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

Jeffrey Thomas Kvaal - Instinet/Nomura Simon M. Leopold - Raymond James & Associates, Inc. Vijay Bhagavath - Deutsche Bank Securities, Inc. George C. Notter - Jefferies LLC Meta A. Marshall - Morgan Stanley & Co. LLC Michael E. Genovese - MKM Partners LLC Steven Sarver - William Blair & Co. LLC Alex Henderson - Needham & Co.

LLC Doug Clark - Goldman Sachs & Co. LLC Patrick Michael Newton - Stifel, Nicolaus & Co., Inc..

Welcome to the Fourth Quarter Year 2017 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 that time. I would now like to turn the conference over to Mr.

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

Thanks, Anita. Welcome to Infinera's fourth quarter and full-year fiscal 2017 conference call. A copy of today's earnings and CFO commentary are available on the investor relations section of our website. Additionally, this call is being recorded, and will be available for replay from the website.

Today's call will include projections and estimates that constitute forward-looking statements. These statements are subject to risks and uncertainties that could cause Infinera's results to differ materially from management's current expectations.

Actual results may differ materially as a result of various risk factors, as included in our most recently filed 10-Q, as well as the earnings release and CFO Commentary furnished with our 8-K filed today.

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

Pursuant to Regulation G, Infinera has provided a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures in its fourth quarter earnings release and CFO Commentary. Revenue guidance is provided using ASC605.

We will adopt ASC606 for Q1 2018 and intend to provide an ASC606 to ASC605 reconciliation when we report first quarter results. I will now turn the call over to our Chief Executive Officer, Tom Fallon..

Good afternoon and thank you for joining us on our fourth quarter 2017 conference call. Joining me today are Brad Feller and Dave Welch. Today, I will review performance in the fourth quarter and share thoughts on our opportunities in 2018 and beyond.

I'll then turn the call over to Brad, who will provide a more detailed financial review and our outlook for the first quarter of 2018. In Q4, we executed well, delivering revenue of $196 million, above our guidance range of $185 million to $195 million. Exceeding guidance was primarily attributable to accelerating traction with ICE4 products.

Top-line growth also was a key driver on the bottom line, enabling us to deliver operating margin and EPS better than our guidance midpoint. Since first releasing our Cloud Xpress 2 last June, our ICE4 products have been on an excellent trajectory, ramping to account for about 20% of product revenue in Q4.

As of the end of Q4, we recognized revenue from 17 customers for ICE4, up from 10 customers from Q3, and expect ICE4 to enable meaningful new customer opportunities moving forward. In metro, we had 12 customers for our new 16QAM XTM II as of the end of Q4.

While relatively small from a revenue standpoint today, early reception of XTM II is positive, and we see opportunities to meaningfully grow its revenue in the coming quarters.

From a customer vertical perspective, ICPs, who were the first adopters of ICE4 products, were the biggest growth driver in Q4, with two large customers deploying CX2 and XT-3300 platforms.

Of note, one of these opportunities was for a data center built in Europe from a large US-based ICP, and contributed significantly to our strong Q4 results in EMEA. Regarding service providers, despite a stagnant overall market, our international Tier 1 business was very strong, growing more than 30% sequentially in Q4.

This growth was driven by strength in the subsea, particularly in the APAC region. Subsea, which fell to roughly 5% run rate in 2016 during our product transition, gained momentum in late 2017 and then exceeded 10% of our revenue in Q4.

With subsea market growth being driven by the most technically-demanding customers in the world, our new strength here is both a clear endorsement of Infinera's technology leadership and an indicator of our future opportunity. In North America, our full-year 2017 revenue was down 21%, primarily due to customer consolidation in cable and telco.

After a tough first half, however, second half revenue in the region was up 8% year-over-year, driven primarily by improved spending from our consolidated cable customers. Internationally, EMEA was strong in Q4, growing 22% sequentially and 6% year-over-year.

APAC was solid as well, capping off an outstanding year in Q4, growing 81% over the previous fourth quarter and 29% for the full-year 2017. While APAC remains a small piece of the business and 8% of overall yearly revenue, we are cautiously optimistic about incremental new opportunities in the region.

As a reminder, we do not currently have business in China. Looking ahead to 2018, we enter the year with momentum, having grown revenue sequentially for the past three quarters, as Brad will detail, anticipating sequential growth in Q1. As we enter the year, we have better-than-usual visibility for the first half of 2018.

The optimism for the first half has grown due to a few factors. First, we had a large cable customer that constrained spending during consolidation and is now accelerating its spending plan for 2018 into the first half.

Second, relative to our outlook last quarter, we have higher confidence that the pipeline we built in the second half of last year will translate to revenue in the near-term. Finally, we're on the cusp of completing our full new product refresh.

I am looking forward to finally being able to deliver our full suite of products and satisfying pent-up demand. While the first half of 2018 looks promising, as is typical, we have less visibility into the second half. Indications continue to be DWDM growth in 2018 outside of China will be light, in the low-single-digit range.

That said, our opportunity for 2018 is somewhat decoupled from the overall market and largely dependent on the pace of recovery from our customer consolidation and adoption of new products.

Trial activity for our new products is robust, with completed trials in the second half of 2017 more than double that of the first half, and several new trials are scheduled to start soon. If successful, these trials should enable us to drive both key network upgrades and important new customer wins later in 2018.

In short, we believe our business opportunity is improving, but we don't have visibility on the magnitude of our second-half opportunities until the middle of the year. Of course, completing our product refresh is imperative to maximize this market opportunity.

I am pleased to report that, in January, we started revenue shipments of our new 1.2 terabit line card for DTN-X and expect to begin shipping XT-3600 lab units during Q1 with general availability planned during Q2.

While our new products released in FY 2017 cover roughly one-third of our addressable market, these recently and soon-to-be-shipping new products enable us to address the remaining two-thirds. The reality is multi-service integrated solutions like DTN-X and XT-3600 remain the bulk of the market.

With these final product releases, we can offer a fully refreshed product suite to our entire customer base. Looking at our end markets in 2018, we are anticipating long-haul, which dropped to roughly 50% of overall revenue in 2017 due to customer consolidation, will return to moderate growth in 2018.

