first question and I had a follow up to that..

Yeah. So I think on the CX2, I anticipate a faster testing cycle. The CX family is a fairly straightforward. It's not trivial, but it's a point-to-point network and it is with the same basic software operating system that the CX1 family has. So I believe that we'll be able to deploy and not go through inordinate amounts for revenue recognition..

Okay. That's good news.

And the other thing I wanted to ask you is on the gross margins, I think Brad called out this one-off warranty impact this current quarter, were underlying gross margins significantly lower due to one-offs or one-off help that you got? Or are they – can you help us understand what organic gross margins were this quarter, so we can kind of get a feel for what the deterioration looks like?.

Yeah. So the warranty item I laid out, Rod, was a contributor, it wasn't the biggest contributor. The biggest contributor was just the mix of our business across different customers and that kind of stuff. Warranty just as our quality continues to get better, that has a positive impact on our overall reserves.

Those are one-time type of items, right, so we would have been closer to guidance, but still above guidance even without the warranty side of things..

Okay.

So just maybe a 1 percentage point or something like that or less impact and then we just move to a significantly lower gross margin, because of the revenue compression next quarter and mix?.

Yeah and there were some investment deals that we bid on and won, that were kind of right on the cusp of Q3 and Q4. Those didn't get deployed in the quarter, so that gives us some mix benefit there as well..

Brad, just on this gross margin point, it seems to me like the narrative kind of changed as we moved through the quarter. You guys started off thinking maybe you could be closer to mid-40s even as you aggressively bid and I think it's more and more a situation like this, there's a lot of complexity and as you work through it you learn more.

Do you feel like you've got your arms around where that – the worst case gross margin at this stage? Or do you feel like there's more to learn as you participate in these deals, bid and so on (43:06) beginning of next year?.

Yeah. So, Rod, the biggest variability is the timing of those deployments and how successful we are with the more aggressive pricing strategy. It's been fairly successful so far. The piece that's harder to figure out is exactly the timing of some of those deployments.

Tom mentioned the year end and I did as well, the year-end CapEx challenges, some of those pushed into Q4 and now are pushing into Q1, potentially because of those CapEx issues.

So it's just hard to tell the timing of it, but as I mentioned before, these are not investments to just go chase low-margin business, these are investments where we are taking lower gross margin now. As they grow and as they deploy with Gen 4, they will be significantly better margins, even better than we've done historically.

So it is really just a timing thing and we're having the confidence in the future that we're okay to take the lower margins now. Do I think they go down into the 30's and this kind of stuff? I don't. But I think in this range, you're going to see for a couple of quarters until we really start to deploy Gen 4..

Okay. Great. Thanks, guys..

Our next question is from Dmitry Netis at William Blair..

Thank you very much for taking my question. I'll ask a simple one on the Gen 4 first. I think you guys said Q1, can we expect that in January, March, February, month? Any more quality on that would be good..

Are you placing a purchase order? What's the....

Let's assume I am..

How many do you want, Dmitry?.

Yeah, how many do you want? We'll move you up in line..

All right.

I'll take that as a January then?.

We're getting it out as fast as we can, Dmitry. You know, quite frankly....

Okay..

...our goal is to have it in early customer testing sometime late this quarter, that's our goal. Our goal will be to start shipping it as early in the quarter as possible. I wouldn't necessarily count on January..

Okay. And as far as the mix of new customers versus existing, how's that looking? I think you did say there was a mix of both.

Are you seeing like overwhelming majority of new customers shipping, taking up orders on CX2, because of the capacity improvements, because of the new modulation scheme, et cetera?.

Yeah, I would put it at, we're going to be in a, I'll say, a little bit of a constrained scenario as we first start shipping it. Our current customers are the ones that are asking for the highest demand and we'll make sure to satisfy that and mix in new customers along the way.

But first things are going to go out to the guys that can deploy it the fastest..

Yeah, the comment around the new customers, Dmitry, is with the specification of the CX2, there's a lot of customers that either didn't deploy the first generation of CX or haven't been customers in the company, they are very interested in that portfolio..

I think Dave's right. A number of our current customers, actually all the large ones, are very interested in the CX2. And those are people who will be able to take it the fastest and deploy it the fastest.

But it is opening up a number of significant opportunities where we have not participated, either as a company or with the CX1, and I believe that's one of the things I'm very excited about. They probably won't be the first customers, because they will have to do more testing.

But I think there's an opportunity with the CX2 to vastly broaden the number of customers that we have in that platform..

Understood. Can I also ask you about the kind of the follow-up on the CapEx challenges you're seeing.

And there are a couple of comments you made which make you sort of believe or make me believe that there may have been isolated to Infinera, but then there's also broader kind of industry comment as far as the kind of money not being there at the end of the year.

And I was just wondering if you could kind of break it into certain customer base of – or customer segment, whether it's a cable, telco, web-scale, is it specific to Infinera customer base? Is it M&A related? Anything you can....

Yeah. So yeah, the reason I highlighted it, because I've been doing this a long time. This is the first time I've come, seen in a quarter that I'm getting consistent messages from a number of sales people and talking to the customers that they have – I guess they have hit their CapEx limit.

And I think that with the last few years what's happened is people have overspent their CapEx early in the year and they've come back to the corporation and asked for more based upon the ability to deploy services and they've been getting that.

And my personal belief is that a few customers that are important to us went through that scenario again this year, and the corporation did not give them relief from their CapEx. We're seeing it from Tier 1s internationally. We're seeing it from wholesale, both domestic and international.

And we're seeing it from at least one cable, which is outside the acquisition. Acquisitions always delay things. So we have that continuing to be a little bit of a burden to us. But this one was not related to acquisitions. So we're seeing it in multiple segments. We only are exposed, obviously, to their transport spend.

So I don't know if they're potentially saying your transport CapEx is capped and we're spending it somewhere else, but I have got it consistently that budgets are frozen. It's not everywhere. But we don't have enough huge customers that if a few of them go – it happens, it's impactful. And that's what we're seeing..

Okay. Just to follow-up on that, you said the transport versus something else. You do have a metro product on the Transmode side of things, so I suppose you are seeing all the RFPs that are coming in on the metro side of things as well, right? So can you just say.

And by the way, as we are discussing Transmode, maybe kind of going back and sort of looking at that acquisition, where the run rate of that business was when you acquired it and where it is today, I know you had seen some challenges.

Have you recovered from those challenges? Have things sort of stabilized on that front? And you had big expectations here in North America for Transmode, whether that's sort of falling behind the expectations or running sort of in line? Just curious on that front as well..

Yeah. So in regard to CapEx, at least one metro customer articulated the CapEx issue and pushed out all of our deliveries from Q4 into next year. Most of it I'm referencing is in regard to classic long haul product, but one specifically was for metro.

In regard to how we're doing in the metro, as I said in the call, I'm certainly disappointed in comparison to what my expectations were. I think in Europe, like I said, we're holding market share. We're growing in Europe about like we – like the market is growing. That's candidly disappointing, we didn't buy the company to hold market share.

In North America, from a number's perspective, I'm disappointed with the results at a revenue level. Having said that, we are winning some accounts and have initial deployments with what I would consider classic Infinera customers. Some of these customers have substantive opportunity and I think it will grow.

It's been slower than I ever thought it would be. We're also using it as an opportunity to continue to work on getting a couple of other of our long haul customers. They started out by saying a number of them, we don't need another metro provider, but now we're at point of looking at potential applications.

So I'd say year of work to go from, we don't need one to, hey, maybe there's something we can use. I'm going to not give up. We're just not going to give up on that. I continue to see some progress in Latin America with the metro product. We continue to grow Latin America both for long haul and with our metro offering and I think that that's good.

I think once we get our next generation of optical capability into the TM Series, it will be a much more compelling capability. It's very hard right now to introduce a platform that doesn't have some of the features that we need in our next-gen optical capability. That's not that far away. We're working very hard to sell it.

I'm disappointed to-date, but I would not say that we haven't made progress in introducing it to important customers with some adoption. The adoption has been slower than I hoped, but we are long-term – we got a long term in this game and I think it will set a foundation for being successful in the metro..

The next question comes from Patrick Newton at Stifel..

Hey, Tom, Dave and Brad, thank you for taking my questions. I guess first two clarifications, Brad. One, I missed what 4Q revenue guidance was.

And then, two, you stated the Cloud Xpress business was down sequentially, but I missed by how much?.

Yeah. So the Q4 revenue guidance is $175 million plus or minus $10 million. On the CX side, we said it was down sequentially, but we didn't quantify it..

We said it was down sequentially off two record quarters and then we said we'd see a very good pipeline of Q4 into next year..

So we can assume that there's a return to growth in Cloud Xpress beginning in 4Q?.

Yeah. I mean I would say more it's in line with the first half when we're seeing very nice growth and then a bit of acceleration as well..

I think that the growth is going to come with the CX2. I think it's going to drive significant volume and dollar growth with the CX2..

Okay. Great. And then, Tom, clearly DCI is a great near-term opportunity, but you seem pretty bullish on second half of 2017 in Metro, and you cited several reasons. But can you elaborate a little bit on what's driving the confidence in cross-selling capabilities, given they've really missed expectations to date.

And then how should be think about the Metro footprint that's available for Infinera, given that several operators have already announced who they are using, and using competing vendors.

So can you – does your opportunity rest with those operators or winners (53:25) have not yet announced 100G Metro upgrades?.

Well, we continue to sell the TM Series to all the operators who have already told us they have Metro strategies and some of those we're being successful in. I think that there is always opportunities if you have a good customer relationship and a good reputation to insert and create opportunity.