We see promising opportunities in multiple customer verticals, with cable anticipated to be a key growth driver. In metro, which was roughly 15% of our overall revenue in 2017, we are building our historic strength with European cable providers and making progress cross-selling to traditional long-haul customers.

In 2017, we added 43 new XTM customers across multiple customer verticals, and having introduced XTM II late last year, see 2018 as an important year to continue planting seeds and establish a foundation for future growth.

In 2018 and upcoming years, we expect upgrades to our installed base and potential business around new fiber-deep initiatives will enable us to increase our market share in metro.

Building on a strong 2017, we also anticipate another good year in subsea, a business that has recovered considerably for us due to positive market receptions of our new ICE4 solutions. Given multiple upcoming trials on our differentiated technologies, our outlook is optimistic for our subsea business.

Finally, DCI, which is comprised of opportunities in long-haul, metro and subsea, was roughly 15% of our 2017 revenue. For 2018, we have a solid pipeline of opportunities with existing customers and some prospective deals with new customers that could materialize in the second half of the year, though today are too early to call.

With the recent organization changes, it should be apparent that we are increasingly focused on our go-to-market execution and strategy.

We made some strategic hires with several intents; first, creating smoother product development and delivery processes to complement our new two-year technology cadence; second, to bring new integrated solutions to customers that cut across our end markets; third, developing new partners to help us expand our reach into communications applications; and finally, aggressively addressing architectural shifts in the customer base with our latest technology.

The intended result is to address new market opportunities and add new customers to our roster, therefore being in a better position to deliver consistent multi-year growth. Today, I'd like to touch on two architectural shifts that we believe present significant multi-year growth opportunities for us.

First, for point-to-point applications, there is a gradual decoupling occurring where line systems and transponders are increasingly being sold separately. The industry refers this to a move to open and disaggregated platforms.

We call this Open ICE and we believe we have both the technological and structural cost advantage in selling our transponders over virtually anyone's line systems. Open ICE matters to customers because it allows them to benefit from Infinera's latest optical engine without having to replace their line system.

Open ICE matters to our investors because it opens up previously unaddressable footprint for our differentiated transponders. I'm encouraged that in Q1 we were awarded our first terrestrial Open ICE deal with a large wholesaler in Europe.

While this shift will likely take some time to develop, we expect to win additional new Open ICE opportunities as Infinera demonstrates its commitment to being the most open optical technology provider in the market.

Second, we continue to believe cable operators' fiber-deep strategies represent a major incremental revenue opportunity for optical networking companies, including Infinera. Fiber-deep will take two orders of magnitude more traffic to the metro edge, requiring significant deployments of optical gear.

As an incumbent supplier to several major cable operators, we believe we are well-positioned to address this optical network extension and anticipate decisions will begin to be made in the second half of the year with revenue to follow over multiple years.

Looking further out, in addition to increasing our go-to-market focus, our restructuring was about putting an organization in place that ensures both faster product delivery in the near-term and perpetually differentiated technology over the long-term.

We are making progress on this front, and with ICE4 products hitting the market, I am pleased that our ICE5 and ICE6 optical engines remain on track. We look forward to providing more details on our optic engine development at OFC in March.

I continue to believe our plan to bring differentiated optical engines to market every two years where we lead on cost and optical performance will hit the mark with customers and, therefore, investors.

In closing, I'm excited that our new product introductions are nearing completion and we are expecting growth and a solid first-half financial performance. While optimistic, my view is we have just turned the corner and are still in recovery mode, with considerable execution required to maximize our opportunities.

Success in the second half will be contingent on completing our remaining new product introductions; continued customer adoption of our refreshed suite of products over the course of 2018; the success of our new go-to-market approach, namely, our ability to win new customers and expand addressable opportunities; and finally, the continued recovery in spending from our consolidated customers.

In particular, while we remain confident in our position with CenturyLink, we are uncertain when spending will begin to improve.

On the bottom line, we remain committed to returning to profitability and positive operating cash flow during the second half of 2018 and are well-positioned to grow profitably in the future as we focus on increasing operating leverage and efficiency.

I will close by thanking our customers, partners, and shareholders for their ongoing commitment to Infinera and a big thank you to our employee as we attack 2018. I will now turn the call over to Brad to discuss the financials..

Thanks, Tom, and good afternoon, everyone. In an effort to streamline this call, we have moved the detailed recap of our Q4 results to the CFO Commentary available on our Investor Relations website. On this call, I will discuss Q4 highlights, our Q1 outlook, and provide some color on the full-year outlook.

I was pleased that in Q4 we delivered revenue above our guidance range and EPS at the higher end of our guidance range. In Q4, revenue was $195.8 million, up 2% sequentially and 8% year-over-year. Revenue exceeded guidance mostly on the strong ramp of our ICE4 products, primarily within the ICP vertical.

Tier 1 revenue grew in the quarter, as demand from key customers in EMEA and APAC more than offset a continued muted spending environment at the new CenturyLink. As expected, cable declined sequentially in Q4, as these customers are not typically large buyers at the end of the year.

Regarding our outlook for the first quarter of fiscal 2018, I'm pleased to announce that we project revenue in Q1 of $200 million, plus or minus $5 million. At the midpoint of this range, Q1 revenue would be up 2% sequentially and 14% year-over-year.

While the first quarter in our industry is typically very challenging, we are projecting sequential growth based on strong demand for our new products, including initial shipments of our 1.2 terabit DTN-X line cards, and a major customer in the cable space increasing their first half 2018 spending.

Beyond cable, we do expect typical Q1 seasonal weakness in our other service provider verticals, as customers take time to establish CapEx budgets at the beginning of the year.

Of note, although we continue to believe we are well-positioned in the new CenturyLink, our forecast for this customer will remain conservative until we have better visibility on the timing and trajectory of a spending recovery, and as such, we are not factoring in a material increase in spending in Q1 from this customer.

As for our ICP customers, we expect the CX2 and XT-3300 should keep our business relatively steady at existing customers and enable opportunities to add new customers in Q1. In summary on revenue, we are pleased with our Q1 outlook and anticipate better than previously expected revenue performance in the first half of the year.

We look forward to releasing our final ICE4 products in the coming months and having a fully refreshed product portfolio to attack the market with for most of 2018. As Tom noted, however, it won't be until mid-year that we have a better view of our second half opportunities.

We are focused on making sure that we continue to take care of existing customers, while creating meaningful opportunities with prospective new customers. Now turning to margins. Non-GAAP gross margin in Q4 was 37.5%, slightly below the midpoint of our guidance range of 36% to 40%, attributable to higher footprint builds from a few large customers.

As a reminder, footprint builds are a positive business indicator that put pressure on margin in the short-term, but enable higher margin revenue from capacity sales over time.

With our new higher capacity solutions, the amount of follow-on capacity to sell over time grows significantly, allowing customers to turn up capacity quickly to address their customer needs, while providing us a substantial software-like revenue stream in the future.

We believe Q4 marks the low point on gross margins, as it is the last quarter we should incur a significant impact related to both the high costs associated with early production runs of ICE4 and fulfilling 2017's commercial bridge deals, the combination of which impacted gross margin by approximately 300 basis points in Q4.

Over the course of 2018, we expect gross margin to gradually improve. We remind investors that the economics of our PIC technology and vertically integrated operating model enable a lower cost structure. As we transition our customers to new optical engines, they benefit from the higher capacities which lead to a lower cost per bit.

We benefit from the ability to deliver more capacity at roughly the same cost per unit, including the ability to spread a largely fixed manufacturing cost over a larger set of units. As for our outlook for Q1, we currently anticipate non-GAAP gross margin to be 40%, plus or minus 200 basis points.

The midpoint of this projected range represents a 250-basis-point improvement over Q4, as the high early production cost units and commercial bridge deals are substantially behind us.

While challenging to predict gross margin in any given quarter, it is not unreasonable to expect by the end of 2018 a 300- to 500-basis-point improvement in gross margin from the Q1 target of 40%.

We expect the mix shift to ICE4 products, which carry a lower cost structure than predecessor products, will be an important driver of margin improvement, along with improving yields over time. In addition, strong customer demand will drive higher production volumes, which should allow us to leverage our relatively fixed cost infrastructure.

This represents a major variable in determining to the extent we can improve gross margins over the course of 2018.

Regarding OpEx, non-GAAP operating expenses were $92 million in Q4, at the higher end of our guidance range of $89 million to $93 million, due to higher commissions associated with higher revenue and an increase in customer lab trial activity. In Q1, we currently anticipate non-GAAP operating expenses will be $95 million, plus or minus $2 million.

Our Q1 expectation reflects incremental R&D and customer lab trial costs required to bring the remaining ICE4 products to market and a New Year reset of payroll taxes and bonuses.

Regarding last quarter's restructuring, we remain on track to deliver our 2018 cost reduction targets on a run-rate basis and intend to reduce costs over the course of FY 2018.

We have already enacted most of these run-rate cost reductions and will continue to balance spending to deliver the final ICE4 products to market and execute our ramped up technology cadence, while still driving greater operating leverage and efficiency.

Regarding full-year 2018 OpEx, our G&A costs should remain fairly steady over the course of the year, while our sales and marketing expense will vary depending on our revenue performance. Base R&D expense should decrease over the year, as we release the final ICE4 products to production.

That said, if we require some incremental R&D to win some of the new opportunities Tom referenced, our R&D expense could be marginally higher. We would only execute on this if it allowed us to beat our revenue plan while driving incremental profit for the year.

Based on our outlook today, we anticipate OpEx will decline over the course of FY 2018, allowing us to exit the year at a quarterly run rate below $90 million.

Overall, in Q4, we had a non-GAAP operating loss of 9.3% and a bottom line net loss of $0.12 per share, at the high end of our guidance and a first step in improvements we anticipate moving forward. On a GAAP basis, we incurred a net loss of $74 million or $0.50 per share.

Beyond our usual non-cash expenses, the largest driver of the difference between our GAAP and non-GAAP results was restructuring expenses of $35 million. For Q1, we currently anticipate an operating loss of 8%, as we steadily improve the results.

Below the line, the combination of interest and other expense in Q1 is expected to net out to approximately $500,000, and tax expense should be approximately $1 million. As a reminder, given our significant NOL balance, our tax expense for the foreseeable future will not be tied to profitability.

And we anticipate taxes should remain in the range of $1 million quarterly. We don't anticipate the new tax regulations will have any significant net impact on our tax expenses for the next several years.

Putting everything together for Q1, the midpoint of our projected guidance translates to a non-GAAP loss of $0.11 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, as the vast majority of our restructuring-related charges were incurred in Q4.

On the balance sheet, given our expectation of an operating loss and potential negative working capital impacts due to timing, we expect our cash balance will decline in Q1. As we did in Q4, we intend to continue to tightly manage spending and CapEx, as we work to return to cash generation, which we anticipate will be in the second half of the year.

As a reminder, our convertible debt matures in June 2018. As of today, our intention is to pay this off with cash and maturity, and not immediately issue a new long-term debt instrument.

Given our expectation of returning to profitability and positive cash flow in the second half of the year, we're inclined to wait until later in the year to determine the appropriate debt structure for our business. I'm pleased with our Q1 outlook and expect solid first-half performance.

Last quarter, we expressed confidence in outgrowing the market during 2018, though we're less confident in our ability to grow 10% or greater for the full year.

Given our better-than-expected outlook for Q1 and solid visibility for Q2, we now see a path to achieving better than 10% growth for the full year, with a potential to exceed this as some things fall the right way over the course of the year. While we see growth opportunities in the second half, at this point our visibility that far out is limited.

Given the degree of uncertainty today around the second half, we encourage investors to temper expectations for now, until we have a better view of opportunities and market conditions. In conclusion, we ended a rough year of 2017 on a high note with improved results and are positioned to continue to build on this as we enter 2018.