When you go to Insight Infinera, if you are, you will see a roadmap of what we're doing, and I think that our new capabilities will help us stimulate demand in the Metro space moving forward. I think that a number of the seeds we're planting now will create opportunities.

Seeds – some of the early deals we won now will create opportunities for growth in the second half of next year in particular as these start to expand into other Metros. There is nothing that says that other than the new platform we're going to go and win a lot of Metro business.

I just see the traction we're making, I see the number of customers we're winning. I think that the new optical engine coming out, all is positive for us..

And I'll add a couple of quick comments on there. First thing, when you win a Metro, we mentioned a couple we win, the time from first revenue to the time to large revenue, it takes a few quarters because there are so many nodes that you have to go address and the planning (54:49) goes around that.

So usually they give you the first routes within the Metro, might not be a lot of dollars associated with it, but it is just the tip of the iceberg because of the amount of properties that they would have. That's the first thing on why it takes time from win to significant revenue.

The other aspect that people need to consider, and we've talked about it before is the different applications within Metro space. We were engaged in a significant number of what I'll call edge activities, mostly in the Mobile Fronthaul and Backhaul type of activity.

On a global basis, we've talked about a number of Fronthaul, Backhaul wins that we've had I think as early as Q2. In that timeframe, we are engaged in a significant number of opportunities there, and we'll see whether they come to fruition or not. Those are big opportunities, but they are the same type of thing that they don't happen in a month.

They are you win and you create momentum across a very large set of footprints. We're very excited about those being, progressing our way to various stages of those bids and we're hopeful that we'll land some of them.

And that leads us to believe the mid-year, later in the year, frankly on the scale of those types of deployments, it's not very far away. And that's just the nature of the large number of edge activities..

And our next question comes from Jeff Kvaal at Nomura..

Yes, gentlemen. Thank you very much for taking the question. I'd like to begin by sort of following on your comments about the fourth quarter spending pattern being a little unusual in your history in the market. Mine too, mine too.

The other thing that was unusual was that carriers typically don't spend more money in the first quarter than they have in first, this, the budgeting process, takes a while.

So how much confidence do you have that the spigots will turn back on in sufficient time in the first quarter that you'll get a decent run rate and that it might actually be a bit of a positive sequential quarter for you? The bigger picture question that we're all trying to ask here is, hey, what does the bottom look like, and when is it, and when might things start getting better?.

Yes. So let me address your seasonality question first, Jeff. You know the reality is Q1 typically for us tends to be a significantly down quarter based on exactly what you mentioned which is budgets got to get approved, they get ramped up.

I think the different dynamic this year is when customers have real demands and real traffic, real customer needs, that tends to go faster. Now, given where we're looking in Q4, I'm very cautious about what Q1 looks like. So time will tell there.

The other thing to keep in mind about Q1 or to understand about Q1 is Q1 and Q2 for us tend to be historically very strong with our cable customers. We've had some M&A activity there. The buying pattern of some of our customers, I think will change to be more even throughout the year versus very front-end loaded in Q1 and Q2.

That could have some impact on our Q1 as well..

Okay.

So the message is don't go crazy thinking about a recovery in the March quarter, I guess, is the message?.

Yes, I would be a bit cautious..

We just don't know..

Okay, and then my second question is where are your CX and CX2 products are – when you are winning there, or where you expect to win, what types of products are you displacing? Are they your own, are they your competitors', or is it possibly is it just an incremental build that you wouldn't have seen before?.

The Gen 3 networks that are deployed out there for the most part are going to continue to consume Gen 3 product. The new routes that come online and overlays and overbuilds or new customers come online, they're all going to be Gen 4 product. New subsidy opportunities are going to be all Gen 4 product.

Data center overbuilds, it's going to be, give me the best bandwidth engine that you've got, and I'll buy that until you get the next best engine that you've got. So they're going to rapidly adopt – I expect them to rapidly adopt and transition to Gen 4 technology quickly.

The benefit is, they're buying more and more bigger chunks of bandwidth in that process as they make that transition..

Yeah, and the other color I would add is you asked what are we displacing, we've largely created this small form factor market and it's grown very nicely for us, but there's still a fair amount of DCI spend that's happening with more traditional metro gear.

And so you can see the players in metro, our expectation is more and more of the true DCI market will move to the small form factor portion which is where the CX and CX2 were targeted..

And I'm going to add onto that, the kind of the inverse of that is, and Tom mentioned it in his script, we are seeing applications to take a DCI-like box, a little profile, something that's very different in character than the pluggable chassis type of configuration that a metro might have had, and they are starting to put those into normal metro (01:01:06) networks as well, where they find the simplicity of the commonality, the simplicity of deploying those within their networks, has a real operational advantage for them..

This concludes our question-and-answer session. I would like to turn the conference back over to Tom Fallon for closing remarks..

Thank you for joining us this afternoon for your questions. We look forward to speaking with you again at Insight Infinera. Have a great day..

The conference is now concluded. Thank you for attending. You may now disconnect..