With initial ICE4 products selling well, XTM II gaining traction and the pending release of our remaining ICE4 products, we are excited about the opportunity to execute on strong customer interest with both existing and new customers.

I'm particularly pleased that having endured a significant technology transition, today we have a clear path to improving profitability by lowering our cost structure, leveraging our vertical integrated manufacturing model and ramping revenue.

Over time, we believe our refreshed product portfolio and faster technology cadence will enable us to get back to delivering best-in-class financial results. And with that, I'd like to turn the call over to the operator to begin the Q&A portion of the call.

Anita?.

The first question today comes from Jeff Kvaal with Nomura Instinet. Please go ahead..

Yes. Thank you all very much. I'm hoping that you can shed a little bit more color into the range of expectations around revenue growth for 2018.

Can you talk about – does the 10% or 10%-plus require your mid-year check-in to be positive or what's baked into that? And then, secondly, if you could help us understand what you've baked in for Microsoft into the full year, loose view, that would be helpful. Thank you..

Yeah. So, Jeff, as we described, we have good visibility for the first half. We see some opportunities in the second half, but don't have those locked down as of yet. So the 10% assumes, obviously, a relatively flat second half. Some things fall the right way for us, that will be what would allow us to exceed that.

Your question specifically about Microsoft, we can't break out any specific customer in terms of what we've baked in..

Yeah. I'm going to add one thing to that, Jeff. We've commented on, we see the market being relatively flat to slightly up, but it's really important to understand that we view our opportunities a bit decoupled from that. We think with ICE4 upgrade opportunities, we have a huge installed base of customers.

And the cadence of when they will decide to upgrade, because I'm pretty sure they're going to upgrade, and how long it takes to qualify, really gives us some significant opportunity, but it's dependent upon when they want to qualify.

Clearly, as we started to ship ICE4 in what I would consider the integrated systems path in Q1, we see a remarkable amount of customers starting to plan upgrades, but only a few of them right now have specific plans. We also see it as opening significant doors to new customers, but they have to qualify it.

So we have every belief that the second half could have reasonable growth. But before we commit to that, we have to go and execute on finishing these products and getting customers to give us definitive plans on what they're going to go do..

It seems as though you typically – well, having waiting for mid-year to see what the third quarter and fourth quarter outlook seems like cutting it pretty close. I mean, typically, I feel like you might have better visibility a little bit ahead of that.

Do you see what I'm saying?.

Yeah. Jeff, we have typically guided one quarter at a time. We gave pretty good insight into two quarters. I've never regretted in this industry not giving more than a one-quarter outlook, because things change pretty dramatically.

And our guidance was right now we see a very positive first half, which would be unusual to say that, and second of all, we said please don't extend that off into the races for the second half because we don't know enough yet..

Okay. (28:34).

Yeah. So, Jeff, we will likely have even better visibility a quarter from now, but we're just not gonna go out that far at this point..

The next question comes from Simon Leopold with Raymond James. Please go ahead..

Thank you. I wanted to get a better understanding around the levers around the gross margin progression.

I think, specifically, I want to see if we could get some idea into what the dependence is in terms of just improving yields on the ICE4 versus something like product mix, customer mix, a little bit of better guidance in terms of how you take your trajectory from roughly 40% in the beginning of year to 43% to 45% exiting 2018.

I want to understand what are the key drivers..

Yeah. So, Simon, the single biggest thing is the volumes in the factories. Obviously, that drives a lower cost profile. The yield profile drives that as well. But even with the success we've had to-date and it being 20% of revenue, it's still a relatively small percentage.

As the year goes on, our expectation, as Tom mentioned, is more and more customers will go to the ICE4 portfolio, and that carries by itself a much better cost structure. The early cost production units that were putting a little bit of drag on margin are behind us, and now everything that ships has a much better cost structure.

Those are the main things that will benefit the margin as the year goes on..

So the customer vertical mix is not a big factor in terms of this?.

It's not the biggest, no..

Great. And then just as a follow-up, it sounds like you're happy with the new cable TV opportunity, and you have some good visibility there. But it also sounds like you're talking about a broader trend around cable TV and fiber-deep.

Could you give us a little bit better perspective as to how much is around a particular project and how much is more of a secular trend in terms of the cable TV vertical? Thank you..

Well, we've been a large provider into the cable space for a long time. We have very good relationships there. Part of what we're seeing in the short-term I would consider to be normal organic growth as bandwidth continues to go up as networks start running out of capacity.

The opportunity to upgrade to ICE4 came at a perfect time for at least one of our customers currently to upgrade, and I anticipate other customers will too. We've also had an opportunity to extend what we have traditionally been with this customer is in the long-haul.

They've given us a couple of opportunities with ICE4 to extend that long-haul presence into some adjacent metros. So, that's kind of our Phase I.

Our Phase II is a broader industry change where the cellphone guys, the cable guys, they're all bringing significant more capacity to the metro edge in a new architecture that they're referred to as Remote PHY. In the cable space, it's bringing two orders of magnitude, more capacity out to the metro. And that means a couple of things.

One, it means that there's going to be a lot more transmission opportunity, both long-haul getting to the metro, regional, and metro. So we are working on some new products, some new architectures that integrate across a couple of our products providing a solution.

So, it's not just a product, but it's a solution that integrates software in a couple of different hardware platforms to handle the transport part of it. We are approaching these cable guys directly.

We're also working to see if we can foster some partnerships with some of the more traditional cable equipment providers who have not really historically solutioned around DWDM and transmission. I think that this opportunity in the market is going to be big.

It's going to last for a long time and I think that it's going to be more transport-rich than it has been historically. So I think as you watch the industry, it's important, whether it's for Infinera or other transport people, who has the opportunity.

Just like 5G is going to be magnificently large for some people over time, I think the Remote PHY is the same type of thing and we think decisions will be probably late this year, and it will probably be something that lasts years or a decade..

Great. Thank you very much.

My pleasure..

The next question comes from Vijay Bhagavath with Deutsche Bank. Please go ahead..

Yeah. Thanks. Hey. Good afternoon. Yeah, Tom, my questions is around your thoughts on streamlining the product platforms to improve gross margins and hopefully get us sooner in terms of profitability, because I do see an overlap in how you have organized your platforms in terms of metro, cloud, long-haul.

There seems to be overlap between many of your platforms. So, any thoughts of like platform consolidation, fewer platforms, quicker out to market, perhaps better margins? Thanks..

Yeah. It's a complicated discussion. I would ask Dave to ask for a minute. We actually have focused a lot on trying to consolidate our product offerings and I think that you will see in our roadmaps moving forward we will do a different kind of approach to some of the products.

I think we've done a purposeful job of bringing products to market that solve specific needs. The CX was designed specifically for data center interconnect, short-reach. The XT was for long-haul for point-to-point. And then we've got, obviously, our integrated platforms, the DTN-X and the XT-3600, which serve two different purposes.

I think what you'll see instead of kind of constrained optimized solutions, what we need to do, Vijay, is get a more elegant approach of how we take an optical engine and create an ability to step and repeat that across multiple platforms much more efficiently. I don't believe it's a product proliferation problem.

It's how do we make the design of those world-class products come out easier.

Dave?.

Yeah. I think what you're trying to get out of your product line is to have a application-efficient series of platforms. There's a couple of functionalities that you've got to do that includes one integrated bandwidth management and one that doesn't.

And so, what we end up with is a streamlined point-to-point-oriented product and then a product that has the capability of some wavelength grooming for network efficiency benefits. We kind of can see that continuing going on.

The consolidation will be as a continued further integration of the XTM product line and a further enhancement of our bandwidth management capabilities.

And building the product out in that fashion, it will enhance our gross margins because we're putting the right functionality and the right node within the network and that will give us a preferred cost structure for those nodes..

The only thing, Vijay, I don't want to use calls to go over product line roadmaps. I think it's a very complicated topic. One of the things I would encourage you to do, if you're going to be at OFC, we're going to give you a pretty good update on our technologies and how we plan on putting them into products and platforms more efficiently..

Perfect. A quick follow-on for Brad, if I may. Brad, how could we think of OpEx as percentage of revenues and sales, OpEx in particular, as we head into the second half? Thanks..

Yeah. So, Vijay, what we've talked about is, obviously our R&D, as a percentage of revenue, has been higher than we've traditionally targeted. Our traditional target has been 20%, and we purposefully ran that higher to get the new products out. As the last two ICE4 products get out, you will see that trend down as a percentage of revenues.

We obviously expect to see leverage on the SG&A side of things. So you should also see that trend down as a percentage of revenues as the year ends. And as I had mentioned in my script, we expect, barring some upside in revenue which would be a good thing for everyone, we expect to exit the year south of a $90 million run rate..

Okay. Thanks..

Yeah..

Thanks, Vijay..

The next question comes from George Notter with Jefferies. Please go ahead..

Hey. Thanks very much. I wanted to ask about your guidance for the full year, the discussion around 10% or 10%-plus. What's embedded in that in terms of the CenturyLink, Level 3 contribution? And then, more broadly, I'd just be curious about kind of where you are with milestones on that account.

I know that you don't have a lot of visibility into Q1 and you're not expecting a whole lot to change there, but are there milestones you can point to in terms of price renegotiations? I know there's an RFP process going on I think on the Level 3 side of the account, organizational structures within their network teams.

Anything you can tell us about in terms of progress towards getting some resolution would be great. Thanks..

Yeah. So, George, to answer the first part of your question, as I mentioned in the scripts, we have a fairly conservative plan for that account. We still think they will be a meaningful customer, but we haven't baked in a lot of growth for the year for that account.

We have expectations that, if things go right in the second half, it will be better than that, but we have not baked in a lot of growth on that account. I'll let Tom give you more color, but we spend a tremendous amount of time with CenturyLink. They're a very important customer for us.

We think the combination with Level 3 produces a very strong company, and we believe we're very well aligned with them. We talked about it as soon as the deal closed. We were having discussions with them on aligning price books and this kind of stuff. We continue to spend a tremendous amount of time with them..

Yeah. George, I'm going to be very careful about commenting on what they're doing internally on org, etcetera. To me, that's something you need to ask them. In regard to us, we've got a new, approved and agreed-to joint pricing contract that we're executing to. It went fairly seamlessly. So we are executing to that in Q1.

And, as Brad said, we're not baking in a lot of upside to them, but we're also not counting on some shoe dropping because of a contract or pricing issue that there's a disruption. It's been public that there's an RFP ongoing. And I would say it's not the Level 3 team.

There's only one team now, there's a CenturyLink team, and that RFP process continues. We're obviously engaged with it, but I'm not going to give any color on that beyond that..

Got it. Great. And then can I also ask about gross margins? So, if I look back, there was kind of two aspects I think to the gross margin pressure, right? One was pricing forward with customers in anticipation of ICE4 product coming.

And I think also there was deals that you guys struck where you would go out and replace older generation products with ICE4 products. I guess I'm just trying to understand those two impacts.

And I want to understand if they're both already embedded in this gross margin guidance you're talking to now, or is there potentially some other benefits as well. That's it. Thanks..

Yeah. So, George, those items are largely behind us. So we finished shipping through the early production units which were higher-cost. We have fulfilled on substantially all of the bridge opportunities. So those are largely behind us. And as we grow the revenues of ICE4 going forward, they don't have any baggage with them.

They just have the much better cost structure of ICE4. Also, as you know, the yields initially on those products are not as good as we would like them to be over time. Over the course of the year, we expect those to increase fairly significantly as well.

And once we have all the ICE4 products out, including AOFX 1200 (41:20) and the XT-3600, you should expect the volumes in the fab to continue to grow as well, which allows us to spread that largely fixed cost over a broader base of units.

So those will all be positive things for gross margin, and you don't have the negative things that we've had for the last couple of quarters..

A big positive, George. You've tracked our company for a long time and you probably understand this. It used to take us about, I don't know, two-and-a-half, three years to achieve targeted yields and volume. That was a really long time. It was new technology for us.

That went down to about two years on our last generation, and now we're actually going to be at targeted yields within a year of introducing the product. And that's a really significant ability.

It implies not only significant learning, we think that our understanding of this technology has advanced and grown a gap in between us and the rest of the industry, but as we talk about a cadence of technology of every two years, being able to achieve our targeted yields in a reasonable period of time becomes not interesting, but it becomes mandatory.

And I think that we are getting our own internal proof points that not only can we deliver the technology in a two-year cadence, but we can do it in such a fashion that the yields will allow us to make a superior margin..

Got it. Thank you..

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

Great. Thanks. I just wanted to ask a couple questions. First, in the script you noted an inventory write-down and I just wanted to get more details on that, particularly given kind of how long ICE3 product was out there. And then, the second question was just on the pricing environment.

You mentioned in 2016, it had been kind of extremely harsh, and just a sense of as you wrapped up 2017, what you're seeing as far as kind of normal 10% to 15% pricing declines year-over-year, or is it more aggressive or less aggressive. Thanks..

Yeah. So, Meta, I'll cover the inventory write-down piece, and I'll let Tom cover the other piece. So, what we did as part of the restructuring is we obviously looked at our go-to market for different products. We looked at how fast the ICE4 technology had advanced and how the cost structures had driven down.

That led us to different decisions related to what products we wanted to focus on different markets. And so we actually made some fairly significant changes in terms of what products we wanted to attack different markets with. That led us to impair some of the inventory just because the demand profile for those wasn't as strong.

We also made some decisions on the manufacturing side where we had a reasonable amount of PIC inventory that we have the ability to build out over time. We chose to shift that capacity to more the Gen 4 and Gen 5 technology.

That allowed us – or caused us to somewhat abandon those products and not incur the additional cost, because the cost structure of the new products was so much better..

One thing, Meta, you implied Gen 3 has been out for a while. It's important for you to realize that the impairment really isn't on Gen 3 type of technology from a PIC perspective. We will sell, I think, massive amounts of Gen 3 for many more years. While we have Gen 4 out now, many of our customers likely won't upgrade for a couple of years.

So I anticipate Gen 3 will be a significant portion certainly for a subset of our customers for a long time. And Brad has said, as part of getting more focused, we've looked at some of our products, and to Vijay's point earlier, some of our products had a bit of overlap and that we found unnecessary.

So, instead of maintaining two, we're converging and killing some products that don't offer a differentiated value. In regard to pricing, 2016 and 2017 were very, very challenging in the pricing market, potentially unprecedented in the system space where a dollar per bit cascaded really tremendously.

I've heard even that bit growth was 100% offset by ASP reduction one of the first times. I don't know if that's true or not, but it's nominally in the right ballpark.

I think it was exceptionally difficult for us because, while new technologies had come to market, particularly the 200-gig, we were having to make commercial price adjustments to bridge that. The good news is, at a product level, we now have our next generation products out, so we don't have to make those commercial adjustments again.

Secondarily, we are seeing what I would consider to be more normal pricing in the industry. Having said that, on any specific deal, there continue to be too many competitors in this industry. I think some of those competitors, quite frankly, won't make it and market share is important to them. So, market share at any price sometimes is the decision.

And, quite frankly, we're going to stay true to our core. We're not going to take a deal unless we can make a fair return on it over time. We're also staying to the positive side. Last year, for a long time, the component guys were kind of sold out to the ICPs in China.

As that demand has freed up, we're getting a bit of relief on the costs side of the equation. So I think this year we're in a much better position to deal with more normal pricing..

Got it. Thank you..

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

Yes. Thank you. You guys gave a lot of detail on the call, so I appreciate that, but I somehow lost the thread in there of what's giving you the better visibility for the first half of 2018.

So, when we look at the sequential growth for instance in the first quarter, can you go over that again, what's driving it?.

Yeah. There's a few things, and I'll give you my perspective then Brad can probably add some detail. The better visibility, quite frankly, comes not trivially from specific backlog and specific upgrade opportunities that customers have committed to us.

When you're doing an upgrade, there's obviously a tremendous amount of work that happens between the companies. Often, we're very involved. Usually, we're very involved with that upgrade process. That causes a lot of interaction and planning to occur.

So the fact that we've got these new products out, the fact that they are planning significant upgrades, demands a level of interaction that's more intimate. So the visibility comes from a significant backlog, a significant pipeline of sales opportunities that – and nothing is 100%, but 90% probability of booking this quarter.

And we have a significant pipeline of deals that we can touch for this quarter for next quarter and a lot of it's driven by, like I said, upgrade. We've also been fortunate to win a few new customers based on ICE4, and those new customers are also now at the contract and PO phase. So, we have – it's more than visibility.

I mean, we're really getting some really good data from POs and upgrade plans.

Brad?.

Yeah. And the only thing I'd add to that is, with the 1.2 terabit line parts for the DTN-X now actually shipping, we're actually seeing customers come and say, oh, wow, it's out now, I need to really start ordering, placing POs.

And so, to Tom's point, there are other opportunities which will potentially hit in the first half, potentially hit in the second half. But when we say good visibility in the first half, it is really deals and customers and opportunities that are either very late stage or closed at this point..

Okay. That's helpful. But I was hoping that the answer would contain a little bit more detail on verticals and products and geographies.

I mean, it sounds pretty broad-based, but are there a few of those categories driving it more than others?.

So, Mike, we talked about a lot of the upside being a cable provider..

Yeah..

Our largest cable providers are in North America. So, that should give you some color on that. We have won some new deals in the ICP side of things with ICE4 that are driving upside. And, quite frankly, the new customers, there are some in the APAC region, there are some in Europe, they're fairly broad spread..

Yeah. I mean, also there's a significant metro opportunity, one that we'll be rolling out in Q2 in Europe. So, cable is certainly a big driver, ICP is a big driver. We've won a couple of metro things. There's a couple of submarine things that we feel very good about. So it's pretty broad, and a lot of it's driven by, quite frankly, our new technology.

In the second half, we are working on a ton of pipeline of things right now that I think – we're in the same spot we were six months ago with trials, with opportunities. So I think that for us the ICE4 upgrade opportunity is non-trivial..

All right. I appreciate it. Thank you..

Yes..

Yeah..

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

Hi, guys. This is Steven Sarver in for Dmitry. Last time we spoke, you guys said that there was a potential third large ICP customer that you could win. You guys currently have two of the top four..

Yes..

Do you guys have any update on that? I know that they are nearing a completion of an RFP, and if you guys do indeed win this customer, I guess, how much upside?.

Yeah. So I must break that apart. We're still making good progress. I believe that we will have an opportunity. I'm reluctant to describe any more of the opportunity than that because it's still being evaluated with them. But my belief is, sometime in the next six months, we will have added them to our customer roster.

But it's, like I said, too early to commit it, but I have high confidence that we will close it. We do have a contract with them now, which was a non-trivial event, but we are missing the magic PO. So, until that happens, it's a high-probability event, but it's not an event..

Understood. And just a follow-up. On CenturyLink, Level 3, I think last quarter you guys said it was roughly or less than 20% of total revenue, and you expected revenue from that customer to decline about 10%.

Sequentially, did you see that in the fourth quarter? And, I guess, what are you expecting for the first quarter? Flat, was the fourth quarter a bottom, or could there be another sequential decline?.

Yeah. So, as we included I think in my commentary and the tables in the press release, the combined company was actually only 13% of revenue in Q4. That is obviously a very low point for them. Q1, as we talked about, we're not anticipating being significantly higher than that. Over the course of the year, we'll see what happens.

We still believe we are very well-positioned there. I think they're being very thoughtful in their planning on what they do as the combined company, and we'll see what happens over the course of the year..

I mean not to beat a dead horse on this, but I'm pretty happy that we're able to have a good Q4 and actual sequential up Q1. And it's not based on what has historically been a company as a combined entity that was a significant portion of our business.

I think we're working very hard to diversify And the opportunity is, if they come back strong, we consider that an upside, because we are being pretty conservative right now. I'm a big fan of the work they're doing and I think that they're going to build a really strong company, but we're just not counting on that happening in the near-term..

Great. Thanks..

The next question comes from Alex Henderson with Needham. Please go ahead..

Thank you very much. So I was hoping you could give us some content around the mix between product and service. You had a pretty strong growth rate in services. Most of that's related to installation in the fourth quarter. I'm assuming that you're seeing that trajectory continue.

Is it a function of the increase into the March quarter heavily skewed to continued sequential growth in that line, that then turns into future line card sales and plant installation? Is that the way we should be thinking about this?.

Yeah. So, Alex, you are correct in the first part of what you said in terms of the growth on the service side being some new footprint we built, new installations we've done. Going forward, you're going to see a mix of things. And obviously, given the product number is a bigger number, the majority of the growth will be on the product side of things.

But obviously our biggest customers, as they install new networks, likely will use us on the service side as well. But the growth going forward will be more skewed towards product, but service will come up a bit as well..

So, does that imply, given the strength in the installations, that there's potential for those initial installations to absorb that capacity and result in some back-half card sales into that footprint? Or do you think it's a longer period before they....

No, I mean I think that wouldn't necessarily impact our service line. But you are correct in thinking that customers not only that have put in things in the past, but also customers that are putting in things currently in terms of footprint, those will add to over time higher-capacity sales.

Every customer is different in terms of when it will happen, but you're absolutely right in thinking about that that we do absolutely believe it'll happen.

And as I mentioned on my script, one of the incremental things that's great about ICE4 is, because our cost structure is so strong, we can deliver a significantly more amount of capacity for a customer and have that stream of high-margin IB licenses over time that ultimately will give us much better gross margin..

So, just following on the second leg of that. I assume that the gross margin on installation services is somewhat lower than consulting-related services.

So, should we be anticipating a somewhat lower GM on the service piece until some of these larger footprint builds mature and the mix starts shifting back to more normalized?.

Yeah. So the service margins, as the installation work that happens, puts pressure on the service margins. But with the advances on the product side, it'll more than offset that..

Right. I'm just trying to figure out the mix between the two. It sounds like the service pressures implies that you're having a little bit more rebound in product and more pressure on the service side as we move....

That's correct..

Okay..

Yeah. That's correct..

That's what I need. Thank you. Very helpful..

Yeah..

The next question comes from Doug Clark with Goldman Sachs. Please go ahead..

Thanks for taking my question. My first one is on the cable point, kind of driving most of the upside in the first half of 2018. Can you give us a sense about the longer-term visibility into that project? It sounds like it's a combination of both a return to spending post-consolidation, but also market share gains or metro expansion gains.

Is this something that could be just a quarter or two quarters in length, or will it extend over a longer-term period?.

That's a hard question. Right now, it's being driven, I would say, above linear by significant upgrade to their network. The good news is that significant upgrade provides a huge amount of footprint for us to fill capacity over time.

I think that the cable space, just like the wireless space, they're in a little bit of a race to bring more capacity out. So I anticipate that market to be a lucrative opportunity for us over a longer period of time. But I think that there will be a burst of opportunity in the next six months that should tamper it back to kind of more normal rates.

So I think it's a combination of the consolidation is done, they've reconciled where they want to build, they've picked us to upgrade their network. The upgrade of the network will have a significant amount of footprint added. That footprint we'll be able to monetize over a longer period of time but it will be at a lower run rate.

So far, we are making them happy. So they're giving us opportunities to expand into adjacent markets where we have not participated before. I'm hopeful that we become a significant portion or player in that portion of the network, but there's a long way between now and then. So we're going to go work every day to make them happy.

We're going to go work every day to win one metro at a time. And over a period of time, I think we could have a substantive opportunity. While that cable guy is going on, we're also addressing several other ones in regard to Remote PHY, both domestically and internationally.

I think that that is a massive opportunity for us and other people in transport. And like I said, it's too early to declare where we sit, but we're having the right meetings with I think an architecture that is extremely compelling.

That's what I talked about, a solution set, where it integrates a number of our platforms into a solution that makes it easy for them to deploy, manage and add capacity. I think our PIC and Instant Network is a unique capability that provides some value there.

So I'm hopeful that there's a really big opportunity over the next several years in this space..

Yeah. So, Doug, just to add a little bit of color to Tom's comment. We see great visibility in the first half based on this build. They would like to do additional things in the second half. We will see if they happen or not. That's a little bit of the uncertainty in the second half that we'll see as the year goes on.

But I agree with Tom on the Remote PHY side of things. That is going to be a step-level function, incremental over time. Now, that won't happen in the second half. There'll be some decisions that are made in the second half, but that will be more revenue over the future years.

And so, if you take their core business plus a growing metro opportunity, you add Remote PHY to that, cable is a very good opportunity for us, not just that customer, but broader in the cable space..

All right. Got it. That was helpful. And then my other question is on the open line system, or I think you call it Open ICE.

At this point, can you talk about customer interest in that? And then, as well, is that a product or technology evolution that you actually think is kind of expansionary and market share gain opportunity? Or could it also be somewhat cannibalistic and substitutive to kind of an existing hardware footprint sale?.

Dave's going to answer first and I'm going to add on..

Yeah. Two things. You actually mentioned two different product offerings. One is an open line system, one is Open ICE. Open ICE refers to our transponders on someone else's line system. As one of the growing but smaller suppliers within the DWDM space, that opportunity creates just huge openings for us within a customer.

There is a lot to do to be able to get over the threshold of adoption of our transponders on other people's line systems, but we are working closely with a number of opportunities to get through those technical and ultimately business barriers to doing that.

Over the long-term, I think it creates a great opportunity for us, what Tom referred to as one of the first commercial wins in that space, and we're hopeful that that propagates through for that.

The open line system, which is a separate product line that is being able to deploy line systems, amplifiers and ROADMs and such, to be able to receive multiple transponders, that's an area that we are also, a number of our customers view us in a leadership position in the technology to be able to do that.

We see that as a requirement to ensure the capability of all of our future higher baud-rate transponders to be able to fit into. And as a result, we will continue to push on that front as well..

Yeah. This is really an interesting thing because our open line system has a flexible grid that allows future baud rates to be deployed upon it. As some of our competitors come out with some of these new capabilities at higher baud rates, we are finding that their old line systems don't accommodate these transponders.

So, either the customer can upgrade to a new line system from our competitor or they can knock on our door and we can give them Open ICE. So, our newest technology running across their installed line system. The challenge, as Dave said, it's really a customer operationalizing challenge, and I think that there's a lot of work that has to be done.

Clearly, with one customer they felt it was well worth their time to go through the challenge of operationalizing a new business model of Open ICE. And I believe that if I look at the number of trials that we have scheduled, our trial backlog is actually more than we can accommodate right now with people wanting to go and try Open ICE.

Maybe they want to use Open ICE, maybe they want to use it as a tool to go and get lower pricing from our competitors. Either way, we're going to go in there. We are going to go and work very hard to convince them that the world's greatest transponder technology is Infinera, and you can deploy that today on somebody else's line system.

Is it going to cannibalize? You're damn right. It's going to cannibalize every open line system or every line system that's out there. That doesn't mean it's going to be ours, but it's going to cannibalize somebody's transponder business. We're going to come up with an open line system and have that out because we're going to play it both ways.

You want to have somebody's transponder run across our gear, that's fine with us. If somebody can build a better transponder for lower cost, you should go with them. I personally don't believe anybody can build a better transponder for a lower cost than we can. So, our job is to create a food fight.

We're going to create a food fight in the industry and we're going to serve up Open ICE..

And, Doug, the other piece I'd add to that that I think is critical for you to understand is this is an opportunity – you heard us refer to new customers probably 18 times on the call. It is very critical for us to add new customers.

And this is an easy way for customers to add us as a new vendor to their network without having to rip out everything they have. And so we've actually seen several new customers that we have never had access to that are actively doing or planning trials with Open ICE..

The next question comes from Patrick Newton with Stifel. Please go ahead..

Yeah. Good afternoon, Tom, Dave, and Brad, thank you for taking my questions. I guess, first one is on the cable side. It's been an area of strength for multiple quarters, clearly contributing now.

Could you help us level set what percentage of revenue cable represents? And then do you see any risk of strength currently having maybe a multi-quarter pause ahead of some of these new architectural deployments that you're speaking to and could that be contributing to some of the lack of visibility in the second half?.

Yeah. So, Patrick, cable in general is 20%, 25% of revenue. It tends to fluctuate from quarter-to-quarter. For example, we talked about in Q4 cable being soft because they don't traditionally buy at the end of the year, but that's roughly what it is on an ongoing basis.

Your question around the pause, I think you see strength with the existing ICE4 products that are out and those are growing very nicely in new opportunities. I think you're going to see customers wanting to adopt the AOFX 1200 (1:06:34) and the XT-3600 as soon as possible.

So I think my expectation is we'll have a good momentum throughout the year and you won't see necessarily the drop-off that you saw in advance of some of the ICE4 stuff coming out..

That's helpful. And, I guess, Brad, it's good to see gross margin moving in the right direction in March..

We'll try to keep it going, bud..

And the outlook for expansion next in the year is also good. But I want to take a longer-term view and think about prior cycles. You previously achieved margins in the high 40s, and even hit 50% for a few quarters.

So, I guess, if we try to put all the pieces together, you have an increased design games of your ICE products, which means you have a tighter window to leverage investments. There's competitor dynamics, cost structure, market trends, et cetera.

I guess, the broader question is, can Infinera get back to prior peak margin levels? Or are there any structural challenges in your model that would preclude you from achieving those prior levels?.

So, Patrick, I'm not going to commit to a timeframe, but I think we absolutely have the ability to ramp margins back in the high-40s or over 50% over time.

Can't say exactly when that will be, but as we continue to bring out new platforms, continue to win new customers, continue to grow the top line, I think we still have the ability to do that, absolutely..

Great. Thank you for taking my questions. Good luck..

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

I just want to thank all of you for joining us this afternoon and for your questions. We look forward to seeing you at OFC and updating you on our continued progress. Have a great day..

This conference is now concluded. Thank you for attending today's presentation. You may now disconnect..